Table of Contents

 

 

 

**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 thequarterly period ended April 3, 2010**

 

**or**

 

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

 

**For thetransition periodfrom              to              .**

 

**Commissionfile number 333-142188**

 

**DJO Finance LLC**

(Exact name of Registrant asspecified in its charter)

 

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

 

Registrant’s telephonenumber, including area code: **(800) 336-5690**

 

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

 

Indicate by check markwhether the registrant has submitted electronically and posted on its corporateWeb site, if any, every Interactive Data File required to be submitted andposted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter)during the preceding 12 months (or for such shorter period that the registrantwas required to submit and post such files). Yes o  No o

 

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

 

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

 

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

 

As of May 12, 2010, 100% of the issuer’s membership interests wereowned by DJO Holdings LLC.

 

 

 

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**DJO FINANCE LLC**

**FORM 10-Q**

**TABLE OF CONTENTS**

 
| ** **    | ** **                                                                                                                        | **Page  No.** |
|---------------|-----------------------------------------------------------------------------------------------------------------------------------|---------------|
| ** **    | **PART I—Financial Information**                                                                                        |          |
| Item 1.  | Condensed  Consolidated Balance Sheets as of April 3, 2010 (Unaudited) and  December 31, 2009                           | 3             |
|          | Unaudited  Condensed Consolidated Statements of Operations for the three months ended  April 3, 2010 and March 28, 2009 | 4             |
|          | Unaudited  Condensed Consolidated Statements of Cash Flows for the three months ended  April 3, 2010 and March 28, 2009 | 5             |
|          | Notes to Unaudited Condensed Consolidated Financial  Statements                                                                   | 6             |
| Item 2.  | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                       | 26            |
| Item 3.  | Quantitative  and Qualitative Disclosures About Market Risk                                                                       | 37            |
| Item 4.  | Controls and  Procedures                                                                                                          | 38            |
| ** **    | **PART II—Other  Information**                                                                                          |          |
| Item 1.  | Legal Proceedings                                                                                                                 | 39            |
| Item 1A. | Risk Factors                                                                                                                      | 40            |
| Item 5.       | Other Information                                                                                                                 | 40            |
| Item 6.  | Exhibits                                                                                                                          | 41            |
| SIGNATURES    |                                                                                                                              | 42            |

 

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**PART I.FINANCIAL INFORMATION**

 

**ITEM 1.FINANCIAL STATEMENTS**

 

**DJOFinance LLC**

 

**Unaudited Condensed Consolidated Balance Sheets**

 

**(inthousands)**

 
| ** **                                                 | ** ** | **April 3,  2010** | ** ** | **December 31,  2009** | ** ** |
|------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| **Assets**                                                 |       |                    |       |                        |       |
| Current assets:                                            |       |                    |       |                        |       |
| Cash and cash equivalents                                  |       | $                       | 54,039     |                        | $          | 44,611 |   |
| Accounts receivable, net                                   |       | 151,245                 |       | 146,212                     |       |
| Inventories, net                                           |       | 94,600                  |       | 95,880                      |       |
| Deferred tax assets, net                                   |       | 39,490                  |       | 40,448                      |       |
| Prepaid expenses and other current assets                  |       | 26,003                  |       | 14,725                      |       |
| Total current assets                                       |       | 365,377                 |       | 341,876                     |       |
| Property and equipment, net                                |       | 81,522                  |       | 86,714                      |       |
| Goodwill                                                   |       | 1,188,736               |       | 1,191,497                   |       |
| Intangible assets, net                                     |       | 1,167,882               |       | 1,187,677                   |       |
| Other non-current assets                                   |       | 40,714                  |       | 42,415                      |       |
| Total assets                                               |       | $                       | 2,844,231  |                        | $          | 2,850,179 |   |
|                                                       |       |                    |       |                        |       |
| **Liabilities and Membership  Equity**                     |       |                    |       |                        |       |
| Current liabilities:                                       |       |                    |       |                        |       |
| Accounts payable                                           |       | $                       | 47,406     |                        | $          | 42,144 |   |
| Accrued interest                                           |       | 36,981                  |       | 10,968                      |       |
| Long-term debt and capital leases, current portion         |       | 12,628                  |       | 15,926                      |       |
| Other current liabilities                                  |       | 83,888                  |       | 90,608                      |       |
| Total current liabilities                                  |       | 180,903                 |       | 159,646                     |       |
| Long-term debt and capital leases, net of current  portion |       | 1,800,172               |       | 1,796,944                   |       |
| Deferred tax liabilities, net                              |       | 329,928                 |       | 321,131                     |       |
| Other non-current liabilities                              |       | 16,041                  |       | 14,089                      |       |
| Total liabilities                                          |       | 2,327,044               |       | 2,291,810                   |       |
|                                                       |       |                    |       |                        |       |
| Commitments and contingencies                              |       |                    |       |                        |       |
|                                                       |       |                    |       |                        |       |
| Membership equity:                                         |       |                    |       |                        |       |
| Paid-in capital                                            |       | 828,112                 |       | 827,617                     |       |
| Accumulated deficit                                        |       | (305,933                | )          | (272,275                    | )          |
| Accumulated other comprehensive income (loss)              |       | (7,170                  | )          | 518                         |       |
| DJO Finance LLC membership equity                          |       | 515,009                 |       | 555,860                     |       |
| Noncontrolling interests                                   |       | 2,178                   |       | 2,509                       |       |
| Total membership equity                                    |       | 517,187                 |       | 558,369                     |       |
| Total liabilities and membership equity                    |       | $                       | 2,844,231  |                        | $          | 2,850,179 |   |

 

See accompanying notes tounaudited condensed consolidated financial statements.

 

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**DJO Finance LLC**

 

**Unaudited Condensed Consolidated Statements ofOperations**

 

**(in thousands)**

 
| ** **                                                                                                                                                                      | ** ** | **Three  Months Ended** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|
| ** **                                                                                                                                                                      | ** ** | **April 3,  2010** | ** ** | **March 28,  2009** | ** ** |
| Net sales                                                                                                                                                                       |       | $                       | 240,076    |   | $ | 217,653 |   |
| Cost of sales (exclusive of amortization of $8.9  million and $9.5 million for the three months ended April 3, 2010 and  March 28, 2009 respectively, included below) |       | 87,354                  |       | 79,000 |   |
| Gross profit                                                                                                                                                                    |       | 152,722                 |       | 138,653 |   |
| Operating expenses:                                                                                                                                                             |       |                    |       |   |   |
| Selling, general and administrative                                                                                                                                             |       | 110,526                 |       | 100,600 |   |
| Research and development                                                                                                                                                        |       | 5,571                   |       | 5,803 |   |
| Amortization of acquired intangibles                                                                                                                                            |       | 19,054                  |       | 19,131 |   |
| Operating income                                                                                                                                                                |       | 17,571                  |       | 13,119 |   |
| Other income (expense):                                                                                                                                                         |       |                    |       |   |   |
| Interest income                                                                                                                                                                 |       | 353                     |       | 336 |   |
| Interest expense                                                                                                                                                                |       | (40,712                 | )          | (38,591 | ) |
| Other expense, net                                                                                                                                                              |       | (780                    | )          | (1,380 | ) |
| Loss from continuing operations before income taxes                                                                                                                             |       | (23,568                 | )          | (26,516 | ) |
| Provision (benefit) for income taxes                                                                                                                                            |       | 9,768                   |       | (11,937 | ) |
| Loss from continuing operations                                                                                                                                                 |       | (33,336                 | )          | (14,579 | ) |
| Income from discontinued operations, net of tax                                                                                                                                 |       | —                  |       | 410 |   |
| Net loss                                                                                                                                                                        |       | (33,336                 | )          | (14,169 | ) |
| Less: Net income attributable to noncontrolling  interests                                                                                                                      |       | 322                     |       | 139 |   |
| Net loss attributable to DJO Finance LLC                                                                                                                                        |       | $                       | (33,658    | ) | $ | (14,308 | ) |

 

See accompanying notes tounaudited condensed consolidated financial statements.

 

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**DJO Finance LLC**

 

**Unaudited Condensed Consolidated Statements of CashFlows**

 

**(in thousands)**

 
| ** **                                                                                                       | ** ** | **Three Months Ended**  | ** ** |
|------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|
| ** **                                                                                                       | ** ** | **April 3,  2010** | ** ** | **March 28,  2009** | ** ** |
| **OPERATING ACTIVITIES:**                                                                                        |       |                    |       |   |   |
| Net loss                                                                                                         |       | $                       | (33,336    | ) | $ | (14,169 | ) |
| Adjustments to reconcile  net loss to net cash provided by operating activities:                                 |       |                    |       |   |   |
| Depreciation                                                                                                     |       | 6,795                   |       | 6,035 |   |
| Amortization of intangibles                                                                                      |       | 19,054                  |       | 19,131 |   |
| Amortization of debt  issuance costs                                                                             |       | 5,313                   |       | 3,256 |   |
| Stock-based compensation                                                                                         |       | 495                     |       | 569 |   |
| Loss on disposal of assets                                                                                       |       | 494                     |       | 157 |   |
| Deferred income taxes                                                                                            |       | 8,736                   |       | (12,135 | ) |
| Provision for doubtful  accounts and sales returns                                                               |       | 8,957                   |       | 9,220 |   |
| Inventory reserves                                                                                               |       | 1,727                   |       | 960 |   |
| Changes in operating assets  and liabilities, net of acquired assets and liabilities:                            |       |                    |       |   |   |
| Accounts receivable                                                                                              |       | (14,515                 | )          | (10,907 | ) |
| Inventories                                                                                                      |       | (905                    | )          | (260 | ) |
| Prepaid expenses, other  assets and liabilities                                                                  |       | (11,582                 | )          | (4,141 | ) |
| Accrued interest                                                                                                 |       | 26,013                  |       | 31,683 |   |
| Accounts payable and other  current liabilities                                                                  |       | 2,614                   |       | (11,791 | ) |
| Net cash provided by  operating activities                                                                       |       | 19,860                  |       | 17,608 |   |
| **INVESTING ACTIVITIES:**                                                                                        |       |                    |       |   |   |
| Acquisition of businesses,  net of cash acquired                                                                 |       | (810                    | )          | (3,929 | ) |
| Purchases of property and  equipment                                                                             |       | (4,111                  | )          | (8,159 | ) |
| Other, net                                                                                                       |       | (524                    | )          | 175 |   |
| Net cash used in investing activities                                                                            |       | (5,445                  | )          | (11,913 | ) |
| **FINANCING ACTIVITIES:**                                                                                        |       |                    |       |   |   |
| Proceeds from long-term debt and revolving line of  credit                                                       |       | 105,130                 |       | — |   |
| Payments on long-term debt and revolving line of  credit                                                         |       | (106,411                | )          | (4,095 | ) |
| Payment of debt issuance costs                                                                                   |       | (3,097                  | )          | — |   |
| Dividend paid to noncontrolling interests                                                                        |       | (529                    | )          | — |   |
| Net cash used in  financing activities                                                                           |       | (4,907                  | )          | (4,095 | ) |
| Effect of exchange rate changes on cash and cash  equivalents                                                    |       | (80                     | )          | (1,339 | ) |
| **Net increase in cash and cash  equivalents**                                                                   |       | 9,428                   |       | 261 |   |
| Cash and cash equivalents at beginning of period                                                                 |       | 44,611                  |       | 30,483 |   |
| **Cash and cash equivalents at  end of period**                                                                  |       | $                       | 54,039     |   | $ | 30,744 |   |
| **Supplemental disclosures of  cash flow information:**                                                          |       |                    |       |   |   |
| Cash paid for interest                                                                                           |       | $                       | 11,331     |   | $ | 3,584 |   |
| Cash paid (received) for income taxes (refunds)                                                                  |       | $                       | 1,602      |   | $ | (673 | ) |
| **Non-cash investing and  financing activities:**                                                                |       |                    |       |   |   |
| Increases in property and equipment and in other  liabilities in connection with capitalized software costs |       | $                       | 2,275      |   | $ | 2,894 |   |

 

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-qualityorthopedic 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, primary care physicians, pain managementspecialists, physical therapists, podiatrists, chiropractors, athletic trainersand other healthcare professionals to treat patients with musculoskeletalconditions resulting from degenerative diseases, deformities, traumatic eventsand sports-related injuries. In addition, many of our non-surgical medicaldevices and related accessories are used by athletes and patients for injuryprevention and at-home physical therapy treatment.

 

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. OurInternational segment offers all of our products to customers outside theUnited States.

 

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

 

On June 12, 2009 we sold our Empi Therapy Solutions(“ETS”) catalog business, formerly known as Rehab Medical Equipment, or RME, toPatterson Medical Supply, Inc. for approximately $21.8 million. As such,results of the ETS business for periods prior to the date of sale have beenpresented as discontinued operations in our consolidated financial statementsand the accompanying notes.

 

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 April 3, 2010 and for the three months ended April 3, 2010 and March 28,2009 have been prepared in accordance with accounting principles generallyaccepted in the United States for interim financial information. Accordingly,they do not include all of the information and disclosures required byaccounting principles generally accepted in the United States for completefinancial statements. These consolidated financial statements should be read inconjunction with the audited consolidated financial statements of the Companyand the notes thereto included in the Company’s Annual Report on Form 10-Kfor the year ended December 31, 2009. The accompanying unaudited condensedconsolidated financial statements as of April 3, 2010 and for the threemonths ended April 3, 2010 and March 28, 2009 have been prepared onthe same basis as the audited consolidated financial statements and include alladjustments consisting of normal recurring accruals which, in the opinion ofmanagement, are necessary for a fair presentation of the financial position,operating results and cash flows for the interim date and interim periodspresented. Results for the interim periods are not necessarily indicative ofthe results to be achieved for the entire year or future periods.

 

**Use of Estimates.**  The preparation of financial statements in conformitywith accounting principles generally accepted in the United States of Americarequires management to make certain estimates and assumptions that affect thereported amounts of assets and liabilities, the disclosure of contingent assetsand 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 ASC Topic 350 (formerly American Institute of Certified Public AccountantsStatement of Position (“SOP”) 98-1, “Accounting for  the Costs of Computer software Developed orObtained for Internal Use”), we capitalize costs of internally developedsoftware during the development stage. Additionally, we capitalize related costs including external consultingcosts, cost of software licenses, and internal payroll and payroll-relatedcosts for employees who are directly associated with a software project.  Software assets are reviewed for impairmentwhen events or circumstances indicate that the carrying value may not berecoverable over the remaining lives of the assets. Upgrades and enhancementsare capitalized if they result in added functionality.  In 2008, we began implementing a new ERPsystem resulting in approximately $14.2 million of capitalized software costsas of April 3, 2010. We will begin amortizing capitalized software uponimplementation of the new ERP system.

 

**Derivative Financial Instruments.**  We account for derivatives pursuant to ASCTopic 815 (formerly SFAS No. 133, “Accounting for Derivative Instrumentsand Hedging”), which requires that all derivative instruments be recognized inthe financial statements and measured at fair value regardless of the purposeor 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 are evaluated.  While our foreign exchange contracts act aseconomic hedges, we have not designated such instruments as hedges under ASCTopic 815. We determine the fair value of our foreign forward contracts inaccordance with ASC Topic 820 (formerly SFAS No. 157, “Fair ValueMeasurement”).  The classification ofgains and losses resulting from changes in the fair values of derivatives isdependent on the intended use of the derivative and its resulting designation.The change in fair value of the derivatives is recorded in unrealized gains orlosses within the statement of operations. At April 3, 2010, the fair value of our foreign exchange forwardcontracts was a gain of $1.1 million and was determined through the use ofmodels that consider various assumptions, including time value, yield curves,as well as other relevant economic measures, which are inputs that areclassified as Level 2 in the valuation hierarchy.

 

*Interest Rate Swap Agreements*

 

We make use of debt financing as a source of funds and are thereforeexposed to interest rate fluctuations in the normal course of business. Ourcredit facilities are subject to floating interest rates. We manage the risk ofunfavorable movements in interest rates by hedging a portion of the outstandingloan balance, thereby locking in a fixed rate on a portion of the principal,reducing the effect of possible rising interest rates and making interestexpense more predictable.  We havedesignated these interest rate swap agreements as cash flow hedges and accountfor our interest rate swap agreements in accordance with ASC Topic 815.  At April 3, 2010, the fair value of ourinterest rate swap agreements was a loss of $11.9 million and was determinedthrough the use of models that consider various assumptions, including timevalue, yield curves, as well as other relevant economic measures, which areinputs that are classified as Level 2 in the valuation hierarchy.

