Table ofContents

 

 

 

**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**FORM 10-Q**

 

| **x**                                                                                                                                                                                                          | ** ** | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934**  |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------|
| ** **                                                                                                                                                                                                     | ** ** | ** **                                                                                                    |
| **For the quarterly period ended June 27, 2009**                                                                                                                                                          |
| ** **                                                                                                                                                                                                     | ** ** | ** **                                                                                                    |
| **or**                                                                                                                                                                                                         |
| ** **                                                                                                                                                                                                     | ** ** | ** **                                                                                                    |
| **o**                                                                                                                                                                                                          | ** ** | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934** |
| ** **                                                                                                                                                                                                     | ** ** | ** **                                                                                                    |
| **For the transition period  from              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 July 31, 2009, 100% of the issuer’s membership interestswere owned by DJO Holdings LLC.

 

 

 

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**DJO FINANCE LLC**

**FORM 10-Q**

**TABLE OFCONTENTS**

 
| ** **                                 | ** **                                                                                                                               | **Page  No.** |
|--------------------------------------------|------------------------------------------------------------------------------------------------------------------------------------------|---------------|
| **PART I—Financial Information** |                                                                                                                                     |
| Item 1.                               | Unaudited Condensed  Consolidated Balance Sheets as of June 27, 2009 and December 31,  2008                                    | 3             |
|                                       | Unaudited  Condensed Consolidated Statements of Operations for the three and six months  ended June 27, 2009 and June 28, 2008 | 4             |
|                                       | Unaudited  Condensed Consolidated Statements of Cash Flows for the six months ended  June 27, 2009 and June 28, 2008           | 5             |
|                                       | Notes to Unaudited Condensed Consolidated Financial  Statements                                                                          | 6             |
| Item 2.                               | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                              | 29            |
| Item 3.                               | Quantitative  and Qualitative Disclosures About Market Risk                                                                              | 42            |
| Item 4T.                              | Controls and  Procedures                                                                                                                 | 43            |
| **PART II—Other  Information**   |                                                                                                                                     |
| Item 1.                               | Legal Proceedings                                                                                                                        | 43            |
| Item 1A.                              | Risk Factors                                                                                                                             | 45            |
| Item 6.                               | Exhibits                                                                                                                                 | 45            |
| SIGNATURES                                 | 46                                                                                                                                       |

 

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**PART I. FINANCIAL INFORMATION**

 

**ITEM 1. FINANCIAL STATEMENTS**

 

**DJOFinance LLC**

 

**Unaudited Condensed Consolidated Balance Sheets**

 

**(inthousands)**

 
| ** **                                                 | ** ** | **June 27,  2009** | ** ** | **December 31,  2008** | ** ** |
|------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| **Assets**                                                 |       |                    |       |                        |       |
| Current assets:                                            |       |                    |       |                        |       |
| Cash and cash equivalents                                  |       | $                       | 41,869     |                        | $          | 30,483 |   |
| Accounts receivable, net                                   |       | 162,819                 |       | 164,618                     |       |
| Inventories, net                                           |       | 98,799                  |       | 103,166                     |       |
| Deferred tax assets, net                                   |       | 35,087                  |       | 34,039                      |       |
| Prepaid expenses and other current assets                  |       | 20,099                  |       | 16,923                      |       |
| Total current assets                                       |       | 358,673                 |       | 349,229                     |       |
| Property and equipment, net                                |       | 82,971                  |       | 86,262                      |       |
| Goodwill                                                   |       | 1,180,454               |       | 1,191,566                   |       |
| Intangible assets, net                                     |       | 1,224,106               |       | 1,260,472                   |       |
| Other non-current assets                                   |       | 47,476                  |       | 52,601                      |       |
| Total assets                                               |       | $                       | 2,893,680  |                        | $          | 2,940,130 |   |
|                                                       |       |                    |       |                        |       |
| **Liabilities and Membership  Equity**                     |       |                    |       |                        |       |
| Current liabilities:                                       |       |                    |       |                        |       |
| Accounts payable                                           |       | $                       | 45,453     |                        | $          | 42,752 |   |
| Accrued interest                                           |       | 20,888                  |       | 10,966                      |       |
| Long-term debt and capital leases, current portion         |       | 11,314                  |       | 11,549                      |       |
| Other current liabilities                                  |       | 102,213                 |       | 104,401                     |       |
| Total current liabilities                                  |       | 179,868                 |       | 169,668                     |       |
| Long-term debt and capital leases, net of current  portion |       | 1,814,161               |       | 1,832,044                   |       |
| Deferred tax liabilities, net                              |       | 317,378                 |       | 329,503                     |       |
| Other non-current liabilities                              |       | 10,094                  |       | 8,806                       |       |
| Total liabilities                                          |       | 2,321,501               |       | 2,340,021                   |       |
|                                                       |       |                    |       |                        |       |
| Commitments and contingencies                              |       |                    |       |                        |       |
|                                                       |       |                    |       |                        |       |
| Membership equity:                                         |       |                    |       |                        |       |
| Additional paid-in capital                                 |       | 825,661                 |       | 824,235                     |       |
| Accumulated deficit                                        |       | (249,235                | )          | (221,842                    | )          |
| Accumulated other comprehensive loss                       |       | (6,276                  | )          | (4,027                      | )          |
| DJO Finance LLC membership equity                          |       | 570,150                 |       | 598,366                     |       |
| Noncontrolling interests                                   |       | 2,029                   |       | 1,743                       |       |
| Total membership equity                                    |       | 572,179                 |       | 600,109                     |       |
| Total liabilities and membership equity                    |       | $                       | 2,893,680  |                        | $          | 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**        | ** ** | **Six Months Ended**          | ** ** |
|------------------------------------------------------------|------------|-------------------------------|------------|-------------------------------|------------|
| ** **                                                 | ** ** | **June 27,********2009** | ** ** | **June 28,********2008** | ** ** | **June 27,********2009** | ** ** | **June 28,********2008** | ** ** |
| Net  sales                                                 |       | $                             | 235,112    |                          | $          | 241,352 |   | $ | 452,765 |   | $ | 473,386 |   |
| Cost  of sales                                             |       | 82,156                        |       | 85,836                        |       | 161,156 |   | 175,300 |   |
| Gross  profit                                              |       | 152,956                       |       | 155,516                       |       | 291,609 |   | 298,086 |   |
| Operating  expenses:                                       |       |                          |       |                          |       |   |   |   |   |
| Selling,  general and administrative                       |       | 108,605                       |       | 115,027                       |       | 209,205 |   | 223,943 |   |
| Research  and development                                  |       | 6,162                         |       | 7,230                         |       | 11,965 |   | 13,906 |   |
| Amortization  of acquired intangibles                      |       | 19,171                        |       | 19,140                        |       | 38,302 |   | 38,256 |   |
| Operating  income                                          |       | 19,018                        |       | 14,119                        |       | 32,137 |   | 21,981 |   |
| Other  income (expense):                                   |       |                          |       |                          |       |   |   |   |   |
| Interest  income                                           |       | 202                           |       | 263                           |       | 538 |   | 850 |   |
| Interest  expense                                          |       | (39,555                       | )          | (42,495                       | )          | (78,146 | ) | (87,682 | ) |
| Other  income, net                                         |       | 2,967                         |       | 288                           |       | 1,587 |   | 1,631 |   |
| Loss  from continuing operations before income taxes       |       | (17,368                       | )          | (27,825                       | )          | (43,884 | ) | (63,220 | ) |
| Benefit  for income taxes                                  |       | (4,995                        | )          | (6,725                        | )          | (16,932 | ) | (17,936 | ) |
| Loss  from continuing operations                           |       | (12,373                       | )          | (21,100                       | )          | (26,952 | ) | (45,284 | ) |
| Income  (loss) from discontinued operations, net of tax    |       | (577                          | )          | 597                           |       | (167 | ) | 819 |   |
| Net  loss                                                  |       | (12,950                       | )          | (20,503                       | )          | (27,119 | ) | (44,465 | ) |
| Less:  Net income attributable to noncontrolling interests |       | 135                           |       | 295                           |       | 274 |   | 495 |   |
| Net  loss attributable to DJO Finance LLC                  |       | $                             | (13,085    | )                             | $          | (20,798 | ) | $ | (27,393 | ) | $ | (44,960 | ) |

 

See accompanying notes tounaudited condensed consolidated financial statements.

 

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**DJOFinance LLC**

 

**Unaudited Condensed Consolidated Statements of Cash Flows**

 

**(in thousands)**

 
| ** **                                                                                                 | ** ** | **Six Months Ended**    | ** ** |
|------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|
| ** **                                                                                                 | ** ** | **June 27,  2009** | ** ** | **June 28,  2008** | ** ** |
| **OPERATING ACTIVITIES:**                                                                                  |       |                    |       |   |   |
| Net loss                                                                                                   |       | $                       | (27,119    | ) | $ | (44,465 | ) |
| Adjustments to reconcile net loss to net cash  provided by (used in) operating activities:                 |       |                    |       |   |   |
| Depreciation                                                                                               |       | 12,969                  |       | 11,192 |   |
| Amortization of intangibles                                                                                |       | 38,302                  |       | 38,256 |   |
| Amortization of debt issuance costs                                                                        |       | 6,457                   |       | 6,849 |   |
| Stock-based compensation                                                                                   |       | 1,426                   |       | 1,227 |   |
| Loss on disposal of assets                                                                                 |       | 253                     |       | 1,176 |   |
| Deferred income taxes                                                                                      |       | (18,109                 | )          | (19,766 | ) |
| Provision for doubtful accounts and sales returns                                                          |       | 17,375                  |       | 10,040 |   |
| Inventory reserves                                                                                         |       | 2,157                   |       | 2,727 |   |
| Gain on disposal of discontinued operations                                                                |       | (458                    | )          | — |   |
| Changes in operating assets and liabilities, net of  acquired assets and liabilities:                      |       |                    |       |   |   |
| Accounts receivable                                                                                        |       | (15,061                 | )          | (27,635 | ) |
| Inventories                                                                                                |       | (206                    | )          | 3,235 |   |
| Prepaid expenses, other assets and liabilities                                                             |       | (2,952                  | )          | 903 |   |
| Accrued interest                                                                                           |       | (9,922                  | )          | 17,807 |   |
| Accounts payable and other current liabilities                                                             |       | 19,545                  |       | (6,731 | ) |
| Net cash provided by (used in) operating activities                                                        |       | 24,657                  |       | (5,185 | ) |
| **INVESTING ACTIVITIES:**                                                                                  |       |                    |       |   |   |
| Acquisition of businesses, net of cash acquired                                                            |       | (4,046                  | )          | (89 | ) |
| Acquisition of intangible assets                                                                           |       | (53                     | )          | (1,060 | ) |
| Purchases of property and equipment                                                                        |       | (11,605                 | )          | (12,555 | ) |
| Proceeds from sale of discontinued operations                                                              |       | 21,846                  |       | — |   |
| Other, net                                                                                                 |       | 422                     |       | 933 |   |
| Net cash provided by (used in) investing activities                                                        |       | 6,564                   |       | (12,771 | ) |
| **FINANCING ACTIVITIES:**                                                                                  |       |                    |       |   |   |
| Proceeds from debt and revolving line of credit                                                            |       | 55,072                  |       | 7,000 |   |
| Payments of revolving line of credit                                                                       |       | (73,996                 | )          | (10,137 | ) |
| Net cash used in  financing activities                                                                     |       | (18,924                 | )          | (3,137 | ) |
| Effect of exchange rate changes on cash and cash  equivalents                                              |       | (911                    | )          | 1,135 |   |
| **Net increase (decrease) in cash  and cash equivalents**                                                  |       | 11,386                  |       | (19,958 | ) |
| Cash and cash equivalents at beginning of period                                                           |       | 30,483                  |       | 63,471 |   |
| **Cash and cash equivalents at  end of period**                                                            |       | $                       | 41,869     |   | $ | 43,513 |   |
| **Supplemental disclosures of  cash flow information:**                                                    |       |                    |       |   |   |
| Cash paid for interest                                                                                     |       | $                       | 61,653     |   | $ | 63,518 |   |
| Cash paid for income taxes                                                                                 |       | $                       | 15         |   | $ | 2,365 |   |
| **Non-cash investing and financing  activities:**                                                          |       |                    |       |   |   |
| Increases in property and equipment and in other  liabilities in connection with capitalizedsoftware costs |       | $                       | 1,889      |   | $ | — |   |

 

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 Financial Accounting StandardsStatement (“SFAS”) No. 131, Disclosures about Segments of an Enterpriseand Related Information (“SFAS 131”). Prior to 2009, we included the international components of the Surgical,Chattanooga, and Empi businesses in either the Surgical or DomesticRehabilitation segments, as their operations were managed domestically.  During the fourth quarter of 2008, weeffected an operational reorganization which resulted in the non-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 Incorporated 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 June 27, 2009 and for the three and six months ended June 27,2009 and June 28, 2008 have been prepared in accordance with accountingprinciples generally accepted in the United States for interim financialinformation. Accordingly, they do not include all of the information anddisclosures required by accounting principles generally accepted in the UnitedStates for complete financial statements. These consolidated financial statementsshould be read in conjunction with the audited consolidated financialstatements of the Company and the notes thereto included in the Company’sAnnual Report on Form 10-K for the year ended December 31, 2008. Theaccompanying unaudited condensed consolidated financial statements as of June 27,2009 and for the three and six months ended June 27, 2009 and June 28,2008 have been prepared on the same basis as the audited consolidated financialstatements and include all adjustments consisting of normal recurring accrualswhich, in the opinion of management, are necessary for a fair presentation ofthe financial position, operating results and cash flows for the interim dateand interim periods presented. Results for the interim periods are not necessarilyindicative of the results to be achieved for the entire year or futureperiods.  At July 31, 2009, thereare no material subsequent events requiring additional disclosure in oramendment to our financial 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 of contingentassets and liabilities at the date of the financial statements and the reportedamounts of revenues and expenses during the reporting period. On an ongoingbasis, management evaluates its estimates, including those related tocontractual allowances, doubtful accounts, inventories, rebates, productreturns, warranty obligations, self insurance, income taxes, goodwill andintangible assets and stock-based compensation. We base our estimates onhistorical experience and on various other assumptions that we believe arereasonable 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. Actual results could differ from thoseestimates.

 

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**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 American Institute of Certified Public Accountants Statement of Position98-1, “Accounting for the Costs of Computer Software Developed or Obtained forInternal Use” (“SOP 98-1”) we capitalize costs of internally developed softwareduring the development stage. Additionally, we capitalize related costs including external consultingcosts, cost of software licenses, and internal payroll and payroll-related costsfor 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 $3.5 million of capitalized software costs asof June 27, 2009.

