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** **

 

** **

**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

** **

**FORM 10-Q**

 

| **x**                                                                                                                                                                                                          | ** ** | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------|
| ** **                                                                                                                                                                                                     | ** ** | ** **                                                                                                   |
| **For the  quarterly period ended March 28, 2009**                                                                                                                                                        |
| ** **                                                                                                                                                                                                     | ** ** | ** **                                                                                                   |
| **or**                                                                                                                                                                                                         |
| ** **                                                                                                                                                                                                     |
| **o**                                                                                                                                                                                                          | ** ** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
| ** **                                                                                                                                                                                                     | ** ** | ** **                                                                                                   |
| **For the  transition period from              to              .** |

 

**Commission file number 333-142188**

 

**DJOFinance 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 markwhether the Registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required tofile such reports), and (2) has been subject to such filing requirementsfor the past 90 days.  Yes x  No o

 

Indicate by check mark whether the registrant has submittedelectronically and posted on its corporate Web site, if any, every InteractiveData File required to be submitted and posted pursuant to Rule 405 ofRegulation S-T (§232.405 of this chapter) during the preceding 12 months (orfor such shorter period that the registrant was required to submit and postsuch files). Yes o  No o

 

Indicate by check markwhether the Registrant is a large accelerated filer, an accelerated filer, anon-accelerated filer, or a smaller reporting company. See the definitions of “largeaccelerated filer”, “accelerated filer”, and “smaller reporting company” in Rule 12b-2of 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 markwhether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act).  Yes o  No x

 

As of May 6, 2009, 100%of the issuer’s membership interests were owned by DJO Holdings LLC.

 

 

 

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**DJO FINANCE LLC**

**FORM 10-Q**

**TABLE OF CONTENTS**

 
| ** **    | ** **                                                                                                                         | **Page  No.** |
|---------------|------------------------------------------------------------------------------------------------------------------------------------|---------------|
| ** **    | **PART I—Financial  Information**                                                                                        |          |
| Item 1.  | Unaudited  Condensed Consolidated Balance Sheets as of March 28, 2009 and  December 31, 2008                             | 3             |
|          | Unaudited Condensed Consolidated Statements of  Operations for the three months ended March 28, 2009 and March 29,  2008 | 4             |
|          | Unaudited Condensed Consolidated Statements of Cash  Flows for the three months ended March 28, 2009 and March 29, 2008  | 5             |
|          | Notes  to Unaudited Condensed Consolidated Financial Statements                                                                    | 6             |
| Item 2.  | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                        | 29            |
| Item 3.  | Quantitative  and Qualitative Disclosures About Market Risk                                                                        | 41            |
| Item 4T. | Controls  and Procedures                                                                                                           | 42            |
| ** **    | **PART II—Other  Information**                                                                                           |          |
| Item 1.  | Legal  Proceedings                                                                                                                 | 43            |
| Item 1A. | Risk Factors                                                                                                                       | 44            |
| Item 5.  | Other  Information                                                                                                                 | 44            |
| Item 6.  | Exhibits                                                                                                                           | 44            |
| SIGNATURES    | 45                                                                                                                                 |

 

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**PART I. FINANCIAL INFORMATION**

** **

**ITEM 1. FINANCIAL STATEMENTS**

**DJO Finance LLC**

** **

**Unaudited Condensed Consolidated Balance Sheets**

** **

**(in thousands)**

 
| ** **                                                | ** ** | **March 28,  2009** | ** ** | **December 31,  2008** | ** ** |
|-----------------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| **Assets**                                                |       |                     |       |                        |       |
| Current assets:                                           |       |                     |       |                        |       |
| Cash and cash equivalents                                 |       | $                        | 30,744     |                        | $          | 30,483 |   |
| Accounts receivable, net                                  |       | 165,984                  |       | 164,618                     |       |
| Inventories, net                                          |       | 102,804                  |       | 103,166                     |       |
| Deferred tax assets, net                                  |       | 35,147                   |       | 34,039                      |       |
| Prepaid expenses and other current assets                 |       | 21,565                   |       | 16,923                      |       |
| Total current assets                                      |       | 356,244                  |       | 349,229                     |       |
| Property and equipment, net                               |       | 86,690                   |       | 86,262                      |       |
| Goodwill                                                  |       | 1,189,446                |       | 1,191,566                   |       |
| Intangible assets, net                                    |       | 1,241,693                |       | 1,260,472                   |       |
| Other non-current assets                                  |       | 49,203                   |       | 52,601                      |       |
| Total assets                                              |       | $                        | 2,923,276  |                        | $          | 2,940,130 |   |
|                                                      |       |                     |       |                        |       |
| **Liabilities and Membership Equity**                     |       |                     |       |                        |       |
| Current liabilities:                                      |       |                     |       |                        |       |
| Accounts payable                                          |       | $                        | 37,943     |                        | $          | 42,752 |   |
| Accrued interest                                          |       | 42,649                   |       | 10,966                      |       |
| Long-term debt and capital leases, current portion        |       | 11,516                   |       | 11,549                      |       |
| Other current liabilities                                 |       | 95,185                   |       | 104,401                     |       |
| Total current liabilities                                 |       | 187,293                  |       | 169,668                     |       |
| Long-term debt and capital leases, net of current portion |       | 1,828,484                |       | 1,832,044                   |       |
| Deferred tax liabilities, net                             |       | 314,256                  |       | 329,503                     |       |
| Other non-current liabilities                             |       | 13,248                   |       | 8,806                       |       |
| Total liabilities                                         |       | 2,343,281                |       | 2,340,021                   |       |
|                                                      |       |                     |       |                        |       |
| Commitments and contingencies                             |       |                     |       |                        |       |
|                                                      |       |                     |       |                        |       |
| Membership equity:                                        |       |                     |       |                        |       |
| Additional paid-in capital                                |       | 824,804                  |       | 824,235                     |       |
| Accumulated deficit                                       |       | (236,150                 | )          | (221,842                    | )          |
| Accumulated other comprehensive loss                      |       | (10,467                  | )          | (4,027                      | )          |
| DJO Finance LLC membership equity                         |       | 578,187                  |       | 598,366                     |       |
| Noncontrolling interests                                  |       | 1,808                    |       | 1,743                       |       |
| Total DJO Finance LLC membership equity                   |       | 579,995                  |       | 600,109                     |       |
| Total liabilities and membership equity                   |       | $                        | 2,923,276  |                        | $          | 2,940,130 |   |

 

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**    | ** ** |
|-----------------------------------------------------------|------------|---------------------------|------------|
| ** **                                                | ** ** | **March 28,   2009** | ** ** | **March 29,   2008** | ** ** |
| Net sales                                                 |       | $                         | 225,385    |   | $ | 239,728 |   |
| Cost of  sales                                            |       | 84,475                    |       | 95,084 |   |
| Gross profit                                              |       | 140,910                   |       | 144,644 |   |
| Operating  expenses:                                      |       |                      |       |   |   |
| Selling,  general and administrative                      |       | 101,996                   |       | 110,612 |   |
| Research and  development                                 |       | 5,803                     |       | 6,676 |   |
| Amortization  of acquired intangibles                     |       | 19,131                    |       | 19,116 |   |
| Operating  income                                         |       | 13,980                    |       | 8,240 |   |
| Other income  (expense):                                  |       |                      |       |   |   |
| Interest  income                                          |       | 336                       |       | 587 |   |
| Interest  expense                                         |       | (38,591                   | )          | (45,187 | ) |
| Other income  (expense), net                              |       | (1,365                    | )          | 1,343 |   |
| Loss before  income taxes                                 |       | (25,640                   | )          | (35,017 | ) |
| Benefit for  income taxes                                 |       | (11,471                   | )          | (11,055 | ) |
| Net loss                                                  |       | (14,169                   | )          | (23,962 | ) |
| Less: Net  income attributable to noncontrolling interest |       | 139                       |       | 200 |   |
| Net loss  attributable to DJO Finance LLC                 |       | $                         | (14,308    | ) | $ | (24,162 | ) |

 

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**   | ** ** |
|-------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|
| ** **                                                                                                  | ** ** | **March 28,  2009** | ** ** | **March 29,  2008** | ** ** |
| **OPERATING ACTIVITIES:**                                                                                   |       |                     |       |   |   |
| Net loss                                                                                                    |       | $                        | (14,169    | ) | $ | (23,962 | ) |
| Adjustments to reconcile net loss to net cash provided by operating  activities:                            |       |                     |       |   |   |
| Depreciation                                                                                                |       | 6,035                    |       | 5,661 |   |
| Amortization of intangibles                                                                                 |       | 19,131                   |       | 19,116 |   |
| Amortization of debt issuance costs                                                                         |       | 3,256                    |       | 3,506 |   |
| Stock-based compensation                                                                                    |       | 569                      |       | 611 |   |
| Loss on disposal of assets                                                                                  |       | 157                      |       | 165 |   |
| Deferred income taxes                                                                                       |       | (12,135                  | )          | (12,208 | ) |
| Provision for doubtful accounts and sales returns                                                           |       | 9,220                    |       | 4,440 |   |
| Inventory reserves                                                                                          |       | 960                      |       | 1,518 |   |
| Changes in operating assets and liabilities, net of acquired assets  and liabilities:                       |       |                     |       |   |   |
| Accounts receivable                                                                                         |       | (10,907                  | )          | (16,172 | ) |
| Inventories                                                                                                 |       | (260                     | )          | 4,623 |   |
| Prepaid expenses, other assets and liabilities                                                              |       | (4,141                   | )          | (3,459 | ) |
| Accrued interest                                                                                            |       | 31,683                   |       | 42,284 |   |
| Accounts payable and other current liabilities                                                              |       | (11,791                  | )          | (18,690 | ) |
| Net cash provided by operating activities                                                                   |       | 17,608                   |       | 7,433 |   |
| **INVESTING ACTIVITIES:**                                                                                   |       |                     |       |   |   |
| Acquisition of businesses, net of cash acquired                                                             |       | (3,929                   | )          | — |   |
| Acquisition of intangibles                                                                                  |       | —                   |       | (675 | ) |
| Purchases of property and equipment                                                                         |       | (8,159                   | )          | (4,272 | ) |
| Other, net                                                                                                  |       | 175                      |       | 456 |   |
| Net cash used in investing activities                                                                       |       | (11,913                  | )          | (4,491 | ) |
| **FINANCING ACTIVITIES:**                                                                                   |       |                     |       |   |   |
| Net cash used in financing activities — payments on long-term debt and  revolving line of credit       |       | (4,095                   | )          | (108 | ) |
| Effect of exchange rate changes on cash and cash equivalents                                                |       | (1,339                   | )          | 1,389 |   |
| **Net increase in cash and cash equivalents**                                                               |       | 261                      |       | 4,223 |   |
| Cash and cash equivalents at beginning of period                                                            |       | 30,483                   |       | 63,471 |   |
| **Cash and cash equivalents at end of period**                                                              |       | $                        | 30,744     |   | $ | 67,694 |   |
| **Supplemental disclosures of cash flow  information:**                                                     |       |                     |       |   |   |
| Cash paid for interest                                                                                      |       | $                        | 3,584      |   | $ | 52 |   |
| Cash paid (received) for income taxes (refund)                                                              |       | $                        | (673       | ) | $ | 1,156 |   |
| **Non-cash investing and financing activities:**                                                            |       |                     |       |   |   |
| Increases in property and equipment and in other liabilities in  connection with capitalized software costs |       | $                        | 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 ofPresentation and Principles of Consolidation.**  We are a global provider of high-quality,orthopedic devices, with a broad range of products used for rehabilitation,pain management and physical therapy. We also develop, manufacture anddistribute a broad range of surgical reconstructive implant products. We offerhealthcare professionals and patients a diverse range of orthopedicrehabilitation products addressing the complete spectrum of preventative,pre-operative, post-operative, clinical and home rehabilitation care. Our productsare used by orthopedic specialists, spine surgeons, primary care physicians,pain management specialists, physical therapists, podiatrists, chiropractors,athletic trainers and other healthcare professionals to treat patients withmusculoskeletal conditions resulting from degenerative diseases, deformities,traumatic events and sports-related injuries. In addition, many of ournon-surgical medical devices and related accessories are used by athletes andpatients for injury prevention and at-home physical therapy treatment.

 

In the first quarter of2009, we changed how we report our segmented financial information inaccordance with Financial Accounting Standards Statement (“SFAS”) No. 131,Disclosures about Segments of an Enterprise and Related Information (“SFAS 131”).  Prior to 2009, we included the internationalcomponents of the Surgical non- U.S., Chattanooga, and Empi businesses ineither the Surgical or Domestic Rehabilitation segments, as their operationswere managed domestically.  During the fourthquarter of 2008, we effected an operational reorganization which resulted inthe non-U.S. components of all of our businesses being managed abroad.  Our restated segment information now reflectsthe international components of all of our business within our Internationalsegment.