 

**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 months endedApril 3, 2010 (in thousands):

 
| ** **                                              | ** ** | **DJO Finance  LLC** | ** ** | **Noncontrolling  Interests** | ** ** | **Total** | ** ** |
|---------------------------------------------------------|------------|----------------------|------------|-------------------------------|------------|-----------|------------|
| Net income (loss), as reported                          |       | $                    | (33,658    | )                             | $          | 322       |       | $ | (33,336 | ) |
| Foreign currency translation adjustments                |       | (7,306               | )          | —                        |       | (7,306    | )          |
| Change in fair value of interest rate swap, net of  tax |       | (382                 | )          | —                        |       | (382      | )          |
| Comprehensive income (loss)                             |       | $                    | (41,346    | )                             | $          | 322       |       | $ | (41,024 | ) |

 

Comprehensiveloss consists of the following for the three months ended March 28, 2009(in thousands):

 
| ** **                                              | ** ** | **DJO Finance  LLC** | ** ** | **Noncontrolling  Interests** | ** ** | **Total** | ** ** |
|---------------------------------------------------------|------------|----------------------|------------|-------------------------------|------------|-----------|------------|
| Net income (loss), as reported                          |       | $                    | (14,308    | )                             | $          | 139       |       | $ | (14,169 | ) |
| Foreign currency translation adjustments                |       | (3,094               | )          | —                        |       | (3,094    | )          |
| Change in fair value of interest rate swap, net of  tax |       | (3,346               | )          | —                        |       | (3,346    | )          |
| Comprehensive income (loss)                             |       | $                    | (20,748    | )                             | $          | 139       |       | $ | (20,609 | ) |

 

**Discontinued Operations**. On June 12, 2009 wesold our ETS catalog business, formerly known as Rehab Medical Equipment, orRME, to Patterson Medical Supply, Inc. for approximately $21.8 million. Assuch, results of the ETS business for periods prior to the date of sale havebeen presented as discontinued operations in our consolidated financialstatements and the accompanying notes.

 

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

 

**Recent Accounting Pronouncements.**  In January 2010, we adopted ASC Topic810 (formerly SFAS No. 167,“Amendments to FASB Interpretation No. 46 (R)”).  ASC Topic 810 amends certain requirements ofFASB Interpretation No. 46, “Consolidation of Variable Interest Entities”(“FIN 46”), including the addition of entities previously considered qualifyingspecial-purpose entities. The adoption of ASC Topic 815 had no impacton our consolidated financial statements.

 

In January 2010, weadopted ASC Topic 860 (formerly SFAS No. 166, “Accounting for theTransfers of Financial Assets as amendment of FASB Statement No. 140” (“SFAS166”) which amends SFAS No. 140, “Accounting for Transfers and Servicingof Financial Assets” (“SFAS 140”).  SFAS166 makes the following amendments to SFAS 140: 1) removes concept ofqualifying special-purpose entities from SFAS 140; 2) modifies the financialcomponents approach used and limits the circumstances in which a transferor hasnot transferred the original financial asset to an entity that is notconsolidated with the transferor in the financial statements; 3) establishesconditions for reporting a transfer of a portion of a financial asset as asale; 4) redefines a participating interest; 5) clarifies that an entity mustconsider all arrangements or agreements made contemporaneously with, or incontemplation of, a transfer, even if not entered into at the time of thetransfer; 6) clarifies that the transferor must evaluate whether it, itsconsolidated affiliates included in the financial statements being presented,or its agency effectively control the transferred financial asset directly orindirectly; 7) requires that the transferor recognize and initially measure atfair value all assets obtained and liabilities incurred as a result of the atransfer of an entire asset or group of financial assets accounted for as asale; 8) removes special provisions for guaranteed mortgage securitizations torequire them to be treated that same as any other transfer of financial assets;9) Removes fair value practicability exception from measuring the proceedsreceived by a transferor in a transfer that meet the conditions for saleaccounting at fair value; and 10) requires enhanced disclosures. The adoption ofASC Topic 860 had no impact on our consolidated financial statements.

 

InSeptember 2009, the FASB issued ASU 2009-13, which amends ASC Topic 605 (formerly EITFIssue No. 08-1, “Revenue Arrangements with Multiple Deliverables.”). ASU2009-13 provides guidance concerning (1) the determination of whether anarrangement involving multiple deliverables contains more than one unit ofaccounting, and (2) the manner in which consideration should be measuredand allocated to the separate units of accounting in the multiple-elementarrangement and is effective for fiscal years beginning on or after June 15,2010. We are currently evaluating the impact, if any, this issue will have onour consolidated financial statements. However, we do not expect that thisissue will result in a change in current practice.

 

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**2. ACCOUNTS RECEIVABLE RESERVES**

 

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

 
| ** **                                        | ** ** | **Three Months Ended**  | ** ** |
|---------------------------------------------------|------------|-------------------------|------------|
| ** **                                        | ** ** | **April 3,  2010** | ** ** | **March 28,  2009** | ** ** |
| Balance, beginning of period                      |       | $                       | 48,306     |   | $ | 36,521 |   |
| Provision for doubtful accounts and sales returns |       | 8,957                   |       | 9,220 |   |
| Write-offs, net of recoveries                     |       | (6,322                  | )          | (5,532 | ) |
| Balance, end of period                            |       | $                       | 50,941     |   | $ | 40,209 |   |

 

**3. INVENTORIES**

 

Inventories consist of the following (in thousands):

 
| ** **                    | ** ** | **April 3,  2010** | ** ** | **December 31,  2009** | ** ** |
|-------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| Components and raw materials  |       | $                       | 25,510     |                        | $          | 29,967 |   |
| Work in process               |       | 5,662                   |       | 3,745                       |       |
| Finished goods                |       | 51,115                  |       | 50,558                      |       |
| Inventory held on consignment |       | 23,041                  |       | 24,121                      |       |
|                          |       | 105,328                 |       | 108,391                     |       |
| Less inventory reserves       |       | (10,728                 | )          | (12,511                     | )          |
|                          |       | $                       | 94,600     |                        | $          | 95,880 |   |

 

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

 
| ** **                         | ** ** | **Three Months Ended**  | ** ** |
|------------------------------------|------------|-------------------------|------------|
| ** **                         | ** ** | **April 3,  2010** | ** ** | **March 28,  2009** | ** ** |
| Balance, beginning of period       |       | $                       | 12,511     |   | $ | 17,798 |   |
| Provision charged to cost of sales |       | 1,727                   |       | 960 |   |
| Write-offs, net of recoveries      |       | (3,510                  | )          | (2,385 | ) |
| Balance, end of period             |       | $                       | 10,728     |   | $ | 16,373 |   |

 

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

 

**4. GOODWILL AND INTANGIBLE ASSETS**

 

A summary of adjustments to our goodwill balance for the three monthsended April 3, 2010 is as follows (in thousands):

 
| Balance, beginning of period |   | $      | 1,191,497 |   |
|------------------------------|--------|--------|-----------|--------|
| Foreign currency translation |   | (2,761 | )         |
| Balance, end of period       |   | $      | 1,188,736 |   |

 

Identifiable intangibleassets consisted of the following as of April 3, 2010 (in thousands):

 
| ** **                                           | ** ** | **Gross Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Intangible Assets,  Net** | ** ** |
|------------------------------------------------------|------------|----------------------------|------------|-------------------------------|------------|-----------------------------|------------|
| Amortizable intangible  assets:                      |       |                       |       |                          |       |                        |       |
| Technology-based                                     |       | $                          | 458,726    |                          | $          | (103,304                    | )          | $ | 355,422 |   |
| Customer-based                                       |       | 487,998                    |       | (106,788                      | )          | 381,210                     |       |
|                                                 |       | $                          | 946,724    |                          | $          | (210,092                    | )          | 736,632 |   |
| Indefinite-lived intangible assets:                  |       |                       |       |                          |       |                        |       |
| Trademarks and trade names                           |       |                       |       |                          |       | 428,269                     |       |
| Accumulated foreign currency translation adjustments |       |                       |       |                          |       | 2,981                       |       |
| Net identifiable intangible assets                   |       |                       |       |                          |       | $                           | 1,167,882  |   |

 

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Identifiable intangible assets consisted of the following as of December 31,2009 (in thousands):

 
| ** **                                            | ** ** | **Gross Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Intangible Assets,  Net** | ** ** |
|-------------------------------------------------------|------------|----------------------------|------------|-------------------------------|------------|-----------------------------|------------|
| Amortizable intangible assets:                        |       |                       |       |                          |       |                        |       |
| Technology-based                                      |       | $                          | 458,726    |                          | $          | (94,385                     | )          | $ | 364,341 |   |
| Customer-based                                        |       | 487,998                    |       | (96,906                       | )          | 391,092                     |       |
|                                                  |       | $                          | 946,724    |                          | $          | (191,291                    | )          | 755,433 |   |
| Indefinite-lived intangible assets:                   |       |                       |       |                          |       |                        |       |
| Trademarks and trade names                            |       |                       |       |                          |       | 428,269                     |       |
| Accumulated foreign currency translation  adjustments |       |                       |       |                          |       | 3,975                       |       |
| Net identifiable intangible assets                    |       |                       |       |                          |       | $                           | 1,187,677  |   |

 

Our amortizable intangible assets are being amortized using thestraight-line method over the weighted average estimated useful lives of 10years for both technology-based and customer-based intangible assets.

 

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

 
| Remaining 2010 |   | $       | 57,713 |   |
|----------------|--------|---------|--------|--------|
| 2011           |   | 75,675  |   |
| 2012           |   | 74,438  |   |
| 2013           |   | 69,189  |   |
| 2014           |   | 67,368  |   |
| Thereafter     |   | 392,249 |   |

 

**5. OTHER CURRENT LIABILITIES**

 

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

 
| ** **                    | ** ** | **April 3,  2010** | ** ** | **December 31,  2009** | ** ** |
|-------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| Wages and related expenses    |       | $                       | 25,652     |                        | $          | 20,668 |   |
| Commissions and royalties     |       | 11,793                  |       | 12,953                      |       |
| Taxes                         |       | 2,283                   |       | 3,061                       |       |
| Integration costs             |       | 3,631                   |       | 6,779                       |       |
| Professional fees             |       | 5,934                   |       | 5,529                       |       |
| Rebates                       |       | 5,030                   |       | 4,482                       |       |
| Accrued ERP costs             |       | 1,881                   |       | 5,800                       |       |
| Interest rate swap derivative |       | 8,477                   |       | 9,701                       |       |
| Other accrued liabilities     |       | 19,207                  |       | 21,635                      |       |
|                          |       | $                       | 83,888     |                        | $          | 90,608 |   |

 

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

 

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

 
| ** **                                                                                                                                                                                       | ** ** | **April 3,  2010** | ** ** | **December 31,  2009** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| Term loan under Senior Secured Credit Facility, net  of unamortized original issue discount ($8.0 million and $9.3 million at  April 3, 2010 and December 31, 2009, respectively) |       | $                       | 929,825    |                        | $          | 1,034,427 |   |
| 10.875% Senior notes, net of unamortized original  issue premium ($4.9 million at April 3, 2010)                                                                                            |       | 679,866                 |       | 575,000                     |       |
| 11.75% Senior subordinated notes                                                                                                                                                                 |       | 200,000                 |       | 200,000                     |       |
| Loans and revolving credit facilities at various  European banks                                                                                                                                 |       | —                  |       | 355                         |       |
| Capital lease obligations and other                                                                                                                                                              |       | 108                     |       | 228                         |       |
| Notes payable for acquisitions                                                                                                                                                                   |       | 3,001                   |       | 2,860                       |       |
|                                                                                                                                                                                             |       | 1,812,800               |       | 1,812,870                   |       |
| Less — current portion                                                                                                                                                                      |       | (12,628                 | )          | (15,926                     | )          |
| Long-term debt and capital leases, net of current  portion                                                                                                                                       |       | $                       | 1,800,172  |                        | $          | 1,796,944 |   |

 

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*Senior Secured Credit Facility*

 

On November 20, 2007, we entered into the Senior Secured CreditFacility which consists of a $1,065.0 million term loan facility maturing May 2014and a $100.0 million revolving credit facility maturing November 2013.We issued the term loan facility at a 1.2% discount, resulting in net proceedsof $1,052.4 million. The original $12.6 million discount is beingamortized as additional interest expense over the term of the term loanfacility increasing the reported outstanding balance accordingly. The marketvalue of our term loan facility was approximately $905.0 million as of April 3,2010 and was determined using trading prices for our term loan on or near thatdate. As of April 3, 2010, no amounts were drawn related to our revolvingcredit facility.

 

*Interest Rate and Fees.*  Borrowings under the Senior Secured CreditFacility bear interest at a rate equal to an applicable margin plus, at ouroption, either (a) a base rate determined by reference to the higher of (1) theprime rate of Credit Suisse and (2) the federal funds rate plus 0.50% or (b) theEurodollar rate determined by reference to the costs of funds for deposits inU.S. dollars for the interest period relevant to each borrowing adjusted forrequired reserves. The initial applicable margin for borrowings under the termloan facility and the revolving credit facility is 2.00% with respect to baserate borrowings and 3.00% with respect to Eurodollar borrowings. The applicablemargin for borrowings under the term loan facility and the revolving creditfacility may be reduced subject to us attaining certain leverage ratios.

 

We use interest rate swap agreements in an effort to hedge our exposureto fluctuating interest rates related to a portion of our Senior Secured CreditFacility (See Note 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% which expired at December 31,2009. In February 2009, we entered into two additional non-amortizinginterest rate swap agreements. The first agreement was for a notional amount of$550.0 million at a fixed LIBOR rate of 1.04% beginning February 2009 andexpired at December 31, 2009. The second is for a notional amount of$750.0 million at a fixed LIBOR rate of 1.88% beginning January 2010through December 2010.  In August 2009,we entered into four new non-amortizing interest swap agreements with notionalamounts aggregating $300.0 million. Each of the four agreements has a termbeginning January 2011 through December 2011. The four agreements areat a weighted average fixed LIBOR rate of 2.5825%.   As of April 3, 2010, our weightedaverage interest rate for all borrowings under the Senior Secured CreditFacility was 4.55%.

 

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. Any mandatory prepayments areapplied to the term loan facilities in direct order of maturity.  Based on estimated excess cash flows for theyear ended December 31, 2009, we were required to make a prepayment of theterm loan outstanding under our Senior Secured Credit Facility of approximately$2.0 million, which we paid in March 2010. We expect to reinvest the netproceeds from our 2009 asset sales during 2010 as permitted by our creditagreement and, as such, our calculation of estimated excess cash flows excludedthose net proceeds. We may voluntarily prepay outstanding loans under theSenior Secured Credit Facility at any time without premium or penalty, providedthat voluntary prepayments of Eurodollar loans made on a date other than thelast day of an interest period applicable thereto shall be subject to customarybreakage costs.  In January 2010 weissued $100 million of new 10.875% Senior Notes (see further discussion notedbelow) and used the net proceeds to make a voluntary prepayment of $101.5million towards the aggregate principal amount of our term loan under theSenior Secured Credit Facility.  As aresult of such prepayment, we accelerated the amortization associated with ourunamortized original discount by approximately $0.8 million relating to theportion of the term loans that were repaid.

 

*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”).

 

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

 

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

 

·                  incur additionalindebtedness;

·                  create liens on assets;

·                  change fiscal years;

·                  enter into sale andleaseback transactions;

·                  engage in mergers orconsolidations;

·                  sell assets;

·                  pay dividends and otherrestricted payments;

·                  make investments, loans oradvances;

·                  repay subordinatedindebtedness;

·                  make certain acquisitions;

·                  engage in certaintransactions with affiliates;

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

·                  amend material agreementsgoverning our subordinated indebtedness; and

·                  change our lines ofbusiness.

 

In addition, the Senior Secured Credit Facility requires us to maintaina maximum senior secured leverage ratio of 4.15:1 as of the twelve months endedApril 3, 2010, stepping down over time to 3.25:1 by the end of 2011. TheSenior Secured Credit Facility also contains certain customary affirmativecovenants and events of default. Our maximum senior secured leverage ratio waswithin the covenant level as of April 3, 2010.

 

*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% Senior Notes (the “10.875% Notes”) under an agreement datedas of November 20, 2007 (the “10.875% Indenture”) among the Issuers, theguarantors party thereto and The Bank of New York Mellon (formerly known as TheBank of New York), as trustee.

 

On January 20,2010, we issued $100.0 million aggregate principal amount of new 10.875%Notes, pursuant to the 10.875% Indenture,that also governs our existing 10.875%Notes due 2014 that were issued on November 20,2007. The net proceeds of the issuance (excluding approximately $2.0 million ofinterest accrued from November 15, 2009 to January 19, 2010, whichamount will be included in the interest payment we will make to noteholders on May 15,2010, the first interest payment date), along with cash on hand, were used torepay $101.5 million aggregate principal amount of existing term loans underthe Senior Secured Credit Facility. In connection with the issuance of thesenotes, we received an unamortized premium of $5.0 million which is capitalizedand amortized over the term of the note within interest expense within ourcondensed consolidated statement of operations.