 

**Derivative Financial Instruments.**

 

We account for derivatives pursuant to SFAS No. 133, “Accountingfor Derivative Instruments and Hedging Activities” (“SFAS 133”), which requiresthat all derivative instruments be recognized in the financial statements andmeasured at fair value regardless of the purpose or intent 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 as hedgesunder SFAS 133.  We account for ourforeign forward contracts in accordance with SFAS No. 157, “Fair ValueMeasurement” (“SFAS 157”).  Theclassification of gains and losses resulting from changes in the fair values ofderivatives is dependent on the intended use of the derivative and itsresulting designation. The change in fair value of the ineffective portion of ahedge, and changes in the fair values of the derivative are recorded in othercomprehensive income and are subsequently recognized in earnings when thehedged item affects earnings.   At June 27,2009, the fair value of our foreign exchange forward contracts was a loss of$12.6 million and was determined through the use of models that considervarious assumptions, including time value, yield curves, as well as otherrelevant economic measures, which are inputs that are classified asLevel 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 SFAS 133 andSFAS 157.  At June 27, 2009,the fair value of our interest rate swap agreements was a loss of $17.8 millionand was determined 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 sixmonths ended June 27, 2009 (in thousands):

 
| ** **                                                         | ** ** | **Three Months**       | ** ** | **Six Months**                          | ** ** |
|--------------------------------------------------------------------|------------|------------------------|------------|-----------------------------------------|------------|
| ** **                                                         | ** ** | **DJO  Finance   LLC** | ** ** | **Non-********controlling   Interests** | ** ** | **Total** | ** ** | **DJO  Finance   LLC** | ** ** | **Non-********controlling   Interests** | ** ** | **Total** | ** ** |
| Net loss, as reported                                              |       | $                      | (12,950    | )                                       | $          | (135 | ) | $ | (13,085 | ) | $ | (27,119 | ) | $ | (274 | ) | $ | (27,393 | ) |
| Foreign currency  translation adjustments                          |       | 4,747                  |       | —                                  |       | 4,747 |   | 1,653 |   | — |   | 1,653 |   |
| Change in fair value of  interest rate swap agreements, net of tax |       | (556                   | )          | —                                  |       | (556 | ) | (3,902 | ) | — |   | (3,902 | ) |
| Comprehensive loss                                                 |       | $                      | (8,759     | )                                       | $          | (135 | ) | $ | (8,894 | ) | $ | (29,368 | ) | $ | (274 | ) | $ | (29,642 | ) |

 

Comprehensiveloss consists of the following for the three and six months ended June 28,2008 (in thousands):

 
| ** **                                                         | ** ** | **Three Months**       | ** ** | **Six Months**                          | ** ** |
|--------------------------------------------------------------------|------------|------------------------|------------|-----------------------------------------|------------|
| ** **                                                         | ** ** | **DJO  Finance   LLC** | ** ** | **Non-********controlling   Interests** | ** ** | **Total** | ** ** | **DJO  Finance   LLC** | ** ** | **Non-********controlling   Interests** | ** ** | **Total** | ** ** |
| Net loss, as reported                                              |       | $                      | (20,503    | )                                       | $          | (295 | ) | $ | (20,798 | ) | $ | (44,465 | ) | $ | (495 | ) | $ | (44,960 | ) |
| Foreign currency  translation adjustments                          |       | (149                   | )          | —                                  |       | (149 | ) | 4,052 |   | — |   | 4,052 |   |
| Change in fair value of  interest rate swap agreements, net of tax |       | 3,284                  |       | —                                  |       | 3,284 |   | (2,708 | ) | — |   | (2,708 | ) |
| Comprehensive loss                                                 |       | $                      | (17,368    | )                                       | $          | (295 | ) | $ | (17,663 | ) | $ | (43,121 | ) | $ | (495 | ) | $ | (43,616 | ) |

 

**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 discontinuedoperation, we make a determination of whether the group of assets beingdisposed of comprises a component of the entity; that is, whether it hashistoric operations and cash flows that can be clearly distinguished (bothoperationally and for financial reporting purposes). We also determine whetherthe cash flows associated with the group of assets have been significantly (orwill be significantly) eliminated from our ongoing operations as a result ofthe disposal transaction and whether we have no significant continuinginvolvement in the operations of the group of assets after the disposaltransaction. If these determinations can be made affirmatively, the results ofoperations of the group of assets being disposed of (as well as any gain orloss on the disposal transaction) are aggregated for separate presentationapart from our continuing operating results in our condensed consolidatedfinancial statements. See Note 3 for a summary of discontinued operations.

 

**Recent Accounting Pronouncements.**  In June 2009, the Financial Accounting Standards Board (“FASB”)issued SFAS No. 168, “The FASB Accounting Standards Codification and theHierarchy of Generally Accepted Accounting Principles” (“SFAS 168”) which makesthe Codification the source of authoritative US Generally Accepted AccountingPrinciples recognized by the FASB and applied to non-governmentalentities.  The statement is effective forinterim periods and fiscal years ending after September 15, 2009.   We will adopt this statement in our thirdquarter ending September 26, 2009.

 

InJune 2009, the FASBissued SFAS No. 167, “Amendments to FASB Interpretation No. 46 (R)” (“SFAS167”) which amends certain requirements of FASB Interpretation No. 46, “Consolidationof Variable Interest entities” (“FIN 46”), including the addition of entities previouslyconsidered qualifying special-purpose entities. The statement is effective for fiscal years beginning after November 15,2009.  We will adopt this statement as ofthe beginning of 2010 and are currently assessing the potential impact ofadoption.

 

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 140, “Accounting for Transfers and Servicing of Financial Assets” (“SFAS140”).  SFAS 166 makes the followingamendments to SFAS 140: 1) removes concept of qualifying special-purposeentities from SFAS 140; 2) modifies the financial components approach used andlimits the circumstances in which a transferor has not transferred the originalfinancial asset to an entity that is not consolidated with the transferor inthe financial statements; 3) establishes conditions for reporting a transfer ofa portion of a financial asset as a sale; 4) redefines a participatinginterest; 5) clarifies that an entity must consider all arrangements oragreements made contemporaneously with, or in contemplation of, a transfer,even if not entered into at the time of the transfer; 6) clarifies that thetransferor must evaluate whether it, its consolidated affiliates included inthe financial statements being presented, or its agency effectively control thetransferred financial asset directly or indirectly; 7) requires that thetransferor recognize and initially measure at fair value all assets obtainedand liabilities incurred as a result of the a transfer of an 

 

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entire asset or group offinancial assets accounted for as a sale; 8) removes special provisions forguaranteed mortgage securitizations to require them to be treated that same asany other transfer of financial assets; 9) Removes fair value practicabilityexception from measuring the proceeds received by a transferor in a transferthat meet the conditions for sale accounting at fair value; and 10) requiresenhanced disclosures.  The statement 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 May 2009, theFASB issued, and we adopted, SFAS No. 165, “Subsequent Events” (“SFAS 165”)which requires entities to disclose certain events that occur after the balancesheet date but before the financial statements are issued.  In addition SFAS 165 requires entities todisclose the date through which the entity evaluated subsequent events and thebasis for such date (See Note 16).

 

We have adopted SFAS No. 161, “Disclosures about DerivativeInstruments and Hedging Activities” (“SFAS 161”) as of January 1, 2009,which requires entities to disclose the fair values of derivative instrumentsand their gains and losses in a tabular format and to provide enhanceddisclosures about (a) how and why they use derivative instruments, (b) howderivative instruments and related hedged items are accounted for under SFA 133and its related interpretations, and (c) how derivative instruments andrelated hedged items affect their financial performance, and cash flows.  Except for adding the required disclosures(see Note 15), the adoption of SFAS 161 had no impact on our consolidatedfinancial statements.

 

We have adopted SFAS No. 160, “Non-controlling Interests inConsolidated Financial Statements- an amendment of ARB No. 51,Consolidated Financial Statements” (“SFAS 160”).  SFAS 160 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.  SFAS 160 requires, among other items, that anoncontrolling interest be included in the consolidated statement of financialposition within equity separate from the parent’s equity; consolidated netincome to be reported at amounts inclusive of both the parent’s andnoncontrolling interest’s shares; and if a subsidiary is deconsolidated, anyretained noncontrolling equity investment in the former subsidiary be measuredat fair value and a gain or loss be recognized in net income based on such fairvalue.  We have applied the presentationand disclosure requirements of SFAS 160 retrospectively.

 

We have adopted SFAS No. 141 (Revised), “Business Combinations” (“SFAS141R”) as of January 1, 2009, which requires the acquiring entity in abusiness 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 SFAS 141R, with theresults of operations attributable to each acquisition included in thecondensed consolidated financial statements from the date of acquisition.

 

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

 

OnFebruary 3, 2009 we acquired DonJoy Orthopaedics Pty., Ltd. an Australiandistributor of DJO products (“DJO Australia”), for a total cash compensation of$3.7 million.  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, is an additional amount payable to the selling shareholderof DJO Australia if certain revenue targets are met by December 31, 2009.

 

Thefair values of the assets acquired and the liabilities assumed were estimatedin accordance with SFAS 141R.  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      |   |

 

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Thepurchase price allocation of the DJO Australia acquisition includedapproximately $1.6 million assigned to intangible assets related to certaincustomer relationships existing on the acquisition date. This value was basedupon an estimate of the future discounted cash flows that would be derived fromthose customers.

 

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 for certain outstandingliabilities.  Our ETS business, which wasincluded within our Domestic Rehabilitation Segment, sold a wide range ofproprietary and third party rehabilitation products to physical therapists andchiropractors through printed catalog and an on-line e-commerce site.  Financial data for the three and six monthsended June 27, 2009 and June 28, 2008 related to discontinuedoperations includes the following (in thousands):

 
| ** **           | ** ** | **Three Months Ended**        | ** ** | **Six Months Ended**          | ** ** |
|----------------------|------------|-------------------------------|------------|-------------------------------|------------|
| ** **           | ** ** | **June 27,********2009** | ** ** | **June 28,********2008** | ** ** | **June 27,  2009** | ** ** | **June 28,  2008** | ** ** |
| Total revenues       |       | $                             | 5,719      |                          | $          | 8,449 |   | $ | 13,450 |   | $ | 16,143 |   |
|                 |       |                          |       |                          |       |   |   |   |   |
| Pre-tax income       |       | $                             | 6,018      |                          | $          | 979 |   | $ | 6,894 |   | $ | 1,357 |   |
| Income tax provision |       | 6,595                         |       | 382                           |       | 7,061 |   | 538 |   |
| Net (loss) income    |       | $                             | (577       | )                             | $          | 597 |   | $ | (167 | ) | $ | 819 |   |

 

Included withindiscontinued operations for the three and six months ended June 27, 2009is a pre-tax gain on disposal of discontinued operations of $6.9 million. Theeffective tax rate of the discontinued operations for the six months ended June 27,2009 is 102%, and differs from the amount which would have been recorded usingthe US statutory tax rate due primarily to a large difference in the book andtax basis of goodwill.

 

**4. ACCOUNTS RECEIVABLE RESERVES**

 

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

 

| ** **                                        | ** ** | **Six Months Ended**     | ** ** |
|---------------------------------------------------|------------|--------------------------|------------|
| ** **                                        | ** ** | **June 27,   2009** | ** ** | **June 28,  2008** | ** ** |
| Balance, beginning of period                      |       | $                        | 36,521     |   | $ | 32,417 |   |
| Provision for doubtful accounts and sales returns |       | 17,375                   |       | 10,040 |   |
| Write-offs, net of recoveries                     |       | (9,345                   | )          | (13,566 | ) |
| Balance, end of period                            |       | $                        | 44,551     |   | $ | 28,891 |   |

 

**5. INVENTORIES**

 

Inventories consist of the following (in thousands):

 

| ** **                    | ** ** | **June 27,  2009** | ** ** | **December 31,   2008** | ** ** |
|-------------------------------|------------|-------------------------|------------|------------------------------|------------|
| Components and raw materials  |       | $                       | 30,788     |                         | $          | 34,015 |   |
| Work in process               |       | 5,695                   |       | 5,310                        |       |
| Finished goods                |       | 52,704                  |       | 59,835                       |       |
| Inventory held on consignment |       | 24,659                  |       | 21,804                       |       |
|                          |       | 113,846                 |       | 120,964                      |       |
| Less—inventory reserves  |       | (15,047                 | )          | (17,798                      | )          |
|                          |       | $                       | 98,799     |                         | $          | 103,166 |   |

 

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

 

| ** **                         | ** ** | **Six Months Ended**    | ** ** |
|------------------------------------|------------|-------------------------|------------|
| ** **                         | ** ** | **June 27,  2009** | ** ** | **June 28,  2008** | ** ** |
| Balance, beginning of period       |       | $                       | 17,798     |   | $ | 18,996 |   |
| Provision charged to cost of sales |       | 2,157                   |       | 2,727 |   |
| Write-offs, net of recoveries      |       | (4,908                  | )          | (5,324 | ) |
| Balance, end of period             |       | $                       | 15,047     |   | $ | 16,399 |   |

 

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 six monthsended June 27, 2009 is as follows (in thousands):

 

| Balance, beginning of period |   | $       | 1,191,566 |   |
|------------------------------|--------|---------|-----------|--------|
| Sale of a business           |   | (11,986 | )         |
| Foreign currency translation |   | (25     | )         |
| Acquisitions (See Note 2)    |   | 899     |      |
| Balance, end of period       |   | $       | 1,180,454 |   |

 

Identifiable intangible assets consisted of the following as of June 27,2009 (in thousands):

 
| ** **                                            | ** ** | **Gross Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Intangible Assets,  Net** | ** ** |
|-------------------------------------------------------|------------|----------------------------|------------|-------------------------------|------------|-----------------------------|------------|
| Amortizable intangible assets:                        |       |                       |       |                          |       |                        |       |
| Technology-based                                      |       | $                          | 458,662    |                          | $          | (75,505                     | )          | $ | 383,157 |   |
| Customer-based                                        |       | 480,001                    |       | (76,835                       | )          | 403,166                     |       |
|                                                  |       | $                          | 938,663    |                          | $          | (152,340                    | )          | 786,323 |   |
| Indefinite-lived intangible assets:                   |       |                       |       |                          |       |                        |       |
| Trademarks                                            |       |                       |       |                          |       | 435,267                     |       |
| Accumulated Foreign currency translation  adjustments |       |                       |       |                          |       | 2,516                       |       |
| Net identifiable intangible assets                    |       |                       |       |                          |       | $                           | 1,224,106  |   |

 

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 |   | $       | 38,303  |   |
|----------------|--------|---------|---------|--------|
| 2010           |   | 75,478  |    |
| 2011           |   | 74,021  |    |
| 2012           |   | 72,650  |    |
| 2013           |   | 67,797  |    |
| Thereafter     |   | 458,074 |    |
|           |   | $       | 786,323 |   |

 

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**7. OTHER CURRENT LIABILITIES**

 

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

 

| ** **                     | ** ** | **June 27,  2009** | ** ** | **December 31,  2008** | ** ** |
|--------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| Wages and related expenses     |       | $                       | 23,873     |                        | $          | 21,695 |   |
| Commissions and royalties      |       | 12,281                  |       | 13,799                      |       |
| Taxes                          |       | 5,307                   |       | 4,943                       |       |
| Professional fees              |       | 4,443                   |       | 2,453                       |       |
| Rebates                        |       | 4,030                   |       | 4,812                       |       |
| Accrued ERP costs              |       | 7,116                   |       | 6,763                       |       |
| Interest rate swap derivatives |       | 16,737                  |       | 13,272                      |       |
| Restructuring Costs            |       | 4,730                   |       | 2,505                       |       |
| Other accrued liabilities      |       | 23,696                  |       | 34,159                      |       |
|                           |       | $                       | 102,213    |                        | $          | 104,401 |   |

 

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

 

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

 

| ** **                                                                                                                                                                                         | ** ** | **June 27,  2009** | ** ** | **December 31,  2008** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| Term loan under Senior Secured Credit Facility, net  of unamortized original issue discount ($10.1 million and $10.9 million  at June 27, 2009 and December 31, 2008, respectively) |       | $                       | 1,041,561  |                        | $          | 1,043,404 |   |
| Revolving loans outstanding under Senior Secured  Credit Facility                                                                                                                                  |       | 8,000                   |       | 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                                                                                                                                   |       | 598                     |       | 891                         |       |
| Capital lease obligations and other                                                                                                                                                                |       | 316                     |       | 298                         |       |
|                                                                                                                                                                                               |       | 1,825,475               |       | 1,843,593                   |       |
| Less current portion                                                                                                                                                                               |       | (11,314                 | )          | (11,549                     | )          |
| Long-term debt and capital leases, net of current  portion                                                                                                                                         |       | $                       | 1,814,161  |                        | $          | 1,832,044 |   |

 

*Senior Secured Credit Facility*

 

On November 20, 2007, we entered into the Senior Secured CreditFacility which consists of a six and a half-year $1,065.0 million termloan facility maturing May 2014 and a six-year $100.0 millionrevolving credit facility maturing November 2013. We issued the term loanfacility of the Senior Secured Credit Facility at a 1.2% discount, resulting innet proceeds of $1,052.4 million. The original $12.6 million discountis being amortized as additional interest expense over the term of the termloan facility and increases the reported outstanding balance accordingly. Themarket value of our term loan facility was approximately $946.4 million as ofJune 27, 2009 and was determined using trading prices for our term loan on ornear that date. As of June 27, 2009, $8.0 million related to our revolvingcredit facility was outstanding. The market value of our revolving creditfacility was approximately $6.8 million as of June 27, 2009 and was determinedusing trading prices for our revolving credit on or near that date.