 

We market and distribute ourproducts through three operating segments, Domestic Rehabilitation,International, and Domestic Surgical Implant. Our Domestic RehabilitationSegment offers to customers in the United States, non-invasive medical productsthat are used before and after surgery to assist in the repair andrehabilitation of soft tissue and bone, and to protect against further injury;electrotherapy devices and accessories used to treat pain and restore musclefunction; iontophoretic devices and accessories used to deliver medication;clinical therapy tables, traction equipment and other clinical therapyequipment; orthotic devices used to treat joint and spine conditions;orthopedic soft goods; rigid knee braces; and vascular systems which includeproducts intended to prevent deep vein thrombosis following surgery. OurDomestic Surgical Implant Segment offers a comprehensive suite ofreconstructive joint products to customers in the United States.  Our International segment offers all of ourproducts to customers outside the United States.

 

Except as otherwiseindicated, references to “us”, “we”, “our”, “DJO”, or “our Company”, refers toDJO Incorporated and its consolidated subsidiaries.

 

Noncontrolling interestsreflect the 50% separate ownership of Medireha GmbH (“Medireha”) not ownedby us, which we have consolidated due to our controlling interest. Ourcontrolling interest consists of our 50% ownership and our control of one ofthe two director seats, our rights to prohibit certain business activities thatare not consistent with our plans for the business and our exclusivedistribution rights for products manufactured by Medireha. All significantintercompany balances and transactions have been eliminated in consolidation.

 

The accompanying unauditedcondensed consolidated financial statements as of March 28, 2009 and forthe three months ended March 28, 2009 and March 29, 2008 have beenprepared in accordance with accounting principles generally accepted in theUnited States for interim financial information. Accordingly, they do notinclude all of the information and disclosures required by accountingprinciples generally accepted in the United States for complete financialstatements. 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, 2008. The accompanying unaudited condensedconsolidated financial statements as of March 28, 2009 and for the threemonths ended March 28, 2009 and March 29, 2008 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.

 

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**Use ofEstimates.**  The preparationof financial statements in conformity with accounting principles generallyaccepted in the United States of America requires management to make certainestimates and assumptions that affect the reported amounts of assets andliabilities, the disclosure of contingent assets and liabilities at the date ofthe financial statements and the reported amounts of revenues and expensesduring the reporting period. On an ongoing basis, management evaluates itsestimates, including those related to contractual allowances, doubtfulaccounts, inventories, rebates, product returns, warranty obligations, selfinsurance, income taxes, goodwill and intangible assets and stock-basedcompensation. We base our estimates on historical experience and on variousother assumptions that we believe are reasonable under the circumstances, theresults of which form the basis for making judgments about the carrying valuesof assets and liabilities that are not readily apparent from other sources.Actual results could differ from those estimates.

** **

**Cash andCash Equivalents.**  Cashconsists of deposits with financial institutions. We consider all short-term,highly liquid investments and investments in money market funds and commercialpaper with original maturities of less than three months at the time ofpurchase to be cash equivalents. While our cash and cash equivalents are ondeposit with high-quality institutions, such deposits exceed Federal DepositInsurance Corporation insured limits.

** **

**Computer Software Costs. **Software is stated at cost less accumulated amortization and isamortized using the straight-line method over its estimated useful life rangingfrom three to seven years.  In accordancewith American Institute of Certified Public Accountants Statement of Position98-1, “Accounting for the Costs of Computer Software Developed or Obtained forInternal Use” (“SOP 98-1”) we capitalize costs of internally developed softwareduring the development stage. Additionally, we capitalize related costs including external consulting costs,cost of software licenses, and internal payroll and payroll-related costs foremployees who are directly associated with a software project.  Software assets are reviewed for impairmentwhen events or circumstances indicate that the carrying value may not berecoverable over the remaining lives of the assets. Upgrades and enhancementsare capitalized if they result in added functionality.  Recently we began implementing a new ERPsystem resulting in approximately $4.5 million of capitalized software costs asof March 28, 2009.

 

**DerivativeFinancial Instruments.**

 

We account for derivativespursuant to SFAS No. 133, “Accounting for Derivative Instruments and HedgingActivities”(“SFAS 133”), 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 exchangeforward contracts to hedge expense commitments that are denominated incurrencies other than the U.S. dollar. The purpose of our foreign currencyhedging activities is to fix the dollar value of specific commitments andpayments to foreign vendors. Before acquiring a derivative instrument to hedgea specific risk, potential natural hedges are evaluated.  While our foreign exchange contracts act aseconomic hedges, we have not designated such instruments as hedges under SFAS133.  We account for our foreign forwardcontracts in accordance with SFAS No. 157, “Fair Value Measurement” (“SFAS157”).  The classification of gains andlosses resulting from changes in the fair values of derivatives is dependent onthe intended use of the derivative and its resulting designation. The change infair value of the ineffective portion of a hedge, and changes in the fairvalues of the derivative are recorded in other comprehensive income and aresubsequently recognized in earnings when the hedge item affects earnings.   At March 28, 2009, the fair value ofour foreign exchange forward contracts was a loss of $16.5 million and wasdetermined through the use of models that consider various assumptions,including time value, yield curves, as well as other relevant economicmeasures, which are inputs that are classified as Level 2 in the valuationhierarchy.

* *

*Interest Rate Swap*

 

We make use of debtfinancing as a source of funds and are therefore exposed to interest ratefluctuations in the normal course of business. Our credit facilities aresubject to floating interest rates. We manage the risk of unfavorable movementsin interest rates by hedging a portion of the outstanding loan balance, therebylocking in a fixed rate on a portion of the principal, reducing the effect ofpossible rising interest rates and making interest expense more predictable.  We have designated these interest rate swapagreements as cash flow hedges and account for our interest rate swapagreements in accordance with SFAS 133 and SFAS 157.  At March 28, 2009, the fair value of ourinterest rate swap agreements was a loss of $18.8 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.

 

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**ForeignCurrency Translation.**  Thefinancial statements of our international subsidiaries, where the localcurrency is the functional currency, are translated into U.S. dollars usingperiod-end exchange rates for assets and liabilities and average exchange ratesduring the period for revenues and expenses. Cumulative translation gains andlosses are excluded from results of operations and recorded as a separatecomponent of consolidated membership equity. Gains and losses resulting fromforeign currency transactions (transactions denominated in a currency otherthan the entity’s local currency) are included in the condensed consolidatedstatements of operations.

 

Comprehensive loss consistsof the following for the three months ended March 28, 2009 (in thousands):

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

 

Comprehensive loss consistsof the following for the three months ended March 29, 2008 (in thousands):

 
| ** **                                             | ** ** | **DJO Finance   LLC** | ** ** | **Noncontrolling   Interests** | ** ** | **Total** | ** ** |
|--------------------------------------------------------|------------|-----------------------|------------|--------------------------------|------------|-----------|------------|
| Net loss, as reported                                  |       | $                     | (23,962    | )                              | $          | (200      | )          | $ | (24,162 | ) |
| Foreign currency translation adjustments               |       | 4,201                 |       | —                         |       | 4,201     |       |
| Change in fair value of interest rate swap, net of tax |       | (5,992                | )          | —                         |       | (5,992    | )          |
| Comprehensive loss                                     |       | $                     | (25,753    | )                              | $          | (200      | )          | $ | (25,953 | ) |

 

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

** **

**RecentAccounting Pronouncements.**  We have adopted SFAS No. 161, “Disclosuresabout Derivative Instruments and Hedging Activities” (“SFAS 161”) as of January 1,2009, which requires entities to disclose the fair values of derivativeinstruments and their gains and losses in a tabular format and to provideenhanced disclosures about (a) how and why they use derivativeinstruments, (b) how derivative instruments and related hedged items areaccounted for under SFA 133 and its related interpretations, and (c) howderivative instruments and related hedged items affect their financialperformance, and cash flows.  Other thanthe required disclosures (see Note 13), the adoption of SFAS 161 had no impacton our consolidated financial statements.

 

We have adopted SFAS No. 160,“Non-controlling Interests in Consolidated Financial Statements- an amendmentof ARB No. 51, Consolidated Financial Statements” (“SFAS 160”).  SFAS 160 amends Accounting Research Bulletin No. 51,“Consolidated Financial Statements”, to establish accounting and reportingstandards for the noncontrolling interest in a subsidiary.  This standard defines a noncontrollinginterest, previously called a minority interest, as the portion of equity in asubsidiary not attributable, directly or indirectly, to a parent.  SFAS 160 requires, among other items, that anoncontrolling interest be included in the consolidated statement of financialposition within equity separate from the parent’s equity; consolidated netincome to be reported at amounts inclusive of both the parent’s andnoncontrolling interest’s shares; and if a subsidiary is deconsolidated, anyretained noncontrolling equity investment in the former subsidiary be measuredat fair value and a gain or loss be recognized in net income based on such fairvalue.  We have applied the presentationand disclosure requirements of SFAS 160 retrospectively.

 

We have adopted SFAS No. 141(Revised), “Business Combinations” (“SFAS 141R”) as of January 1, 2009, whichrequires the acquiring entity in a business combination to recognize all theassets acquired and liabilities assumed in the transaction; establishes theacquisition-date fair value as the measurement objective for all assetsacquired and liabilities assumed; and requires the acquirer to disclose toinvestors and other users all of the information they need to evaluate andunderstand the nature and financial effect of the business combination (seeNote 2).

 

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**2. ACQUISITIONS**

 

We account for acquisitionsin accordance with SFAS 141R, with the results of operations attributable toeach acquisition included in the condensed consolidated financial statementsfrom the date of acquisition.

*** ***

***Acquisition of Donjoy OrthopaedicsPty., Ltd.***

 

OnFebruary 3, 2009 we acquired DonJoy Orthopaedics Pty., Ltd. an Australiandistributor of DJO products (“DJO Australia”), for a total cash compensation of$3.7 million.  Our primary reason for theacquisition of DJO Australia is to move from an indirect sales model (i.e.,sales to distributors at a discount) to a direct sales model, resulting in increasedgross profit and operating income. Pursuant to the terms of the acquisition agreement and included withinthe purchase price, is an additional amount payable to the selling shareholderof DJO Australia if certain revenue targets are met by December 31, 2009.

 

Thefair values of the assets acquired and the liabilities assumed were estimatedin accordance with SFAS 141R.  Thepurchase price was allocated as follows to the fair values of the net tangibleand intangible asset acquired:

 
| Cash                   |   | $     | 912    |   |
|------------------------|--------|-------|--------|--------|
| Accounts receivable    |   | 397   |   |
| Inventories            |   | 725   |   |
| Other assets           |   | 12    |   |
| Liabilities assumed    |   | (636  | )      |
| Intangible assets      |   | 1,614 |   |
| Deferred tax liability |   | (484  | )      |
| Goodwill               |   | 957   |   |
| Total purchase price   |   | $     | 3,497  |   |

 

Thepurchase price allocation included approximately $1.6 million assigned tointangible assets related to certain customer relationships existing on theacquisition date. This value was based upon an estimate of the futurediscounted cash flows that would be derived from those customers.

 

Goodwillrepresents the excess of the purchase price over the fair value of tangible andidentifiable intangible assets acquired and liabilities assumed.  A value of approximately $1.0 million,representing the difference between the total purchase price and the aggregatefair value assigned to the net tangible assets acquired and the liabilitiesassumed and the identifiable intangible assets acquired, was assigned togoodwill.