 

The 10.875% Notes require semi-annual interest payments ofapproximately $36.7 million each May 15 and November 15 and are due November 15,2014. The market value of the 10.875% Notes was approximately $713.8 million asof April 3, 2010 and was determined using trading prices for the 10.875%Notes on or near that date. We believe the trading prices reflect certaindifferences between prevailing market terms and conditions and the actual termsof 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.

 

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

 

*Covenants.*  The 10.875% Indenture contains covenantslimiting, among other things, our and our restricted subsidiaries’ ability toincur additional indebtedness or issue certain preferred and convertibleshares, pay dividends on, redeem, repurchase or make distributions in respectof the capital stock of DJO or make other restricted payments, make certaininvestments, sell certain assets, create liens on certain assets to securedebt, consolidate, merge, sell or otherwise dispose of all or substantially allof our assets, enter into certain transactions with affiliates, and designateour subsidiaries as unrestricted subsidiaries. As of April 3, 2010, wewere in compliance with all applicable covenants.

 

*11.75% Senior Subordinated Notes Payable*

 

The Issuers issued$200.0 million aggregate principal amount of 11.75% senior subordinatednotes in November 2006 (the “11.75% Notes”). The 11.75% Notes requiresemi-annual interest payments of approximately $11.8 million each May 15and November 15 and are due November 15, 2014.

 

The market value of the 11.75% Notes was approximately $217.0 millionas of April 3, 2010 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.

 

*Debt Issue Costs*

 

We incurred $30.7 million, $27.6 million, and $10.2 million of debtissue costs in connection with the Senior Secured Credit Facility, the 10.875%Notes, and the 11.75% Notes, respectively, including $3.1 million incurred inthe three months ended April 3, 2010 in connection with the sale of thenew 10.875% Notes . These costs have been capitalized and are included in othernon-current assets in the condensed consolidated balance sheets at April 3,2010 and December 31, 2009. Debt issue costs are being amortized over theterms of the respective debt instruments through November 2014.

 

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

 

*2007 Stock Incentive Plan*

 

We have one active equitycompensation plan, the DJO Incorporated 2007 Incentive Stock Plan (the “2007Plan”), under which we are authorized to grant options up to 7,500,000 shares,subject to adjustment in certain events. Options issued under the 2007 Plan canbe either incentive stock options or non-qualified stock options. The exerciseprice of stock options granted will not be less than 100% of the fair marketvalue of the underlying shares on the date of grant, and will expire no morethan ten years from the date of grant. 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 

 

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period of time (typically five years)contingent solely upon the awardees’ continued employment with us (“Time-BasedTranche”). As initially adopted, another one-third of stock options will vestover a specified performance period (typically five years) from the date ofgrant upon the achievement of certain pre-determined performance targets basedon Adjusted EBITDA and free cash flow on an annual basis (“Performance-BasedTranche”), as defined in the DJO Form Option Agreement. As amended in March 2009,the final one-third of stock options will vest based upon achieving a minimuminternal rate of return (“IRR”) and a minimum return of money on of investedcapital (“MOIC”), as defined in the DJO Form Option Agreement and is eachmeasured with respect to Blackstone’s aggregate investment in our capital, tobe achieved by Blackstone following a liquidation of all or a portion of itsinvestment in our capital stock (“Enhanced Market-Return Tranche”).

 

During March 2010, the Compensation Committee approved furthermodifications to the terms of the outstanding options and the DJO Form OptionAgreement. The Time-Based Tranche and Enhanced Market-Return Tranche termsremain the same as discussed above. The financial performance targets for thefuture years of the Performance-Based Tranche were replaced by targets withdifferent financial metrics. These new targets are similar to the EnhancedMarket-Return Tranche as they require achievement of a minimum IRR and MOIC,each measured with respect to Blackstone’s aggregate investment in our capitalstock, to be achieved by Blackstone following a liquidation of all or a portionof its investment in our capital stock (referred to herein as the “Market-ReturnTranche”). As a result of this modification, the Market-Return Tranche has botha performance component and a market condition component.

 

Options granted under the 2007 Plan contain change-in-controlprovisions that cause the vesting of the Time-Based Tranche upon the occurrenceof a change-in-control. Specifically, the Time-Based Tranche will becomeimmediately exercisable upon the occurrence of a change-in-control if theoptionee remains in continuous employment of the Company until the consummationof the change-in-control. This provision does not operate to vest theMarket-Return or the Enhanced Market-Return Tranches which require theachievement of the IRR and MOIC targets by Blackstone on its equity investmentin us.

 

*Employee Stock Options*

 

During the three months ended April 3, 2010 we granted 194,050stock options under the 2007 Plan to our executive officers, senior management,and certain other employees.

 

We recorded non-cash compensation expense of approximately $0.4 millionand $0.5 million for the three months ended April 3, 2010 and March 28,2009, respectively, associated with stock options issued under the 2007 Plan.We record compensation expense for awards with a service or market conditionratably over the service period.  Werecord compensation expense for awards with a performance condition only to theextent deemed probable of achievement. We are required to reassess at each reporting period whether theachievement of any performance condition is probable, at which time we wouldrecognize the related compensation expense over the remaining performance orservice period, if any. To date, no amount has been recorded for the MarketReturn or the Enhanced Market-Return Tranches, as achievement of theperformance component is not deemed probable at this time.

 

The fair value of each option is estimated on the date of grant, usingthe Black-Scholes-Merton option pricing model for service awards and a binomialmodel for market based awards. In estimating fair value for new options issuedunder the 2007 Plan, expected volatility was based completely on historicalvolatility of comparable publicly-traded companies. As our historical shareoption exercise experience does not provide a reasonable basis upon which toestimate the expected term, we used the simplified approach to calculate theexpected term. Expected life is calculated in two tranches based on theemployment level defined as executive or employee. The risk-free rate used incalculating fair value of service and performance-based stock options forperiods within the expected term of the option is based on the U.S. Treasuryyield bond curve in effect at the time of grant. As a result of the 2009modification, we will no longer use the original grant date fair value tomeasure compensation cost and have re-assessed the assumptions used todetermine the fair value of options at the date of modification and atsubsequent grant dates.

 

The assumptions used to calculate the fair value of options granted areevaluated and revised, as necessary, to reflect market conditions andexperience. The following table presents the assumptions we used in calculatingthe fair value of employee stock options for the three months ended April 3,2010 and March 28, 2009:

 
| ** **               | ** ** | **Three  Months Ended** | ** ** |
|--------------------------|------------|-------------------------|------------|
| ** **               | ** ** | **April 3,  2010** | ** ** | **March 28,  2009** | ** ** |
| Expected dividends       |       | 0.0                     | %          | 0.0 | % |
| Expected volatility      |       | 34.5                    | %          | 34.4 | % |
| Risk-free rate           |       | 3.0                     | %          | 2.3 | % |
| Expected term (in years) |       | 6.4 years               |       | 6.3 years |   |

 

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*Non-Employee Stock Options*

 

Duringthe three months ended April 3, 2010 we did not grant any additional stockoptions under the 2007 Plan to non-employees (“non-employee options”). Thenon-statutory stock option agreement for the non-employees states that theoptions have an exercise price of $16.46 per share, which was equal to 100% ofthe estimated fair market value of the stock and will become effective upon thedefined effective date and expire ten years from that date. A number of sharesequal to 25% of the options granted become vested and exercisable at the end ofeach of the first four years subsequent to the effective date, provided theoptionee is still affiliated with and providing services to the Company. Thenon-employee option agreement does not include any performance requirements onthe optionee’s part in order to vest in the options granted.  Non-employee options are accounted for inaccordance with ASC Topic 505 (formerly Emerging Issues Task Force Issue No. 96-18,“Accounting for Equity Instruments That are Issued to Other Than Employees forAcquiring, or in Conjunction with Selling Goods or Services”) which states thatthe fair value of each option will be re-measured at the end of each reportingperiod until vested, when the final fair value of the vesting of the option isdetermined. We recorded non-cash compensation expense of approximately $0.1million for each of the three months ended April 3, 2010 and March 28,2009.

 

**8. 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.  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 our home electrotherapy, iontophoresis, and home traction products. Weprimarily sell these products directly to patients or to physical therapyclinics. For products sold to patients, we arrange billing to the patients andtheir third party payors.

 

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

 

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

 

·                  *AthleteDirect.*  Our Athlete Direct business unit offers our Compexelectrostimulation device to consumers, which range 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.

 

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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.

 
| ** **                                      | ** ** | **Three Months Ended**  | ** ** |
|-------------------------------------------------|------------|-------------------------|------------|
| ** **                                      | ** ** | **April 3,  2010** | ** ** | **March 28,  2009** | ** ** |
| **Net sales:**                                  |       |                    |       |   |   |
| Domestic Rehabilitation Segment                 |       | $                       | 159,220    |   | $ | 147,204 |   |
| International Segment                           |       | 63,894                  |       | 55,146 |   |
| Domestic Surgical Implant Segment               |       | 16,962                  |       | 15,303 |   |
| Consolidated net sales                          |       | $                       | 240,076    |   | $ | 217,653 |   |
| **Gross profit:**                               |       |                    |       |   |   |
| Domestic Rehabilitation Segment                 |       | $                       | 103,972    |   | $ | 96,188 |   |
| International Segment                           |       | 37,729                  |       | 31,505 |   |
| Domestic Surgical Implant Segment               |       | 13,462                  |       | 11,898 |   |
| Expenses not allocated to segments/Eliminations |       | (2,441                  | )          | (938 | ) |
| Consolidated gross profit                       |       | $                       | 152,722    |   | $ | 138,653 |   |
| **Operating income:**                           |       |                    |       |   |   |
| Domestic Rehabilitation Segment                 |       | $                       | 40,648     |   | $ | 33,742 |   |
| International Segment                           |       | 15,318                  |       | 10,063 |   |
| Domestic Surgical Implant Segment               |       | 2,748                   |       | 2,460 |   |
| Expenses not allocated to segments/Eliminations |       | (41,143                 | )          | (33,146 | ) |
| Consolidated operating income                   |       | $                       | 17,571     |   | $ | 13,119 |   |

 

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**  | ** ** |
|----------------------------------------------|------------|-------------------------|------------|
| ** **                                   | ** ** | **April 3,  2010** | ** ** | **March 28,  2009** | ** ** |
| **Net sales:**                               |       |                    |       |   |   |
| United States                                |       | $                       | 172,504    |   | $ | 162,017 |   |
| Germany                                      |       | 21,072                  |       | 16,747 |   |
| Other Europe, Middle East, & Africa |       | 25,806                  |       | 28,614 |   |
| Asia Pacific                                 |       | 6,233                   |       | 3,051 |   |
| Other                                        |       | 14,461                  |       | 7,224 |   |
|                                         |       | $                       | 240,076    |   | $ | 217,653 |   |

 

**9. INCOME TAXES**

 

Income taxes for the interim periods presented have been included inthe accompanying condensed consolidated financial statements on the basis of anestimated annual effective tax rate, adjusted for discrete items. The taxexpense for these periods differed from the amount which would have beenrecorded using the U.S. statutory tax rate due primarily to the impact ofnondeductible expenses, foreign taxes, and deferred taxes on the assumedrepatriation of foreign earnings. Because our current annual financialprojection results in a marginal net pre-tax loss, the impact of the nondeductibleexpenses, foreign taxes, and deferred taxes on the assumed repatriation offoreign earnings causes our projected annualized effective tax rate to benegative.*** ***Giventhe relationship between fixed dollar tax items and pre-tax financial results,the projected effective tax rate can change materially based on smallvariations of income.

 

For the three months ended April 3, 2010, we recorded income taxexpense of approximately $9.8 million on a pre-tax loss of approximately $23.6million, resulting in a negative 41.5% effective tax rate.  For the three months ended March 28,2009, we recorded an income tax benefit of approximately $11.9 million on apre-tax loss of approximately $26.5 million, resulting in a 44.9% effective taxrate. The difference in the tax benefit and tax expense recorded during thefirst quarter of 2009 and the first quarter of 2010 is primarily due todifferences in the projected annualized effective tax rates for each year asdetermined by the Company.  In addition, a beneficial impact of a tax lawchange was recorded during the first quarter of 2009 as a discrete item.

 

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Weand our subsidiaries file income tax returns in the U.S. federal jurisdiction,various states and foreign jurisdictions. With few exceptions, we are no longersubject to U.S. federal, state and local, or non-U.S. income tax examinationsby tax authorities for years before 2005. The Internal Revenue Service (“IRS”)is currently examining the 2005 and 2006 tax years. It is anticipated that theexamination will be completed during 2010. At December 31, 2009, our grossunrecognized tax benefits were $19.1 million. For the three months ended April 3,2010, we did not have any material increases in unrecognized tax benefits. Ourtotal gross unrecognized tax benefits were $19.1 million at April 3, 2010,including $1.6 million related to interest and penalties.  There is a reasonable possibility that theclosing of the IRS examination could result in a material reduction to ourunrecognized tax benefits within the next twelve months. Due to the fact thatthe audit has not been finalized, the amount of the unrecognized tax benefitsthat may be reduced can not be reasonably estimated. Due to our adoption of ASCTopic 805 (formerly SFAS No. 141R, “Business Combinations”) on January 1,2009, all unrecognized tax benefits will impact our effective tax rate uponrecognition. We believe that it is reasonably possible that an increase of $0.2million in unrecognized tax benefits related to various immaterial stateexposures may be necessary within the next twelve months.

 

**10. RESTRUCTURING AND RELATED CHARGES**

 

In June 2009, we announced our plans to close ourChattanooga manufacturing and distribution facility, located in Hixson,Tennessee, and to integrate the operations of the Chattanooga site into ourother existing sites. The transition of our Chattanooga activities is expectedto take approximately nine to 12 months to complete. We do not expect to incuradditional material cash expenses as a result of the transition.

 

A summary of the activity relating to therestructuring is as follows (in thousands):

 
| ** **                        | ** ** | **Severance &  Employee  Retention** | ** ** | **Other** | ** ** | **Total** | ** ** |
|-----------------------------------|------------|-----------------------------------------------|------------|-----------|------------|-----------|------------|
| Balance at January 1, 2009   |       | —                                        |       | —    |       | —    |       |
| Expensed during period            |       | 4,896                                         |       | 479       |       | 5,375     |       |
| Payments made during period       |       | (847                                          | )          | (74       | )          | (921      | )          |
| Balance at December 31, 2009 |       | 4,049                                         |       | 405       |       | 4,454     |       |
| Expensed during period            |       | 1,111                                         |       | 123       |       | 1,234     |       |
| Payments made during period       |       | (1,963                                        | )          | (197      | )          | (2,160    | )          |
| Balance at April 3, 2010     |       | $                                             | 3,197      |      | $          | 331       |       | $ | 3,528 |   |
|                                   |            |                                               |            |           |            |           |            |  |  |  |

 

Expenses incurred related to the transitionof our Chattanooga activities are recorded within selling, general andadministrative expense in our condensed consolidated statements of operations.

 

**11. COMMITMENTS AND CONTINGENCIES**

 

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

 

We are currently defendants in approximately 80product liability cases, including a lawsuit in Canada seeking class actionstatus, related to a disposable drug infusion pump product manufactured by twothird party manufacturers that we distributed through our Bracing and Supportsbusiness unit of our Domestic Rehabilitation segment. We discontinued our saleof these products in the second quarter of 2009. These cases have been broughtagainst the manufacturers and certain distributors of these pumps, and in somecases, the manufacturers of the anesthetics used in these pumps. All of theselawsuits allege that the use of these pumps with certain anesthetics in certainshoulder surgeries over prolonged periods have resulted in cartilage damage tothe plaintiffs. We have sought indemnity and tendered the defense of thesecases to the two manufacturers who supplied these pumps to us, to theirproducts liability carriers and to our products liability carriers. Theproducts liability carriers for both manufacturers have accepted coverage forour defense of these claims; however, both manufacturers have rejected ourtenders of indemnity. The base policy for one of the manufacturers has beenexhausted and the excess liability carriers for that manufacturer are notobligated to provide a defense until a 

 

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$5 million self-insured retention has been paid. Ourproducts liability carrier has accepted coverage of these cases, subject to areservation of the right to deny coverage for customary matters, includingpunitive damages and off-label promotion. The lawsuits allege damages rangingfrom unspecified amounts to claims between $1.0 million and $10.0 million.These cases are in varying stages from initial pleading and discovery topre-trial preparation. We could be exposed to material liabilities if ourinsurance coverage is not available or inadequate and the resources of the twomanufacturers, including their respective products liability insurancepolicies, are unavailable or insufficient to pay the defense costs andsettlements or judgments in these cases.