 

*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 agreementamortizes through December 2009. As of June 27, 2009, the remainingnotional amount of the swap was $450.0 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. The second is for anotional amount of $750.0 million at a fixed LIBOR rate of 1.88% beginning January 2010through December 2010. As of June 27, 2009, our weighted averageinterest rate for all borrowings under the Senior Secured Credit Facility was3.7%.

 

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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.

 

*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. Wehave not been required to make any mandatory pre-payments through June 27,2009.  We may voluntarily prepayoutstanding loans under the Senior Secured Credit Facility at any time withoutpremium or penalty, provided that voluntary prepayments of Eurodollar loansmade on a date other than the last day of an interest period applicable theretoshall be subject 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 declining maximum senior secured leverage ratio of 4.50:1 as of the twelvemonths ended June 27, 2009 and stepping down over time to 3.25:1 by theend of 2011. The Senior Secured Credit Facility also contains certain customaryaffirmative covenants and events of default. Our maximum senior securedleverage ratio was within the covenant level as of June 27, 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. On July 2, 2008, our amended registration statement, filed in June 2008on Form S-4 with the Securities and Exchange Commission (the “Commission”)relating to an offer to exchange these privately issued 10.875% Notes, forregistered 10.875% Notes was declared effective. The exchange offer wascompleted July 31, 2008.

 

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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 $503.1 million as of June 27, 2009 and was determined usingtrading 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.

 

*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 convertible shares,pay dividends on, redeem, repurchase or make distributions in respect of thecapital 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 June 27, 2009, wewere 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$11.8 million each May 15 and November 15 and are due November 15,2014.

 

The market value of the 11.75% Notes was approximately $144.0 millionas of June 27, 2009 and was determined using trading prices for the 11.75%Notes on or near that date. We believe the trading prices reflect certaindifferences between prevailing market terms and conditions and the actual termsof 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.

 

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*Debt Issue Costs*

 

We incurred $24.5 million, $10.2 million, and $30.7 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 June 27, 2009 and December 31, 2008. Debt issuecosts are being amortized over the terms of the respective debt instrumentsthrough November 2014.

 

**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, while the final one-third wasoriginally determined to vest based upon achieving enhanced pre-determinedperformance targets based on Adjusted EBITDA and free cash flow (“EnhancedPerformance-Based Tranche”). The DJO Form Option Agreement includescertain forfeiture provisions upon an awardees’ separation from service withus.

 

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 a minimumthreshold amount of the budgeted Adjusted EBITDA and of the free cash flowtargets for 2009. The financial targets for the Performance-Based Tranches forthe years 2010-2012 remain unchanged. The vesting provisions of thePerformance-Based Tranche were modified to provide that upon achievement of theannual target for a given year, the annual portion of the tranche associatedwith all prior years will also vest to the extent not previously vested. Thefinancial performance targets for the entire Enhanced Performance-Based Tranchewere replaced by targets with different financial metrics. These new targetsrequire achievement of a minimum internal rate of return (“IRR”) and multipleof invested capital (“MOIC”), each measured with respect to Blackstone’saggregate investment in our capital stock, to be achieved by Blackstonefollowing a liquidation of all or a portion of its investment in our capitalstock. As a result of this modification, the Enhanced Performance-Based Tranchehas both a performance component and a market 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 six months ended June 27, 2009 we granted 594,782 stockoptions under the 2007 Plan to our executive officers, senior management, andcertain other employees.

 

We recorded non-cash compensation expense of approximately $0.8 millionand $1.3 million in the three and six months ended June 27, 2009,respectively, associated with stock options issued under the 2007 Plan. Werecorded non-cash compensation expense of approximately $0.6 million and $1.2million in the three and six months ended June 28, 2008, respectively,associated with stock options issued under the 2007 Plan. We recordcompensation expense for awards with a performance condition only to the extentdeemed probable of achievement. We reassess at each reporting period whetherachievement of the pre-determined performance targets based on the financialmetrics discussed above is probable for the options related to thePerformance-Based Tranche to vest.

 

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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 expected term,we used the simplified approach to calculate the expected term. Expected lifeis 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 the extentdeemed probable of achievement, with the exception of market-based optionspreviously modified during the first quarter of 2008 and reallocated to theTime-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 ourPerformance-Based Tranche as the performance targets under the original grantwere not achieved.  As a result of themodification of the 2009 targets and our actual results for the six monthsended June 27, 2009, we now believe that it is probable that we willachieve the 2009 performance targets.  As such, for the six months ended June 27,2009, 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, no amounthas been recorded for the Enhanced Performance-Based Tranche, as achievement ofthe performance component is not deemed probable at this time.

 

As a result of the 2009 modification and in accordance with FAS 123(R), we will no longer use the original grant date fair value to measurecompensation cost and have re-assessed the assumptions used to determine thefair value of options at the date of modification. The following table presentsthe assumptions we used in calculating the fair value of employee stock optionsfor the six months ended June 27, 2009 and June 28, 2008:

 

| ** **               | ** ** | **Six Months Ended**    | ** ** |
|--------------------------|------------|-------------------------|------------|
| ** **               | ** ** | **June 27,  2009** | ** ** | **June 28,  2008** | ** ** |
| Expected dividends       |       | 0.0                     | %          | 0.0 | % |
| Expected volatility      |       | 34.4                    | %          | 27.4% - 60.0 | % |
| Risk-free rate           |       | 2.3                     | %          | 3.22% - 4.7 | % |
| Expected term (in years) |       | 6.3 years               |       | 4.7 - 7.1 years |   |

 

*Non-Employee Stock Options*

 

During the six months ended June 27, 2009 we have granted 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. The non-employeeoption agreement does not include any performance requirements on the optionee’spart in order to vest in the options granted. Non-employee options are accounted for in accordance with EmergingIssues Task Force (“EITF”) Issue No. 96-18, “Accounting for EquityInstruments That are Issued to Other Than Employees for Acquiring, or inConjunction with Selling Goods or Services” (“EITF 96-18”).  In accordance with EITF 96-18, the fair valueof each option will be re-measured at the end of each reporting period untilvested, when the final fair value of the vesting of the option isdetermined.  We recorded non-cashcompensation expense of approximately $63,000 and $147,000 thousand for thethree and six months ended June 27, 2009, respectively and approximately$15,000 in each of the three and six month periods ended June 28, 2008,associated with non-employee stock options issued under the 2007 Plan.

 

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**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 asdefined by SFAS 131.  Prior to 2009, weincluded the international components of the Surgical non-U.S., Chattanooga,and Empi businesses in either the Surgical or Domestic Rehabilitation segments,as their operations were managed domestically. During the fourth quarter of 2008, we effected an operationalreorganization which resulted in the non-U.S. components of all of our businessesbeing managed abroad.  As a result, thesegment financial data for the three and six months ended June 27, 2009reflects this new segmentation and the data for the three and six months ended June 28,2008, 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 categories of home electrotherapy, iontophoresis, andhome traction.

 

·                  *Regeneration*.  Our Regeneration business unit primarilysells of 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.

 

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| ** **                                      | ** ** | **Three Months Ended**        | ** **    | **Six Months Ended**          | ** ** |
|-------------------------------------------------|------------|-------------------------------|---------------|-------------------------------|------------|
| ** **                                      | ** ** | **June 27,********2009** | ** **    | **June 28,********2008** | ** ** | **June 27,********2009** | ** ** | **June 28,********2008** | ** ** |
| **Net sales:**                                  |       |                          |          |                          |       |   |   |   |   |
| Domestic Rehabilitation Segment                 |       | $                             |  160,095 |                          | $          |  155,889 |   | $ |  306,809 |   | $ | 305,582 |   |
| International Segment                           |       | 58,639                        |          | 70,165                        |       | 114,275 |   | 136,309 |   |
| Domestic Surgical Implant Segment               |       | 16,378                        |          | 15,298                        |       | 31,681 |   | 31,495 |   |
| Consolidated net sales                          |       | $                             |  235,112 |                          | $          |  241,352 |   | $ |  452,765 |   | $ |  473,386 |   |
| ** **                                      |       |                          |          |                          |       |   |   |   |   |
| **Gross profit:**                               |       |                          |          |                          |       |   |   |   |   |
| Domestic Rehabilitation Segment                 |       | $                             |  106,199 |                          | $          |  99,732 |   | $ |  202,387 |   | $ |  195,478 |   |
| International Segment                           |       | 34,706                        |          | 43,860                        |       | 66,211 |   | 82,057 |   |
| Domestic Surgical Implant Segment               |       | 12,864                        |          | 12,502                        |       | 24,762 |   | 25,976 |   |
| Expenses not allocated to segments/Eliminations |       | (813                          | )             | (578                          | )          | (1,751 | ) | (5,425 | ) |
| Consolidated gross profit                       |       | $                             |  152,956 |                          | $          |  155,516 |   | $ |  291,609 |   | $ |  298,086 |   |
| ** **                                      |       |                          |          |                          |       |   |   |   |   |
| **Operating income:**                           |       |                          |          |                          |       |   |   |   |   |
| Domestic Rehabilitation Segment                 |       | $                             |  45,395  |                          | $          |  32,740 |   | $ |  79,137 |   | $ |  64,033 |   |
| International Segment                           |       | 12,868                        |          | 18,137                        |       | 22,931 |   | 31,564 |   |
| Domestic Surgical Implant Segment               |       | 3,717                         |          | 3,097                         |       | 6,177 |   | 6,216 |   |
| Expenses not allocated to segments/Eliminations |       | (42,962                       | )             | (39,855                       | )          | (76,108 | ) | (79,832 | ) |
| Consolidated operating income                   |       | $                             |  19,018  |                          | $          |  14,119 |   | $ |  32,137 |   | $ |  21,981 |   |

 

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**        | ** ** | **Six Months Ended**          | ** ** |
|----------------------------------------------|------------|-------------------------------|------------|-------------------------------|------------|
| ** **                                   | ** ** | **June 27,********2009** | ** ** | **June 28,********2008** | ** ** | **June 27,********2009** | ** ** | **June 28,********2008** | ** ** |
| **Net sales:**                               |       |                          |       |                          |       |   |   |   |   |
| United States                                |       | $                             | 170,725    |                          | $          | 171,187 |   | $ | 332,743 |   | $ | 337,077 |   |
| Germany                                      |       | 17,953                        |       | 20,980                        |       | 34,700 |   | 41,220 |   |
| Other Europe, Middle East, & Africa |       | 32,779                        |       | 38,045                        |       | 61,393 |   | 73,686 |   |
| Asia Pacific                                 |       | 3,798                         |       | 3,418                         |       | 6,848 |   | 6,518 |   |
| Other                                        |       | 9,857                         |       | 7,722                         |       | 17,081 |   | 14,885 |   |
|                                         |       | $                             | 235,112    |                          | $          | 241,352 |   | $ | 452,765 |   | $ | 473,386 |   |

 

**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 have beenrecorded using the U.S. statutory tax rate due primarily to the impact offoreign taxes, including favorable adjustments related to prior year foreigntaxes, deferred taxes on the assumed repatriation of foreign earnings and thefavorable impact of new California legislation discussed below.

 

For the three and six months ended June 27, 2009, we recorded anincome tax benefit of approximately $5.0 million and $16.9 million,respectively, on pre-tax losses of approximately $17.4 million and $43.9million, respectively.  For the three andsix months ended June 28, 2008, we recorded an income tax benefit ofapproximately $6.7 million and $17.9 million, respectively, on pre-tax lossesof approximately $27.8 million and $63.2 million, respectively.

 

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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 2004. At December 31, 2008, our grossunrecognized tax benefits were $15.4 million. For the three and six months ended June 27, 2009, we increased(decreased) our gross unrecognized tax benefits by ($0.2) million and $0.3million, respectively, due to additions and settlements of unrecognized taxbenefits related to tax positions of prior years.  For the three and six months ended June 27,2009, we recognized an additional $0.1 million and $0.3 million, respectively,in interest and penalties.  Our totalgross unrecognized tax benefits were $15.7 million at June 27, 2009,including $1.5 million related to interest and penalties.  We anticipate that approximately $0.6 millionof gross uncertain tax positions related to our Compex acquisition willdecrease in the next twelve months. In addition, we anticipate that $0.3million of our remaining unrecognized tax positions, each of which areindividually immaterial, may be recognized by June 27, 2010 as a result ofa lapse of statute of limitations. Due to the adoption of SFAS 141R on January 1,2009, all of our unrecognized tax benefits will impact our effective tax rateupon recognition. We believe that it is reasonably possible that an increase of$0.4 million in unrecognized tax benefits related to various immaterial stateexposures may be necessary within the next twelve months.

 

**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 to12 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.

 

A summary of the activity relating to therestructuring for the three and six month period ended June 27, 2009 is asfollows (in thousands):

 
| ** **                   | ** ** | **Severance &  Employee  Retention** | ** **   |
|------------------------------|------------|-----------------------------------------------|--------------|
| Balance, beginning of period |       | $                                             |  — |   |
| Expensed during period       |       | 985                                           |         |
| Payments made during period  |       | (25                                           | )            |
| Balance, end of period       |       | $                                             |  960    |   |

 

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 45 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, themanufacturers of the anesthetics used in these pumps, and the healthcareprofessionals involved in providing the pumps to their patients. 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, but we are still seeking confirmation from the twomanufacturers that they will indemnify us under the respective distributionagreements in the event that the coverage under their respective insurancepolicies is insufficient.  Our productliability carrier has also accepted coverage of these cases, subject tocustomary reservations, and was providing us with the defense until the carrierfor the manufacturers began providing a defense. The lawsuits allege damagesranging from unspecified amounts to claims between $1.0 million and$10.0 million. These cases are 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 $25.0 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 aggregatedeductible of $1.0 million for all product liability claims. We believe ourcurrent product liability insurance coverage is adequate. However, if a productliability claim or series of claims is brought against us for uninsuredliabilities or in excess of our insurance coverage, our business could suffermaterially. In addition, in certain instances, a product liability claim couldalso result in our having to recall some of our products, which could result insignificant costs to us. As of June 27, 2009 and December 31, 2008,we have accrued approximately $1.9 million and $1.8 million, respectively,for product liability claims expenses based upon previous claim experience inpart due to the fact that in 2003 we exceeded the coverage limits in effect atthat time for certain historical product liability claims involving one of ourdiscontinued Surgical implant products and such products are excluded fromcoverage 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 auditor also recommended that we recall aseries of ultrasound devices that had experienced operating issues in 2005, andwe are implementing such a recall. We received a warning letter from the FDA inJune 2008 relating to reporting issues on the muscle stimulator devicecomplaints 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 the warningletter 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.