 

**3. ACCOUNTS RECEIVABLE RESERVES**

 

A summary of activity in ouraccounts receivable reserves for doubtful accounts and sales returns is presentedbelow (in thousands):

 
| ** **                                        | ** ** | **Three Months Ended**    | ** ** |
|---------------------------------------------------|------------|---------------------------|------------|
| ** **                                        | ** ** | **March 28,   2009** | ** ** | **March 29,  2008** | ** ** |
| Balance, beginning of period                      |       | $                         | 36,521     |   | $ | 32,417 |   |
| Provision for doubtful accounts and sales returns |       | 9,220                     |       | 4,440 |   |
| Write-offs, net of recoveries                     |       | (5,532                    | )          | (5,895 | ) |
| Balance, end of period                            |       | $                         | 40,209     |   | $ | 30,962 |   |

 

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**4. INVENTORIES**

 

Inventories consist of thefollowing (in thousands):

 
| ** **                    | ** ** | **March 28,  2009** | ** **    | **December 31,   2008** | ** ** |
|-------------------------------|------------|--------------------------|---------------|------------------------------|------------|
| Components and raw materials  |       | $                        | 34,475        |                         | $          | 34,015 |   |
| Work in process               |       | 5,467                    |          | 5,310                        |       |
| Finished goods                |       | 55,023                   |          | 59,835                       |       |
| Inventory held on consignment |       | 24,212                   |          | 21,804                       |       |
|                          |       | 119,177                  |          | 120,964                      |       |
| Less—inventory reserves  |       | (16,373                  | )             | (17,798                      | )          |
|                          |       | $                        |  102,804 |                         | $          | 103,166 |   |

 

A summary of the activity inour reserves for estimated slow moving, excess, obsolete and otherwise impairedinventory is presented below (in thousands):

 
| ** **                         | ** ** | **Three Months Ended**   | ** ** |
|------------------------------------|------------|--------------------------|------------|
| ** **                         | ** ** | **March 28,  2009** | ** ** | **March 29,  2008** | ** ** |
| Balance, beginning of period       |       | $                        | 17,798     |   | $ | 18,996 |   |
| Provision charged to cost of sales |       | 960                      |       | 1,518 |   |
| Write-offs, net of recoveries      |       | (2,385                   | )          | (3,152 | ) |
| Balance, end of period             |       | $                        | 16,373     |   | $ | 17,362 |   |

 

The write-offs to thereserve were principally related to the disposition of fully reservedinventory.

** **

**5. GOODWILL AND INTANGIBLE ASSETS**

 

A summary of adjustments toour goodwill balance for the three months ended March 28, 2009 is asfollows (in thousands):

 
| Balance, beginning of period |   | $      | 1,191,566 |   |
|------------------------------|--------|--------|-----------|--------|
| Foreign currency translation |   | (3,077 | )         |
| Acquisition (See Note 2)     |   | 957    |      |
| Balance, end of period       |   | $      | 1,189,446 |   |

 

Identifiable intangibleassets consisted of the following as of March 28, 2009 (in thousands):

 
| ** **                                           | ** ** | **Gross Carrying  Amount** | ** **    | **Accumulated  Amortization** | ** ** | **Intangibles,  Net** | ** ** |
|------------------------------------------------------|------------|----------------------------|---------------|-------------------------------|------------|-----------------------|------------|
| Amortizable intangible assets:                       |       |                       |          |                          |       |                  |       |
| Technology-based                                     |       | $                          | 458,612       |                          | $          | (65,999               | )          | $ | 392,613 |   |
| Customer-based                                       |       | 480,001                    |          | (67,170                       | )          | 412,831               |       |
|                                                 |       | $                          |  938,613 |                          | $          | (133,169              | )          | 805,444 |   |
| Indefinite-lived intangible assets:                  |       |                       |          |                          |       |                  |       |
| Trademarks                                           |       |                       |          |                          |       | 435,267               |       |
| Accumulated Foreign currency translation adjustments |       |                       |          |                          |       | 982                   |       |
| Total identifiable intangible assets                 |       |                       |          |                          |       | $                     | 1,241,693  |   |

 

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

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

 

Our amortizable intangibleassets are being amortized over the estimated useful lives of 10 and nine yearson a weighted average basis for technology-based and customer-basedintangibles, respectively.

 

Estimated amortizationexpense related to acquired intangible assets for the next five years andthereafter is as follows (in thousands):

 
| Remaining 2009 |   | $       | 57,345        |   |
|----------------|--------|---------|---------------|--------|
| 2010           |   | 75,478  |          |
| 2011           |   | 74,096  |          |
| 2012           |   | 72,650  |          |
| 2013           |   | 67,796  |          |
| Thereafter     |   | 458,079 |          |
|           |   | $       |  805,444 |   |

 

**6. OTHER CURRENT LIABILITIES**

 

Other current liabilitiesconsist of the following (in thousands):

 
| ** **                             | ** ** | **March 28,  2009** | ** **   | **December 31,  2008** | ** ** |
|----------------------------------------|------------|--------------------------|--------------|-----------------------------|------------|
| Wages and related expenses             |       | $                        | 21,231       |                        | $          | 21,695 |   |
| Commissions and royalties              |       | 11,721                   |         | 13,799                      |       |
| Taxes                                  |       | 4,969                    |         | 4,943                       |       |
| Professional fees                      |       | 4,753                    |         | 2,453                       |       |
| Rebates                                |       | 3,628                    |         | 4,812                       |       |
| Accrued ERP costs                      |       | 6,761                    |         | 6,763                       |       |
| Interest rate swap derivative          |       | 14,737                   |         | 13,272                      |       |
| Foreign exchange contracts derivatives |       | 3,006                    |         | 4,162                       |       |
| Other accrued liabilities              |       | 24,379                   |         | 32,502                      |       |
|                                   |       | $                        |  95,185 |                        | $          | 104,401 |   |

 

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

 

Long-term debt (includingcapital lease obligations) consists of the following (in thousands):

 
| ** **                                                                                                                                                                                               | ** ** | **March 28,  2009** | ** ** | **December 31,  2008** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| Term loan under Senior Secured Credit Facility, net of unamortized  original issue discount ($10.5 million and $10.9 million at  March 28, 2009 and December 31, 2008, respectively) |       | $                        | 1,043,809  |                        | $          | 1,043,404 |   |
| Revolving loans outstanding under Senior Secured Credit Facility                                                                                                                                         |       | 20,000                   |       | 24,000                      |       |
| 10.875% Senior notes                                                                                                                                                                                     |       | 575,000                  |       | 575,000                     |       |
| 11.75% Senior subordinated notes                                                                                                                                                                         |       | 200,000                  |       | 200,000                     |       |
| Loans and revolving credit facilities at various European banks                                                                                                                                          |       | 827                      |       | 891                         |       |
| Capital lease obligations and other                                                                                                                                                                      |       | 364                      |       | 298                         |       |
|                                                                                                                                                                                                     |       | 1,840,000                |       | 1,843,593                   |       |
| Less current portion                                                                                                                                                                                     |       | (11,516                  | )          | (11,549                     | )          |
| Long-term debt and capital leases, net of current portion                                                                                                                                                |       | $                        | 1,828,484  |                        | $          | 1,832,044 |   |

 

*Senior Secured Credit Facility*

 

On November 20, 2007,we entered into the Senior Secured Credit Facility which consists of a six anda half-year $1,065.0 million term loan facility and a six-year$100.0 million revolving credit facility. We issued the term loan facilityof the Senior Secured Credit Facility at a 1.2% discount, resulting in netproceeds of $1,052.4 million. The $12.6 million discount is beingamortized as additional interest expense over the term of the term loanfacility and increases the reported outstanding balance accordingly. As of March 28,2009, $20.0 million related to our revolving credit facility was outstanding.

* *

*InterestRate and Fees.*  Borrowingsunder the Senior Secured Credit Facility bear interest at a rate equal to anapplicable margin plus, at our option, either (a) a base rate determinedby reference to the higher of (1) the prime rate of Credit Suisse and (2) thefederal funds rate plus 0.50% or (b) the Eurodollar rate determined byreference to the costs of funds for deposits in U.S. dollars for the interestperiod relevant to each borrowing adjusted for required reserves. The initialapplicable margin for borrowings under the term loan facility and the revolvingcredit facility is 2.00% with respect to base rate borrowings and 3.00% withrespect to Eurodollar borrowings. The applicable margin for borrowings underthe term loan facility and the revolving credit facility may be reduced subjectto us attaining certain leverage ratios.

 

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% in an effort to hedge ourexposure to fluctuating interest rates related to a portion of our SeniorSecured Credit Facility (see Note 13). The swap agreement amortizesthrough December 2009. As of March 28, 2009, the remaining notionalamount of the swap was $470.0 million. In February 2009, we entered intotwo interest rate swap agreements. The first is for a notional amount of $550.0million at a fixed LIBOR rate of 1.04% beginning February 2009 through December 2009.The second is for a notional amount of $750.0 million at a fixed LIBOR rate of1.88% beginning January 2010 through December 2010. As of March 28,2009, our weighted average interest rate for all borrowings under the SeniorSecured Credit Facility was 3.91%.

 

In addition to payinginterest on outstanding principal under the Senior Secured Credit Facility, weare required to pay a commitment fee to the lenders under the revolving creditfacility with respect to the unutilized commitments thereunder. The initialcommitment fee rate is 0.50% per annum. The commitment fee rate may be reducedsubject to us attaining certain leverage ratios. We must also pay customaryletter of credit fees.

* *

*PrincipalPayments.*  We arerequired to pay annual payments in equal quarterly installments on the loansunder the term loan facility in an amount equal to 1.00% of the funded totalprincipal amount during the first six years and three months following theclosing of the Senior Secured Credit Facility, with any remaining amountpayable at maturity. Principal amounts outstanding under the revolving creditfacility are due and payable in full at maturity.

* *

*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 

 

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(including insurance and condemnationproceeds) by DJO Finance LLC (“DJOFL”) and its restricted subsidiaries, subjectto certain exceptions to be agreed upon, including a 100% reinvestment right ifreinvested or committed to reinvest within 15 months of such sale ordisposition so long as reinvestment is completed within 180 daysthereafter; and (3) 100% of the net cash proceeds from issuances orincurrences of debt by DJOFL and its restricted subsidiaries, other thanproceeds from debt permitted to be incurred under the Senior Secured CreditAgreement. The foregoing mandatory prepayments will be applied to the term loanfacilities in direct order of maturity. We have not been required to make anymandatory pre-payments through March 28, 2009.  We may voluntarily prepay outstanding loansunder the Senior Secured Credit Facility at any time without premium orpenalty, provided that voluntary prepayments of Eurodollar loans made on a dateother than the last day of an interest period applicable thereto shall be subjectto customary breakage costs.

* *

*Guaranteeand Security.*  Allobligations under the Senior Secured Credit Facility are unconditionallyguaranteed by DJO Holdings LLC (“Holdings”) and each existing and future directand indirect wholly-owned domestic subsidiary of DJOFL other than immaterialsubsidiaries, unrestricted subsidiaries and subsidiaries that are precluded bylaw or regulation from guaranteeing the obligations (collectively, the “Guarantors”).

 

All obligations under theSenior Secured Credit Facility, and the guarantees of those obligations, aresecured by pledges of 100% of the capital stock of DJOFL, 100% of the capitalstock of each wholly owned domestic subsidiary and 65% of the capital stock ofeach wholly owned foreign subsidiary that is, in each case, directly owned byDJOFL or one of the Guarantors; and a security interest in, and mortgages on,substantially all tangible and intangible assets of Holdings, DJOFL and eachGuarantor.

* *

*CertainCovenants 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:

 

·                  incuradditional indebtedness;

·                  create liens onassets;

·                  change fiscalyears;

·                  enter into saleand leaseback transactions;

·                  engage inmergers or consolidations;

·                  sell assets;

·                  pay dividendsand other restricted payments;

·                  makeinvestments, loans or advances;

·                  repaysubordinated indebtedness;

·                  make certainacquisitions;

·                  engage incertain transactions with affiliates;

·                  restrict theability of restricted subsidiaries that are not Guarantors to pay dividends ormake distributions;

·                  amend materialagreements governing our subordinated indebtedness; and

·                  change ourlines of business.

 

In addition, the SeniorSecured Credit Facility requires us to maintain a declining maximum seniorsecured leverage ratio of 4.65:1 as of the twelve months ended March 28,2009 and stepping down over time to 3.25:1 by the end of 2011. The SeniorSecured Credit Facility also contains certain customary affirmative covenantsand events of default. Our maximum senior secured leverage ratio was within thecovenant level as of March 28, 2009.

* *

*10.875% Senior Notes Payable*

 

On November 20, 2007,DJOFL and DJO Finance Corporation (“Finco”) (collectively, the “Issuers”)issued $575.0 million aggregate principal amount of 10.875% Notes under anagreement dated as of November 20, 2007 (the “10.875% Indenture”) amongthe Issuers, the guarantors party thereto and The Bank of New York Mellon(formerly known as The Bank of New York), as trustee. On July 2, 2008, ouramended registration statement, filed in June 2008 on Form S-4 withthe Securities and Exchange Commission 

 

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(the “Commission”) relating to an offer toexchange these privately issued 10.875% Notes, for registered 10.875% Notes wasdeclared effective. The exchange offer was completed July 31, 2008.

 

The 10.875% Notes requiresemi-annual interest payments of approximately $31.3 million each May 15and November 15 and are due November 15, 2014. The market value ofthe 10.875% Notes was approximately $425.5 million as of March 28, 2009and was determined using trading prices for the 10.875% Notes on or near thatdate. We believe the trading prices reflect certain differences between prevailingmarket terms and conditions and the actual terms of our 10.875% Notes.