 

We maintain products liability insurance that issubject to annual renewal. Our current policy covers claims reported between July 1,2009 and June 30, 2010 and provides for coverage (together with excesspolicies) of up to a limit of $80 million, provided that the top layer of $25million excess over $55 million covers only claims reported after February 25,2010 and the next layer down of $10 million excess over $45 million covers onlyclaims reported after February 18, 2010. This coverage is subject to aself-insured retention of $500,000 for claims related to pain pumps describedabove and claims related to the IceMan cold therapy product, a self-insuredretention of $250,000 on claims related to all other invasive products and a self-insuredretention of $50,000 on claims related to all other non-invasive products, withan aggregate self-insured retention of $1.0 million for all products liabilityclaims. In addition, the top layer of $25 million excess over $55 million has aseparate self-insured retention of $50,000 per claim.  Our prior two products liability policiescover claims reported between July 1, 2007 and February 15, 2008 andbetween February 15, 2008 and July 1, 2009, respectively.  The 2007-2008 policy provides for coverage(together with excess policies) of up to a limit of $20 million and the2008-2009 policy provides for coverage (together with excess policies) of up toa limit of $25 million.  Certain of thepain pump cases described above were reported under and are covered by thesetwo policies.  If a products liabilityclaim or series of claims is brought against us for uninsured liabilities or inexcess of our insurance coverage, our business could suffer materially. Inaddition, in certain instances, a products liability claim could also result inour having to recall some of our products, which could result in significantcosts to us. On our condensed consolidated balance sheet as of April 3,2010 and December 31, 2009, we have accrued approximately $1.1 million and$2.0 million, respectively, for expenses related to products liabilityclaims.  The amount accrued is based uponprevious claim experience in part due to the fact that in 2003 we exceeded thecoverage limits in effect at that time for certain historical product liabilityclaims involving one of our discontinued surgical implant products and suchproducts are excluded from coverage under our current policies.

 

Dueto the nature of our business, we are subject to a variety of audits bygovernment agencies and other private interests.  In the third quarter of2009, we received a Form FDA-483 “Inspectional Observations” in connectionwith an FDA audit of our Surgical Implant Segment, stating that: (1) wefailed to follow our standard operating procedures to ensure that the designsof certain products were correctly transferred into production; (2) wefailed to adequately analyze certain quality data to identify existing andpotential causes of nonconforming product and quality problems, resulting indisposal or reworking of certain nonconforming parts in the later stages of ourproduction processes; (3) our complaint handling procedures were not welldefined to ensure that all complaints are processed in a uniform and timelymanner; and (4) we failed to follow our standard operating proceduresrelated to procurement to minimize receipt of nonconforming materials fromsuppliers. We promptly implemented corrective action that we believe adequatelyaddress each Inspectional Observation and submitted a timely response to theFDA. We cannot assure you that the FDA will agree with our actions or will nottake further action in the future, including issuing a warning letter relatedto these observations, seeking injunction, initiating seizure, or delayingreview of pending applications.

 

On April 15, 2009, we became aware of a *qui tam*action filed in Federal Court inBoston, Massachusetts in March 2005 and amended in December 2007 thatnames us as a defendant along with each of the other companies thatmanufactures and sells external bone growth stimulators, as well as ourprincipal stockholder, The Blackstone Group, and the principal stockholder ofone of the other companies in the bone growth stimulation business. This caseis captioned United States *ex rel.*Beirmanv. Orthofix International, N.V., *et al.*,Civil Action No. 05-10557 (D. Mass.). The case was sealed when originallyfiled and unsealed in March 2009. The plaintiff, or relator, alleges thatthe defendants have engaged in Medicare fraud and violated Federal and statefalse claims acts from the time of the original introduction of the devices byeach defendant to the present by seeking reimbursement for bone growthstimulators as a purchased item rather than a rental item. The relator alsoalleges that the defendants are engaged in other marketing practicesconstituting violations of the Federal and various state anti-kickbackstatutes. On December 4, 2009, we filed a motion to dismiss the relator’scomplaint, and we are currently awaiting a response from the relator. Shortlybefore becoming aware of the *qui**tam*action, we were advised that our bonegrowth stimulator business was the subject of an investigation by theDepartment of Justice (“DOJ”), and on April 10, 2009, we were served witha subpoena under the Health Insurance Portability and Accountability Act (“HIPAA”)seeking numerous documents relating to the marketing and sale by us of bonegrowth stimulators. On September 21, 2009, we were served with a secondHIPAA subpoena related to this DOJ investigation seeking additional documentsrelating to the marketing and sale by us of bone growth stimulators. We believethat these subpoenas are related to the DOJ’s investigation of the allegationsin the *qui tam*action, althoughthe DOJ has decided not to intervene in the *quitam*action at this time. We believe that our marketing practices inthe bone growth stimulation business are in compliance with applicable legalstandards and we intend to defend this case and investigation vigorously. Wecan make no assurance as to the resources that will be needed to respond tothese matters or the final outcome of such action.

 

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**12. RELATED PARTY TRANSACTIONS**

 

Blackstone Management Partners V L.L.C. (“BMP”), an affiliate of ourmajor shareholder, provides certain monitoring, advisory and consultingservices to us for an annual monitoring fee equal to the greater of$7.0 million or 2% of consolidated EBITDA as defined in the Transactionand Monitoring Fee Agreement, payable in the first quarter of each year. At anytime in connection with or in anticipation of a change of control of DJOFL, asale of all or substantially all of DJOFL’s assets or an initial publicoffering of common stock of DJOFL, BMP may elect to receive, in lieu ofremaining annual monitoring fee payments, a single lump sum cash payment equalto the then-present value of all then-current and future annual monitoring feespayable under the transaction and monitoring fee agreement, assuming ahypothetical termination date of the agreement to be the twelfth anniversary ofsuch election. The monitoring fee agreement will continue until the earlier ofthe twelfth anniversary of the date of the agreement or such date as DJOFL andBMP may mutually determine. DJOFL will agree to indemnify BMP and itsaffiliates, directors, officers, employees, agents and representatives from andagainst all liabilities relating to the services contemplated by thetransaction and monitoring fee agreement and the engagement of BMP pursuant to,and the performance of BMP and its affiliates of the services contemplated by,the transaction and monitoring fee agreement. For each of the three month periodsended April 3, 2010 and March 28, 2009, we recognized $1.75 millionrelated to the monitoring fee, which is recorded as a component of selling,general and administrative expense in our condensed consolidated statements ofoperations.

 

**13. 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 ASC Topic815.  Before acquiring a derivativeinstrument to hedge a specific risk, potential natural hedges are evaluated.Derivative instruments are only utilized to manage underlying exposures thatarise from our business operations. Factors considered in the decision to hedgean underlying market exposure include the materiality of the risk, thevolatility of the market, the duration of the hedge, and the availability,effectiveness and cost of derivative instruments.  At April 3, 2010, we had foreignexchange forward contracts, with a notional amount of $188.9 million MexicanPesos, or approximately $14.1 million and an aggregate fair market value ofapproximately $1.1 million. These foreign exchange forward contracts expireweekly throughout the fiscal year 2010.

 

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 enteredinto an interest rate swap agreement related to the Senior Secured CreditFacility for a notional amount of $515.0 million at a fixed LIBOR rate of4.205% which expired on December 31, 2009. In February 2009, we entered into two new non-amortizing interestrate swap agreements.  The firstagreement was for a notional amount of $550.0 million at a fixed LIBOR rate of1.04% beginning in February 2009 which expired on December 31,2009.  The second agreement is for anotional amount of $750.0 million at a fixed LIBOR rate of 1.88% with a termbeginning January 2010 through December 2010.  In August 2009, we entered into four newnon-amortizing interest swap agreements with notional amounts aggregating$300.0 million. Each of the four agreements has a term beginning January 2011through December 2011. The four agreements are at a weighted average fixedLIBOR rate of 2.5825%.  We havedesignated these interest rate swap agreements as cash flow hedges under ASCTopic 815.

 

In accordance with ASC Topic 820, 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 April 3, 2010, 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.

 

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

 
| ** **                   | ** ** | **April 3,  2010** | ** ** | **December 31,  2009** | ** ** |
|------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| **Assets:**                  | ** ** | ** **              | ** ** | ** **                  | ** ** |
| Foreign exchange contracts   |       | $                       | 1,128      |                        | $          | 89 |   |
| Total derivative assets      |       | $                       | 1,128      |                        | $          | 89 |   |
| ** **                   | ** ** | ** **              | ** ** | ** **                  | ** ** |
| **Liabilities:**             | ** ** | ** **              | ** ** | ** **                  | ** ** |
| Interest rate swaps          |       | $                       | 11,872     |                        | $          | 11,244 |   |
| Total derivative liabilities |       | $                       | 11,872     |                        | $          | 11,244 |   |

 

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

 
| ** **                                  | ** ** | **Location of Gain or   (Loss)** | ** ** | **Amount of Gain or   (Loss)** | ** ** |
|---------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| **Three Months Ended  April 3, 2010**  | ** ** | ** **                       | ** ** | ** **                     | ** ** |
| Foreign exchange contracts                  |       | Other income (expense), net      |       | $                              | 1,128      |   |
| Interest rate swaps                         |       | Interest expense                 |       | (3,195                         | )          |
| Total net loss                              |       |                             |       | $                              | (2,067     | ) |
| ** **                                  | ** ** | ** **                       | ** ** | ** **                     | ** ** |
| **Three Months Ended  March 28, 2009** | ** ** | ** **                       | ** ** | ** **                     | ** ** |
| Foreign exchange contracts                  |       | Other income (expense), net      |       | $                              | (3,006     | ) |
| Interest rate swaps                         |       | Interest expense                 |       | (3,377                         | )          |
| Total net loss                              |       |                             |       | $                              | (6,383     | ) |

 

**14. SUPPLEMENTAL GUARANTOR CONDENSED CONSOLIDATINGFINANCIAL STATEMENTS**

 

DJOFL and its direct wholly-owned subsidiary, Finco, issued the 10.875%Notes with aggregate principal amounts of $575.0 million and $100.0million on November 20, 2007 and January 20, 2010, respectively. On November 3,2006, DJOFL and Finco issued the 11.75% Notes with an aggregate principalamount of $200.0 million. Finco was formed solely to act as a co-issuer ofthe notes, has only nominal assets and does not conduct any operations. TheIndentures generally prohibit Finco from holding any assets, becoming liablefor any obligations, or engaging in any business activity. The 10.875% Notesare jointly and severally, fully and unconditionally guaranteed, on anunsecured senior basis by all of the DJOFL’s domestic subsidiaries (other thanthe co-issuer) that are 100% owned, directly or indirectly, by DJOFL (the “Guarantors”).The 11.75% Notes are jointly and severally, fully and unconditionallyguaranteed, on an unsecured senior subordinated basis by the Guarantors. Ourforeign subsidiaries (the “Non-Guarantors”) do not guarantee the notes. TheGuarantors also unconditionally guarantee the Senior 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 April 3, 2010 and December 31, 2009 andfor the three months ended April 3, 2010 and March 28, 2009,respectively.

 

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**DJO Finance LLC**

 

**UnauditedCondensed Consolidating Balance Sheets**

**As of April 3,2010**

**(inthousands)**

 
| ** **                                                | ** ** | **DJOFL** | ** ** | **Guarantors** | ** ** | **Non-  Guarantors** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|-----------------------------------------------------------|------------|-----------|------------|----------------|------------|----------------------|------------|------------------|------------|------------------|------------|
| **Assets**                                                |       |      |       |           |       |                 |       |             |       |             |       |
| Current assets:                                           |       |      |       |           |       |                 |       |             |       |             |       |
| Cash and cash equivalents                                 |       | $         | 4,012      |           | $          | 33,162               |       | $                | 16,865     |             | $          | — |   | $ | 54,039 |   |
| Accounts receivable, net                                  |       | —    |       | 115,204        |       | 36,041               |       | —           |       | 151,245          |       |
| Inventories, net                                          |       | —    |       | 79,742         |       | 25,138               |       | (10,280          | )          | 94,600           |       |
| Deferred tax assets, net                                  |       | —    |       | 35,981         |       | 3,655                |       | (146             | )          | 39,490           |       |
| Prepaid expenses and other current assets                 |       | 118       |       | 22,376         |       | 3,509                |       | —           |       | 26,003           |       |
| Total current assets                                      |       | 4,130     |       | 286,465        |       | 85,208               |       | (10,426          | )          | 365,377          |       |
| Property and equipment, net                               |       | —    |       | 72,006         |       | 13,119               |       | (3,603           | )          | 81,522           |       |
| Goodwill                                                  |       | —    |       | 1,108,702      |       | 110,184              |       | (30,150          | )          | 1,188,736        |       |
| Intangible assets, net                                    |       | —    |       | 1,129,679      |       | 38,203               |       | —           |       | 1,167,882        |       |
| Investment in subsidiaries                                |       | 1,271,686 |       | 1,657,685      |       | 35,804               |       | (2,965,142       | )          | 33               |       |
| Intercompany receivable                                   |       | 1,059,721 |       | —         |       | —               |       | (1,059,721       | )          | —           |       |
| Other non-current assets                                  |       | 37,893    |       | 1,389          |       | 1,399                |       | —           |       | 40,681           |       |
| Total assets                                              |       | $         | 2,373,430  |           | $          | 4,255,926            |       | $                | 283,917    |             | $          | (4,069,042 | ) | $ | 2,844,231 |   |
| **Liabilities and Membership  Equity**                    |       |      |       |           |       |                 |       |             |       |             |       |
| Current liabilities:                                      |       |      |       |           |       |                 |       |             |       |             |       |
| Accounts payable                                          |       | $         | —     |           | $          | 38,754               |       | $                | 8,652      |             | $          | — |   | $ | 47,406 |   |
| Long-term debt and capital leases, current portion        |       | 9,594     |       | 65             |       | 2,969                |       | —           |       | 12,628           |       |
| Other current liabilities                                 |       | 48,730    |       | 53,400         |       | 18,739               |       | —           |       | 120,869          |       |
| Total current liabilities                                 |       | 58,324    |       | 92,219         |       | 30,360               |       | —           |       | 180,903          |       |
| Long-term debt and capital leases, net of current portion |       | 1,800,097 |       | 75             |       | —               |       | —           |       | 1,800,172        |       |
| Deferred tax liabilities, net                             |       | —    |       | 315,261        |       | 14,667               |       | —           |       | 329,928          |       |
| Intercompany payable, net                                 |       | —    |       | 963,527        |       | 96,194               |       | (1,059,721       | )          | —           |       |
| Other non-current liabilities                             |       | —    |       | 13,008         |       | 3,033                |       | —           |       | 16,041           |       |
| Total liabilities                                         |       | 1,858,421 |       | 1,384,090      |       | 144,254              |       | (1,059,721       | )          | 2,327,044        |       |
| Noncontrolling interests                                  |       | —    |       | —         |       | 2,178                |       | —           |       | 2,178            |       |
| Total membership equity                                   |       | 515,009   |       | 2,871,836      |       | 137,485              |       | (3,009,321       | )          | 515,009          |       |
| Total liabilities and membership equity                   |       | $         | 2,373,430  |           | $          | 4,255,926            |       | $                | 283,917    |             | $          | (4,069,042 | ) | $ | 2,844,231 |   |

 

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**DJOFinance LLC**

 

**CondensedConsolidating Balance Sheets**

**As of December 31,2009**

**(inthousands)**

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

 

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**DJOFinance LLC**

 