 

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 as defendants us and 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 to intervenein 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 certainmonitoring, advisory and consulting services to us for an annual monitoring feeequal to the greater of $7.0 million or 2% of consolidated EBITDA asdefined in the Transaction and Monitoring Fee Agreement, payable in the firstquarter of each year. At any time in connection with or in anticipation of achange of control of DJOFL, a sale of all or substantially all of DJOFL’sassets or an initial public offering of common stock of DJOFL, BMP may elect toreceive, in lieu of remaining annual monitoring fee payments, a single lump sumcash payment equal to the then-present value of all then-current and futureannual monitoring fees payable under the transaction and monitoring feeagreement, assuming a hypothetical termination date of the agreement to be thetwelfth anniversary of such election. The monitoring fee agreement willcontinue until the earlier of the twelfth anniversary of the date of the agreementor such date as DJOFL and BMP may mutually determine. DJOFL will agree toindemnify BMP and its affiliates, directors, officers, employees, agents andrepresentatives from and against all liabilities relating to the servicescontemplated by the transaction and monitoring fee agreement and the engagementof BMP pursuant to, and the performance of BMP and its affiliates of theservices contemplated by, the transaction and monitoring fee agreement. Foreach of the three and six month periods ended June 27, 2009 and June 28,2008, we recognized $1.75 million and $3.5 million, respectively, related tothe monitoring fee, which is recorded as a component of selling, general andadministrative expense in the unaudited condensed consolidated statements of operations.

 

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**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 SFAS 133.  Before acquiring a derivative instrument tohedge a specific risk, potential natural hedges are evaluated. Derivativeinstruments are only utilized to manage underlying exposures that arise fromour business operations. Factors considered in the decision to hedge anunderlying market exposure include the materiality of the risk, the volatilityof the market, the duration of the hedge, and the availability, effectivenessand cost of derivative instruments.  At June 27,2009, we had 34 foreign exchange forward contracts, with a notional amount of$12.9 million and an aggregate fair market value of approximately $12.6 million.These foreign exchange forward contracts expire weekly throughout the fiscalyear 2009.

 

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 $450.0 millionas of June 27, 2009).  In February 2009we entered into two new non-amortizing interest rate swap agreements related tothe Senior Secured Credit Facility.  Thefirst agreement is for a notional amount of $550.0 million at a fixed LIBORrate of 1.04% beginning February 2009 amortizing through December 2009(the notional amount was $550.0 million as of June 27, 2009).  The second agreement is for a notional amountof $750.0 million at a fixed LIBOR rate of 1.88% with a term beginning January 2010through December 2010.  We havedesignated these interest rate swap agreements as cash flow hedges under SFAS133.

 

In accordance with SFAS No. 157, we follow the three levels of thefair value hierarchy for disclosure of the inputs to valuation. This hierarchyprioritizes the inputs into three broad levels as follows. Level 1 inputsare quoted prices (unadjusted) in active markets for identical assets orliabilities. Level 2 inputs are quoted prices for similar assets andliabilities in active markets or inputs that are observable for the asset orliability, either directly or indirectly through market corroboration, forsubstantially the full term of the financial instrument. Level 3 inputsare unobservable inputs based on our own assumptions used to measure assets andliabilities at fair value. A financial asset or liability’s classificationwithin the hierarchy is determined based on the lowest level input that issignificant to the fair value measurement. At June 27, 2009, the fairvalue of our interest rate swap agreements and our foreign currency exchangeforward contracts were determined through the use of models that considervarious assumptions, including time value, yield curves, as well as otherrelevant economic measures, which are inputs that are classified asLevel 2 in the valuation hierarchy.

 

The following table summarizes our derivative instruments, which, sincethe fair values reflect losses are, included within other current andnon-current liabilities in our condensed consolidated balance sheets (inthousands):

 

| ** **                   | ** ** | **June 27,  2009** | ** ** | **December 31,  2008** | ** ** |
|------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| **Liabilities:**             | ** ** | ** **              | ** ** | ** **                  | ** ** |
| Foreign exchange contracts   |       | $                       | 366        |                        | $          | 4,162 |   |
| Interest rate swaps          |       | 17,853                  |       | 13,272                      |       |
| Total derivative liabilities |       | $                       | 18,219     |                        | $          | 17,434 |   |

 

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

 
| ** **                 | ** ** | ** **                       | ** ** | **Three Months Ended**        | ** ** | **Six Months Ended**          | ** ** |
|----------------------------|------------|----------------------------------|------------|-------------------------------|------------|-------------------------------|------------|
| ** **                 | ** ** | **Location of Gain or   (Loss)** | ** ** | **June 27,********2009** | ** ** | **June 28,********2008** | ** ** | **June 27,********2009** | ** ** | **June 28,********2008** | ** ** |
|                       | ** ** | ** **                       | ** ** | ** **                    | ** ** | ** **                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Foreign exchange contracts |       | Other income (expense), net      |       | $                             | (366       | )                             | $          |  371 |   | $ | (3,372 | ) | $ |  751 |   |
| Interest rate swaps        |       | Interest expense                 |       | (4,251                        | )          | (1,877                        | )          | (7,628 | ) | (1,081 | ) |
| Total net loss             |       |                             |       | $                             | (4,617     | )                             | $          |  (1,506 | ) | $ | (11,000 | ) | $ |  (330 | ) |

 

21

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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 Finco fromholding any assets, becoming liable for any obligations, or engaging in anybusiness activity. The 10.875% Notes are jointly and severally, fully andunconditionally guaranteed, on an unsecured senior basis by all of the DJOFL’sdomestic subsidiaries (other than 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 June 27, 2009 and December 31, 2008 andfor the three and six months ended June 27, 2009 and June 28, 2008,respectively.

 

22

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**DJO Finance LLC**

 

**Unaudited Condensed Consolidating Balance Sheets**

**As of June 27,2009**

**(inthousands)**

 
| ** **                                                      | ** ** | **DJOFL** | ** ** | **Guarantors** | ** ** | **Non-  Guarantors** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|-----------------------------------------------------------------|------------|-----------|------------|----------------|------------|----------------------|------------|------------------|------------|------------------|------------|
| **Assets**                                                      |       |      |       |           |       |                 |       |             |       |             |       |
| Current assets:                                                 |       |      |       |           |       |                 |       |             |       |             |       |
| Cash and cash equivalents                                       |       | $         | —     |           | $          | 27,350               |       | $                | 14,519     |             | $          | — |   | $ | 41,869 |   |
| Accounts receivable, net                                        |       | —    |       | 126,024        |       | 36,795               |       | —           |       | 162,819          |       |
| Inventories, net                                                |       | —    |       | 79,064         |       | 24,490               |       | (4,755           | )          | 98,799           |       |
| Deferred tax assets, net                                        |       | —    |       | 35,960         |       | 289                  |       | (1,162           | )          | 35,087           |       |
| Prepaid expenses and other current assets                       |       | 73        |       | 16,066         |       | 3,960                |       | —           |       | 20,099           |       |
| Total current assets                                            |       | 73        |       | 284,464        |       | 80,053               |       | (5,917           | )          | 358,673          |       |
| Property and equipment, net                                     |       | —    |       | 71,972         |       | 12,649               |       | (1,650           | )          | 82,971           |       |
| Goodwill                                                        |       | —    |       | 1,108,703      |       | 71,751               |       | —           |       | 1,180,454        |       |
| Intangible assets, net                                          |       | —    |       | 1,191,646      |       | 32,460               |       | —           |       | 1,224,106        |       |
| Investment in subsidiaries                                      |       | 1,235,151 |       | 2,335,391      |       | 46,228               |       | (3,616770        | )          | —           |       |
| Intercompany receivable                                         |       | 1,153,937 |       | —         |       | —               |       | (1,153,937       | )          | —           |       |
| Other non-current assets                                        |       | 44,314    |       | 823            |       | 2,339                |       | —           |       | 47,476           |       |
| Total assets                                                    |       | $         | 2,433,475  |           | $          | 4,992,999            |       | $                | 245,480    |             | $          | (4,778,274 | ) | $ | 2,893,680 |   |
| **Liabilities and Membership  Equity**                          |       |      |       |           |       |                 |       |             |       |             |       |
| Current liabilities:                                            |       |      |       |           |       |                 |       |             |       |             |       |
| Accounts payable                                                |       | $         | —     |           | $          | 38,663               |       | $                | 6,786      |             | $          | 4 |   | $ | 45,453 |   |
| Long-term debt and capital leases, current portion              |       | 10,650    |       | 196            |       | 468                  |       | —           |       | 11,314           |       |
| Other current liabilities                                       |       | 38,763    |       | 61,006         |       | 23,332               |       | —           |       | 123,101          |       |
| Total current liabilities                                       |       | 49,413    |       | 99,865         |       | 30,586               |       | 4                |       | 179,868          |       |
| Long-term debt and capital leases, net of  current portion |       | 1,813,912 |       | 110            |       | 139                  |       | —           |       | 1,814,161        |       |
| Deferred tax liabilities, net                                   |       | —    |       | 306,514        |       | 11,879               |       | (1,015           | )          | 317,378          |       |
| Intercompany payable, net                                       |       | —    |       | 1,071,622      |       | 82,315               |       | (1,153,937       | )          | —           |       |
| Other non-current liabilities                                   |       | —    |       | 10,004         |       | 90                   |       | —           |       | 10,094           |       |
| Total liabilities                                               |       | 1,863,325 |       | 1,488,115      |       | 125,009              |       | (1,154,948       | )          | 2,321,501        |       |
| Total membership equity                                         |       | 570,150   |       | 3,504,884      |       | 120,471              |       | (3,623,326       | )          | 572,179          |       |
| Total liabilities and membership equity                         |       | $         | 2,433,475  |           | $          | 4,992,999            |       | $                | 245,480    |             | $          | (4,776,274 | ) | $ | 2,893,680 |   |

 

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**DJO Finance LLC**

 

**Unaudited Condensed 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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**DJO Finance LLC**

 

**Unaudited Condensed Consolidating Statements ofOperations**

**For the ThreeMonths Ended June 27, 2009**

**(inthousands)**

 
| ** **                                                   | ** ** | **DJOFL** | ** ** | **Guarantors** | ** ** | **Non-  Guarantors** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|--------------------------------------------------------------|------------|-----------|------------|----------------|------------|----------------------|------------|------------------|------------|------------------|------------|
| Net sales                                                    |       | $         | —     |           | $          | 194,514              |       | $                | 67,771     |             | $          | (27,173 | ) | $ | 235,112 |   |
| Cost of sales                                                |       | —    |       | 69,537         |       | 44,833               |       | (32,214          | )          | 82,156           |       |
| Gross profit                                                 |       | —    |       | 124,977        |       | 22,938               |       | 5,041            |       | 152,956          |       |
| Operating expenses:                                          |       |      |       |           |       |                 |       |             |       |             |       |
| Selling, general and administrative                          |       | —    |       | 89,428         |       | 19,177               |       | —           |       | 108,605          |       |
| Research and development                                     |       | —    |       | 5,428          |       | 734                  |       | —           |       | 6,162            |       |
| Amortization of acquired intangibles                         |       | —    |       | 18,639         |       | 532                  |       | —           |       | 19,171           |       |
| Operating income                                             |       | —    |       | 11,482         |       | 2,495                |       | 5,041            |       | 19,018           |       |
| Other income (expense):                                      |       |      |       |           |       |                 |       |             |       |             |       |
| Interest income                                              |       | 4,657     |       | 749            |       | 150                  |       | (5,354           | )          | 202              |       |
| Interest expense                                             |       | (39,410   | )          | (4,689         | )          | (801                 | )          | 5,345            |       | (39,555          | )          |
| Other income, net                                            |       | 21,668    |       | 15,073         |       | 1,217                |       | (34,991          | )          | 2,967            |       |
| Income (loss)from continuing operations before  income taxes |       | (13,085   | )          | 22,615         |       | 3,061                |       | (29,959          | )          | (17,368          | )          |
| Provision (benefit) for income taxes                         |       | —    |       | (6,388         | )          | 1,393                |       | —           |       | (4,995           | )          |
| Income (loss) from discontinued operations, net              |       | —    |       | (577           | )          | —               |       | —           |       | (577             | )          |
| Net (loss) income                                            |       | (13,085   | )          | 28,426         |       | 1,668                |       | (29,959          | )          | (12,950          | )          |
| Noncontrolling interests                                     |       | —    |       | —         |       | 135                  |       | —           |       | 135              |       |
| Net income (loss) attributable to DJO Finance LLC            |       | $         | (13,085    | )              | $          | 28,426               |       | $                | 1,533      |             | $          | (29,959 | ) | $ | (13,085 | ) |

 

**DJO Finance LLC**

 

**Unaudited Condensed Consolidating Statements ofOperations**

**For the SixMonths Ended June 27, 2009**

**(inthousands)**

** **
| ** **                                                   | ** ** | **DJOFL** | ** ** | **Guarantors** | ** ** | **Non-  Guarantors** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|--------------------------------------------------------------|------------|-----------|------------|----------------|------------|----------------------|------------|------------------|------------|------------------|------------|
| Net sales                                                    |       | $         | —     |           | $          | 381,296              |       | $                | 128,750    |             | $          | (57,281 | ) | $ | 452,765 |   |
| Cost of sales                                                |       | —    |       | 138,633        |       | 84,399               |       | (61,876          | )          | 161,156          |       |
| Gross profit                                                 |       | —    |       | 242,663        |       | 44,351               |       | 4,595            |       | 291,609          |       |
| Operating expenses:                                          |       |      |       |           |       |                 |       |             |       |             |       |
| Selling, general and administrative                          |       | —    |       | 169,641        |       | 39,564               |       | —           |       | 209,205          |       |
| Research and development                                     |       | —    |       | 10,490         |       | 1,475                |       | —           |       | 11,965           |       |
| Amortization of acquired intangibles                         |       | —    |       | 37,278         |       | 1,024                |       | —           |       | 38,302           |       |
| Operating income                                             |       | —    |       | 25,254         |       | 2,288                |       | 4,595            |       | 32,137           |       |
| Other income (expense):                                      |       |      |       |           |       |                 |       |             |       |             |       |
| Interest income                                              |       | 9,386     |       | 1,437          |       | 481                  |       | (10,766          | )          | 538              |       |
| Interest expense                                             |       | (77,840   | )          | (9,465         | )          | (1,604               | )          | 10,763           |       | (78,146          | )          |
| Other income (expense), net                                  |       | 41,061    |       | 8,629          |       | 442                  |       | (48,545          | )          | 1,587            |       |
| Income (loss)from continuing operations before  income taxes |       | (27,393   | )          | 25,855         |       | 1,607                |       | (43,953          | )          | (43,884          | )          |
| Provision (benefit) for income taxes                         |       | —    |       | (17,490        | )          | 558                  |       | —           |       | (16,932          | )          |
| Income (loss) from discontinued operations, net              |       | —    |       | (167           | )          | —               |       | —           |       | (167             | )          |
| Net (loss) income                                            |       | (27,393   | )          | 43,178         |       | 1,049                |       | (43,953          | )          | (27,119          | )          |
| Noncontrolling interests                                     |       | —    |       | —         |       | 274                  |       | —           |       | 274              |       |
| Net income (loss) attributable to DJO Finance LLC            |       | $         | (27,393    | )              | $          | 43,178               |       | $                | 775        |             | $          | (43,953 | ) | $ | (27,393 | ) |