* *

*OptionalRedemption.*  Under the10.875% Indenture, prior to November 15, 2011, the Issuers have the optionto redeem some or all of the 10.875% Notes for cash at a redemption price equalto 100% of the then outstanding principal balance plus an applicable make-wholepremium plus accrued and unpaid interest. Beginning on November 15, 2011,the Issuers may redeem some or all of the 10.875% Notes at a redemption priceof 105.438% of the then outstanding principal balance plus accrued and unpaidinterest. The redemption price decreases to 102.719% and 100% of the thenoutstanding principal balance at November 2012 and 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 redemption priceequal to 110.875% of the principal amount then outstanding, in each case, withproceeds we raise, or a direct or indirect parent company raises, in certainofferings of equity of DJOFL or its direct or indirect parent companies, aslong as at least 65% of the aggregate principal amount of the notes issuedremains outstanding.

* *

*Change ofControl.*  Upon theoccurrence of a change of control, unless DJOFL has previously sent orconcurrently sends a notice exercising its optional redemption rights withrespect to all of the then-outstanding 10.875% Notes, DJOFL will be required tomake an offer to repurchase all of the then-outstanding 10.875% Notes at 101%of their principal amount, plus accrued and 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 March 28, 2009, 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 the11.75% Notes was approximately $121.0 million as of March 28, 2009and was determined using trading prices for the 11.75% Notes on or near thatdate. We believe the trading prices reflect certain differences betweenprevailing market terms and conditions and the actual terms of our 11.75%Notes.

 

The 11.75% Notes containsimilar provisions as the 10.875% Notes with respect to change of control andcovenant requirements. Under the Indenture governing the 11.75% Notes (the “11.75%Indenture”), prior to November 15, 2010, the Issuers have the option toredeem some or all of the 11.75% Notes for cash at a redemption price equal to100% of the then outstanding principal balance plus an applicable make-wholepremium plus accrued and unpaid interest. Beginning on November 15, 2010,the Issuers may redeem some or all of the 11.75% Notes at a redemption price of105.875% of the then outstanding principal balance plus accrued and unpaidinterest on the 11.75% Notes. The redemption price decreases to 102.938% and100% of the then outstanding principal balance at November 2011 and November 2012,respectively. Additionally, from time to time, before November 15, 2009,the Issuers may redeem up to 35% of the 11.75% Notes at a redemption priceequal to 111.75% of the principal amount then outstanding, in each case, withproceeds we raise, or a direct or indirect parent company raises, in certainofferings of equity of DJOFL or its direct or indirect parent companies, aslong as at least 65% of the aggregate principal amount of the notes issuedremains outstanding.

 

Our ability to continue tomeet the covenants related to our indebtedness specified above in futureperiods will depend, in part, on events beyond our control, and we may notcontinue to meet those ratios. A breach of any of these covenants in the future

 

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could result in a default under the SeniorSecured Credit Facility, the 11.75% Indenture and the 10.875% Indenture(collectively, the “Indentures”), at which time the lenders could elect todeclare all amounts outstanding under the Senior Secured Credit Facility to beimmediately due and payable. Any such acceleration would also result in adefault under the Indentures.

* *

*Debt Issue Costs*

 

We incurred $30.7 million,$24.5 million, and $10.2 million of debt issue costs in connection with theSenior Secured Credit Facility, the 10.875% Notes, and the 11.75% Notes,respectively. These costs have been capitalized and are included in othernon-current assets in the condensed consolidated balance sheets at March 28,2009 and December 31, 2008. Debt issue costs are being amortized over theterms of the respective debt instruments through November 2014.

** **

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

* *

*2007 Stock Incentive Plan*

 

We have one active equity plan, the DJO Incorporated 2007 IncentiveStock Plan (the “2007 Plan”), which is authorized to grant options up to7,500,000 shares, subject to adjustment in certain events. Options issued underthe 2007 Plan can be either incentive stock options or non-qualified stockoptions. The exercise price of stock options granted will not be less than 100%of the fair market value of the underlying shares on the date of grant, andwill expire no more than ten years from the date of grant. In addition, weadopted a form of non-statutory stock option agreement (the “DJO Form OptionAgreement”) for employee stock option awards under the 2007 Plan. Under the DJOForm Option Agreement, one-third of stock options will vest over aspecified period of time (typically five years) contingent solely upon theawardees’ continued employment with us (“Time-Based Tranche”). Anotherone-third of stock options will vest over a specified performance period(typically four to five years) from the date of grant upon the achievement ofcertain pre-determined performance targets based on Adjusted EBITDA and freecash flow on an annual basis (“Performance-Based Tranche”), as defined in theDJO Form Option Agreement, while the final one-third was originallydetermined to vest based upon achieving enhanced pre-determined performancetargets based on Adjusted EBITDA and free cash flow (“EnhancedPerformance-Based Tranche”). The DJO Form Option Agreement includescertain forfeiture provisions upon an awardees’ separation from service withus.

 

During March 2009, wemade modifications to the terms of the outstanding options and the 2007 Plan.The Time-Based Tranche terms remain the same as discussed above. Theperformance conditions for the portion of the options within thePerformance-Based Tranche that vest based on 2009 financial performance weremodified to require achievement of the levels of Adjusted EBITDA and free cashflow that were established in connection with our 2009 budget process. As withthe original terms of such options, the optionees may earn 80% or more of suchportion of options upon achievement of at least a minimum threshold amount ofthe budgeted Adjusted EBITDA and of the free cash flow targets for 2009. Thefinancial targets for the Performance-Based Tranches for the years 2010-2012remain unchanged. The vesting provisions of the Performance-Based Tranche weremodified to provide that upon achievement of the annual target for a givenyear, the annual portion of the tranche associated with all prior years willalso vest to the extent not previously vested. The financial performancetargets for the entire Enhanced Performance-Based Tranche were replaced bytargets with different financial metrics. These new targets require achievementof a minimum internal rate of return (“IRR”) and multiple of invested capital (“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. As a result of this modification, theEnhanced Performance-Based Tranche has both a performance component and amarket condition component.

 

Options granted under the2007 Plan contain change-in-control provisions that cause the vesting of aportion of the tranches upon the occurrence of a change-in-control, as follows:1) the option shares in the Time-Based Tranche will become immediatelyexercisable upon the occurrence of a change-in-control if the optionee remainsin continuous employment of the Company until the consummation of thechange-in-control and 2) the option shares of the Performance-Based Tranchefor the year in which such change-in-control is consummated and for anysubsequent performance periods will become immediately exercisable if theoptionee remains in continuous employment of the Company until the consummationof the change-in-control. This provision does not operate to vest the EnhancedPerformance-Based Tranche which requires the achievement of the IRR and MOICtargets by Blackstone on its equity investment in us.

 

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*Employee Stock Options*

 

During the three monthsended March 28, 2009 we granted 594,782 stock options under the 2007 Planto our executive officers, senior management, and certain other employees.

 

We recorded non-cashcompensation expense of approximately $0.5 million and $0.6 million in thethree months ended March 28, 2009 and March 29, 2008, respectively,associated with stock options issued under the 2007 Plan. We recordcompensation expense for awards with a performance condition only to the extentdeemed probable of achievement. We reassess at each reporting period whetherachievement of the pre-determined performance targets based on the financialmetrics discussed above is probable for the options related to thePerformance-Based Tranche to vest.

 

The fair value of eachoption award is estimated on the date of grant, or modification, using theBlack-Scholes-Merton option pricing model for service and performance basedawards, and a binomial model for market based awards. In estimating fair valuefor new options issued under the 2007 Plan, expected volatility was basedcompletely on historical volatility of comparable publicly-traded companies. Asour historical share option exercise experience does not provide a reasonablebasis upon which to estimate the expected term, we used the simplified approachto calculate the expected term. Expected life is calculated in two tranchesbased on the employment level defined as executive or employee. The risk-freerate used in calculating fair value of service and performance-based stockoptions for periods within the expected term of the option is based on the U.S.Treasury yield bond curve in effect at the time of grant.

 

We record expense for awardswith a performance condition only to the extent deemed probable of achievement,with the exception of market-based options previously modified during the firstquarter of 2008 and reallocated to the Time-Based and Performance-BasedTranches.  The expense related to thepreviously modified options is recognized ratably over the expected term of thestock options using the original grant-date fair value regardless of theprobability of achieving the performance conditions.  We are required to reassess at each reportingperiod whether the achievement of any performance condition is probable, atwhich time we would recognize the related compensation expense over theremaining performance or service period, if any. During 2008 we did notrecognize compensation expense associated with our Performance-Based Tranche asthe performance targets under the original grant were not achieved.  We believe that if a modification of theperformance targets did not occur, that performance targets would have beenconsidered improbable for the current quarter and no compensation expense wouldhave been recognized.  As a result of our2009 modification, we now believe that it is probable that we will achieve the2009 performance targets.  As such, for the three months ended March 28,2009, we recognized compensation expense for the modified options and theannual portion of the tranche associated with the 2008 options that were notpreviously vested.  To date, noamount has been recorded for the Enhanced Performance-Based Tranche, asachievement of the performance component is not deemed probable at this time.

 

As a result of the 2009,modification and in accordance with FAS 123 (R), we will no longer use theoriginal grant date fair value to measure compensation cost and havere-assessed the assumptions used to determine the fair value of options at thedate of modification. The following table presents the assumptions we used incalculating the fair value of employee stock options for the three months endedMarch 28, 2009 and March 29, 2008:

 
| ** **               | ** ** | **Three Months Ended**   | ** ** |
|--------------------------|------------|--------------------------|------------|
| ** **               | ** ** | **March 28,  2009** | ** ** | **March 29,  2008** | ** ** |
| Expected dividends       |       | 0.0                      | %          | 0.0 | % |
| Expected volatility      |       | 34.4                     | %          | 27.4%  - 60.0 | % |
| Risk-free rate           |       | 2.3                      | %          | 2.8%  - 4.7 | % |
| Expected term (in years) |       | 6.3 years           |       | 4.9 - 7.1 years |   |

 

*Non-Employee Stock Options*

 

During the three monthsended March 28, 2009 we have granted 800 stock options under the 2007 Planto non-employees (“non-employee options”). The non-statutory stock optionagreement for the non-employees states that the options have an exercise priceof $16.46 per share, which was equal to 100% of the estimated fair market valueof the stock and will become effective upon the defined effective date andexpire ten years from that date. A number of shares equal to 25% of the optionsgranted become vested and exercisable at the end of each of the first fouryears subsequent to the effective date, provided the optionee is stillaffiliated with and providing services to the Company. The non-employee optionagreement does not include any performance requirements on the 

 

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optionee’s part in order to vest in theoptions granted.  Non-employee optionsare accounted for in accordance with Emerging Issues Task Force (“EITF”) Issue No. 96-18,“Accounting for Equity Instruments That are Issued to Other Than Employees forAcquiring, or in Conjunction with Selling Goods or Services” (“EITF 96-18”).  In accordance with EITF 96-18, the fair valueof each option will be re-measured at the end of each reporting period untilvested, when the final fair value of the vesting of the option is determined.  We recorded non-cash compensation expense ofapproximately $0.1 million for the three months ended March 28, 2009,associated with non-employee stock options issued under the 2007 Plan.

** **

**9. SEGMENT AND GEOGRAPHIC INFORMATION**

 

We provide a broad array of orthopedic rehabilitation and regeneration products,as well as implants to customers in the United States and abroad.  In the first quarter of 2009, we changed howwe report financial information to the Chief Operating Decision Maker asdefined by SFAS 131.  Prior to 2009, weincluded the international components of the Surgical non- U.S., Chattanooga,and Empi businesses in either the Surgical or Domestic Rehabilitation segments,as their operations were managed domestically. During the fourth quarter of 2008, we effected an operational reorganizationwhich resulted in the non-U.S. components of all of our businesses beingmanaged abroad.  As a result, the segmentfinancial data for the three months ended March 28, 2009 reflects this newsegmentation and the data for the three months ended March 29, 2008, asnoted below, has been restated to reflect this change.  We currently develop, manufacture anddistribute our products through the following three operating segments:

*** ***

***Domestic Rehabilitation Segment***

 

Our Domestic RehabilitationSegment, which generates its revenues in the United States, is divided intofive main businesses:

 

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

 

·                  *Empi. *Our Empi business unitoffers products in the category of home electrotherapy, iontophoresis, and hometraction. This business also includes our Rehab Med + Equipment business (“RME”),which sells a wide range of proprietary and third party rehabilitation productsto physical therapists and chiropractors through a printed catalog and anon-line e-commerce site.