**UnauditedCondensed Consolidating Statements of Operations**

**For theThree Months Ended April 3, 2010**

**(inthousands)**

 
| ** **                                                                | ** ** | **DJOFL** | ** ** | **Guarantors** | ** ** | **Non-  Guarantors** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|---------------------------------------------------------------------------|------------|-----------|------------|----------------|------------|----------------------|------------|------------------|------------|------------------|------------|
| Net sales                                                                 |       | $         | —     |           | $          | 210,811              |       | $                | 70,349     |             | $          | (41,084 | ) | $ | 240,076 |   |
| Cost of sales (exclusive of amortization of $8.9  million included below) |       | —    |       | 83,564         |       | 43,688               |       | (39,898          | )          | 87,354           |       |
| Gross profit                                                              |       | —    |       | 127,247        |       | 26,661               |       | (1,186           | )          | 152,722          |       |
| Operating expenses:                                                       |       |      |       |           |       |                 |       |             |       |             |       |
| Selling, general and administrative                                       |       | —    |       | 90,095         |       | 20,431               |       | —           |       | 110,526          |       |
| Research and development                                                  |       | —    |       | 4,732          |       | 839                  |       | —           |       | 5,571            |       |
| Amortization of acquired intangibles                                      |       | —    |       | 18,077         |       | 977                  |       | —           |       | 19,054           |       |
| Operating income                                                          |       | —    |       | 14,343         |       | 4,414                |       | (1,186           | )          | 17,571           |       |
| Other income (expense):                                                   |       |      |       |           |       |                 |       |             |       |             |       |
| Interest income                                                           |       | 10,750    |       | 803            |       | 150                  |       | (11,350          | )          | 353              |       |
| Interest expense                                                          |       | (40,342   | )          | (10,787        | )          | (933                 | )          | 11,350           |       | (40,712          | )          |
| Other income (expense), net                                               |       | (4,066    | )          | (25,508        | )          | (731                 | )          | 29,525           |       | (780             | )          |
| Income (loss) from continuing operations before  income taxes             |       | (33,658   | )          | (21,149        | )          | 2,900                |       | 28,339           |       | (23,568          | )          |
| Provision (benefit) for income taxes                                      |       | —    |       | 8,784          |       | 984                  |       | —           |       | 9,768            |       |
| Net income (loss)                                                         |       | (33,658   | )          | (29,933        | )          | 1,916                |       | 28,339           |       | (33,336          | )          |
| Less: Net income attributable tononcontrolling  interests                 |       | —    |       | —         |       | 322                  |       | —           |       | 322              |       |
| Net income (loss) attributable to DJO Finance LLC                         |       | $         | (33,658    | )              | $          | (29,933              | )          | $                | 1,594      |             | $          | 28,339 |   | $ | (33,658 | ) |

 

**DJOFinance LLC**

 

**UnauditedCondensed Consolidating Statements of Operations**

**For theThree Months Ended March 28, 2009**

**(inthousands)**

** **
| ** **                                                                | ** ** | **DJOFL** | ** ** | **Guarantors** | ** ** | **Non-  Guarantors** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|---------------------------------------------------------------------------|------------|-----------|------------|----------------|------------|----------------------|------------|------------------|------------|------------------|------------|
| Net sales                                                                 |       | $         | —     |           | $          | 186,782              |       | $                | 60,979     |             | $          | (30,108 | ) | $ | 217,653 |   |
| Cost of sales (exclusive of amortization of $9.5  million included below) |       | —    |       | 69,096         |       | 39,566               |       | (29,662          | )          | 79,000           |       |
| Gross profit                                                              |       | —    |       | 117,686        |       | 21,413               |       | (446             | )          | 138,653          |       |
| Operating expenses:                                                       |       |      |       |           |       |                 |       |             |       |             |       |
| Selling, general and administrative                                       |       | —    |       | 80,213         |       | 20,387               |       | —           |       | 100,600          |       |
| Research and development                                                  |       | —    |       | 5,062          |       | 741                  |       | —           |       | 5,803            |       |
| Amortization of acquired intangibles                                      |       | —    |       | 18,639         |       | 492                  |       | —           |       | 19,131           |       |
| Operating income                                                          |       | —    |       | 13,772         |       | (207                 | )          | (446             | )          | 13,119           |       |
| Other income (expense):                                                   |       |      |       |           |       |                 |       |             |       |             |       |
| Interest income                                                           |       | 4,729     |       | 688            |       | 331                  |       | (5,412           | )          | 336              |       |
| Interest expense                                                          |       | (38,430   | )          | (4,776         | )          | (797                 | )          | 5,412            |       | (38,591          | )          |
| Other income (expense), net                                               |       | 19,393    |       | (6,444         | )          | (775                 | )          | (13,554          | )          | (1,380           | )          |
| Income (loss) from continuing operations before  income taxes             |       | (14,308   | )          | 3,240          |       | (1,448               | )          | (14,000          | )          | (26,516          | )          |
| Benefit for income taxes                                                  |       | —    |       | (11,102        | )          | (835                 | )          | —           |       | (11,937          | )          |
| Income from discontinued operations, net                                  |       | —    |       | 410            |       | —               |       | —           |       | 410              |       |
| Net income (loss)                                                         |       | (14,308   | )          | 14,752         |       | (613                 | )          | (14,000          | )          | (14,169          | )          |
| Less: Net income attributable tononcontrolling  interests                 |       | —    |       | —         |       | 139                  |       | —           |       | 139              |       |
| Net income (loss) attributable to DJO Finance LLC                         |       | $         | (14,308    | )              | $          | 14,752               |       | $                | (752       | )                | $          | (14,000 | ) | $ | (14,308 | ) |

 

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**DJO Finance LLC**

 

**UnauditedCondensed Consolidating Statements of Cash Flows**

**For theThree Months Ended April 3, 2010**

**(inthousands)**

 
| ** **                                                                                          | ** ** | **DJOFL** | ** ** | **Guarantors** | ** ** | **Non-  Guarantors** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|-----------|------------|----------------|------------|----------------------|------------|------------------|------------|------------------|------------|
| **OPERATING ACTIVITIES:**                                                                           |       |      |       |           |       |                 |       |             |       |             |       |
| Net income (loss)                                                                                   |       | $         | (33,658    | )              | $          | (29,933              | )          | $                | 1,916      |             | $          | 28,339 |   | $ | (33,336 | ) |
| Adjustments to reconcile net income (loss) to net  cash provided by (used in) operating activities: |       |      |       |           |       |                 |       |             |       |             |       |
| Depreciation                                                                                        |       | —    |       | 5,625          |       | 1,218                |       | (48              | )          | 6,795            |       |
| Amortization of intangibles                                                                         |       | —    |       | 18,077         |       | 977                  |       | —           |       | 19,054           |       |
| Amortization of debt issuance costs                                                                 |       | 5,313     |       | —         |       | —               |       | —           |       | 5,313            |       |
| Stock-based compensation                                                                            |       | —    |       | 495            |       | —               |       | —           |       | 495              |       |
| Loss on disposal of assets                                                                          |       | —    |       | 530            |       | 30                   |       | (66              | )          | 494              |       |
| Deferred income taxes                                                                               |       | —    |       | 8,094          |       | 642                  |       | —           |       | 8,736            |       |
| Non-cash income from subsidiaries                                                                   |       | 6,832     |       | 518,439        |       | 20,655               |       | (545,926         | )          | —           |       |
| Provision for doubtful accounts and sales returns                                                   |       | —    |       | 8,762          |       | 195                  |       | —           |       | 8,957            |       |
| Inventory reserves                                                                                  |       | —    |       | 1,397          |       | 330                  |       | —           |       | 1,727            |       |
| Changes in operating assets and liabilities, net of  acquired assets and liabilities:               |       |      |       |           |       |                 |       |             |       |             |       |
| Accounts receivable                                                                                 |       | —    |       | (10,918        | )          | (3,597               | )          | —           |       | (14,515          | )          |
| Inventories                                                                                         |       | —    |       | 997            |       | (1,993               | )          | 91               |       | (905             | )          |
| Prepaid expenses, other assets and liabilities                                                      |       | 49        |       | 11,140         |       | (22,771              | )          | —           |       | (11,582          | )          |
| Accounts payable and other current liabilities                                                      |       | 26,182    |       | 1,130          |       | 1,316                |       | (1               | )          | 28,627           |       |
| Net cash (used in) provided by operating activities                                                 |       | 4,718     |       | 533,835        |       | (1,082               | )          | (517,611         | )          | 19,860           |       |
| **INVESTING ACTIVITIES:**                                                                           |       |      |       |           |       |                 |       |             |       |             |       |
| Acquisition of businesses, net of acquired cash                                                     |       | —    |       | (810           | )          | —               |       | —           |       | (810             | )          |
| Purchases of property and equipment                                                                 |       | —    |       | (3,124         | )          | (1,724               | )          | 737              |       | (4,111           | )          |
| Other, net                                                                                          |       | —    |       | (283           | )          | (241                 | )          | —           |       | (524             | )          |
| Net cash (used in) provided by investing activities                                                 |       | —    |       | (4,217         | )          | (1,965               | )          | 737              |       | (5,445           | )          |
| **FINANCING ACTIVITIES:**                                                                           |       |      |       |           |       |                 |       |             |       |             |       |
| Intercompany                                                                                        |       | (3,709    | )          | (513,558       | )          | 32,783               |       | 484,484          |       | —           |       |
| Payments on long-term debt and revolving line of  credit                                            |       | (105,899  | )          | (287           | )          | (225                 | )          | —           |       | (106,411         | )          |
| Proceeds from long-term debt and revolving line of  credit                                          |       | 105,000   |       | —         |       | 130                  |       | —           |       | 105,130          |       |
| Payment of debt issuance costs                                                                      |       | (3,097    | )          | —         |       | —               |       | —           |       | (3,097           | )          |
| Dividend paid to noncontrolling interests                                                           |       | —    |       | —         |       | (529                 | )          | —           |       | (529             | )          |
| Net cash (used in) financing activities                                                             |       | (7,705    | )          | (513,845       | )          | 32,159               |       | 484,484          |       | (4,907           | )          |
| Effect of exchange rate changes on cash and cash  equivalents                                       |       | —    |       | —         |       | (32,470              | )          | 32,390           |       | (80              | )          |
| **Net increase (decrease) in cash  and cash equivalents**                                           |       | (2,987    | )          | 15,773         |       | (3,358               | )          | —           |       | 9,428            |       |
| Cash and cash equivalents at beginning of period                                                    |       | 6,999     |       | 17,389         |       | 20,223               |       | —           |       | 44,611           |       |
| Cash and cash equivalents at end of period                                                          |       | $         | 4,012      |           | $          | 33,162               |       | $                | 16,865     |             | $          | — |   | $ | 54,039 |   |

 

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**DJOFinance LLC**

 

**UnauditedCondensed Consolidating Statements of Cash Flows**

**For theThree Months Ended March 28, 2009**

**(inthousands)**

 
| ** **                                                                                          | ** ** | **DJOFL** | ** ** | **Guarantors** | ** ** | **Non-  Guarantors** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|-----------|------------|----------------|------------|----------------------|------------|------------------|------------|------------------|------------|
| **OPERATING ACTIVITIES:**                                                                           |       |      |       |           |       |                 |       |             |       |             |       |
| Net income (loss)                                                                                   |       | $         | (14,308    | )              | $          | 14,752               |       | $                | (613       | )                | $          | (14,000 | ) | $ | (14,169 | ) |
| Adjustments to reconcile net income (loss) to net  cash provided by (used in) operating activities: |       |      |       |           |       |                 |       |             |       |             |       |
| Depreciation                                                                                        |       | —    |       | 5,302          |       | 889                  |       | (156             | )          | 6,035            |       |
| Amortization of intangibles                                                                         |       | —    |       | 18,639         |       | 492                  |       | —           |       | 19,131           |       |
| Amortization of debt issuance costs                                                                 |       | 3,256     |       | —         |       | —               |       | —           |       | 3,256            |       |
| Stock-based compensation                                                                            |       | —    |       | 569            |       | —               |       | —           |       | 569              |       |
| Loss on disposal of assets                                                                          |       | —    |       | 83             |       | 72                   |       | 2                |       | 157              |       |
| Deferred income taxes                                                                               |       | —    |       | (14,262        | )          | (22                  | )          | 2,149            |       | (12,135          | )          |
| Non-cash income from subsidiaries                                                                   |       | (19,393   | )          | 19,272         |       | —               |       | 121              |       | —           |       |
| Provision for doubtful accounts and sales returns                                                   |       | —    |       | 9,041          |       | 179                  |       | —           |       | 9,220            |       |
| Inventory reserves                                                                                  |       | —    |       | 855            |       | 105                  |       | —           |       | 960              |       |
| Changes in operating assets and liabilities, net of  acquired assets and liabilities:               |       |      |       |           |       |                 |       |             |       |             |       |
| Accounts receivable                                                                                 |       | —    |       | (12,111        | )          | 1,204                |       | —           |       | (10,907          | )          |
| Inventories                                                                                         |       | —    |       | (1,412         | )          | (2,240               | )          | 3,392            |       | (260             | )          |
| Prepaid expenses, other assets and liabilities                                                      |       | 185       |       | (4,460         | )          | 261                  |       | (127             | )          | (4,141           | )          |
| Accounts payable and other current liabilities                                                      |       | 31,730    |       | (13,764        | )          | 1,884                |       | 42               |       | 19,892           |       |
| Net cash (used in) provided by operating activities                                                 |       | 1,470     |       | 22,504         |       | 2,211                |       | (8,577           | )          | 17,608           |       |
| **INVESTING ACTIVITIES:**                                                                           |       |      |       |           |       |                 |       |             |       |             |       |
| Acquisition of businesses, net of cash acquired                                                     |       | —    |       | (3,023         | )          | (906                 | )          | —           |       | (3,929           | )          |
| Purchases of property and equipment                                                                 |       | —    |       | (6,953         | )          | (1,072               | )          | (134             | )          | (8,159           | )          |
| Other, net                                                                                          |       | —    |       | 175            |       | —               |       | —           |       | 175              |       |
| Net cash (used in) provided by investing activities                                                 |       | —    |       | (9,801         | )          | (1,978               | )          | (134             | )          | (11,913          | )          |
| **FINANCING ACTIVITIES:**                                                                           |       |      |       |           |       |                 |       |             |       |             |       |
| Intercompany                                                                                        |       | 2,530     |       | (14,247        | )          | 3,006                |       | 8,711            |       | —           |       |
| Payments on revolving line of credit                                                                |       | (4,000    | )          | (70            | )          | (25                  | )          | —           |       | (4,095           | )          |
| Proceeds from debt and revolving line of credit                                                     |       |      |       |           |       |                 |       |             |       |             |       |
| Net cash (used in) financing activities                                                             |       | (1,470    | )          | (14,317        | )          | 2,981                |       | 8,711            |       | (4,095           | )          |
| Effect of exchange rate changes on cash and cash  equivalents                                       |       | —    |       | —         |       | (1,339               | )          | —           |       | (1,339           | )          |
| **Net increase (decrease) in cash  and cash equivalents**                                           |       | —    |       | (1,614         | )          | 1,875                |       | —           |       | 261              |       |
| Cash and cash equivalents at beginning of period                                                    |       | —    |       | 14,373         |       | 16,110               |       | —           |       | 30,483           |       |
| Cash and cash equivalents at end of period                                                          |       | $         | —     |           | $          | 12,759               |       | $                | 17,985     |             | $          | — |   | $ | 30,744 |   |

 

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

 

**Forward Looking Statements**

 

The following management’s discussion and analysis contains “forwardlooking statements” within the meaning of Section 27A of the SecuritiesAct of 1933, as amended, and Section 21E of the Securities Exchange Act of1934, as amended, that represent our expectations or beliefs concerning futureevents, including, but not limited to, statements regarding growth in sales ofour products, profit margins and the sufficiency of our cash flow for futureliquidity and capital resource needs. These forward-looking statements arefurther qualified by important factors that could cause actual results todiffer materially from those in the forward-looking statements. These factorsare described under the heading “Risk Factors” below. The section entitled “RiskFactors” contained in Part II, Item 1A of this report, and similardiscussions in our other SEC filings including our 2009 Annual Report on Form 10-Kfiled with the Commission on March 5, 2010, 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 globalprovider of high-quality orthopedic devices, with a broad range of productsused for rehabilitation, pain management and physical therapy. We also develop,manufacture and distribute a broad range of surgical reconstructive implantproducts. We are one of the largest non-surgical orthopedic rehabilitationdevice companies in the world, as measured by revenues. Many of our productshave leading market positions. We believe that our strong brand names,comprehensive range of products, focus on quality, innovation and customerservice, extensive distribution network, and our strong relationships withorthopedic and physical therapy professionals have contributed to our leadingmarket positions. We believe that we are one of only a few orthopedic devicecompanies that offer healthcare professionals and patients a diverse range oforthopedic rehabilitation products addressing the complete spectrum ofpreventative, pre-operative, post-operative, clinical and home rehabilitationcare. Our products are used by orthopedic specialists, primary care physicians,pain management specialists, physical therapists, podiatrists, chiropractors,athletic trainers and other healthcare professionals to treat patients withmusculoskeletal conditions resulting from degenerative diseases, deformities,traumatic events and sports-related injuries. In addition, many of ournon-surgical medical devicesandrelated accessories are used by athletes and patients for injury prevention andat-home physical therapy treatment

 

On June 12, 2009 we sold our ETS catalog business to PattersonMedical Supply, Inc. for approximately $21.8 million. As such, results ofthe ETS business for periods prior to the date of sale have been presented asdiscontinued operations.