 

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**DJO Finance LLC**

 

**Unaudited Condensed Consolidating Statements ofOperations**

**For theThree Months Ended June 28, 2008**

**(inthousands)**

 
| ** **                                                    | ** ** | **DJOFL** | ** ** | **Guarantors** | ** ** | **Non-  Guarantors** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|---------------------------------------------------------------|------------|-----------|------------|----------------|------------|----------------------|------------|------------------|------------|------------------|------------|
| Net sales                                                     |       | $         | —     |           | $          | 194,688              |       | $                | 70,451     |             | $          | (23,787 | ) | $ | 241,352 |   |
| Cost of sales                                                 |       | —    |       | 70,717         |       | 38,948               |       | (23,829          | )          | 85,836           |       |
| Gross profit                                                  |       | —    |       | 123,971        |       | 31,503               |       | 42               |       | 155,516          |       |
| Operating expenses:                                           |       |      |       |           |       |                 |       |             |       |             |       |
| Selling, general and administrative                           |       | —    |       | 90,107         |       | 24,924               |       | (4               | )          | 115,027          |       |
| Research and development                                      |       | —    |       | 6,528          |       | 702                  |       | —           |       | 7,230            |       |
| Amortization of acquired intangibles                          |       | —    |       | 18,589         |       | 551                  |       | —           |       | 19,140           |       |
| Operating income                                              |       | —    |       | 8,747          |       | 5,326                |       | 46               |       | 14,119           |       |
| Other income (expense):                                       |       |      |       |           |       |                 |       |             |       |             |       |
| Interest income                                               |       | 10,572    |       | 966            |       | 195                  |       | (11,470          | )          | 263              |       |
| Interest expense                                              |       | (42,347   | )          | (10,607        | )          | (1,013               | )          | 11,472           |       | (42,495          | )          |
| Other income (expense), net                                   |       | 10,977    |       | 465            |       | (177                 | )          | (10,977          | )          | 288              |       |
| Income (loss) from continuing operations before  income taxes |       | (20,798   | )          | (429           | )          | 4,331                |       | (10,933          | )          | (27,825          | )          |
| Provision (benefit) for income taxes                          |       | —    |       | (7,627         | )          | 902                  |       | —           |       | (6,725           | )          |
| Income (loss) from discontinued operations, net               |       | —    |       | 597            |       | —               |       | —           |       | 597              |       |
| Net (loss) income                                             |       | (20,798   | )          | 7,795          |       | 3,429                |       | (10,933          | )          | (20,503          | )          |
| Noncontrolling interests                                      |       | —    |       | —         |       | 295                  |       | —           |       | 295              |       |
| Net income (loss)                                             |       | $         | (20,798    | )              | $          | 7,795                |       | $                | 3,134      |             | $          | (10,933 | ) | $ | (20,798 | ) |

 

**DJO Finance LLC**

 

**Unaudited Condensed Consolidating Statements ofOperations**

**For the SixMonths Ended June 28, 2008**

**(inthousands)**

 
| ** **                                                    | ** ** | **DJOFL** | ** ** | **Guarantors** | ** ** | **Non-  Guarantors** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|---------------------------------------------------------------|------------|-----------|------------|----------------|------------|----------------------|------------|------------------|------------|------------------|------------|
| Net sales                                                     |       | $         | —     |           | $          | 383,757              |       | $                | 133,718    |             | $          | (44,089 | ) | $ | 473,386 |   |
| Cost of sales                                                 |       | —    |       | 144,475        |       | 75,005               |       | (44,180          | )          | 175,300          |       |
| Gross profit                                                  |       | —    |       | 239,282        |       | 58,713               |       | 91               |       | 298,086          |       |
| Operating expenses:                                           |       |      |       |           |       |                 |       |             |       |             |       |
| Selling, general and administrative                           |       | —    |       | 177,305        |       | 46,644               |       | (6               | )          | 223,943          |       |
| Research and development                                      |       | —    |       | 12,485         |       | 1,421                |       | —           |       | 13,906           |       |
| Amortization of acquired intangibles                          |       | —    |       | 37,179         |       | 1,077                |       | —           |       | 38,256           |       |
| Operating income                                              |       | —    |       | 12,313         |       | 9,571                |       | 97               |       | 21,981           |       |
| Other income (expense):                                       |       |      |       |           |       |                 |       |             |       |             |       |
| Interest income                                               |       | 26,321    |       | 2,408          |       | 347                  |       | (28,226          | )          | 850              |       |
| Interest expense                                              |       | (87,307   | )          | (26,530        | )          | (2,073               | )          | 28,228           |       | (87,682          | )          |
| Other income (expense), net                                   |       | 16,026    |       | 841            |       | 790                  |       | (16,026          | )          | 1,631            |       |
| Income (loss) from continuing operations before  income taxes |       | (44,960   | )          | (10,968        | )          | 8,635                |       | (15,927          | )          | (63,220          | )          |
| Provision (benefit) for income taxes                          |       | —    |       | (19,940        | )          | 2,004                |       | —           |       | (17,936          | )          |
| Income (loss) from discontinued operations, net               |       | —    |       | 819            |       | —               |       | —           |       | 819              |       |
| Net (loss) income                                             |       | (44,960   | )          | 9,791          |       | 6,631                |       | (15,927          | )          | (44,465          | )          |
| Noncontrolling interests                                      |       | —    |       | —         |       | 495                  |       | —           |       | 495              |       |
| Net income (loss)                                             |       | $         | (44,960    | )              | $          | 9,791                |       | $                | 6,136      |             | $          | (15,927 | ) | $ | (44,960 | ) |

 

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**DJO Finance LLC**

 

**Unaudited Condensed Consolidating Statements of CashFlows**

**For the SixMonths Ended June 27, 2009**

**(inthousands)**

 
| ** **                                                                                                    | ** ** | **DJOFL** | ** ** | **Guarantors** | ** ** | **Non-  Guarantors** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|---------------------------------------------------------------------------------------------------------------|------------|-----------|------------|----------------|------------|----------------------|------------|------------------|------------|------------------|------------|
| **OPERATING ACTIVITIES:**                                                                                     |       |      |       |           |       |                 |       |             |       |             |       |
| Net loss (income)                                                                                             |       | $         | (27,393    | )              | $          | 43,178               |       | $                | 1,049      |             | $          | (43,953 | ) | $ | (27,119 | ) |
| Adjustments to reconcile net income (loss)  to net cash provided by (used in) operating activities: |       |      |       |           |       |                 |       |             |       |             |       |
| Depreciation                                                                                                  |       | —    |       | 10,850         |       | 2,334                |       | (215             | )          | 12,969           |       |
| Amortization of intangibles                                                                                   |       | —    |       | 37,278         |       | 1,024                |       | —           |       | 38,302           |       |
| Amortization of debt issuance costs                                                                           |       | 6,457     |       | —         |       | —               |       | —           |       | 6,457            |       |
| Stock-based compensation                                                                                      |       | —    |       | 1,426          |       | —               |       | —           |       | 1,426            |       |
| Loss on disposal of assets                                                                                    |       | —    |       | 145            |       | 206                  |       | (98              | )          | 253              |       |
| Gain on disposal of discontinued operations                                                                   |       | —    |       | (458           | )          | —               |       | —           |       | (458             | )          |
| Deferred income taxes                                                                                         |       | —    |       | (20,381        | )          | 123                  |       | 2,149            |       | (18,109          | )          |
| Non-cash income from subsidiaries                                                                             |       | (41,061   | )          | 16,254         |       | 3                    |       | 24,804           |       | —           |       |
| Provision for doubtful accounts and sales returns                                                             |       | —    |       | 16,961         |       | 414                  |       | —           |       | 17,375           |       |
| Inventory reserves                                                                                            |       | —    |       | 1,703          |       | 454                  |       | —           |       | 2,157            |       |
| Changes in operating assets and liabilities,  net of acquired assets and liabilities:                    |       |      |       |           |       |                 |       |             |       |             |       |
| Accounts receivable                                                                                           |       | —    |       | (12,873        | )          | (2,188               | )          | —           |       | (15,061          | )          |
| Inventories                                                                                                   |       | —    |       | 2,420          |       | (2,471               | )          | (155             | )          | (206             | )          |
| Prepaid expenses, other assets and liabilities                                                                |       | 229       |       | (5,888         | )          | 3,045                |       | (338             | )          | (2,952           | )          |
| Accounts payable and other current liabilities                                                                |       | 9,613     |       | (888           | )          | 642                  |       | 256              |       | 9,623            |       |
| Net cash (used in) provided by  operating activities                                                     |       | (52,155   | )          | 89,727         |       | 4,635                |       | (17,550          | )          | 24,657           |       |
| **INVESTING ACTIVITIES:**                                                                                     |       |      |       |           |       |                 |       |             |       |             |       |
| Acquisition of businesses, net cash acquired                                                                  |       | —    |       | (2,417         | )          | (1,629               | )          | —           |       | (4,046           | )          |
| Acquisition of intangibles                                                                                    |       | —    |       | (53            | )          | —               |       | —           |       | (53              | )          |
| Purchases of property and equipment                                                                           |       | —    |       | (8,785         | )          | (2,854               | )          | 34               |       | (11,605          | )          |
| Proceeds from sale of discontinued operations                                                                 |       | —    |       | 21,846         |       | —               |       | —           |       | 21,846           |       |
| Other, net                                                                                                    |       | —    |       | 422            |       | —               |       | —           |       | 422              |       |
| Net cash (used in) provided by  investing activities                                                     |       | —    |       | 11,013         |       | (4,483               | )          | 34               |       | 6,564            |       |
| **FINANCING ACTIVITIES:**                                                                                     |       |      |       |           |       |                 |       |             |       |             |       |
| Intercompany                                                                                                  |       | 70,819    |       | (87,783        | )          | (552                 | )          | 17,516           |       | —           |       |
| Payments on revolving line of credit                                                                          |       | (73,663   | )          | 23             |       | (356                 | )          | —           |       | (73,996          | )          |
| Proceeds from debt and revolving line of credit                                                               |       | 54,999    |       | (3             | )          | 76                   |       | —           |       | 55,072           |       |
| Net cash (used in) financing activities                                                                       |       | 52,155    |       | (87,763        | )          | (832                 | )          | 17,516           |       | (18,924          | )          |
| Effect of exchange rate changes on cash and cash  equivalents                                                 |       | —    |       | —         |       | (911                 | )          | —           |       | (911             | )          |
| **Net increase (decrease) in cash  and cash equivalents**                                                     |       | —    |       | 12,977         |       | (1,591               | )          | —           |       | 11,386           |       |
| Cash and cash equivalents at beginning of period                                                              |       | —    |       | 14,373         |       | 16,110               |       | —           |       | 30,483           |       |
| Cash and cash equivalents at end of period                                                                    |       | $         | —     |           | $          | 27,350               |       | $                | 14,519     |             | $          | — |   | $ | 41,869 |   |

 

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**DJO Finance LLC**

 

**Unaudited Condensed Consolidating Statements of CashFlows**

**For the SixMonths Ended June 28, 2008**

**(inthousands)**

 
| ** **                                                                                                    | ** ** | **DJOFL** | ** ** | **Guarantors** | ** ** | **Non-  Guarantors** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|---------------------------------------------------------------------------------------------------------------|------------|-----------|------------|----------------|------------|----------------------|------------|------------------|------------|------------------|------------|
| **OPERATING ACTIVITIES:**                                                                                     |       |      |       |           |       |                 |       |             |       |             |       |
| Net Loss                                                                                                      |       | $         | (44,960    | )              | $          | 9,791                |       | $                | 6,631      |             | $          | (15,929 | ) | $ | (44,465 | ) |
| Adjustments to reconcile net income (loss)  to net cash provided by (used in) operating activities: |       |      |       |           |       |                 |       |             |       |             |       |
| Depreciation                                                                                                  |       | —    |       | 9,010          |       | 2,552                |       | (370             | )          | 11,192           |       |
| Amortization of intangibles                                                                                   |       | —    |       | 37,179         |       | 1,077                |       | —           |       | 38,256           |       |
| Amortization of debt issuance costs                                                                           |       | 6,849     |       | —         |       | —               |       | —           |       | 6,849            |       |
| Stock-based compensation                                                                                      |       | —    |       | 1,227          |       | —               |       | —           |       | 1,227            |       |
| Loss on disposal of assets                                                                               |       | —    |       | 977            |       | 247                  |       | (48              | )          | 1,176            |       |
| Deferred income taxes                                                                                         |       | —    |       | (19,551        | )          | (215                 | )          | —           |       | (19,766          | )          |
| Non-cash income from subsidiaries                                                                             |       | (16,026   | )          | —         |       | —               |       | 16,026           |       | —           |       |
| Provision for doubtful accounts and  sales returns                                                       |       | —    |       | 9,697          |       | 343                  |       | —           |       | 10,040           |       |
| Inventory reserves                                                                                            |       | —    |       | 2,481          |       | 246                  |       | —           |       | 2,727            |       |
| Changes in operating assets and liabilities,  net of acquired assets and liabilities:                    |       |      |       |           |       |                 |       |             |       |             |       |
| Accounts receivable                                                                                           |       | —    |       | (18,242        | )          | (9,393               | )          | —           |       | (27,635          | )          |
| Inventories                                                                                                   |       | —    |       | 2,583          |       | 599                  |       | 53               |       | 3,235            |       |
| Prepaid expenses, other assets and liabilities                                                                |       | 9         |       | (1,106         | )          | 2,000                |       | —           |       | 903              |       |
| Accounts payable and other current liabilities                                                                |       | 17,722    |       | (8,531         | )          | 1,887                |       | —           |       | 11,076           |       |
| Net cash (used in) provided by  operating activities                                                     |       | (36,406   | )          | 25,515         |       | 5,974                |       | (268             | )          | (5,185           | )          |
| **INVESTING ACTIVITIES:**                                                                                     |       |      |       |           |       |                 |       |             |       |             |       |
| Acquisition of businesses, net of cash acquired                                                               |       | —    |       | (89            | )          | —               |       | —           |       | (89              | )          |
| Acquisition of intangible assets                                                                              |       | —    |       | (1,060         | )          |                 |       |             |       | (1,060           | )          |
| Purchases of property and equipment                                                                           |       | —    |       | (10,256        | )          | (2,567               | )          | 268              |       | (12,555          | )          |
| Other, net                                                                                                    |       | —    |       | 933            |       | —               |       | —           |       | 933              |       |
| Net cash (used in) provided by investing activities                                                           |       | —    |       | (10,472        | )          | (2,567               | )          | 268              |       | (12,771          | )          |
| **FINANCING ACTIVITIES:**                                                                                     |       |      |       |           |       |                 |       |             |       |             |       |
| Intercompany                                                                                                  |       | 38,550    |       | (32,899        | )          | (5,651               | )          | —           |       | —           |       |
| Proceeds from debt and revolving line of credit                                                               |       | 7,000     |       | —         |       | —               |       | —           |       | 7,000            |       |
| Payments on debt and revolving line of credit                                                                 |       | (9,663    | )          | (140           | )          | (334                 | )          | —           |       | (10,137          | )          |
| Net cash provided by (used in)  financing activities                                                     |       | 35,887    |       | (33,039        | )          | (5,985               | )          | —           |       | (3,137           | )          |
| Effect of exchange rate changes on cash and cash  equivalents                                                 |       | —    |       | —         |       | 1,135                |       | —           |       | 1,135            |       |
| **Net decrease in cash and  cash equivalents**                                                           |       | (519      | )          | (17,996        | )          | (1,443               | )          | —           |       | (19,958          | )          |
| Cash and cash equivalents at beginning of period                                                              |       | 519       |       | 44,694         |       | 18,258               |       | —           |       | 63,471           |       |
| Cash and cash equivalents at end of period                                                                    |       | $         | —     |           | $          | 26,698               |       | $                | 16,815     |             | $          | — |   | $ | 43,513 |   |

 

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**ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTSOF 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 Patterson MedicalSupply, Inc. for approximately $21.0 million plus an additional payment forcertain outstanding liabilities. As such, results of the ETS business forperiods prior to the date of sale, have been presented as discontinuedoperations.