 

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

 

·                  *Chattanooga. *Our Chattanooga businessunit offers products in the clinical rehabilitation market in the 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, primarily athletes and peopleinterested in improving their fitness to the competitive athlete, to assistathletic training programs through muscle development and to accelerate musclerecovery after training sessions.

*** ***

***International Segment***

 

Our International Segment,which generates most of its revenues in Europe, sells all of our products andcertain third party products through a combination of direct salesrepresentatives and independent distributors.

 

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***Domestic Surgical Implant Segment***

 

Our Domestic Surgical ImplantSegment develops, manufactures and markets a wide variety of knee, hip andshoulder implant products that serve the orthopedic reconstructive jointimplant market in the United States.

 

Information regarding ourreportable business segments is presented below (in thousands). Thisinformation excludes the impact of certain expenses not allocated to segments,primarily general corporate expenses and non-recurring charges related to ourintegration activities. All prior periods presented have been restated toreflect our current reportable segments.

 
| ** **                                      | ** ** | **Three Months Ended**   | ** ** |
|-------------------------------------------------|------------|--------------------------|------------|
| ** **                                      | ** ** | **March 28,  2009** | ** ** | **March 29,  2008** | ** ** |
| **Net sales:**                                  |       |                     |       |   |   |
| Domestic Rehabilitation Segment                 |       | $                        | 154,446    |   | $ | 157,387 |   |
| International Segment                           |       | 55,636                   |       | 66,144 |   |
| Domestic Surgical Implant Segment               |       | 15,303                   |       | 16,197 |   |
| Consolidated net sales                          |       | $                        | 225,385    |   | $ | 239,728 |   |
| **Gross profit:**                               |       |                     |       |   |   |
| Domestic Rehabilitation Segment                 |       | $                        | 98,445     |   | $ | 97,820 |   |
| International Segment                           |       | 31,505                   |       | 38,197 |   |
| Domestic Surgical Implant Segment               |       | 11,898                   |       | 13,474 |   |
| Expenses not allocated to segments/Eliminations |       | (938                     | )          | (4,847 | ) |
| Consolidated gross profit                       |       | $                        | 140,910    |   | $ | 144,644 |   |
| **Operating income:**                           |       |                     |       |   |   |
| Domestic Rehabilitation Segment                 |       | $                        | 34,624     |   | $ | 31,671 |   |
| International Segment                           |       | 10,063                   |       | 13,427 |   |
| Domestic Surgical Implant Segment               |       | 2,460                    |       | 3,119 |   |
| Expenses not allocated to segments/Eliminations |       | (33,167                  | )          | (39,977 | ) |
| Consolidated operating income                   |       | $                        | 13,980     |   | $ | 8,240 |   |

 

The accounting policies ofthe reportable segments are the same as the accounting policies of the Company.We allocate resources and evaluate the performance of segments based on netsales, gross profit, operating income and other non-GAAP measures as defined.Moreover, we do not allocate assets to reportable segments because asignificant portion of assets are shared by the segments.

 

**Geographic Area**

 

Following are our net salesby geographic area, based on location of customer (in thousands):

 
| ** **                                   | ** ** | **Three Months Ended**   | ** **    |
|----------------------------------------------|------------|--------------------------|---------------|
| ** **                                   | ** ** | **March 28,  2009** | ** **    | **March 29,  2008** | ** ** |
| **Net sales:**                               |       |                     |          |   |   |
| United States                                |       | $                        | 169,749       |   | $ | 173,584 |   |
| Germany                                      |       | 16,747                   |          | 20,240 |   |
| Other Europe, Middle East, & Africa |       | 28,614                   |          | 35,641 |   |
| Asia Pacific                                 |       | 3,051                    |          | 3,100 |   |
| Other                                        |       | 7,224                    |          | 7,163 |   |
|                                         |       | $                        |  225,385 |   | $ | 239,728 |   |

 

**10. INCOME TAXES**

 

Income taxes for the interimperiods presented have been included in the accompanying unaudited condensedconsolidated financial statements on the basis of an estimated annual effectivetax rate, adjusted for discrete items. The tax benefit for these periodsdiffered from the amount which would have been recorded using the U.S.statutory tax rate due primarily to the impact of foreign taxes, includingfavorable adjustments related to prior year foreign taxes, deferred taxes onthe assumed repatriation of foreign earnings and the favorable impact of newCalifornia legislation discussed below.

 

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For the three months ended March 28,2009, we recorded an income tax benefit of approximately $11.5 million, onpre-tax losses of approximately $25.6 million. For the three months ended March 29, 2008, we recorded an incometax benefit of approximately $11.1 million, on pre-tax losses ofapproximately $35.0 million.

 

During the first quarter of2009, the state of California enacted legislation which will allow corporatetaxpayers to elect to use a single sales factor apportionment formula toapportion business income to California for tax years beginning on or after January 1,2011. We anticipate making this election in fiscal year 2011 and thereafter. Inthe first quarter of 2009, we recorded a tax benefit of $4.0 million related tothe enactment of this legislation which represents a reduction in our netdeferred tax liabilities due to a lower effective state tax rate.

 

We and our subsidiaries fileincome tax returns in the U.S. federal jurisdiction, various states and foreignjurisdictions. With few exceptions, we are no longer subject to U.S. federal,state and local, or non-U.S. income tax examinations by tax authorities foryears before 2004. For the three months ended March 28, 2009, our grossunrecognized tax benefit of $15.4 million as recorded on December 31,2008 was increased by $0.5 million due to additional unrecognized taxbenefits related to tax positions of prior years.  For the three months ended March 28,2009, we also recognized an additional $0.2 million in interest andpenalties.  We have $1.4 million accruedfor the payment of interest and penalties accrued at March 28, 2009. Weanticipate that approximately $0.6 million of gross uncertain tax positionsrelated to our Compex acquisition will decrease in the next twelve months. Inaddition, we anticipate that $0.3 million of our remaining unrecognized taxpositions, each of which are individually immaterial, may be recognized by March 27,2010 as a result of a lapse of statue of limitations. Due to the adoption ofSFAS 141R on January 1, 2009, all of our unrecognized tax benefits willimpact our effective tax rate upon recognition. We believe that it isreasonably possible that an increase of $0.4 million in unrecognized taxbenefits related to various immaterial state exposures may be necessary withinthe next twelve months.

** **

**11. COMMITMENTS ANDCONTINGENCIES**

 

The manufacture and sale oforthopedic devices and related products exposes us to significant risks ofproduct liability claims, lawsuits and product recalls. From time to time, wehave been, and we are currently, the subject of a number of product liabilityclaims and lawsuits relating to our products. We are currently defendants inapproximately 30 product liability cases related to a disposable drug infusionpump product manufactured by two third party manufacturers that we distributethrough our Bracing and Supports business unit of our Domestic Rehabilitationsegment. We intend to discontinue our sale of these products in the secondquarter of 2009. These cases have been brought against the manufacturers andcertain distributors of these pumps, the manufacturers of the anesthetics usedin these pumps, and the healthcare professionals involved in providing thepumps to their patients. All of these lawsuits allege that the use of thesepumps with certain anesthetics in certain shoulder surgeries over prolongedperiods have resulted in cartilage damage to the plaintiffs. We have soughtindemnity and tendered the defense of these cases both to the manufacturers whohave supplied these pumps to us and to our product liability carrier. Bothmanufacturers have indicated they would accept our tender of defense in thesecases.  The product liability carrier forboth of the two manufacturers has accepted coverage for our defense of theseclaims.  In addition, our productliability carrier has accepted coverage of these cases, subject to customaryreservations, and was providing us with the defense until the carrier for themanufacturers began providing a defense. The lawsuits allege damages rangingfrom unspecified amounts to claims between $1.0 million and$10.0 million. These cases are in varying stages of discovery.

 

We currently carry productliability insurance up to a limit of $25.0 million, subject to adeductible of $50,000 on non-invasive products and a deductible of $250,000 oninvasive products and an aggregate deductible of $750,000 for all productliability claims. Our insurance policy is subject to annual renewal. We believeour current product liability insurance coverage is adequate. If a productliability claim or series of claims is brought against us for uninsuredliabilities or in excess of our insurance coverage, our business could suffermaterially. In addition, in certain instances a product liability claim couldalso result in our having to recall some of our products, which could result insignificant costs to us. As of March 28, 2009 and December 31, 2008,we have accrued approximately $2.0 million and $1.8 million, respectively,for product liability claims expense based upon previous claim experience inpart due to the fact that in 2003 we exceeded the coverage limits in effect atthat time for certain historical product liability claims involving  one of our discontinued Surgical implantproducts and such products are excluded from coverage under our currentpolicies.

 

Dueto the nature of our business, we are subject to a variety of audits bygovernment agencies and other private interests.  In the first quarter of 2008, we received aU.S. Food and Drug Administration (“FDA”) Form 483 “InspectionalObservations” in connection with an FDA audit of the Chattanooga division ofour Domestic Rehabilitation Segment, stating that we failed to report certaincustomer complaints claiming that our muscle stimulator devices malfunctioned,and that we did not adequately implement 

 

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correctiveand preventive action to prevent recurrence of potential product failuresrelating to our muscle stimulator devices. The auditor also recommended that werecall a series of ultrasound devices that had experienced operating issues in2005, and we are implementing such a recall. We received a warning letter fromthe FDA in June 2008 relating to reporting issues on the muscle stimulatordevice complaints and requesting software verification and validation plans andreports regarding the correction of problems associated with the ultrasoundproduct. We believe that we are in a position to address these areas of concernadequately. However, we cannot assure you that the FDA will not take further actionalong these lines in the future.

 

Weare an authorized Medicare supplier and provide a variety of our productsdirectly to Medicare beneficiaries and seek reimbursement from the applicableMedicare Administrative Contractor. CIGNA Governmental Services (“CIGNA”) is that contractor in the westernregion of the United States.  As aMedicare supplier, we are subject to periodic audits of our operations, and in November 2008we were advised that as a result of such an audit, CIGNA was asserting that wehad been overpaid in the amount of approximately $6.0 million from January 1,2006 to April 9, 2007.  This figurerepresented Medicare reimbursements for claims we submitted on Medicarebeneficiaries for our bone growth stimulator product during that period oftime.  The reason asserted by CIGNA thatMedicare was not obligated to provide reimbursement on these claims is that wefailed to maintain a California Home Medical Device Retail Exemptee Licenseduring such 15 month period.  We believethat this licensing program does not apply to our business and appealed theassessment of the overpayment.  In March 2009we received a letter from CIGNA agreeing with our position and reversing theasserted overpayment entirely.  As aresult, we reversed the $6.0 million liability we had accrued in November 2008.

 

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

 

**12. RELATED PARTY TRANSACTIONS**

 

In November 2007,Blackstone Management Partners V L.L.C. (“BMP”) agreed to provide certainmonitoring, advisory and consulting services to us for an annual monitoring feeequal to the greater of $7.0 million or 2% of consolidated EBITDA asdefined in the Transaction and Monitoring Fee Agreement, payable in the firstquarter of each year. At any time in connection with or in anticipation of achange of control of DJOFL, a sale of all or substantially all of DJOFL’sassets or an initial public offering of common stock of DJOFL, BMP may elect toreceive, in lieu of remaining annual monitoring fee payments, a single lump sumcash payment equal to the then-present value of all then-current and futureannual monitoring fees payable under the transaction and monitoring feeagreement, assuming a hypothetical termination date of the agreement to be thetwelfth anniversary of such election. The monitoring fee agreement willcontinue until the earlier of the twelfth anniversary of the date of theagreement or such date as DJOFL and BMP may mutually determine. DJOFL willagree to indemnify BMP and its affiliates, directors, officers, employees,agents and representatives from and against all liabilities relating to theservices contemplated by the transaction and monitoring fee agreement and theengagement of BMP pursuant to, and the performance of BMP and its affiliates ofthe services contemplated by, the transaction and monitoring fee agreement. Foreach of the three month periods ended March 28, 2009 and March 29,2008, we recognized $1.8 million related to the monitoring fee. This isrecorded as a component of selling, general and administrative expense in theunaudited condensed consolidated statements of operations.

 

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**13. DERIVATIVE INSTRUMENTS**

 

We operate internationallyand are therefore exposed to foreign currency exchange rate fluctuations in thenormal course of our business, in particular to changes in the Mexican Peso dueto our Mexico-based manufacturing operations that incur costs that are largelydenominated in Mexican Pesos. As part of our risk management strategy, we usederivative instruments to hedge portions of our exposure. While our foreignexchange contracts act as economic hedges, we have not designated suchinstruments as hedges under SFAS 133. Before acquiring a derivative instrument to hedge a specific risk,potential natural hedges are evaluated. Derivative instruments are onlyutilized to manage underlying exposures that arise from our businessoperations. Factors considered in the decision to hedge an underlying marketexposure include the materiality of the risk, the volatility of the market, theduration of the hedge, and the availability, effectiveness and cost ofderivative instruments.   At March 28,2009 we have 55 foreign exchange forward contracts, with a fair market value ofapproximately $19.5 million and expire weekly throughout the fiscal year 2009.