 

We provide a broad array of orthopedic rehabilitation and regenerationproducts, as well as implants to customers in the United States and abroad. Wecurrently develop, manufacture and distribute our products through thefollowing 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 our home electrotherapy, iontophoresis, and home traction products. Weprimarily sell these products directly to patients or to physical therapyclinics. For products sold to patients, we arrange billing to the patients andtheir third party payors.

 

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·                  *Regeneration*.  Our Regeneration business unit sells our bonegrowth stimulation products. We sell these products either directly to patientsor to independent distributors. For products sold to patients, we arrangebilling to the patients and their third party payors.

 

·                  *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 8 to our condensedconsolidated financial statements for additional information regarding oursegments.

 

Set forth below is net revenue, gross profit and operating incomeinformation for our reporting segments for the three months ended April 3,2010 and March 28, 2009, respectively. This information excludesintersegment and certain expenses not allocated to segments, primarily generalcorporate expenses and non-recurring charges related to our integrationactivities.

 
| ** **                                         | ** ** | **Three Months Ended**  | ** ** |
|----------------------------------------------------|------------|-------------------------|------------|
| **($ in thousands)**                     | ** ** | **April 3,  2010** | ** ** | **March 29,  20098** | ** ** |
| **Domestic Rehabilitation:**                       |       |                    |       |   |   |
| Net sales                                          |       | $                       | 159,220    |   | $ | 147,204 |   |
| Gross profit                                       |       | $                       | 103,972    |   | $ | 96,188 |   |
| Gross profit margin                                |       | 65.3                    | %          | 65.3 | % |
| Operating income                                   |       | $                       | 40,648     |   | $ | 33,742 |   |
| Operating income as a percent of net segment sales |       | 25.5                    | %          | 22.9 | % |
| **International:**                                 |       |                    |       |   |   |
| Net sales                                          |       | $                       | 63,894     |   | $ | 55,146 |   |
| Gross profit                                       |       | $                       | 37,729     |   | $ | 31,505 |   |
| Gross profit margin                                |       | 59.0                    | %          | 57.1 | % |
| Operating income                                   |       | $                       | 15,318     |   | $ | 10,063 |   |
| Operating income as a percent of net segment sales |       | 24.0                    | %          | 18.2 | % |
| **Domestic Surgical Implant:**                     |       |                    |       |   |   |
| Net sales                                          |       | $                       | 16,962     |   | $ | 15,303 |   |
| Gross profit                                       |       | $                       | 13,462     |   | $ | 11,898 |   |
| Gross profit margin                                |       | 79.4                    | %          | 77.7 | % |
| Operating income                                   |       | $                       | 2,748      |   | $ | 2,460 |   |
| Operating income as a percent of net segment sales |       | 16.2                    | %          | 16.1 | % |

 

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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**  |    |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------|---------|
|                                                                                                                                                                   |   | **April 3,  2010** |    | **March 28,  2009** |   |
| Net sales                                                                                                                                                              |   | $                       | 240,076 |   | 100.0 | % | $ | 217,653 |   | 100.0 | % |
| Cost of sales (exclusive of amortization of $8.9  million and $9.5 million for the three months ended April 3, 2010 and March  28, 2009, respectively, included below) |   | 87,354                  |    | 36.4 |   | 79,000 |   | 36.3 |   |
| Gross profit                                                                                                                                                           |   | 152,722                 |    | 63.6 |   | 138,653 |   | 63.7 |   |
| Operating expenses:                                                                                                                                                    |   |                    |    |   |   |   |   |   |   |
| Selling, general and administrative                                                                                                                                    |   | 110,526                 |    | 46.0 |   | 100,600 |   | 46.2 |   |
| Research and development                                                                                                                                               |   | 5,571                   |    | 2.3 |   | 5,803 |   | 2.7 |   |
| Amortization of acquired intangibles                                                                                                                                   |   | 19,054                  |    | 7.9 |   | 19,131 |   | 8.8 |   |
| Operating income                                                                                                                                                       |   | 17,571                  |    | 7.3 |   | 13,119 |   | 6.0 |   |
| Other income (expense):                                                                                                                                                |   |                    |    |   |   |   |   |   |   |
| Interest income                                                                                                                                                        |   | 353                     |    | 0.1 |   | 336 |   | 0.2 |   |
| Interest expense                                                                                                                                                       |   | (40,712                 | )       | (17.0 | ) | (38,591 | ) | (17.7 | ) |
| Other expense, net                                                                                                                                                     |   | (780                    | )       | (0.3 | ) | (1,380 | ) | (0.6 | ) |
| Loss from continuing operations before income  taxes                                                                                                                   |   | (23,568                 | )       | (9.8 | ) | (26,516 | ) | (12.2 | ) |
| Provision (benefit) for income taxes                                                                                                                                   |   | 9,768                   |    | 4.1 |   | (11,937 | ) | (5.5 | ) |
| Income from discontinued operations, net                                                                                                                               |   | —                  |    | — |   | 410 |   | 0.2 |   |
| Net loss                                                                                                                                                               |   | (33,336                 | )       | (13.9 | ) | (14,169 | ) | (6.5 | ) |
| Less: Income attributable to noncontrolling  interest                                                                                                                  |   | 322                     |    | 0.1 |   | 139 |   | 0.1 |   |
| Net loss attributable to DJO Finance LLC                                                                                                                               |   | $                       | (33,658 | ) | (14.0 | )% | $ | (14,308 | ) | (6.6 | )% |

 

***Three Months Ended April 3,2010 compared to Three Months Ended March 28, 2009***

 

*Net Sales.*  Our net sales for the three months ended April 3,2010 were $240.1 million, representing an increase of 10.3% from net sales of$217.7 million for the three months ended March 28, 2009.  This increase was driven by increased salesacross all business units as well as $4.2 million of favorable changes inforeign exchange rates compared to rates in effect for the three months ended March 28,2009.  Net sales for the three monthsended April 3, 2010 were also favorably impacted by $14.8 million due tofour additional shipping days compared to the three months ended March 28,2009. In addition, first quarter 2010 revenue growth was impacted by thediscontinuation of certain unprofitable product lines in our Chattanooga and Bracingand Supports businesses in 2009 and the sale of a small, non-core spine productline in 2009 by DJO surgical. The discontinued/sold product lines generatedrevenue of $2.5 million in the first quarter of 2009.

 

For the three months ended April 3, 2010, we generated 26.6% ofour net sales from customers outside the United States as compared to 25.4% forthe three months ended March 28, 2009. Additionally, sales of newproducts, which include products that have been on the market less than oneyear, were $8.8 million for the three months ended April 3, 2010 comparedto new product sales of $15.2 million for the three months ended March 28,2009.

 

The following table sets forth the mix of our net sales for the threemonths ended April 3, 2010 compared to the three months ended March 28,2009:

 
| ** **                        | ** ** | **Three Months Ended**  | ** ** | ** **             | ** ** | ** **                     | ** ** |
|-----------------------------------|------------|-------------------------|------------|------------------------|------------|--------------------------------|------------|
| **($ in  thousands)**        | ** ** | **April 3,  2010** | ** ** | **% of Net  Revenues** | ** ** | **March 28,********2009** | ** ** | **% of Net  Revenues** | ** ** | **Increase  (Decrease)** | ** ** | **% Increase  (Decrease)** | ** ** |
| Domestic Rehabilitation Segment   |       | $                       | 159,220    |                   | 66.3       | %                              | $          | 147,204 |   | 67.6 | % | $ | 12,016 |   | 8.2 | % |
| International Segment             |       | 63,894                  |       | 26.6                   |       | 55,146                         |       | 25.4 |   | 8,748 |   | 15.9 |   |
| Domestic Surgical Implant Segment |       | 16,962                  |       | 7.1                    |       | 15,303                         |       | 7.0 |   | 1,659 |   | 10.8 |   |
| **Consolidated net sales**        |       | $                       | 240,076    |                   | 100.0      | %                              | $          | 217,653 |   | 100.0 | % | $ | 22,423 |   | 10.3 | % |

 

Net sales in our Domestic Rehabilitation Segment were $159.2 millionfor the three months ended April 3, 2010, reflecting an increase of 8.2%from net sales of $147.2 million for the three months ended March 28,2009. The increase was driven by increased sales across business units,including $9.8 million in sales due to the benefit of four additional sellingdays in the three months ended April 3, 2010 as compared to the threemonths ended March 28, 2009.

 

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Net sales in our International Segment for the three months ended April 3,2010 were $63.9 million, reflecting an increase of 15.9% from net sales of$55.1 million for the three months ended March 28, 2009. The increase wasdriven primarily by increased sales across all business units, $4.2 million offavorable changes in foreign exchange rates compared to rates in effect for thethree months ended March 28, 2009, and $3.9 million in sales due to thebenefit of four additional selling days in the three months ended April 3,2010 as compared to the three months ended March 28, 2009.

 

Net sales in our Domestic Surgical Implant Segment increased to$17.0 million for the three months ended April 3, 2010 from $15.3million for the three months ended March 28, 2009, representing a 10.8%increase over the same period in the prior year. The increase was drivenprimarily by $1.1 million in sales due to the benefit of four additionalselling days in the three months ended April 3, 2010 as compared to thethree months ended March 28, 2009, as well as an increase in sales of ourshoulder products.

 

*Gross Profit.*  Consolidated gross profit as a percentage ofnet sales was 63.6%, for the three months ended April 3, 2010 compared to63.7% for the three months ended March 28, 2009. Our gross profit marginfor the three months ended April 3, 2010 is essentially in line with theprior year period as the impact of a less favorable mix of products sold wasoffset by $3.2 million of favorable changes in foreign currency exchange rates.

 

Gross profit in our Domestic Rehabilitation Segment as a percentage ofnet sales was 65.3% for each of the three months ended April 3, 2010 and March 28,2009.

 

Gross profit in our International Segment as a percentage of net salesincreased to 59.1% for the three months ended April 3, 2010 from 57.1% forthe three months ended March 28, 2009. The increase was primarily driven by favorable changes in foreignexchange rates of approximately $3.2 million and the impact of a more favorablemix of products sold.

 

Gross profit in our Domestic Surgical Implant Segment as a percentageof gross sales increased to 79.4% for the three months ended April 3, 2010from 77.8% for the three months ended March 28, 2009. The increase wasprimarily driven by a higher margin mix of products sold.

 

*Selling, General and Administrative.*  Our selling, general and administrativeexpenses increased to $110.5 million for the three months ended April 3,2010 from $100.6 million for the three months ended March 28, 2009primarily due to higher non-recurring costs associated with our integrationactivities. The following table sets forth certain non-recurring costsassociated with our integration activities and the implementation of our new globalERP system:

 
| ** **                                 | ** ** | **Three Months Ended**        | ** ** |
|--------------------------------------------|------------|-------------------------------|------------|
| **($ in  thousands)**                 | ** ** | **April 3,********2010** | ** ** | **March 28,  2009** | ** ** |
| Employee severance and relocation expenses |       | $                             | 1,424      |   | $ | 659 |   |
| Integration expenses                       |       | 8,278                         |       | 2,991 |   |
| ERP implementation                         |       | 3,277                         |       | 4,231 |   |
|                                       |       | $                             | 12,979     |   | $ | 7,881 |   |

 

Employee severance andrelocation for the three months ended April 3, 2010 included $0.8 millionof severance payments made to employees in connection with our Chattanoogaintegration, and $0.6 million of severance related to other restructuringactivities. Employeeseverance and relocation expenses for the three months ended March 28,2009 included $0.3 million of severance payments made to employees inconnection with restructuring at our international locations and $0.4 millionof severance payments made to employees in connection with integrationactivities following the November 2007 ReAble Therapeutics, Inc.acquisition of DJO Opco Holdings, Inc. (“DJO Merger”). Integration expensefor the three months ended April 3, 2010 included $5.2 million, $1.9million, and $1.2 million of integration costs incurred in connection with ourChattanooga integration, our recent sales reorganization, and otheracquisitions, respectively.  Integrationexpense for the three months ended March 28, 2009 included $3.9 millionand $4.9 million of integration costs incurred in connection with restructuringat our international locations, and domestic locations, respectively, partially offset bya $6.0 million reversal of an accrual made in 2008 for alleged reimbursementclaims due to the favorable settlement of the dispute.

 

*Research and Development.*  Our research and development expensedecreased to $5.6 million for the three months ended April 3, 2010 from$5.8 million for the three months ended March 28, 2009. As a percentage ofnet sales, research and development expense decreased slightly to 2.3% for thethree months ended April 3, 2010 from 2.7% in the three months ended March 28,2009, primarily reflecting cost savings initiatives.

 

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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 20 years. Our amortization of acquired intangibleswas $19.1 million for each of the three months ended April 3, 2010 and March 28,2009. At April 3, 2010, we expect the future amortization of intangiblesto be approximately $57.7 million for the remainder of 2010, $75.7 million in2011, $74.4 million in 2012, $69.2 million in 2013, $67.4 million in 2014, and$392.2 for the periods thereafter.

 

*Interest Expense.*  Our interest expense increased to $40.7million for the three months ended April 3, 2010 from $38.6 millionfor the three months ended March 28, 2009. The increase is primarily due to additional debt issuance costs incurredin the first quarter of 2010 related to our issuance of $100 million aggregateprincipal amount of new 10.875% Senior Notes, pursuant to the indenture datedas of November 20, 2007 among DJO and DJO Finance Corporation, theguarantors party thereto and the Bank of New York Mellon (formerly known as theBank of New York), as trustee, that also governs our existing 10.875% Notes due2014 that were issued on November 20, 2007, which are amortized throughinterest expense.

 

*Other Income (Expense).*  Net other expense decreased to $0.8 millionfor the three months ended April 3, 2010 from $1.4 million of netother expense for the three months ended March 28, 2009.  Both amounts primarily reflect net foreigncurrency transaction losses.

 

*Provision (Benefit) for Income Taxes.*  For the three months ended April 3,2010, we recorded an income tax provision of $9.8 million on a pre-tax loss of$23.6 million, resulting in a negative 41.5% effective tax rate.  For the three months ended March 28,2009, we recorded $11.9 million of income tax benefit on a pre-tax loss of$26.5 million, resulting in a 44.9% effective tax rate.  The difference in the tax benefit and taxexpense recorded during the first quarter of 2009 and the first quarter of 2010is primarily due to differences in the expected annualized effective tax ratesfor each year as determined by the Company.  In addition, a beneficialimpact of a tax law change was recorded during the first quarter of 2009 as adiscrete item.  Because our current annual financial projection results ina marginal net pre-tax loss, the impact of the nondeductible expenses, foreigntaxes, and deferred taxes on the assumed repatriation of foreign earningscauses our projected annualized effective tax rate to be negative. Given therelationship between fixed dollar tax items and pre-tax financial results, theprojected effective tax rate can change materially based on small variations ofincome.

 

**Liquidity and Capital Resources**

 

As of April 3, 2010, our primary source of liquidity consisted ofcash and cash equivalents totaling $54.0 million and $100.0 million ofavailable borrowings under our revolving credit facility, described below.Working capital at April 3, 2010 was $184.5 million. We believe that ourexisting cash, plus the amounts we expect to generate from operations andamounts available through our revolving credit facility, will be sufficient tomeet our operating needs for the next twelve months, including working capitalrequirements, capital expenditures, and debt and interest repayment obligations.While we currently believe that we will be able to meet all of our financialcovenants imposed by our Senior Secured Credit Facility, there is no assurancethat we will in fact be able to do so or that, if we do not, we will be able toobtain from our lenders waivers of default or amendments to the Senior SecuredCredit Facility in the future. We and our subsidiaries, affiliates orsignificant shareholders (including Blackstone and its affiliates) may fromtime to time, in our or their sole discretion, purchase, repay, redeem orretire any of our outstanding debt or equity securities (including any publiclyissued debt securities), in privately negotiated or open market transactions,by tender offer or otherwise.