 

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 as defined by SFAS 131.  Prior to2009, we included the international components of the Surgical, Chattanooga,and Empi businesses in either the Surgical or Domestic Rehabilitation segments,as their operations were managed domestically. During the fourth quarter of 2008, we effected an operationalreorganization which resulted in the non-U.S. components of all of ourbusinesses being managed abroad.  As aresult, the segment financial data for the three and six months ended June 27,2009 reflects this new segmentation and the data for the three and six monthsended June 28, 2008, as noted below, has been restated to reflect thischange.  We currently develop,manufacture and distribute our products through the following three operatingsegments:

 

***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 of ourbone growth 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 six months ended June 27,2009 and June 28, 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**        | ** **    | **Six Months Ended**          | ** ** |
|----------------------------------------------------|------------|-------------------------------|---------------|-------------------------------|------------|
| **($ in thousands)**                          | ** ** | **June 27,********2009** | ** **    | **June 28,********2008** | ** ** | **June 27,********2009** | ** ** | **June 28,********2008** | ** ** |
| **Domestic Rehabilitation:**                       |       |                          |          |                          |       |   |   |   |   |   |   |   |   |
| Net sales                                          |       | $                             |  160,095 |                          | $          | 155,889 |   | $ | 306,809 |   | $ |  305,582 |   |
| Gross profit                                       |       | $                             |  106,199 |                          | $          | 99,732 |   | $ | 202,387 |   | $ |  195,478 |   |
| Gross profit margin                                |       | 66.3                          | %             | 64.0                          | %          | 66.0 | % | 64.0 | % |
| Operating income                                   |       | $                             |  45,395  |                          | $          | 32,740 |   | $ | 79,137 |   | $ |  64,033 |   |
| Operating income as a percent of net segment sales |       | 28.4                          | %             | 21.0                          | %          | 25.8 | % | 21.0 | % |
| **International:**                                 |       |                          |          |                          |       |   |   |   |   |   |   |   |   |
| Net sales                                          |       | $                             |  58,639  |                          | $          | 70,165 |   | $ | 114,275 |   | $ |  136,309 |   |
| Gross profit                                       |       | $                             |  34,706  |                          | $          | 43,860 |   | $ | 66,211 |   | $ |  82,057 |   |
| Gross profit margin                                |       | 59.2                          | %             | 62.5                          | %          | 57.9 | % | 60.2 | % |
| Operating income                                   |       | $                             |  12,868  |                          | $          | 18,137 |   | $ | 22,931 |   | $ |  31,564 |   |
| Operating income as a percent of net segment sales |       | 21.9                          | %             | 25.8                          | %          | 20.1 | % | 23.2 | % |
| **Domestic Surgical Implant:**                     |       |                          |          |                          |       |   |   |   |   |   |   |   |   |
| Net sales                                          |       | $                             |  16,378  |                          | $          | 15,298 |   | $ | 31,681 |   | $ |  31,495 |   |
| Gross profit                                       |       | $                             |  12,864  |                          | $          | 12,502 |   | $ | 24,762 |   | $ |  25,976 |   |
| Gross profit margin                                |       | 78.6                          | %             | 81.7                          | %          | 78.2 | % | 82.5 | % |
| Operating income                                   |       | $                             |  3,717   |                          | $          | 3,097 |   | $ | 6,177 |   | $ |  6,216 |   |
| Operating income as a percent of net segment sales |       | 22.7                          | %             | 20.2                          | %          | 19.5 | % | 19.7 | % |

 

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

 

OnFebruary 3, 2009 we acquired DonJoy Orthopaedics Pty., Ltd., an Australiandistributor of DJO products (“DJO Australia”), for a total cash compensation of$3.7 million.  Pursuant to the terms ofthe acquisition agreement and included within the purchase price, is anadditional amount payable to the selling shareholder of DJO Australia ifcertain revenue targets are met by December 31, 2009.  The fair values of the assets acquired andthe liabilities assumed were estimated in accordance with SFAS 141R.

 

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**Results of Operations**

 

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

 
| ** **                                           | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** |       |
|------------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                           | ** ** | **June 27, 2009**      | ** ** | **June 28, 2008**    | ** ** | **June 27, 2009** | ** ** | **June 28, 2008** |   |
| Net sales                                            |       | $                      | 235,112    |                 | 100.0      | % | $ | 241,352 |   | 100.0 | % | $ | 452,765 |   | 100.0 | % | $ | 473,386 |   | 100.0 | % |
| Cost of sales                                        |       | 82,156                 |       | 34.9                 |       | 85,836 |   | 35.6 |   | 161,156 |   | 35.6 |   | 175,300 |   | 37.0 |   |
| Gross profit                                         |       | 152,956                |       | 65.1                 |       | 155,516 |   | 64.4 |   | 291,609 |   | 64.4 |   | 298,086 |   | 63.0 |   |
| Operating  expenses:                                 |       |                   |       |                 |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Selling, general and administrative                  |       | 108,605                |       | 46.2                 |       | 115,027 |   | 47.7 |   | 209,205 |   | 46.2 |   | 223,943 |   | 47.3 |   |
| Research and development                             |       | 6,162                  |       | 2.6                  |       | 7,230 |   | 3.0 |   | 11,965 |   | 2.6 |   | 13,906 |   | 2.9 |   |
| Amortization of acquired intangibles                 |       | 19,171                 |       | 8.2                  |       | 19,140 |   | 7.9 |   | 38,302 |   | 8.5 |   | 38,256 |   | 8.1 |   |
| Operating income                                     |       | 19,018                 |       | 8.1                  |       | 14,119 |   | 5.8 |   | 32,137 |   | 7.1 |   | 21,981 |   | 4.6 |   |
| Other income  (expense):                             |       |                   |       |                 |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest income                                      |       | 202                    |       | 0.1                  |       | 263 |   | 0.1 |   | 538 |   | 0.1 |   | 850 |   | 0.2 |   |
| Interest expense                                     |       | (39,555                | )          | (16.8                | )          | (42,495 | ) | (17.6 | ) | (78,146 | ) | (17.3 | ) | (87,682 | ) | (18.5 | ) |
| Other income (expense), net                          |       | 2,967                  |       | 1.3                  |       | 288 |   | 0.1 |   | 1,587 |   | 0.4 |   | 1,631 |   | 0.3 |   |
| Loss from  continuing operations before income taxes |       | (17,368                | )          | (7.4                 | )          | (27,825 | ) | (11.5 | ) | (43,884 | ) | (9.7 | ) | (63,220 | ) | (13.4 | ) |
| Benefit for income taxes                             |       | (4,995                 | )          | (2.1                 | )          | (6,725 | ) | (2.8 | ) | (16,932 | ) | (3.7 | ) | (17,936 | ) | (3.8 | ) |
| Income (loss) from discontinued operations, net      |       | (577                   | )          | (0.2                 | )          | 597 |   | 0.2 |   | (167 | ) | (0.0 | ) | 819 |   | 0.2 |   |
| Net loss                                             |       | (12,950                | )          | (5.5                 | )          | (20,503 | ) | (8.5 | ) | (27,119 | ) | (6.0 | ) | (44,465 | ) | (9.4 | ) |
| Noncontrolling interests                             |       | 135                    |       | 0.1                  |       | 295 |   | 0.1 |   | 274 |   | 0.1 |   | 495 |   | 0.1 |   |
| Net loss attributable to DJO Finance LLC             |       | $                      | (13,085    | )                    | (5.6       | )% | $ | (20,798 | ) | (8.6 | )% | $ | (27,393 | ) | (6.1 | )% | $ | (44,960 | ) | (9.4 | )% |

 

***Three Months Ended June 27,2009 compared to Three Months Ended June 28, 2008***

 

Net Sales.  Our net sales for thethree months ended June 27, 2009 were $235.1 million, representing adecrease of 2.6% from net sales of $241.4 million for the three months ended June 28,2008.  This decrease was primarily drivenby $8.5 million of unfavorable changes in foreign exchange rates compared torates in effect for the three months ended June 28, 2008.

 

For the three months ended June 27, 2009, we generated 24.9% ofour net sales from customers outside the United States as compared to 29.1% forthe three months ended June 28, 2008. Additionally, sales of new products,which include products that have been on the market less than one year, were$5.5 million for the three months ended June 27, 2009, compared to newproduct sales of $12.0 million for the three months ended June 28, 2008.

 

The following table sets forth the mix of our net sales for the threemonths ended June 27, 2009 compared to the three months ended June 28,2008:

 
| ** **                        | ** ** | **Three Months Ended**  | ** ** | ** **             | ** ** | ** **                    | ** ** |
|-----------------------------------|------------|-------------------------|------------|------------------------|------------|-------------------------------|------------|
| **($ in thousands)**         | ** ** | **June 27,  2009** | ** ** | **% of Net  Revenues** | ** ** | **June 28,********2008** | ** ** | **% of Net  Revenues** | ** ** | **Increase  (Decrease)** | ** ** | **% Increase  (Decrease)** | ** ** |
| Domestic Rehabilitation Segment   |       | $                       | 160,095    |                   | 68.1       | %                             | $          | 155,889 |   | 64.6 | % | $ | 4,206 |   | 2.7 | % |
| International Segment             |       | 58,639                  |       | 24.9                   |       | 70,165                        |       | 29.1 |   | (11,526 | ) | (16.4 | ) |
| Domestic Surgical Implant Segment |       | 16,378                  |       | 7.0                    |       | 15,298                        |       | 6.3 |   | 1,080 |   | 7.1 |   |
| **Consolidated net sales**        |       | $                       | 235,112    |                   | 100.0      | %                             | $          | 241,352 |   | 100.0 | % | $ | (6,240 | ) | (2.6 | )% |

 

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Net sales in our Domestic Rehabilitation Segment were $160.1 millionfor the three months ended June 27, 2009, reflecting an increase of 2.7%over net sales of $155.9 million for the three months ended June 28, 2008.The increase was driven primarily by growth across the majority of our productlines, partially offset by declines in revenues in our Chattanooga business.

 

Net sales in our International Segment for the three months ended June 27,2009 were $58.7 million, reflecting a decrease of 16.4% from net sales of $70.2million for the three months ended June 28, 2008. The decrease was drivenprimarily by $8.5 million of unfavorable changes in foreign exchange ratescompared to rates in effect for the three months ended June 28, 2008 andreduced sales of consumer products and clinical physical therapy equipment.

 

Net sales in our Domestic Surgical Implant Segment increased to $16.4million from $15.3 million for the three months ended June 27, 2009,representing a 7.1% increase over the same period in the prior year. Theincrease was driven primarily by an increase in sales for our shoulder productline.

 

*Gross Profit.*  Consolidated gross profit as a percentage ofnet sales increased to 65.1% for the three months ended June 27, 2009 from64.4% for the three months ended June 28, 2008. The increase in our grossprofit margin is primarily attributable to cost improvement initiativesimplemented in the past year and the benefits of a more favorable mix ofproducts sold, partially offset by unfavorable changes in foreign exchangerates of approximately $6.2 million.

 

Gross profit in our Domestic Rehabilitation Segment as a percentage ofnet sales increased to 66.3% for the three months ended June 27, 2009 from64.0% for the three months ended June 28, 2008. The increase was primarilydriven by cost improvement initiatives and the benefits of a more a favorablemix of products sold.

 

Gross profit in our International Segment as a percentage of net salesdecreased to 59.2% for the three months ended June 27, 2009 from 62.5% forthe three months ended June 28, 2008. The decrease was primarily driven by unfavorable changes in foreignexchange rates of approximately $6.2 million.

 

Gross profit in our Domestic Surgical Implant Segment as a percentageof gross sales decreased to 78.5% for the three months ended June 27, 2009from 81.7% for the three months ended June 28, 2008. The decrease wasprimarily driven by a lower margin mix in products sold and, to a lesserextent, higher inventory obsolescence costs.

 

*Selling, General and Administrative.*  Our selling, general and administrativeexpenses decreased to $108.6 million for the three months ended June 27,2009 from $115.0 million for the three months ended June 28, 2008 due tooverall cost savings initiatives and $5.4 million of lower incremental costs asa result of our integration activities, partially offset by $7.4 million ofcosts related to the implementation of our new global ERP system. The followingtable sets forth certain non-recurring costs associated with our integrationactivities and ERP implementation:

 

| ** **                                 | ** ** | **Three Months Ended**        | ** ** |
|--------------------------------------------|------------|-------------------------------|------------|
| **($ in thousands)**                  | ** ** | **June 27,********2009** | ** ** | **June 28,  2008** | ** ** |
| Employee severance and relocation expenses |       | $                             | 2,144      |   | $ | 5,308 |   |
| Integration expenses                       |       | 5,894                         |       | 8,176 |   |
| ERP implementation                         |       | 7,846                         |       | 399 |   |
|                                       |       | $                             | 15,884     |   | $ | 13,883 |   |

 

Employee severance and relocation for the three months ended June 27,2009 included $1.8 million of severance payments made to employees inconnection with our recent company-wide headcount reduction and $0.3 million ofseverance payments made to employees in connection with integration activitiesfollowing the DJO Merger and restructuring at our international locations.   Employee severance and relocation expensesfor the three months ended June 28, 2008 consisted of $1.9 million ofseverance payments made to employees in connection with the DJO Merger, $0.6million of severance payments made to employees in connection with otheracquisitions and $2.8 million of payments and other expenses in connection withthe termination of one of our executive officers. Integration expense for thethree months ended June 27, 2009 included $1.0 million, $4.0 million, and$0.9 million of integration costs accrued in connection with restructuring atour international locations, the DJO Merger, and the integration of the operations of the Chattanooga siteinto our other existing sites, respectively.  Integration expenses for the three monthsended June 28, 2008 included $7.1 million of integration costs accrued inconnection with the DJO Merger and $1.1 million of integration costs related toother acquisitions.

 

*Research and Development.*  Our research and development expensedecreased to $6.2 million for the three months ended June 27, 2009 from$7.2 million for the three months ended June 28, 2008. As a percentage ofnet sales, research and development expense decreased slightly to 2.6% from3.0% in the three months ended June 28, 2008.

 

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*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 of $19.2 million for the three months ended June 27, 2009 isin line with the three months ended June 28, 2008.

 

*Interest Expense.*  Our interest expense decreased to $39.6million for the three months ended June 27, 2009 from interest expense of$42.5 million for the three months ended June 28, 2008.  The decrease is primarily related to reducedinterest rates.

 

*Other Income (Expense).*  Net other income increased to $3.0 millionfor the three months ended June 27, 2009 from $0.3 million for thethree months ended June 28, 2008. Both amounts primarily reflect net foreign currency transaction gains.