 

Additionally, we make use ofdebt financing as a source of funds and are therefore exposed to interest ratefluctuations in the normal course of business. Our credit facilities aresubject to floating interest rates. We manage the risk of unfavorable movementsin interest rates by hedging a portion of the outstanding loan balance, therebylocking in a fixed rate on a portion of the principal, reducing the effect ofpossible rising interest rates and making interest expense morepredictable.  On November 20, 2007,we entered into an interest rate swap agreement related to the Senior SecuredCredit Facility for a notional amount of $515.0 million at a fixed LIBORrate of 4.205% amortizing through an expiration date in December 2009 (thenotional amount was $470.0 millionas of March 28, 2009).  In February 2009 we entered into two newinterest rate swap agreements related to the Senior Secured CreditFacility.  The first agreement is for anotional amount of $550.0 million at a fixed LIBOR rate of 1.04% beginning February 2009amortizing through December 2009. The second agreement is for a notional amount of $750.0 million at afixed LIBOR rate of 1.88% with a term beginning January 2010 through December 2010.  We have designated these interest rate swapagreements as cash flow hedges under SFAS 133.

 

In accordance with SFAS No. 157,we follow the three levels of the fair value hierarchy for disclosure of theinputs to valuation. This hierarchy prioritizes the inputs into three broadlevels as follows. Level 1 inputs are quoted prices (unadjusted) in activemarkets for identical assets or liabilities. Level 2 inputs are quotedprices for similar assets and liabilities in active markets or inputs that areobservable for the asset or liability, either directly or indirectly throughmarket corroboration, for substantially the full term of the financialinstrument. Level 3 inputs are unobservable inputs based on our ownassumptions used to measure assets and liabilities at fair value. A financialasset or liability’s classification within the hierarchy is determined based onthe lowest level input that is significant to the fair value measurement. At March 28,2009, the fair value of our interest rate swap agreements and our foreigncurrency exchange forward contracts were determined through the use of modelsthat consider various assumptions, including time value, yield curves, as wellas other relevant economic measures, which are inputs that are classified asLevel 2 in the valuation hierarchy.

 

The following tablesummarizes the fair values of our derivative instruments, included within othercurrent and non-current liabilities in our condensed consolidated balancesheets (in thousands):

 
| ** **                   | ** ** | **March 28,  2009** | ** ** | **December 31,  2008** | ** ** |
|------------------------------|------------|-------------------------------|------------|----------------------------------|------------|
| **Liabilities:**             | ** ** | ** **                    | ** ** | ** **                       | ** ** |
| Foreign exchange contracts   |       | $                             | 16,494     |                             | $          | 16,133 |   |
| Interest rate swaps          |       | 18,767                        |       | 13,272                           |       |
| Total derivative liabilities |       | $                             | 35,261     |                             | $          | 29,405 |   |

 

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The following tablesummarizes the effect our derivative instruments have on our condensedconsolidated statements of operations (in thousands):

 
| ** **                                 | ** ** | **Location of Gain or   (Loss)** | ** ** | **Amount of Gain or   (Loss)** | ** ** |
|--------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| **Three Months Ended March 28, 2009** | ** ** | ** **                       | ** ** | ** **                     | ** ** |
| Foreign exchange contracts                 |       | Other  income (expense), net     |       | $                              | (3,006     | ) |
| Interest rate swaps                        |       | Interest  expense                |       | (3,377                         | )          |
| Total net gain/ (loss)                     |       |                             |       | $                              | (6,383     | ) |
| ** **                                 | ** ** | ** **                       | ** ** | ** **                     | ** ** |
| **Three Months Ended March 29, 2008** | ** ** | ** **                       | ** ** | ** **                     | ** ** |
| Foreign exchange contracts                 |       | Other  income (expense), net     |       | $                              | 380        |   |
| Interest rate swaps                        |       | Interest  expense                |       | 796                            |       |
| Total net gain/ (loss)                     |       |                             |       | $                              | 1,176      |   |

 

**14. SUPPLEMENTAL GUARANTOR CONDENSED CONSOLIDATINGFINANCIAL STATEMENTS**

 

On November 20, 2007,DJOFL and its direct wholly-owned subsidiary, Finco, issued the 10.875% Noteswith an aggregate principal amount of $575.0 million. 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 presentthe financial position, results of operations and cash flows of DJOFL, theGuarantors, the Non-Guarantors and certain eliminations as of March 28,2009 and December 31, 2008 and for the three months ended March 28,2009 and March 29, 2008, respectively.

 

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**DJO Finance LLC**

** **

**Unaudited Condensed Consolidating Balance Sheets**

**As of March 28, 2009**

**(in thousands)**

 
| ** **                                                | ** ** | **DJOFL** | ** ** | **Guarantors** | ** ** | **Non-  Guarantors** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|-----------------------------------------------------------|------------|-----------|------------|----------------|------------|----------------------|------------|------------------|------------|------------------|------------|
| **Assets**                                                |       |      |       |           |       |                 |       |             |       |             |       |
| Current assets:                                           |       |      |       |           |       |                 |       |             |       |             |       |
| Cash and cash equivalents                                 |       | $         | —     |           | $          | 12,759               |       | $                | 17,985     |             | $          | — |   | $ | 30,744 |   |
| Accounts receivable, net                                  |       | —    |       | 133,179        |       | 32,805               |       | —           |       | 165,984          |       |
| Inventories, net                                          |       | —    |       | 88,575         |       | 24,033               |       | (9,804           | )          | 102,804          |       |
| Deferred tax assets, net                                  |       | —    |       | 35,991         |       | 276                  |       | (1,120           | )          | 35,147           |       |
| Prepaid expenses and other current assets                 |       | 118       |       | 18,420         |       | 3,238                |       | (211             | )          | 21,565           |       |
| Total current assets                                      |       | 118       |       | 288,924        |       | 78,337               |       | (11,135          | )          | 356,244          |       |
| Property and equipment, net                               |       | —    |       | 76,267         |       | 12,064               |       | (1,641           | )          | 86,690           |       |
| Goodwill                                                  |       | —    |       | 1,120,688      |       | 68,758               |       | —           |       | 1,189,446        |       |
| Intangible assets, net                                    |       | —    |       | 1,210,234      |       | 31,459               |       | —           |       | 1,241,693        |       |
| Investment in subsidiaries                                |       | 1,210,006 |       | 2,321,225      |       | 51,863               |       | (3,583,094       | )          | —           |       |
| Intercompany receivable                                   |       | 1,230,039 |       | —         |       | —               |       | (1,230,039       | )          | —           |       |
| Other non-current assets                                  |       | 47,100    |       | (131           | )          | 2,234                |       | —           |       | 49,203           |       |
| Total assets                                              |       | $         | 2,487,263  |           | $          | 5,017,207            |       | $                | 244,715    |             | $          | (4,825,909 | ) | $ | 2,923,276 |   |
| **Liabilities and Membership Equity**                     |       |      |       |           |       |                 |       |             |       |             |       |
| Current liabilities:                                      |       |      |       |           |       |                 |       |             |       |             |       |
| Accounts payable                                          |       | $         | —     |           | $          | 30,573               |       | $                | 7,369      |             | $          | 1 |   | $ | 37,943 |   |
| Long-term debt and capital leases, current portion        |       | 10,650    |       | 193            |       | 673                  |       | —           |       | 11,516           |       |
| Other current liabilities                                 |       | 61,437    |       | 53,189         |       | 23,419               |       | (211             | )          | 137,834          |       |
| Total current liabilities                                 |       | 72,087    |       | 83,955         |       | 31,461               |       | (210             | )          | 187,293          |       |
| Long-term debt and capital leases, net of current portion |       | 1,828,160 |       | 161            |       | 163                  |       | —           |       | 1,828,484        |       |
| Deferred tax liabilities, net                             |       | —    |       | 303,927        |       | 11,302               |       | (973             | )          | 314,256          |       |
| Intercompany payable, net                                 |       | 8,828     |       | 1,140,508      |       | 89,757               |       | (1,239,093       | )          | —           |       |
| Other non-current liabilities                             |       | —    |       | 13,161         |       | 87                   |       | —           |       | 13,248           |       |
| Total liabilities                                         |       | 1,909,075 |       | 1,541,712      |       | 132,770              |       | (1,240,276       | )          | 2,343,281        |       |
| Membership equity                                         |       | 578,188   |       | 3,475,495      |       | 111,945              |       | (3,585,633       | )          | 579,995          |       |
| Total liabilities and membership equity                   |       | $         | 2,487,263  |           | $          | 5,017,207            |       | $                | 244,715    |             | $          | (4,825,909 | ) | $ | 2,923,276 |   |

 

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**DJO Finance LLC**

** **

**Unaudited Condensed Consolidating Balance Sheets**

**As of December 31, 2008**

**(in thousands)**

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

 

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**DJO Finance LLC**

** **

**Unaudited Condensed Consolidating Statements ofOperations**

**For the Three Months Ended March 28, 2009**

**(in thousands)**

 
| ** **                                                     | ** ** | **DJOFL** | ** ** | **Guarantors** | ** ** | **Non-  Guarantors** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|----------------------------------------------------------------|------------|-----------|------------|----------------|------------|----------------------|------------|------------------|------------|------------------|------------|
| Net sales                                                      |       | $         | —     |           | $          | 194,514              |       | $                | 60,979     |             | $          | (30,108 | ) | $ | 225,385 |   |
| Cost of sales                                                  |       | —    |       | 74,571         |       | 39,566               |       | (29,662          | )          | 84,475           |       |
| Gross profit                                                   |       | —    |       | 119,943        |       | 21,413               |       | (446             | )          | 140,910          |       |
| Operating expenses:                                            |       |      |       |           |       |                 |       |             |       |             |       |
| Selling, general and administrative                            |       | —    |       | 81,609         |       | 20,387               |       | —           |       | 101,996          |       |
| Research and development                                       |       | —    |       | 5,062          |       | 741                  |       | —           |       | 5,803            |       |
| Amortization of acquired intangibles                           |       | —    |       | 18,639         |       | 492                  |       | —           |       | 19,131           |       |
| Operating income                                               |       | —    |       | 14,633         |       | (207                 | )          | (446             | )          | 13,980           |       |
| Other income (expense):                                        |       |      |       |           |       |                 |       |             |       |             |       |
| Interest income                                                |       | 4,729     |       | 688            |       | 331                  |       | (5,412           | )          | 336              |       |
| Interest expense                                               |       | (38,430   | )          | (4,776         | )          | (803                 | )          | 5,418            |       | (38,591          | )          |
| Other income (expense), net                                    |       | 19,393    |       | (6,429         | )          | (775                 | )          | (13,554          | )          | (1,365           | )          |
| Income (loss) before income taxes and noncontrolling interests |       | (14,308   | )          | 4,116          |       | (1,454               | )          | (13,994          | )          | (25,640          | )          |
| Provision (benefit) for income taxes                           |       | —    |       | (10,636        | )          | (835                 | )          | —           |       | (11,471          | )          |
| Noncontrolling Interest                                        |       | —    |       | —         |       | 139                  |       | —           |       | 139              |       |
| Net income (loss)                                              |       | $         | (14,308    | )              | $          | 14,752               |       | $                | (758       | )                | $          | (13,994 | ) | $ | (14,308 | ) |

 