 

A summary of the changes in our cash and cash equivalents for the threemonths ended April 3, 2010 and March 28, 2009 is as follows:

 
| ** **                                                    | ** ** | **Three Months Ended**  | ** ** |
|---------------------------------------------------------------|------------|-------------------------|------------|
| ** **                                                    | ** ** | **April 3,  2010** | ** ** | **March 28,  2009** | ** ** |
| Cash provided by operating activities                         |       | $                       | 19,860     |   | $ | 17,608 |   |
| Cash used in investing activities                             |       | (5,445                  | )          | (11,913 | ) |
| Cash used in financing activities                             |       | (4,907                  | )          | (4,095 | ) |
| Effect of exchange rate changes on cash and cash  equivalents |       | (80                     | )          | (1,339 | ) |
| Net increase in cash and cash equivalents                     |       | $                       | 9,428      |   | $ | 261 |   |

 

***Cash Flows***

 

Operatingactivities provided cash of $19.9 million and $17.6 million for the threemonths ended April 3, 2010 and March 28, 2009, respectively. Cashprovided by operating activities for the three months ended April 3, 2010primarily reflected our net income after adjustment for non-cash charges and afavorable net change in operating assets and liabilities. Cash provided byoperating activities for the three months ended March 28, 2009 primarily reflected our net income afteradjustment for non-cash charges and a favorable net change in operating assetsand liabilities. Cash paid for interest was $11.3 million and $3.6million for the three months ended April 3, 2010 and March 28, 2009,respectively.

 

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Investing activities used $5.4 million and $11.9 million of cashfor the three months ended April 3, 2010 and March 28, 2009,respectively. Cash used in investing activities for the three months ended April 3,2010 primarily consisted of $4.1 million of purchases of property andequipment, which was mostly related to our new ERP system and a $0.8 millionpayment related to an earn out provision associated with our 2009 Australiaacquisition. Cash used in investing activities for the three months ended March 28,2009 primarily consisted of purchases of property and equipment totaling $8.2million, including $1.2 million for our new ERP system and the acquisition of businessesfor a total of $3.9 million, net of cash acquired.

 

Financing activities used$4.9 million and $4.1 million of cash in the three months ended April 3,2010 and March 28, 2009, respectively. Cash used infinancing activities for the three months ended April 3, 2010 wasprimarily related to long-term debt payments of $106.4 million and the paymentof $3.1 million in debt issuance costs incurred in connection with the issuanceof our new 10.875% Senior Notes partially offset by proceeds of $105.1 millionfrom the new Senior Notes. Cash used in financing activities for thethree months ended March 28, 2009 represented net payments on long-termdebt and revolving lines of credit.

 

For the remainder of 2010, we expect to spend total cash ofapproximately $162.7 million for the following:

 

· approximately $39.3 million for scheduledprincipal and estimated interest payments on our senior secured creditfacility;

 

· approximately $96.9million for scheduled interest payments on our senior notes; and

 

· approximately $26.5 million for capitalexpenditures, including $5.3 million for our ERP system.

 

Inaddition, we expect to spend up to an additional $6.6 million implementing our new ERP system capitalproject over the remainder of the project, which will be recorded as expense.

 

***Indebtedness***

 

As of April 3, 2010, we had approximately $1,812.8 million inaggregate indebtedness outstanding.

 

*Senior Secured Credit Facility*

 

*Overview.*  The Senior Secured Credit Facility providessenior secured financing of $1,165.0 million, consisting of a$1,065.0 million term loan facility and a $100.0 million revolvingcredit facility. We issued the term loan facility at a 1.2% discount, resultingin net proceeds of $1,052.4 million. In addition, we are permitted,subject to receipt of additional commitments from participating lenders andcertain other conditions, to incur up to an additional $150.0 million ofborrowings under the Senior Secured Credit Facility.

 

*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 6).  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% which expired on December 31,2009.  In February 2009, we enteredinto two additional non-amortizing interest rate swap agreements. The first wasfor a notional amount of $550.0 million at a fixed LIBOR rate of 1.04%beginning in February 2009 which expired on December 31, 2009. Thesecond is for a notional amount of $750.0 million at a fixed LIBOR rate of1.88% beginning January 2010 through December 2010.  In August 2009, we entered into four newnon-amortizing interest swap agreements with notional amounts aggregating$300.0 million. Each of the four agreements has a term beginning January 2011through December 2011. The four agreements are at a weighted average fixedLIBOR rate of 2.5825%.  As of April 3,2010, our weighted average interest rate for all borrowings under the SeniorSecured Credit Facility was 4.55%.

 

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

 

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

 

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

 

·                  incur additionalindebtedness;

 

·                  create liens on assets;

 

·                  change fiscal years;

 

·                  enter into sale andleaseback transactions;

 

·                  engage in mergers orconsolidations;

 

·                  sell assets;

 

·                  pay dividends and make otherrestricted payments;

 

·                  make investments, loans oradvances;

 

·                  repay subordinatedindebtedness;

 

·                  make certain acquisitions;

 

·                  engage in certaintransactions with affiliates;

 

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

 

·                  amend material agreementsgoverning our subordinated indebtedness; and

 

·                  change our lines ofbusiness.

 

Pursuant to the terms of the credit agreement relating to the SeniorSecured Credit Facility, we are required to maintain a maximum senior securedleverage ratio consolidated senior debt to Adjusted EBITDA, of 4.15:1 as of the12 months ended April, 3, 2010, stepping down over time to 3.25:1 by the end of2011. Adjusted EBITDA represents net income (loss) plus interest expense, net,provision (benefit) for income taxes and depreciation and amortization, furtheradjusted for non-cash items, non-recurring items and other adjustment itemspermitted in calculating covenant compliance under our Senior Secured CreditFacility and the Indentures (“Adjusted EBITDA”). As of April 3, 2010 ouractual senior leverage ratio was within the required ratio at 3.31:1.

 

*10.875% Senior Notes and 11.75% Senior SubordinatedNotes*

 

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

 

·                  incur additional debt orissue certain preferred shares;

 

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

 

·                  make certain investments;

 

·                  sell certain assets;

 

·                  create liens on certain assetsto secure debt;

 

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·                  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 twelvemonths ended April 3, 2010, measured on that date, was 1.85:1.Notwithstanding these limitations, the aggregate amount of term loan increasesand revolving commitment increases shall not exceed the greater of (i) $150.0 millionand (ii) the additional aggregate amount of secured indebtedness whichwould be permitted to be incurred as of any date of determination (assuming forthis purpose that the full amount of any revolving credit increase had beenutilized as of such date) such that, after giving pro forma effect to suchincurrence (and any other transactions consummated on such date), the seniorsecured leverage ratio for the immediately preceding test period would not begreater than 4.00:1. Fixed charges is defined in the Indentures as consolidatedinterest expense plus all cash dividends or other distributions paid on anyseries of preferred stock of any restricted subsidiary and all dividends orother distributions accrued on any series of disqualified stock.

 

*Covenant Compliance*

 

The following is a summary of our covenantrequirements and pro forma ratios as of April 3, 2010:

 
| ** **                                                                                                       | ** ** | **Covenant  Requirements** | ** ** | **Actual  Ratios** | ** ** |
|------------------------------------------------------------------------------------------------------------------|------------|----------------------------|------------|--------------------|------------|
| **Senior Secured Credit Facility**                                                                               |       |                       |       |               |       |
| Maximum ratio of consolidated net senior secured  debt to Adjusted EBITDA                                        |       | 4.15:1                     |       | 3.31:1             |       |
| **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                     |       | 1.85:1             |       |

 

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 $675.0 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 were unableto repay those amounts, the lenders under the Senior Secured Credit Facilitycould proceed against the collateral granted to them to secure thatindebtedness. We have pledged a significant portion of our assets as collateralunder the Senior Secured Credit Facility. Any acceleration under the SeniorSecured Credit Facility would also result in a default under the Indenturesgoverning the notes, which could lead to the noteholders electing to declarethe principal, premium, if any, and interest on the then outstanding notesimmediately due and payable. In addition, under the Indentures governing thenotes, our ability to engage in activities such as incurring additionalindebtedness, making investments, refinancing subordinated indebtedness, payingdividends and entering into certain merger transactions is governed, in part,by our ability to satisfy tests based on Adjusted EBITDA.

 

Adjusted EBITDA is defined as net income (loss) attributable to DJOFinance LLC, plus loss from discontinued operations,  interest expense, net, provision (benefit)for income taxes and depreciation and amortization, further adjusted fornon-cash items, non-recurring items and other adjustment items permitted incalculating covenant compliance under our Senior Secured Credit Facility andIndentures. We believe that the presentation of Adjusted EBITDA is appropriateto provide additional information to investors about the calculation of, andcompliance with, certain financial covenants in our Senior Secured CreditFacility and the Indentures. Adjusted EBITDA is a material component of thesecovenants.

 

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

 

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

 

The following table provides a reconciliation from our net loss toAdjusted EBITDA for the three and twelve months ended April 3, 2010. Theterms and related calculations are defined in the credit agreement relating toour Senior Secured Credit Facility and the Indentures.

 
| **(in  thousands)**                                                                          | ** ** | **Three Months  Ended  April 3, 2010** | ** ** | **Twelve Months  Ended  April 3, 2010** | ** ** |
|----------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                                                                   | ** ** | **(unaudited)**                             | ** ** |
| Net loss attributable to DJO Finance LLC                                                     |       | $                                           | (33,658    | )                                            | $          | (69,783 | ) |
| Loss from discontinued operations, net                                                       |       | —                                      |       | 729                                          |       |
| Interest expense, net                                                                        |       | 40,359                                      |       | 158,103                                      |       |
| Income tax provision                                                                         |       | 9,768                                       |       | 27                                           |       |
| Depreciation and amortization                                                                |       | 25,851                                      |       | 112,833                                      |       |
| Non-cash items (a)                                                                           |       | 491                                         |       | 4,102                                        |       |
| Non-recurring items (b)                                                                      |       | 12,979                                      |       | 52,718                                       |       |
| Other adjustment items, before cost savings (c)                                              |       | 5,755                                       |       | 4,981                                        |       |
| Other adjustment items—future cost savings  applicable for twelve month period only (d) |       | NA                                          |       | 800                                          |       |
| Adjusted EBITDA                                                                              |       | $                                           | 61,545     |                                         | $          | 264,510 |   |

 

(a)          Non-cash items are comprisedof the following:

 
| **(in  thousands)**                | ** ** | **Three Months  Ended  April 3, 2010** | ** ** | **Twelve Months  Ended  April 3, 2010** | ** ** |
|------------------------------------|------------|---------------------------------------------|------------|----------------------------------------------|------------|
| ** **                         | ** ** | **(unaudited)**                             | ** ** |
| Stock compensation expense         |       | $                                           | 495        |                                         | $          | 3,308 |   |
| Loss (gain) on disposal  of assets |       | (4                                          | )          | 794                                          |       |
| Total non-cash items               |       | $                                           | 491        |                                         | $          | 4,102 |   |

 

(b)           Non-recurring items are comprised ofthe following:

 
| **(in  thousands)**                   | ** ** | **Three Months  Ended  April 3, 2010** | ** **   | **Twelve Months  Ended  April 3, 2010** | ** ** |
|---------------------------------------|------------|---------------------------------------------|--------------|----------------------------------------------|------------|
| ** **                            | ** ** | **(unaudited)**                             | ** **   |
| Employee severance and relocation (1) |       | $                                           |  1,424  |                                         | $          |  9,411 |   |
| Integration expense (2)               |       | 8,278                                       |         | 26,187                                       |       |
| ERP implementation                    |       | 3,277                                       |         | 17,120                                       |       |
| Total non-recurring items             |       | $                                           |  12,979 |                                         | $          |  52,718 |   |

 

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(1)         Employee severance andrelocation for the three months ended April 3, 2010 included $0.8 millionof severance payments made to employees in connection with our Chattanoogaintegration and $0.6 million of severance related to other restructuringactivities. Employee severance and relocation for the twelve months ended April 3,2010 included $6.2 million, $1.8 million, and $1.4 million of severancepayments made to employees in connection with our Chattanooga integration, ourcompany-wide headcount reduction, and other acquisitions, respectively.

 

(2)         Integration expense for thethree months ended April 3, 2010 included $5.2 million, $1.9 million, and$1.2 million of integration costs accrued in connection with the Chattanooga integration, our recentsales reorganization andother recent acquisitions, respectively.  Integration expense for the twelve monthsended April 3, 2010 included $16.3 million, $5.2 million, $2.2 million,$1.2 million, and $1.3 million of integration costs incurred in connection withdomestic restructuring, our Chattanooga integration, restructuring at ourinternational locations, our recent sales reorganization,  and other acquisitions, respectively.

 

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

 
| **(in  thousands)**                                                     | ** ** | **Three  Months  Ended  April 3, 2010** | ** **  | **Twelve  Months  Ended  April 3, 2010** | ** ** |
|-------------------------------------------------------------------------|------------|----------------------------------------------|-------------|-----------------------------------------------|------------|
| ** **                                                              | ** ** | **(unaudited)**                              | ** **  |
| Blackstone monitoring fee                                               |       | $                                            |  1,750 |                                          | $          |  7,000 |   |
| Noncontrolling interests                                                |       | 322                                          |        | 906                                           |       |
| Pre-acquisition EBITDA-applicable for the twelve  month period only (1) |       | NA                                           |        | 600                                           |       |
| Pre-disposition EBITDA-applicable for the twelve  month period only (2) |       | NA                                           |        | (255                                          | )          |
| Other (3)                                                               |       | 3,683                                        |        | (3,270                                        | )          |
| Total other adjustment items, before cost savings                       |       | $                                            |  5,755 |                                          | $          |  4,981 |   |

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(1)         For the twelve months ended April 3,2010 included pre-acquisition Adjusted EBITDA for two Canadian subsidiariesacquired in August 2009.

 

(2)         Represents pre-closingAdjusted EBITDA related to certain immaterial product lines sold in fiscal year2009.

 

(3)         For the three months ended April 3,2010 included approximately $2.3 million related to fees associated with our January 2010debt offering and various litigation settlements and net foreign currencytransaction (gains) losses. For the three months ended March 28, 2009included net foreign currency transaction (gains) losses.  For the twelve months ended April 3,2010 included a $3.1 million gain related to the sale of certain product lines,approximately $2.3 million related to fees associated with our January 2010debt offering and various litigation settlements, and net foreign currencytransaction (gains) losses.

 

(d)                                 For the twelvemonths ended April 3, 2010 included projected cost savings of $0.8 millionin connection with our two Canadian subsidiaries acquired in August 2009.

 

**CriticalAccounting Policies and Estimates**

 

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

 

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

 

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

 

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

 

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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 three months ended April 3, 2010 and March 28,2009, we reserved for and reduced gross revenues from third party payors by 32%and 31%, 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 68% of our netrevenues for the each of the three months ended April 3, 2010 and March 28,2009, and approximately 67% and 62% of our net accounts receivable for thethree months ended April 3, 2010 and March 28, 2009, respectively. Weexperienced write-offs of less than 1% of related net revenues for the threemonths ended April 3, 2010 and March 28, 2009, respectively. Ourthird party reimbursement customers including insurance companies, managed carecompanies and certain governmental payors, such as Medicare, include all of ourOfficeCare customers, most of our Empi customers, and certain other customersof our Domestic Rehabilitation Segment. Our third-party payor customersrepresented approximately 32% and 28% of our net revenues for the three monthsended April 3, 2010 and March 28, 2009, respectively, andapproximately 33% and 38% of our net accounts receivable for the three monthsended April 3, 2010 and March 28, 2009, respectively. For the threemonths ended April 3, 2010 and March 28, 2009, we estimate bad debtexpense to be approximately 7% and 8%, 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 substantiallyattributable to sales volume, sales growth and to reimburse the distributor forcertain discounts. We record estimated reductions to revenue for customerrebate programs based upon historical 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 three months prior to purchase.If the patient has a long-term need for the device, these insurance companiesmay authorize purchase of the device after such time period. When the device ispurchased, most providers require that rental payments previously made on thedevice be credited toward the purchase price. These credits are processed atthe time the payment is received for the purchase of the device, which createsa time lag between billing for a sale and processing the rental credit. Ourrental credit reserve estimates unprocessed rental credits based on the numberof devices converted to purchase. The reserve is calculated by first assessingthe number of our products being rented during the relevant period and ourhistorical conversion rate of rentals to sales, and then reducing our revenueby the applicable amount. We provide for these reserves by reducing our grossrevenue. The cost to refurbish rented products is expensed as incurred as partof cost of sales.

 

***Inventory Reserves***

 

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

 

We consign a portion of our inventory to allow our products to beimmediately dispensed to patients. This requires a large amount of inventory tobe on hand for the products we sell through consignment arrangements. It alsoincreases the sensitivity of these products to obsolescence reserve estimates.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.