 

*Benefit for Income Taxes.*  For the three months ended June 27,2009, we recorded $5.0 million of income tax benefit on a pre-tax loss of $17.4million.  For the three months ended June 28,2008, we recorded $6.7 million of income tax benefit on a pre-tax loss of$27.8 million.

 

***Six Months Ended June 27, 2009compared to Six Months Ended June 28, 2008***

 

Net Sales.  Our net sales for thesix months ended June 27, 2009 were $452.8 million, representing adecrease of 4.4% from net sales of $473.4 million for the six months ended June 28,2008.  This decrease was primarily drivenby $16.6 million of unfavorable changes in foreign exchange rates compared torates in effect for the six months ended June 28, 2008 and fewer shippingdays as the first half of 2009 had only 124.5 days compared to 127 days in thefirst half of 2008.

 

For the six months ended June 27, 2009, we generated 25.2% of ournet sales from customers outside the United States as compared to 28.8% for thesix months ended June 28, 2008. Additionally, sales of new products, whichinclude products that have been on the market less than one year, were $8.6million for the six months ended June 27, 2009, compared to new productsales of $20.3 million for the six months ended June 28, 2008.

 

The following table sets forth the mix of our net sales for the sixmonths ended June 27, 2009 compared to the six months ended June 28,2008:

 
| ** **                         | ** ** | **Six Months Ended**    | ** ** | ** **             | ** ** | ** **                    | ** ** |
|------------------------------------|------------|-------------------------|------------|------------------------|------------|-------------------------------|------------|
| **($ in thousands)**          | ** ** | **June 27,  2009** | ** ** | **% of Net  Revenues** | ** ** | **June 28,********2008** | ** ** | **% of Net  Revenues** | ** ** | **Increase  (Decrease)** | ** ** | **% Increase  (Decrease)** | ** ** |
| Domestic Rehabilitation Segments   |       | $                       | 306,809    |                   | 67.8       | %                             | $          | 305,582 |   | 64.6 | % | $ | 1,227 |   | 0.4 | % |
| International Segments             |       | 114,275                 |       | 25.2                   |       | 136,309                       |       | 28.8 |   | (22,034 | ) | (16.2 | ) |
| Domestic Surgical Implant Segments |       | 31,681                  |       | 7.0                    |       | 31,495                        |       | 6.6 |   | 186 |   | 0.6 |   |
| **Consolidated net sales**         |       | $                       | 452,765    |                   | 100.0      | %                             | $          | 473,386 |   | 100.0 | % | $ | (20,621 | ) | (4.4 | )% |

 

Net sales in our Domestic Rehabilitation Segment were $306.8 millionfor the six months ended June 27, 2009, reflecting a slight increase of0.4% from net sales of $305.6 million for the six months ended June 28,2008. The increase was driven primarily by second quarter growth across themajority of our product lines, mostly offset by declines in revenues in ourChattanooga business, fewer shipping days as the first half of 2009 had only124.5 days compared to 127 days in the first half of 2008 and a slowdown in certaincustomer purchasing during the first quarter due to the overall global economicdecline.

 

Net sales in our International Segment for the six months ended June 27,2009 were $114.3 million, reflecting a decrease of 16.2% from net sales of$136.3 million for the six months ended June 28, 2008. The decrease wasdriven primarily by $16.6 million of unfavorable changes in foreign exchangerates compared to rates in effect for the six months ended June 28, 2008,reduced sales of consumer products and clinical physical equipment, and fewershipping days as the first half of 2009 had only 124.5 days compared to 127days in the first half of 2008.

 

Net sales in our Domestic Surgical Implant Segment increased slightlyto $31.7 million from $31.5 million for the six months ended June 27,2009, representing a 0.6% increase over the same period in the prior year. Theincrease was driven primarily by an increase in sales for our shoulder productline, mostly offset by fewer shipping days as the first half of 2009 had only124.5 days as compared to 127 days in the first half of 2008, a slight declinein sales for our knee product line, and the overall global economic decline.

 

*Gross Profit.*  Consolidated gross profit as a percentage ofnet sales increased to 64.4% for the six months ended June 27, 2009 from63.0% for the six months ended June 28, 2008. The increase in our grossprofit margin is primarily attributable to cost improvement initiativesimplemented in the past year and the benefits of a more favorable mix of productssold, partially offset by unfavorable changes in foreign exchange rates ofapproximately $12.0 million. Additionally, the increase in gross profit wasdriven by reduced amortization of purchased inventory fair value adjustmentsrelated to prior year acquisitions of $4.7 million.

 

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Gross profit in our Domestic Rehabilitation Segment as a percentage ofnet sales increased to 66.0% for the six months ended June 27, 2009 from64.0% for the six months ended June 28, 2008. The increase was primarilydriven by cost improvements initiatives implemented in the past year, thebenefits of a more favorable mix of products sold, and reduced amortization ofpurchased inventory fair value adjustments related to prior year acquisitionsof $4.7 million.

 

Gross profit in our International Segment as a percentage of net salesdecreased to 57.9% for the six months ended June 27, 2009 from 60.2% forthe six months ended June 28, 2008. The decrease was primarily driven by unfavorable changes in foreignexchange rates of approximately $12.0 million.

 

Gross profit in our Domestic Surgical Implant Segment as a percentageof gross sales decreased to 78.2% for the six months ended June 27, 2009from 82.5% for the six months ended June 28, 2008. The decrease wasprimarily driven by lower margin mix in products sold and higher inventoryobsolescence costs.

 

*Selling, General and Administrative.*  Our selling, general and administrativeexpenses decreased to $209.2 million for the six months ended June 27,2009 from $223.9 million for the six months ended June 28, 2008 due tooverall cost savings initiatives and $10.7 million of lower incremental costsas a result of our integration activities, partially offset by $11.7 million ofcosts related to the implementation of our new global ERP system. The followingtable sets forth certain non-recurring costs associated with our integrationactivities and ERP implementation:

 

| ** **                                 | ** ** | **Six Months Ended**          | ** ** |
|--------------------------------------------|------------|-------------------------------|------------|
| **($ in thousands)**                  | ** ** | **June 27,********2009** | ** ** | **June 28,  2008** | ** ** |
| Employee severance and relocation expenses |       | $                             | 2,803      |   | $ | 6,368 |   |
| Integration expenses                       |       | 14,785                        |       | 15,957 |   |
| Reversal of reimbursement claims           |       | (6,000                        | )          | — |   |
| ERP implementation                         |       | 12,077                        |       | 399 |   |
|                                       |       | $                             | 23,665     |   | $ | 22,724 |   |

 

Employee severance and relocation expenses for the six months ended June 27,2009 included $1.8 million of severance payments made to employees inconnection with our recent company-wide headcount reduction and $1.0 million ofseverance payments made to employees in connection with integration activitiesfollowing the DJO Merger and restructuring at our international locations.  Employee severance and relocation expensesfor the six months ended June 28, 2008 consisted of $2.8 million ofseverance payments made related to the DJO Merger, $0.8 million of severancepayments to employees in connection with other acquisitions and $2.8 million ofpayments and other expenses in connection with the termination of one of ourexecutive officers.  Integration expensefor the six months ended June 27, 2009 included $4.7 million and $9.9million of integration costs accrued in connection with restructuring at ourinternational locations and the DJO Merger, respectively, partially offset by a$6.0 million reversal of an accrual made in 2008 for alleged reimbursementclaims due to the favorable settlement of the dispute.  Integration expenses for the six months endedJune 28, 2008 included $13.0 million and $3.0 million of integration costsaccrued in connection with the DJO Merger and other acquisitions, respectively.

 

*Research and Development.*  Our research and development expensedecreased to $12.0 million for the six months ended June 27, 2009 from$13.9 million for the six months ended June 28, 2008. As a percentageof net sales, research and development expense decreased slightly to 2.6% from2.9% in the six months ended June 28, 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 of $38.3 million for the six months ended June 27, 2009 is inline with the six months ended June 28, 2008.

 

*Interest Expense.*  Our interest expense decreased to $78.1million for the six months ended June 27, 2009 from interest expense of$87.7 million for the six months ended June 28, 2008.  The decrease is primarily related to reducedinterest rates.

 

*Other Income (Expense).*  Net other expense was $1.6 million for boththe six months ended June 27, 2009 and June 28, 2008.  Both amounts primarily reflect net foreigncurrency transaction gains.

 

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*Benefit for Income Taxes.*  For the six months ended June 27, 2009,we recorded $16.9 million of income tax benefit on a pre-tax loss of $43.9million.  For the six months ended June 28,2008, we recorded $17.9 million of income tax benefit on a pre-tax loss of$63.2 million.

 

During the first quarter of 2009, the state of California enacted legislationwhich will allow corporate taxpayers to elect to use a single sales factorapportionment formula to apportion business income to California for tax yearsbeginning on or after January 1, 2011. We anticipate making this electionin fiscal year 2011 and thereafter. In the first quarter of 2009, we recorded atax benefit of $3.8 million related to the enactment of this legislation whichrepresents a reduction in our net deferred tax liabilities due to a lowereffective state tax rate.

 

**Liquidity and Capital Resources**

 

As of June 27, 2009, our primary source of liquidity consisted ofcash and cash equivalents totaling $41.9 million and $92.0 million of availableborrowings under our revolving credit facility, described below. Workingcapital at June 27, 2009 was $178.8 million. We believe that our existingcash, plus the amounts we expect to generate from operations and amountsavailable through our revolving credit facility, will be sufficient to meet ouroperating needs for the next twelve months, including working capitalrequirements, capital expenditures, and debt and interest repaymentobligations. While we currently believe that we will be able to meet all of ourfinancial covenants imposed by our Senior Secured Credit Facility, there is noassurance that we will in fact be able to do so or that, if we do not, we willbe able to obtain from our lenders waivers of default or amendments to theSenior Secured Credit Facility in the future. We and our subsidiaries,affiliates or significant shareholders (including Blackstone and itsaffiliates) may from time to time, in our or their sole discretion, purchase,repay, redeem or retire any of our outstanding debt or equity securities(including any publicly issued debt securities), in privately negotiated oropen market transactions, by tender offer or otherwise.

 

A summary of the changes in our cash and cash equivalents for the sixmonths ended June 27, 2009 and June 28, 2008 is as follows:

 

| ** **                                                    | ** ** | **Six Months Ended**    | ** ** |
|---------------------------------------------------------------|------------|-------------------------|------------|
| ** **                                                    | ** ** | **June 27,  2009** | ** ** | **June 28,  2008** | ** ** |
| Cash provided by (used in) operating activities               |       | $                       | 24,657     |   | $ | (5,185 | ) |
| Cash provided by (used in) investing activities               |       | 6,564                   |       | (12,771 | ) |
| Cash used in financing activities                             |       | (18,924                 | )          | (3,137 | ) |
| Effect of exchange rate changes on cash and cash  equivalents |       | (911                    | )          | 1,135 |   |
| Net increase (decrease) in cash and cash  equivalents         |       | $                       | 11,386     |   | $ | (19,958 | ) |

 

***Cash Flows***

 

Operatingactivities provided cash of $24.7 million for the six months ended June 27,2009 as compared to $5.2 million of cash used for the six months ended June 28,2008. Cash provided by operating activities for the six months ended June 27,2009 primarily reflected our net income after adjustment for non-cash chargesand favorable net change in operating assets and liabilities. Cash used inoperating activities for the six months ended June 28, 2008 primarily reflects our net loss and anegative net change in operating assets and liabilities partially offset byfavorable adjustments for non-cash charges. Cash paid for interest was$61.7 million and $63.5 million for the six months ended June 27, 2009 andJune 28, 2008, respectively.

 

Investing activities provided cash of $6.6 million for the six monthsended June 27, 2009 as compared to $12.8 million of cash used for thesix months ended June 28, 2008, respectively. Cash provided by investingactivities for the six months ended June 27, 2009 primarily consisted of$21.8 million of proceeds from the sales of assets, mainly ETS, partiallyoffset by purchases of property and equipment totaling $11.6 million, including$1.6 million for our new ERP system, and the acquisition of businesses for atotal of $4.0 million, net of cash. Cash used in investing activities for thesix months ended June 28, 2008 was primarily used for purchases ofproperty and equipment amounting to $12.6 million, including approximately $3.0million for the purchase of our new global ERP system.

 

Financing activities used $18.9 million and $3.1 million of cash forthe six months ended June 27, 2009 and June 28, 2008, respectively.Cash used in financing activities for the six months ended June 27, 2009and the six months ended June 28, 2008 represented net payments onlong-term debt and revolving lines of credit.

 

For the remainder of 2009, we expect to spend total cash ofapproximately $108.5 million for the following:

 

· approximately$46.7 million for scheduled principal and estimated interest payments on oursenior secured credit facility;

 

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

 

· approximately$18.8 million for capital expenditures, including $3.5 million for our ERPsystem.

 

Inaddition, we expect to spend up to an additional $24.1 million implementing our new ERP system capitalproject over approximately the next 18 months.

 

***Indebtedness***

 

As of June 27, 2009, we had approximately $1,825.5 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 of the Senior Secured CreditFacility at a 1.2% discount, resulting in net proceeds of$1,052.4 million. In addition, we are permitted, subject to receipt ofadditional commitments from participating lenders and certain other conditions,to incur up to an additional $150.0 million of borrowings under the SeniorSecured 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 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 13).  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 June 27, 2009, the remaining notional amount of the swap was $450.0million. In February 2009, we entered into two additional non-amortizinginterest rate swap agreements. The first is for a notional amount of $550.0million at a fixed LIBOR rate of 1.04% beginning February 2009 through December 2009.The second is for a notional amount of $750.0 million at a fixed LIBOR rate of1.88% beginning January 2010 through December 2010. As of June 27,2009, our weighted average interest rate for all borrowings under the Senior SecuredCredit Facility is 3.7%.

 

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 unutilized commitmentsthereunder. The initial commitment fee rate is 0.50% per annum. The commitmentfee rate may be reduced subject to us attaining certain leverage ratios. Wemust 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;

 

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·                  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 make distributions;

 

·                  amend material agreementsgoverning our subordinated indebtedness; and

 

·                  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 June 27, 2009, we were requiredto maintain a senior leverage ratio not to exceed 4.50:1. At June 27, 2009our senior leverage ratio was 4.16:1.

 

*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 June 27, 2009, measured on that date, was 1.61:1. Notwithstandingthese limitations, the aggregate amount of term loan increases and revolvingcommitment 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 4.0:1. 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.

 

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*Covenant Compliance*

 

The following is a summary of our covenantrequirements and pro forma ratios as of June 27, 2009:

 

| ** **                                                                                                       | ** ** | **Covenant  Requirements** | ** ** | **Actual  Ratios** | ** ** |
|------------------------------------------------------------------------------------------------------------------|------------|----------------------------|------------|--------------------|------------|
| **Senior Secured Credit Facility**                                                                               |       |                       |       |               |       |
| Maximum ratio of consolidated net senior secured  debt to Adjusted EBITDA                                        |       | 4.50:1                     |       | 4.16:1             |       |
| **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                     |       | 1.61:1             |       |

 

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, loss from discontinued operations, plus interest expense, net, provision (benefit) for income taxes anddepreciation and amortization, further adjusted for non-cash items,non-recurring items and other adjustment items permitted in calculatingcovenant compliance under our Senior Secured Credit Facility and Indentures. Webelieve that the presentation of Adjusted EBITDA is appropriate to provideadditional information to investors about the calculation of, and compliancewith, certain financial covenants in our Senior Secured Credit Facility and theIndentures. Adjusted EBITDA is a material component of these covenants.