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**DJO Finance LLC**

** **

**Unaudited Condensed Consolidating Statements ofOperations**

**For the Three Months Ended March 29, 2008**

**(in thousands)**

 
| ** **                                                     | ** ** | **DJOFL** | ** ** | **Guarantors** | ** ** | **Non-  Guarantors** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|----------------------------------------------------------------|------------|-----------|------------|----------------|------------|----------------------|------------|------------------|------------|------------------|------------|
| Net sales                                                      |       | $         | —     |           | $          | 196,763              |       | $                | 63,267     |             | $          | (20,302 | ) | $ | 239,728 |   |
| Cost of sales                                                  |       | —    |       | 79,378         |       | 36,057               |       | (20,351          | )          | 95,084           |       |
| Gross profit                                                   |       | —    |       | 117,385        |       | 27,210               |       | 49               |       | 144,644          |       |
| Operating expenses:                                            |       |      |       |           |       |                 |       |             |       |             |       |
| Selling, general and administrative                            |       | —    |       | 88,894         |       | 21,720               |       | (2               | )          | 110,612          |       |
| Research and development                                       |       | —    |       | 5,957          |       | 719                  |       | —           |       | 6,676            |       |
| Amortization of acquired intangibles                           |       | —    |       | 18,590         |       | 526                  |       | —           |       | 19,116           |       |
| Operating income                                               |       | —    |       | 3,944          |       | 4,245                |       | 51               |       | 8,240            |       |
| Other income (expense):                                        |       |      |       |           |       |                 |       |             |       |             |       |
| Interest income                                                |       | 15,749    |       | 1,442          |       | 152                  |       | (16,756          | )          | 587              |       |
| Interest expense                                               |       | (44,960   | )          | (15,923        | )          | (1,060               | )          | 16,756           |       | (45,187          | )          |
| Other income (expense), net                                    |       | 5,049     |       | 376            |       | 967                  |       | (5,049           | )          | 1,343            |       |
| Income (loss) before income taxes and noncontrolling interests |       | (24,162   | )          | (10,161        | )          | 4,304                |       | (4,998           | )          | (35,017          | )          |
| Provision (benefit) for income taxes                           |       | —    |       | (12,157        | )          | 1,102                |       | —           |       | (11,055          | )          |
| Noncontrolling interests                                       |       | —    |       | —         |       | 200                  |       | —           |       | 200              |       |
| Net income (loss)                                              |       | $         | (24,162    | )              | $          | 1,996                |       | $                | 3,002      |             | $          | (4,998 | ) | $ | (24,162 | ) |

 

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**DJO Finance LLC**

** **

**Unaudited Condensed Consolidating Statements of CashFlows**

**For the Three Months Ended March 28, 2009**

**(in thousands)**

 
| ** **                                                                                          | ** ** | **DJOFL** | ** ** | **Guarantors** | ** ** | **Non-  Guarantors** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|-----------|------------|----------------|------------|----------------------|------------|------------------|------------|------------------|------------|
| **OPERATING ACTIVITIES:**                                                                           |       |      |       |           |       |                 |       |             |       |             |       |
| Net income (loss)                                                                                   |       | $         | (14,308    | )              | $          | 14,752               |       | $                | (619       | )                | $          | (13,994 | ) | $ | (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         |       | 2,205                |       | (8,571           | )          | 17,608           |       |
| **INVESTING ACTIVITIES:**                                                                           |       |      |       |           |       |                 |       |             |       |             |       |
| Acquisition of businesses, net 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        | )          | 3,012                |       | 8,705            |       | —           |       |
| Payments on debt and revolving line of credit                                                       |       | (4,000    | )          | (70            | )          | (25                  | )          | —           |       | (4,095           | )          |
| Net cash (used in) financing activities                                                             |       | (1,470    | )          | (14,317        | )          | 2,987                |       | 8,705            |       | (4,095           | )          |
| Effect of exchange rate changes on cash and cash equivalents                                        |       | —    |       | —         |       | (1,339               | )          | —           |       | (1,339           | )          |
| **Net 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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**DJO Finance LLC**

** **

**Unaudited Condensed Consolidating Statements of CashFlows**

**For the Three Months Ended March 29, 2008**

**(in thousands)**

 
| ** **                                                                                          | ** ** | **DJOFL** | ** ** | **Guarantors** | ** ** | **Non-  Guarantors** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|-----------|------------|----------------|------------|----------------------|------------|------------------|------------|------------------|------------|
| **OPERATING ACTIVITIES:**                                                                           |       |      |       |           |       |                 |       |             |       |             |       |
| Net income (loss)                                                                                   |       | $         | (24,162    | )              | $          | 1,996                |       | $                | 3,202      |             | $          | (4,998 | ) | $ | (23,962 | ) |
| Adjustments to reconcile net income (loss) to net cash provided by  (used in) operating activities: |       |      |       |           |       |                 |       |             |       |             |       |
| Depreciation                                                                                        |       | —    |       | 4,636          |       | 1,222                |       | (197             | )          | 5,661            |       |
| Amortization of intangibles                                                                         |       | —    |       | 18,590         |       | 526                  |       | —           |       | 19,116           |       |
| Amortization of debt issuance costs                                                                 |       | 3,506     |       | —         |       | —               |       | —           |       | 3,506            |       |
| Stock-based compensation                                                                            |       | —    |       | 611            |       | —               |       | —           |       | 611              |       |
| Asset impairments and loss on disposal of assets                                                    |       | —    |       | 115            |       | 57                   |       | (7               | )          | 165              |       |
| Deferred income taxes                                                                               |       | —    |       | (12,208        | )          | —               |       | —           |       | (12,208          | )          |
| Non-cash income from subsidiaries                                                                   |       | (5,049    | )          | —         |       | —               |       | 5,049            |       | —           |       |
| Provision for doubtful accounts and sales returns                                                   |       | —    |       | 4,264          |       | 176                  |       | —           |       | 4,440            |       |
| Inventory reserves                                                                                  |       | —    |       | 1,449          |       | 69                   |       | —           |       | 1,518            |       |
| Changes in operating assets and liabilities, net of acquired assets  and liabilities:               |       |      |       |           |       |                 |       |             |       |             |       |
| Accounts receivable                                                                                 |       | —    |       | (12,393        | )          | (3,779               | )          | —           |       | (16,172          | )          |
| Inventories                                                                                         |       | —    |       | 3,682          |       | 944                  |       | (3               | )          | 4,623            |       |
| Prepaid expenses, other assets and liabilities                                                      |       | (795      | )          | (3,739         | )          | 1,075                |       | —           |       | (3,459           | )          |
| Accounts payable and other current liabilities                                                      |       | 42,212    |       | (18,238        | )          | (380                 | )          | —           |       | 23,594           |       |
| Net cash provided by (used in) operating activities                                                 |       | 15,712    |       | (11,235        | )          | 3,112                |       | (156             | )          | 7,433            |       |
| **INVESTING ACTIVITIES:**                                                                           |       |      |       |           |       |                 |       |             |       |             |       |
| Acquisition of businesses, net of cash acquired                                                     |       | —    |       | (675           | )          | —               |       | —           |       | (675             | )          |
| Proceeds from sale of assets                                                                        |       | —    |       | 2              |       | —               |       | —           |       | 2                |       |
| Purchases of property and equipment                                                                 |       | —    |       | (2,962         | )          | (1,466               | )          | 156              |       | (4,272           | )          |
| Other, net                                                                                          |       | —    |       | (450           | )          | 904                  |       | —           |       | 454              |       |
| Net cash used in investing activities                                                               |       | —    |       | (4,085         | )          | (562                 | )          | 156              |       | (4,491           | )          |
| **FINANCING ACTIVITIES:**                                                                           |       |      |       |           |       |                 |       |             |       |             |       |
| Intercompany                                                                                        |       | (16,231   | )          | 19,865         |       | (3,634               | )          | —           |       | —           |       |
| Payments on long-term obligations                                                                   |       | —    |       | (70            | )          | (38                  | )          | —           |       | (108             | )          |
| Net cash provided (used in) by financing activities                                                 |       | (16,231   | )          | 19,795         |       | (3,672               | )          | —           |       | (108             | )          |
| Effect of exchange rate changes on cash and cash equivalents                                        |       | —    |       | —         |       | 1,389                |       | —           |       | 1,389            |       |
| **Net increase (decrease) in cash and cash equivalents**                                            |       | (519      | )          | 4,475          |       | 267                  |       | —           |       | 4,223            |       |
| Cash and cash equivalents at beginning of period                                                    |       | 519       |       | 44,694         |       | 18,258               |       | —           |       | 63,471           |       |
| Cash and cash equivalents at end of period                                                          |       | $         | —     |           | $          | 49,169               |       | $                | 18,525     |             | $          | — |   | $ | 67,694 |   |

 

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**ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTSOF OPERATIONS**

** **

**Forward Looking Statements**

 

The following management’sdiscussion and analysis contains “forward looking statements” within themeaning of Section 27A of the Securities Act of 1933 and Section 21Eof the Securities Exchange Act of 1934 that represent our expectations orbeliefs concerning future events, including, but not limited to, statementsregarding growth in sales of our products, profit margins and the sufficiencyof our cash flow for future liquidity and capital resource needs. Theseforward-looking statements are further qualified by important factors that couldcause actual results to differ materially from those in the forward-lookingstatements. Some of these factors are described under the heading “Risk Factors”below. The section entitled “Risk Factors” contained in Part II,Item 1A of this report, and similar discussions in our other SEC filingsincluding our 2008 Annual Report on Form 10-K filed with the Commission onMarch 11, 2009, describe some important risk factors that may affect ourbusiness, financial condition, results of operations, and/or liquidity. Resultsactually achieved may differ materially from expected results included in thesestatements as a result of these or other factors.

** **

**Introduction**

 

This management’s discussionand analysis of financial condition and results of operations is intended toprovide an understanding of our results of operations, financial condition andwhere appropriate, factors that may affect future performance.

 

The following discussionshould be read in conjunction with the condensed consolidated financial statementsand related notes to those financial statements as well as the other financialdata included elsewhere in this 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 the largest non-surgical orthopedic rehabilitation devicecompany in the United States and among the largest globally, as measured byrevenues. Many of our products have leading market positions. We believe thatour strong brand names, comprehensive range of products, focus on quality,innovation and customer service, extensive distribution network, and our strongrelationships with orthopedic and physical therapy professionals havecontributed to our leading market positions. We believe that we are one of onlya few orthopedic device companies that offer healthcare professionals andpatients a diverse range of orthopedic rehabilitation products addressing thecomplete spectrum of preventative, pre-operative, post-operative, clinical andhome rehabilitation care. Our products are used by orthopedic specialists,spine surgeons, primary care physicians, pain management specialists, physicaltherapists, podiatrists, chiropractors, athletic trainers and other healthcareprofessionals to treat patients with musculoskeletal conditions resulting fromdegenerative diseases, deformities, traumatic events and sports-relatedinjuries. In addition, many of our non-surgical medical devices and relatedaccessories are used by athletes and patients for injury prevention and at-homephysical therapy treatment.

 

We provide a broad array of orthopedic rehabilitation and regenerationproducts, as well as implants to customers in the United States andabroad.  In the first quarter of 2009, wechanged how we report financial information to the Chief Operating DecisionMaker as defined by SFAS 131.  Prior to2009, we included the international components of the Surgical non- U.S.,Chattanooga, and Empi businesses in either the Surgical or DomesticRehabilitation segments, as their operations were managed domestically.  During the fourth quarter of 2008, weeffected an operational reorganization which resulted in the non-U.S.components of all of our businesses being managed abroad.  As a result, the segment financial data forthe three months ended March 28, 2009 reflects this new segmentation andthe data for the three months ended March 29, 2008, as noted below, hasbeen restated to reflect this change.  Wecurrently develop, manufacture and distribute our products through thefollowing three operating segments:

*** ***

***Domestic Rehabilitation Segment***

 

Our Domestic RehabilitationSegment, which generates its revenues in the United States, is divided intofive main businesses:

 

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

 

·                  *Empi. *Our Empi business unitoffers products in the category of home electrotherapy, iontophoresis, and hometraction. This business also includes our Rehab Med + Equipment business (“RME”),which sells a wide range of proprietary and third party rehabilitation productsto physical therapists and chiropractors through a printed catalog and anon-line e-commerce site.

 

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

 

·                  *Chattanooga. *Our Chattanooga businessunit offers products in the clinical rehabilitation market in the 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, primarily athletes and peopleinterested in improving their fitness to the competitive athlete, to assistathletic training programs through muscle development and to accelerate musclerecovery after training sessions.

*** ***

***International Segment***

 

Our International Segment,which generates most of its revenues in Europe, sells all of our products andcertain third party products through a combination of direct salesrepresentatives and independent distributors.

*** ***

***Domestic Surgical Implant Segment***

 

Our Domestic SurgicalImplant Segment develops, manufactures and markets a wide variety of knee, hipand shoulder implant products that serve the orthopedic reconstructive jointimplant market in the United States.

 

Our three operating segmentsenable us to reach a diverse customer base through multiple distributionchannels and give us the opportunity to provide a wide range of orthopedicdevices and related products to orthopedic specialists operating in a varietyof patient treatment settings. These three segments constitute our threereportable segments. See Note 9 to our unaudited condensed consolidatedfinancial statements for additional information regarding our segments.