 

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***Goodwill and Intangible Assets***

 

In accordance with ASC Topic 350 (formerly SFAS No. 142, “Goodwilland Other Intangible Assets”), we do not amortize goodwill. In lieu ofamortization, we are required to perform an annual review for impairment.Goodwill is recorded as the difference, if any, between the aggregateconsideration paid for an acquisition and the fair value of the net tangibleand intangible assets acquired. The amounts and useful lives assigned tointangible assets acquired, other than goodwill, impact the amount and timingof future amortization, and the amount assigned to in-process research anddevelopment which is expensed immediately. The value of our intangible assets,including goodwill, could be impacted by future adverse changes such as: (i) anyfuture declines in our operating results, (ii) a further decline in thevaluation of comparable company stocks, (iii) a further significantslowdown in the worldwide economy or our industry or (iv) any failure tomeet the performance projections included in our forecasts of future operatingresults. We estimated the fair values of our reporting units primarily usingthe income approach valuation methodology that includes the discounted cashflow method, taking into consideration the market approach and certain marketmultiples as a validation of the values derived using the discounted cash flowmethodology. The discounted cash flows for each reporting unit were based ondiscrete financial forecasts developed by management for planning purposes.Cash flows beyond the discrete forecasts were estimated using a terminal valuecalculation, which incorporated historical and forecasted financial trends foreach identified reporting unit and considered long-term earnings growth ratesfor publicly traded peer companies. Future cash flows were discounted topresent value. Specifically, the income approach valuations included reportingunit cash flow discount rates ranging from 10.5% to 12.6% and terminal valuegrowth rates of 3%. Publicly available information regarding the marketcapitalization was also considered in assessing the reasonableness of thecumulative fair values of our reporting units estimated using the discountedcash flow methodology.  Significantmanagement judgment is required in the forecasts of future operating resultsthat are used in the discounted cash flow method of valuation. The estimates wehave used are consistent with the plans and estimates that we use to manage ourbusiness. It is possible, however, that the plans may change and estimates usedmay prove to be inaccurate. If our actual results, or the plans and estimatesused in future impairment analyses, are lower than the original estimates usedto assess the recoverability of these assets, we could incur significantimpairment charges.

 

We perform an impairment analysis on our goodwill on an annual basis inthe fourth quarter and in certain other circumstances when impairmentindicators are present. Our annual impairment test related to goodwill did notindicate any impairment.

 

Furthermore, ASC Topic 350 states that intangible assets with indefinite lives shouldbe tested annually in lieu of being amortized. This testwork compares the fair value of the intangible with itscarrying amount.  To determine the fairvalue we applied the relief from royalty method (“RFR”).  Under the RFR method, the value of the tradename is determined by calculating the present value of the after-tax cost savingsassociated with owning the asset and therefore not being required to payroyalties for its use during the asset’s indefinite life. Significant judgmentsinherent in this analysis include the selection of appropriate discount rates,estimating future cash flows and the identification of appropriate terminalgrowth rate assumptions.  Discount rateassumptions are based on an assessment of the risk inherent in the projectedfuture cash generated by the respective intangible assets.  Also subject to judgment are assumptionsabout royalty rates, which are based on the estimated rates at which similarbrands and trademarks are being licensed in the 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 $168.6 millionat April 3, 2010 and primarily related to reserves for accounts receivableand inventory, accrued expenses, and net operating loss carryforwards (seeNote 9 to our condensed consolidated financial statements). As of April 3,2010, we maintained a valuation allowance of $6.1 million due to uncertaintiesrelated to our ability to realize certain net operating loss carryforwardsacquired 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.

 

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***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 April 3, 2010, we had $937.8million 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% which expired on December 31, 2009. In February 2009,we entered into two additional non-amortizing interest rate swap agreements.The first was for a notional amount of $550.0 million at a fixed LIBOR rate of1.04% beginning in February 2009 which expired on December 31, 2009.The second is for a notional amount of $750.0 million at a fixed LIBOR rate of1.88% beginning January 2010 amortizing through December 2010.  In August 2009, we entered into four newnon-amortizing interest swap agreements with notional amounts aggregating$300.0 million. Each of the four agreements has a term beginning January 2011through December 2011. The four agreements are at a weighted average fixedLIBOR rate of 2.5825%.   The fair valueof our interest rate swap agreement recorded in the accompanying condensedconsolidated balance sheets as of April 3, 2010 and December 31, 2009was a loss of approximately $11.9 million and $11.2 million, respectively,and is recorded in other current and non-current liabilities. A hypothetical 1%increase in variable interest rates for the remaining portion of the SeniorSecured Credit Facility not covered by the swaps would have impacted ourearnings and cash flow, for the three months ended April 3, 2010, byapproximately $0.5 million. Our senior notes of approximately$875.0 million consisted of fixed rate notes at April 3, 2010. We mayuse additional derivative financial instruments where appropriate to manage ourinterest rate risk. However, as a matter of policy, we do not enter intoderivative or other financial investments for trading or speculative purposes.

 

***Foreign Currency Risk***

 

Due to the global reach of our business, we are exposed to market riskfrom changes in foreign currency exchange rates, particularly with respect tothe U.S. dollar compared to the Euro and the Mexican Peso. 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 currency derivativesto hedge against our investment in our European subsidiaries or their operatingresults, which are converted into U.S. Dollars at period-end and average rates,respectively. However, as we continue to expand our business throughacquisitions and organic growth, the sales of our products that are denominatedin foreign currencies has increased as well as the costs associated with ourforeign subsidiaries which operate in currencies other than the U.S. dollar.Accordingly, our future results could be materially impacted by changes inthese or other factors. For the three months ended April 3, 2010, salesdenominated in foreign currencies accounted for approximately 22.8 % of ourconsolidated net sales, of which 17.9% were denominated in the Euro. In addition,our exposure to fluctuations in foreign currencies arises because certain ofour subsidiaries enter into purchase or sale transactions using a currencyother than its functional currency. Our Mexico-based manufacturing operationsincur costs that are largely denominated in Mexican Pesos. Accordingly, ourfuture results could be materially impacted by changes in foreign exchangerates or other factors. Occasionally, we seek to reduce the potential impact ofcurrency fluctuations on our business through hedging transactions. At April 3,2010, we had foreign exchange forward contracts with an aggregate notionalamount of $188.9 million Mexican Pesos, or approximately $14.1 million, and anaggregate fair market value of approximately $1.1 million. These contractsexpire weekly throughout the fiscal year 2010. For the three months ended April 3, 2010 we recognized anunrealized gain of approximately $1.1 million, and for the three months ended March 29,2009, we recognized an unrealized loss of approximately $3.0 million, relatedto these contracts, which is included in other income (expense) in ourcondensed consolidated statements of operations.

 

**ITEM 4. CONTROLS AND PROCEDURES**

 

***Disclosure Controls and Procedures***

 

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

 

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

 

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*** ***

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

 

                During the firstquarter of 2010 we made changes to our internal control over financialreporting in connection with the transition to the new ERP system at ourSurgical Implant Business. This ongoing implementation has materially changedhow transactions are being processed and has also changed the structure andoperation of some internal controls. While the ERP changes materially affectedour internal control over financial reporting during the current quarter ended April 3,2010, the implementation has proceeded to date without material adverse effectson our internal control over financial reporting.  Additionally, we established additionaltemporary compensating controls, including transactional validation and additionalreconciliation procedures to ensure the accuracy of the reported amounts. Weexpect to maintain certain of these additional temporary compensating controlsfor a period of time.

 

Except for those changes made in connection with the new ERP system,there were no other changes in the Company’s internal control over financialreporting (as that term is defined in Rules 13a-15(f) and 15d-15(f) underthe Exchange Act) during the quarter covered by this report that havematerially affected, or are reasonably likely to materially affect, our internalcontrol over 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.

 

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

 

We are currently defendants in approximately 80product liability cases, including a lawsuit in Canada seeking class actionstatus, related to a disposable drug infusion pump product manufactured by twothird party manufacturers that we distributed through our Bracing and Supportsbusiness unit of our Domestic Rehabilitation segment. We discontinued our saleof these products in the second quarter of 2009. These cases have been broughtagainst the manufacturers and certain distributors of these pumps, and in somecases, the manufacturers of the anesthetics used in these pumps. All of theselawsuits allege that the use of these pumps with certain anesthetics in certainshoulder surgeries over prolonged periods have resulted in cartilage damage tothe plaintiffs. We have sought indemnity and tendered the defense of thesecases to the two manufacturers who supplied these pumps to us, to theirproducts liability carriers and to our products liability carriers. Theproducts liability carriers for both manufacturers have accepted coverage forour defense of these claims; however, both manufacturers have rejected ourtenders of indemnity. The base policy for one of the manufacturers has beenexhausted and the excess liability carriers for that manufacturer are notobligated to provide a defense until a $5 million self-insured retention hasbeen paid. Our products liability carrier has accepted coverage of these cases,subject to a reservation of the right to deny coverage for customary matters,including punitive damages and off-label promotion. The lawsuits allege damagesranging from unspecified amounts to claims between $1.0 million and $10.0million. These cases are in varying stages from initial pleading and discoveryto pre-trial preparation. We could be exposed to material liabilities if ourinsurance coverage is not available or inadequate and the resources of the twomanufacturers, including their respective products liability insurancepolicies, are unavailable or insufficient to pay the defense costs andsettlements or judgments in these cases.

 

We maintain products liability insurance that issubject to annual renewal. Our current policy covers claims reported between July 1,2009 and June 30, 2010 and provides for coverage (together with excesspolicies) of up to a limit of $80 million, provided that the top layer of $25million excess over $55 million covers only claims reported after February 25,2010 and the next layer down of $10 million excess over $45 million covers onlyclaims reported after February 18, 2010. This coverage is subject to aself-insured retention of $500,000 for claims related to pain pumps describedabove and claims related to the IceMan cold therapy product, a self-insuredretention of $250,000 on claims related to all other invasive products and aself-insured retention of $50,000 on claims related to all other non-invasiveproducts, with an aggregate self-insured retention of $1.0 million for allproducts liability claims. In addition, the top layer of $25 million excessover $55 million has a separate self-insured retention of $50,000 perclaim.  Our prior two products 

 

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liabilitypolicies cover claims reported between July 1, 2007 and February 15,2008 and between February 15, 2008 and July 1, 2009,respectively.  The 2007-2008 policyprovides for coverage (together with excess policies) of up to a limit of $20million and the 2008-2009 policy provides for coverage (together with excesspolicies) of up to a limit of $25 million. Certain of the pain pump cases described above were reported under andare covered by these two policies.  If aproducts liability claim or series of claims is brought against us foruninsured liabilities or in excess of our insurance coverage, our businesscould suffer materially. In addition, in certain instances, a productsliability claim could also result in our having to recall some of our products,which could result in significant costs to us. On our condensed consolidatedbalance sheet as of April 3, 2010 and December 31, 2009, we haveaccrued approximately $1.1 million and $2.0 million, respectively, for expensesrelated to products liability claims. The amount accrued is based upon previous claim experience in part dueto the fact that in 2003 we exceeded the coverage limits in effect at that timefor certain historical product liability claims involving one of ourdiscontinued surgical implant products and such products are excluded fromcoverage under our current policies.

 

On April 15, 2009, we became aware of a *qui tam*action filed in Federal Court inBoston, Massachusetts in March 2005 and amended in December 2007 thatnames us as a defendant along with each of the other companies thatmanufactures and sells external bone growth stimulators, as well as ourprincipal stockholder, The Blackstone Group, and the principal stockholder ofone of the other companies in the bone growth stimulation business. This caseis captioned United States *ex rel.*Beirmanv. Orthofix International, N.V., *et al.*,Civil Action No. 05-10557 (D. Mass.). The case was sealed when originallyfiled and unsealed in March 2009. The plaintiff, or relator, alleges thatthe defendants have engaged in Medicare fraud and violated Federal and statefalse claims acts from the time of the original introduction of the devices byeach defendant to the present by seeking reimbursement for bone growthstimulators as a purchased item rather than a rental item. The relator alsoalleges that the defendants are engaged in other marketing practicesconstituting violations of the Federal and various state anti-kickbackstatutes. On December 4, 2009, we filed a motion to dismiss the relator’scomplaint, and we are currently awaiting a response from the relator. Shortlybefore becoming aware of the *qui**tam*action, we were advised that our bonegrowth stimulator business was the subject of an investigation by theDepartment of Justice (“DOJ”), and on April 10, 2009, we were served witha subpoena under the Health Insurance Portability and Accountability Act (“HIPAA”)seeking numerous documents relating to the marketing and sale by us of bonegrowth stimulators. On September 21, 2009, we were served with a secondHIPAA subpoena related to this DOJ investigation seeking additional documentsrelating to the marketing and sale by us of bone growth stimulators. We believethat these subpoenas are related to the DOJ’s investigation of the allegationsin the *qui tam*action, althoughthe DOJ has decided not to intervene in the *quitam*action at this time. We believe that our marketing practices inthe bone growth stimulation business are in compliance with applicable legalstandards and we intend to defend this case and investigation vigorously. Wecan make no assurance as to the resources that will be needed to respond tothese matters or the final outcome of such action.

 

**ITEM 1A.  RISKFACTORS**

 

For a discussion of theCompany’s potential risks or uncertainties, please see Part I,Item IA, of the Company’s Annual Report on Form 10-K for the fiscalyear ended December 31, 2009 filed with the Commission on March 5,2010. There have beenno material changes to the risk factors disclosed in such Form 10-K.

 

**ITEM 5.  OTHERINFORMATION**

 

OnMarch 19, 2010, the Compensation Committee of the Board of Directors ofDJO Incorporated, the parent of DJO Finance LLC, authorized further revisionsto the vesting provisions of options under the 2007 Incentive Stock Plan. Theserevisions will be reflected in option awards made after this action and will bereflected in amendments to outstanding options, including options granted toour named executive officers.  As aresult of a prior amendment in 2009 to the vesting provisions, one-third of theoptions granted in 2008 and 2009 contained a Time-Based Tranche (with vestingbased on continued employment with the Company), one-third contained a Performance-BasedTranche (with vesting based on Adjusted EBITDA and free cash flow targets) andone-third contained an Enhanced Market Return Tranche (with vesting based onthe achievement by The Blackstone Group of a minimum internal rate of return(IRR) and a minimum return of money on invested capital (MOIC) for Blackstoneon its investment in the Company). The Compensation Committee agreed withmanagement’s determination that the Adjusted EBITDA and free cash flow resultsfor 2009 resulted in the vesting of approximately 90% of the shares included inthe Performance-Based Tranche for 2009 for all outstanding options, andpursuant to a “catch-up” provision also resulted in the vesting ofapproximately 90% of the shares included in the Performance-Based Tranche for2008 for all outstanding options granted in that year.  The Compensation Committee noted that theperformance targets for 2009 had previously been modified, but that nomodification had been made or was contemplated to be made for the performancetargets for 2010 or beyond.  Unless suchtargets were modified, the likelihood of the Company meeting the performancetargets for 2010 or beyond was remote, and the Compensation Committeedetermined that these future targets under the Performance-Based Tranche, whichhad been designed at the time of the adoption of the 2007 Incentive Stock Plan,would not sufficiently incentivize executives because the likelihood of theCompany meeting such targets was remote. The Compensation Committee determinedthat further modification of the future performance targets of thePerformance-Based Tranche was not consistent with the purposes of the 2007Incentive Stock Plan, and that a more appropriate measure for the vesting ofthis tranche was a measure similar to that adopted for the Enhanced MarketReturn Tranche.  Accordingly, for futureoption awards and for outstanding 

 

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optionawards, the vesting metrics for the former Performance-Based Tranche, which asa result of this amendment will now be referred to as the “Market ReturnTranche”, were established as a minimum IRR for Blackstone on its investment inthe Company and a minimum MOIC for Blackstone on its investment in theCompany.  These investment returnmetrics, both of which must be satisfied for vesting to occur, will be similarto those established for the Enhanced Market Return Tranche and will apply toone-third of the shares covered by future option awards and to shares coveredby the former Performance-Based Tranche in outstanding options awards for theportion of this tranche that is subject to vesting for the years 2010 andbeyond.  Those portions of thePerformance-Based Tranche of outstanding 2008 and 2009 option awards relatingto performance in 2008 and 2009 that were not vested as described above basedon the 2009 results were considered forfeited and returned to the availableoption pool under the 2007 Incentive Stock Plan.

 

**ITEM 6. EXHIBITS**

 

(a)*                   **Exhibits*

 
| 3.1   |   | Certificate  of Formation of DJOFL and amendments thereto (incorporated by reference to  Exhibit 3.1 to DJOFL’s Annual Report on Form 10-K, filed on  March 5, 2009).                      |
|-------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 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:  May 12, 2010 |   | By:                      | /s/  LESLIE H. CROSS |
|                     |   |                     | Leslie  H. Cross

*President,  Chief Executive Officer and Director* |
|                     |   |                     |   |
| Date:  May 12, 2010 |   | By:                      | /s/  VICKIE L. CAPPS |
|                     |   |                     | Vickie  L. Capps

*Executive Vice President, Chief Financial Officer and  Treasurer* |

 

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