 

Adjusted EBITDA should not be considered as an alternative to netincome or other performance measures presented in accordance with GAAP, or asan alternative to cash flow from operations as a measure of our liquidity.Adjusted EBITDA does not represent net loss or cash flow from operations asthose terms are defined by GAAP and does not necessarily indicate whether cashflows will be sufficient to fund cash needs. In particular, the definition ofAdjusted EBITDA in the Indentures and our Senior Secured Credit Facility allowsus to add back certain non-cash, extraordinary, unusual or non-recurringcharges that are deducted in calculating net loss. However, these are 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.

 

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The following table provides a reconciliation from our net loss toAdjusted EBITDA for the three and twelve months ended June 27, 2009. Theterms and related calculations are defined in the credit agreement relating toour Senior Secured Credit Facility and the Indentures.

 
| **(in thousands)**                                                                           | ** ** | **Three Months  Ended  June 27, 2009** | ** ** | **Twelve Months  Ended  June 27, 2009** | ** ** |
|----------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                                                                   | ** ** | **(unaudited)**                             | ** ** |
| Net loss attributable to DJO Finance LLC                                                     |       | $                                           | (13,085    | )                                            | $          | (80,219 | ) |
| Loss from discontinued operations, net                                                       |       | 577                                         |       | 39                                           |       |
| Interest expense, net                                                                        |       | 39,353                                      |       | 162,276                                      |       |
| Income tax benefit                                                                           |       | (4,995                                      | )          | (48,677                                      | )          |
| Depreciation and amortization                                                                |       | 26,076                                      |       | 124,309                                      |       |
| Non-cash items (a)                                                                           |       | 924                                         |       | 1,676                                        |       |
| Non-recurring items (b)                                                                      |       | 15,884                                      |       | 45,275                                       |       |
| Other adjustment items, before cost savings (c)                                              |       | (1,033                                      | )          | 17,315                                       |       |
| Other adjustment items—future cost savings  applicable for twelve month period only (d) |       | NA                                          |       | 20,584                                       |       |
| Adjusted EBITDA                                                                              |       | $                                           | 63,701     |                                         | $          | 242,578 |   |

 

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

 
| **(in thousands)**         | ** ** | **Three Months  Ended  June 27, 2009** | ** ** | **Twelve Months  Ended  June 27, 2009** | ** ** |
|----------------------------|------------|---------------------------------------------|------------|----------------------------------------------|------------|
| ** **                 | ** ** | **(unaudited)**                             | ** ** |
| Stock compensation expense |       | $                                           | 857        |                                         | $          | 1,581 |   |
| Loss on disposal of assets |       | 67                                          |       | 95                                           |       |
| Total non-cash items       |       | $                                           | 924        |                                         | $          | 1,676 |   |

 

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

 
| **(in thousands)**                    | ** ** | **Three Months  Ended  June 27, 2009** | ** ** | **Twelve Months  Ended  June 27, 2009** | ** ** |
|---------------------------------------|------------|--------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                            | ** ** | **(unaudited)**                                  | ** ** |
| Employee severance and relocation (1) |       | $                                                | 2,144      |                                              | $          | 7,672 |   |
| Integration expense (2)               |       | 5,894                                            |       | 20,678                                            |       |
| ERP implementation                    |       | 7,846                                            |       | 16,925                                            |       |
| Total non-recurring items             |       | $                                                | 15,884     |                                              | $          | 45,275 |   |

 

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(1)          Employee severance and relocation for the threemonths ended June 27, 2009 included $1.8 million of severance paymentsmade to employees in connection with our recent company-wide headcountreduction and $0.3 million of severance payments made to employees inconnection with integration activities following the DJO Merger andrestructuring at our international locations.  Employee severance and relocation for the twelve months ended June 27,2009 included $1.8 million of severance payments made to employees inconnection with our recent company-wide headcount reduction and $5.9 million ofemployee severance incurred in connection with the DJO Merger, certain otheracquisitions, and restructuring at our international locations.

 

(2)          Integration expense for thethree months ended June 27, 2009 included $1.0 million, $4.0 million, and$0.9 million of integration costs accrued in connection with restructuring atour international locations, the DJO Merger, and the integration of the operations of the Chattanooga siteinto our other existing sites, respectively.  Integration expense for the twelve monthsended June 27, 2009 included $19.5 million, $4.6 million, and $2.5 millionof integration costs accrued in connection with the DJO Merger, restructuringat our international locations and certain other smaller acquisitions,respectively, partially offset by a $6.0 million reversal of an accrual made in2008 for alleged reimbursement claims due to the favorable settlement of thedispute.

 

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(c)           Other adjustment items, before futurecost savings, are comprised of the following:

 
| **(in thousands)**                                                      | ** ** | **Three Months  Ended  June 27, 2009** | ** ** | **Twelve Months  Ended  June 27, 2009** | ** ** |
|-------------------------------------------------------------------------|------------|--------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                              | ** ** | **(unaudited)**                                  | ** ** |
| Blackstone monitoring fee                                               |       | $                                                | 1,749      |                                              | $          | 7,000 |   |
| Noncontrolling interest                                                 |       | 134                                              |       | 827                                               |       |
| Pre-acquisition EBITDA-applicable for the twelve  month period only (1) |       | NA                                               |       | 859                                               |       |
| Other (2)                                                               |       | (2,916                                           | )          | 8,629                                             |       |
| Total other adjustment items, before cost savings                       |       | $                                                | (1,033     | )                                                 | $          | 17,315 |   |

 

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(1)          Represents pre-acquisition adjusted EBITDA forAustralia subsidiary acquired in February 2009.

 

(2)          Other adjustment items for the three months ended June 27,2009 included net foreign currency transaction (gains) losses.  Other adjustment items for the twelve monthsended June 27, 2009 included foreign currency transaction losses of $9.2million partially offset by a favorable $1.1 million settlement of a litigationcontingency.

 

(d)                                 Includesprojected cost savings related to headcount reductions, facilitiesconsolidation and production efficiencies in connection with the DJO Merger.

 

**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 the UnitedStates. The preparation of these financial statements requires us to makeestimates 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 with establishingthese 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 six months ended June 27, 2009 and June 28,2008, 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 75% of ournet revenues for the six months ended June 27, 2009 and June 28,2008, respectively, and approximately 44% and 69% of our net accountsreceivable for the six months ended June 27, 2009 and June 28, 2008,respectively. We experienced write-offs of less than 1% of related net revenuesfor the six months ended June 27, 2009 and June 28, 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 

 

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customersof our Domestic Rehabilitation Segment. Our third-party payor customersrepresented approximately 33% and 25% of our net revenues for the six monthsended June 27, 2009 and June 28, 2008, respectively, andapproximately 56% and 31% of our net accounts receivable for the six monthsended June 27, 2009 and June 28, 2008, respectively. For the sixmonths ended June 27, 2009 and June 28, 2008, we estimate bad debtexpense to be approximately 7% and 5%, respectively, of gross revenues fromthese third party reimbursement customers. If the financial condition of ourcustomers were to deteriorate resulting in an impairment of their ability tomake payments or if third party payors were to deny claims for late filings,incomplete information or other reasons, additional provisions may be required.Additions to this reserve are reflected as selling, general and administrativeexpense.

 

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 the device becredited toward the purchase price. These credits are processed at the time thepayment is received for the purchase of the device, which creates a time lagbetween billing for a sale and processing the rental credit. Our rental creditreserve estimates unprocessed rental credits based on the number of devicesconverted to purchase. The reserve is calculated by first assessing the numberof our products being rented during the relevant period and our historicalconversion rate of rentals to sales, and then reducing our revenue by theapplicable amount. We provide for these reserves by reducing our gross revenue.The cost to refurbish rented products is expensed as incurred as part of costof 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.As this 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 SFAS No. 142, “Goodwill and Other IntangibleAssets” (SFAS 142”), we do not amortize goodwill. In lieu of amortization, weare required to perform an annual review for impairment. Goodwill is recordedas the difference, if any, between the aggregate consideration paid for anacquisition and the fair value of the net tangible and intangible assetsacquired. The amounts and useful lives assigned to intangible assets acquired,other than goodwill, impact the amount and timing of future amortization, andthe amount assigned to in-process research and development which is expensedimmediately. The value of our intangible assets, including goodwill, could beimpacted by future adverse changes such as: (i) any future declines in ouroperating results, (ii) a further decline in the valuation of comparablecompany stocks, (iii) a further significant slowdown in the worldwideeconomy or our industry or (iv) any failure to meet the performanceprojections included in our forecasts of future operating results. We estimatedthe fair values of our reporting units primarily using the income approachvaluation methodology that includes the discounted cash flow method, taking intoconsideration the market approach and certain market multiples as a validationof the values derived using the discounted cash flow methodology. Thediscounted cash flows for each reporting unit were based on discrete financialforecasts developed by management for planning purposes. Cash flows beyond thediscrete forecasts were estimated using a terminal value calculation, whichincorporated historical and forecasted financial trends for each identifiedreporting unit and considered long-term earnings growth rates for publiclytraded peer companies. Future cash flows were discounted to present value byincorporating the present value techniques discussed in FASB Concepts Statement7, “Using Cash Flow Information andPresent Value in Accounting Measurements,” or Concepts Statement 7.Specifically, the income approach valuations included reporting unit cash flowdiscount rates ranging from 10.8% to 11.6% and terminal value growth rates of3%. Publicly available information 

 

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regardingthe market capitalization was also considered in assessing the reasonablenessof the cumulative fair values of our reporting units estimated using thediscounted cash flow methodology. Significant management judgment is required in the forecasts of futureoperating results that are used in the discounted cash flow method ofvaluation. The estimates we have used are consistent with the plans andestimates that we use to manage our business. It is possible, however, that theplans may change and estimates used may prove to be inaccurate. If our actualresults, or the plans and estimates used in future impairment analyses, arelower than the original estimates used to assess the recoverability of theseassets, we could incur significant impairment 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 SFAS142 in June 2009.  Our June 2009impairment test did not indicate any impairment.

 

Furthermore, SFAS 142 states that intangibleassets with indefinite lives should be tested annually in lieu of beingamortized.  This testwork compares thefair value of the intangible with its carrying amount.  To determine the fair value we applied therelief 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.

 

***Deferred Tax Asset ValuationAllowance***

 

We recognize deferred tax assets and liabilities based on thedifferences between the financial statement carrying amount and the tax basesof assets, liabilities and net operating loss carryforwards. We establishvaluation allowances when the recovery of a deferred tax asset is not likelybased on historical 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 $180.0 millionat June 27, 2009 and primarily related to reserves for accounts receivableand inventory, accrued expenses, and net operating loss carryforwards (seeNote 11 to our unaudited condensed consolidated financial statements). Asof June 27, 2009, we maintained a valuation allowance of $7.2 million dueto uncertainties related to our ability to realize certain net operating losscarryforwards acquired in connection with prior 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 June 27, 2009, we had $1,051.7million 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 $450.0 million as of June 27, 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 June 27, 2009). The second is fora notional amount of $750.0 million at a fixed LIBOR rate of 1.88% beginning January 2010amortizing through December 2010. The fair value of our interest rate swapagreement recorded in the accompanying condensed consolidated balance sheets asof June 27, 2009 and December 31, 2008 was a loss of approximately$17.8 million and $13.3 million, respectively, and is recorded in othercurrent and non-current liabilities. A hypothetical 1% increase in variableinterest rates for the remaining portion of the Senior Secured Credit Facilitynot covered by the swaps would have impacted our earnings and cash flow, forthe six months ended June 27, 2009, by approximately $0.3 million. Oursenior notes of approximately $775.0 million consisted of fixed rate notesat June 27, 2009. We may use additional derivative financial instrumentswhere appropriate to manage our interest rate risk. However, as a matter ofpolicy, we do not enter into derivative or other financial investments fortrading or speculative purposes.

 

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***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 six months ended June 27,2009, our average monthly sales denominated in foreign currencies wasapproximately $10.4 million and $26.4 million, respectively, of which $9.5million and $22.8 million, respectively, was derived from Euro denominatedsales. In addition, our exposure to fluctuations in foreign currencies arisesbecause certain of our subsidiaries enter into purchase or sale transactionsusing a currency other than its functional currency. Our Mexico-basedmanufacturing operations incur costs that are largely denominated in MexicanPesos. Accordingly, our future results could be materially impacted by changesin foreign exchange rates or other factors. Occasionally, we seek to reduce thepotential impact of currency fluctuations on our business through hedgingtransactions. At June 27, 2009, we had 34 foreign exchange forwardcontracts, with a notional amount of $12.9 million and an aggregate fair marketvalue of approximately $12.6 million. These contracts expire weekly throughoutthe fiscal year 2009.  For the three andsix months ended June 27, 2009, we recognized a loss in the statement ofoperations on Mexico Peso forward contracts of approximately $0.4 million and$3.4 million, respectively.  For thethree and six months ended June 28, 2008, we recognized a gain in thestatement of operations on Mexico Peso forward contracts of approximately $0.4million and $0.8 million, respectively.

 

**ITEM 4T. CONTROLS AND PROCEDURES**

 

***Disclosure Controls and Procedures***

 

We maintain disclosure controls and procedures (as the term is defined inRules 13a-15(e) and 15d-15(e) under the Securities Exchange Actof 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 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 45 product liabilitycases related to 

 

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adisposable 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, the manufacturers ofthe anesthetics used in these pumps, and the healthcare professionals involvedin providing the pumps to their patients. All of these lawsuits allege that theuse of these pumps with certain anesthetics in certain shoulder surgeries overprolonged periods have resulted in cartilage damage to the plaintiffs. We have soughtindemnity and tendered the defense of these cases to the two manufacturers whosupplied these pumps to us, to their products liability carrier and to ourproduct liability carrier. The product liability carrier for both of the twomanufacturers has accepted coverage for our defense of these claims, but we arestill seeking confirmation from the two manufacturers that they will indemnifyus under the respective distribution agreements in the event that the coverageunder their respective insurance policies is insufficient.  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 began providinga defense. The lawsuits allege damages ranging from unspecified amounts toclaims between $1.0 million and $10.0 million. These cases are invarying 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 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 aggregatedeductible of $1.0 million for all product liability claims. We believe ourcurrent product liability insurance coverage is adequate. However, if a productliability claim or series of claims is brought against us for uninsuredliabilities or in excess of our insurance coverage, our business could suffermaterially. In addition, in certain instances, a product liability claim couldalso result in our having to recall some of our products, which could result insignificant costs to us. As of June 27, 2009 and December 31, 2008,we have accrued approximately $1.9 million and $1.8 million, respectively,for product liability claims expenses based upon previous claim experience inpart due to the fact that in 2003 we exceeded the coverage limits in effect atthat time for certain historical product liability claims involving one of ourdiscontinued Surgical implant products and such products are excluded fromcoverage 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.

 

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 as defendants us and 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.

 

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**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. There have been no material changes to the risk factors disclosed in suchForm 10-K.

 

**ITEM 6. EXHIBITS**

 

(a)*                   **Exhibits*

 
| 2.1+  |   | Asset  Purchase Agreement, dated June 12, 2009, by and between Patterson Medical  Supply, Inc. and Empi, Inc.                                                                                   |
|-------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 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:  July 31, 2009 | By:                      | /s/  LESLIE H. CROSS |
|                      |                     | Leslie  H. Cross*President, Chief Executive Officer and Director*(Authorized Signatory) |
|                      |                     |   |
| Date:  July 31, 2009 | By:                      | /s/  VICKIE L. CAPPS |
|                      |                     | Vickie  L. Capps*Executive Vice President, Chief Financial  Officer and Treasurer*(Authorized Signatory) |

 

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