 

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Set forthbelow is net revenue, gross profit and operating income information for ourreporting segments for the three months ended March 28, 2009 and March 29,2008, respectively. This information excludes intersegment and certain expensesnot allocated to segments (which are primarily comprised of general corporateexpenses for all periods presented). All prior periods presented have beenrestated to reflect our current reportable segments.

 
| ** **                                          | ** ** | **Three Months Ended**   | ** ** |
|-----------------------------------------------------|------------|--------------------------|------------|
| **($ in thousands)**                      | ** ** | **March 28,  2009** | ** ** | **March 29,  2008** | ** ** |
| **Domestic Rehabilitation:**                        |       |                     |       |   |   |
| Net sales                                           |       | $                        | 154,446    |   | $ | 157,387 |   |
| Gross profit                                        |       | $                        | 98,445     |   | $ | 97,820 |   |
| Gross profit margin                                 |       | 63.7                     | %          | 62.2 | % |
| Operating income                                    |       | $                        | 34,624     |   | $ | 31,671 |   |
| Operating income as a percent of net  segment sales |       | 22.4                     | %          | 20.1 | % |
| **International:**                                  |       |                     |       |   |   |
| Net sales                                           |       | $                        | 55,636     |   | $ | 66,144 |   |
| Gross profit                                        |       | $                        | 31,505     |   | $ | 38,197 |   |
| Gross profit margin                                 |       | 56.6                     | %          | 57.7 | % |
| Operating income                                    |       | $                        | 10,063     |   | $ | 13,427 |   |
| Operating income as a percent of net  segment sales |       | 18.1                     | %          | 20.3 | % |
| **Domestic Surgical Implant:**                      |       |                     |       |   |   |
| Net sales                                           |       | $                        | 15,303     |   | $ | 16,197 |   |
| Gross profit                                        |       | $                        | 11,898     |   | $ | 13,474 |   |
| Gross profit margin                                 |       | 77.7                     | %          | 83.2 | % |
| Operating income                                    |       | $                        | 2,460      |   | $ | 3,119 |   |
| Operating income as a percent of net  segment sales |       | 16.1                     | %          | 19.3 | % |

 

***Acquisition ofDonjoy Orthopaedics Pty. Ltd.***

 

On February 3, 2009 we acquired DonJoy Orthopaedics Pty., Ltd., anAustralian distributor of DJO products (“DJO Australia”), for a total cashcompensation of $3.7 million.  Pursuantto the terms of the acquisition agreement and included within the purchaseprice, is an additional amount payable to the selling shareholder of DJOAustralia if certain revenue targets are met by December 31, 2009.  The fair values of the assets acquired andthe liabilities assumed were estimated in accordance with SFAS 141R.

 

**Results of Operations**

 

The followingtable sets forth our statements of operations as a percentage of sales for theperiods indicated:

 
| ** **                                             | ** ** | **Three Months Ended**   | ** ** |
|--------------------------------------------------------|------------|--------------------------|------------|
| ** **                                             | ** ** | **March 28,  2009** | ** ** | **March 29,  2008** | ** ** |
| Net sales                                              |       | $                        | 225,385    |   | 100.0 | % | $ | 239,728 |   | 100.0 | % |
| Cost of sales                                          |       | 84,475                   |       | 37.5 |   | 95,084 |   | 39.7 |   |
| Gross profit                                           |       | 140,910                  |       | 62.5 |   | 144,644 |   | 60.3 |   |
| Operating expenses:                                    |       |                     |       |   |   |   |   |   |   |
| Selling, general and administrative                    |       | 101,996                  |       | 45.2 |   | 110,612 |   | 46.1 |   |
| Research and development                               |       | 5,803                    |       | 2.6 |   | 6,676 |   | 2.8 |   |
| Amortization of acquired intangibles                   |       | 19,131                   |       | 8.5 |   | 19,116 |   | 8.0 |   |
| Operating income                                       |       | 13,980                   |       | 6.2 |   | 8,240 |   | 3.4 |   |
| Other income (expense):                                |       |                     |       |   |   |   |   |   |   |
| Interest income                                        |       | 336                      |       | 0.1 |   | 587 |   | 0.2 |   |
| Interest expense                                       |       | (38,591                  | )          | (17.1 | ) | (45,187 | ) | (18.8 | ) |
| Other income (expense), net                            |       | (1,365                   | )          | (0.6 | ) | 1,343 |   | 0.6 |   |
| Loss before income taxes and noncontrolling  interests |       | (25,640                  | )          | (11.4 | ) | (35,017 | ) | (14.6 | ) |
| Benefit for income taxes                               |       | (11,471                  | )          | (5.1 | ) | (11,055 | ) | (4.6 | ) |
| Noncontrolling interests                               |       | 139                      |       | 0.1 |   | 200 |   | 0.1 |   |
| Net loss                                               |       | $                        | (14,308    | ) | (6.3 | )% | $ | (24,162 | ) | (10.1 | )% |

 

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***Three Months Ended March 28,2009 compared to Three Months Ended March 29, 2008***

* *

*Net Sales.* Our net sales for the three months ended March 28, 2009 were $225.4million, representing a decrease of 6.0% from net sales of $239.7 millionfor the three months ended March 29, 2008. This decrease was primarily driven by $8.6 million of unfavorablechanges in foreign exchange rates compared to rates in effect for the threemonths ended March 29, 2008 and fewer shipping days as the first quarterof 2009 had only 60.5 days compared to 63 days in the first quarter of 2008.

 

For the threemonths ended March 28, 2009, we generated 24.7% of our net sales fromcustomers outside the United States as compared to 27.6% for the three monthsended March 29, 2008. Additionally, sales of new products, which includeproducts that have been on the market less than one year, were $15.2 millionfor the three months ended March 28, 2009, compared to new product salesof $13.8 million for the three months ended March 29, 2008.

 

The following tablesets forth the mix of our net sales for the three months ended March 28,2009 compared to the three months ended March 29, 2008:

 
| ** **                        | ** ** | **Three Months Ended**   | ** ** | ** **             | ** ** | ** **                     | ** ** |
|-----------------------------------|------------|--------------------------|------------|------------------------|------------|--------------------------------|------------|
| **($ in thousands)**         | ** ** | **March 28,  2009** | ** ** | **% of Net  Revenues** | ** ** | **March  29,  2008** | ** ** | **% of Net  Revenues** | ** ** | **Increase  (Decrease)** | ** ** | **% Increase  (Decrease)** | ** ** |
| Domestic Rehabilitation Segment   |       | $                        | 154,446    |                   | 68.5       | %                              | $          | 157,387 |   | 65.6 | % | $ | (2,941 | ) | (1.9 | )% |
| International Segment             |       | 55,636                   |       | 24.7                   |       | 66,144                         |       | 27.6 |   | (10,508 | ) | (15.9 | ) |
| Domestic Surgical Implant Segment |       | 15,303                   |       | 6.8                    |       | 16,197                         |       | 6.8 |   | (894 | ) | (5.5 | ) |
| **Consolidated net sales**        |       | $                        | 225,385    |                   | 100.0      | %                              | $          | 239,728 |   | 100.0 | % | $ | (14,343 | ) | (6.0 | )% |

 

Net sales inour Domestic Rehabilitation Segment were $154.4 million for the three monthsended March 28, 2009, reflecting a decrease of 1.9% from net sales of$157.4 million for the three months ended March 29, 2008. The decrease wasdriven primarily by fewer shipping days as the first quarter of 2009 had only60.5 days compared to 63 days in the first quarter of 2008 and, to a lesserextent, a slowdown in certain customer purchasing due to the overall globaleconomic decline.

 

Net sales inour International Segment for the three months ended March 28, 2009 were$55.6 million, reflecting a decrease of 15.9% from net sales of $66.1 millionfor the three months ended March 29, 2008. The decrease was drivenprimarily by $8.6 million of unfavorable changes in foreign exchange ratescompared to rates in effect for the three months ended March 29, 2008 andfewer shipping days as the first quarter of 2009 had only 60.5 days compared to63 days in the first quarter of 2008.

 

Net sales inour Domestic Surgical Implant Segment decreased to $15.3 million from $16.2million for the three months ended March 28, 2009, representing a 5.5%decrease over the same period in the prior year. The decrease was drivenprimarily by fewer shipping days as the first quarter of 2009 had only 60.5days as compared to 63 days in the first quarter of 2008 and a slight declinein sales for our knee product line.

* *

*Gross Profit.* Consolidated gross profit as a percentage of net sales increased to62.5% for the three months ended March 28, 2009 from 60.3% for the threemonths ended March 29, 2008. The increase in our gross profit margin isprimarily attributable to cost improvement initiatives implemented in the pastyear, partially offset by unfavorable changes in foreign exchange rates ofapproximately $6.0 million. Additionally, the increase in gross profit wasdriven by reduced amortization of purchased inventory fair value adjustments relatedto prior year acquisitions of $4.7 million.

 

Gross profitin our Domestic Rehabilitation Segment as a percentage of net sales increasedto 63.7% for the three months ended March 28, 2009 from 62.2% for thethree months ended March 29, 2008. The increase was primarily driven by byreduced amortization of purchased inventory fair value adjustments related toprior year acquisitions of $4.7 million.

 

Gross profitin our International Segment as a percentage of net sales decreased to 56.6%for the three months ended March 28, 2009 from 57.7% for the three monthsended March 29, 2008.  The decreasewas primarily driven by unfavorable changes in foreign exchange rates ofapproximately $6.0 million partially offset by cost improvement initiativesimplemented in the past year.

 

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Gross profitin our Domestic Surgical Implant Segment as a percentage of gross salesdecreased to 77.7% for the three months ended March 28, 2009 from 83.2%for the three months ended March 29, 2008. The decrease was primarilydriven by lower margin sales and the overall economic decline.

* *

*Selling, General and Administrative.*  Our selling, general and administrativeexpenses decreased to $102.0 million for the three months ended March 28,2009 from $110.6 million for the three months ended March 29, 2008 due tooverall cost savings initiatives and $5.2 million of lower incremental costs asa result of our integration activities, partially offset by $4.2 million ofcosts related to the implementation of our new global ERP system. The followingtable sets forth certain non-recurring costs associated with our integrationactivities and ERP implementation:

 
| ** **                                 | ** ** | **Three Months Ended**   | ** **  |
|--------------------------------------------|------------|--------------------------|-------------|
| **($ in thousands)**                  | ** ** | **March 28,  2009** | ** **  | **March  29,  2008** | ** ** |
| Employee severance and relocation expenses |       | $                        | 681         |   | $ | 1,060 |   |
| Integration expenses                       |       | 8,996                    |        | 7,781 |   |
| Reversal of reimbursement claims           |       | (6,000                   | )           | — |   |
| ERP implementation                         |       | 4,231                    |        | — |   |
|                                       |       | $                        |  7,908 |   | $ | 8,841 |   |

 

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 DJO Merger. Employee severance and relocation expensesfor the three months ended March 29, 2008 included payments to formerReAble executives.  Integration expense forthe three months ended March 28, 2009 included $3.9 million and $4.9million of integration costs incurred in connection with restructuring at ourinternational locations and the DJO Merger, respectively, partially offset by a$6.0 million reversal of an accrual made in 2008 for alleged reimbursementclaims due to the favorable settlement of the dispute.  Integration expenses for the three monthsended March 29, 2008 included $6.8 million of integration costs relatedthe DJO Merger and certain other smaller acquisitions and $1.0 million ofintegration costs related to Blackstone’s 2006 acquisition of ReAble.

* *

*Research and Development.*  Our research and development expensedecreased to $5.8 million for the three months ended March 28, 2009 from$6.7 million for the three months ended March 29, 2008. As apercentage of net sales, research and development expense decreased slightly to2.6% from 2.8% in the three months ended March 29, 2008.

* *

*Amortization of Acquired Intangibles.*  Amortization of acquired intangibles includesamortization expense related to intangible assets acquired in connection withour acquisitions. The intangible assets are being amortized over the estimatedlives ranging from two to twenty years. Our amortization of acquired intangiblesof $19.1 million for the three months ended March 28, 2009 is in line withthe three months ended March 29, 2008.

* *

*Interest Expense.*  Our interest expense decreased to $38.6million for the three months ended March 28, 2009 from interest expense of$45.2 million for the three months ended March 29, 2008.  The decrease is primarily related to reducedinterest rates.

* *

*Other Income (Expense).*  Net other expense was $1.4 million for thethree months ended March 28, 2009 as compared to net other income of$1.3 million for the three months ended March 29, 2008.  Both amounts primarily reflect net foreigncurrency transaction losses or gains.

* *

*Benefit for Income Taxes.*  For the three months ended March 28,2009, we recorded $11.5 million of income tax benefit on a pre-tax loss of$25.6 million.  For the three monthsended March 29, 2008, we recorded $11.1 million of income tax benefiton a pre-tax loss of $35.0 million.

 

During thefirst quarter of 2009, the state of California enacted legislation which willallow corporate taxpayers to elect to use a single sales factor apportionmentformula to apportion business income to California for tax years beginning onor after January 1, 2011. We anticipate making this election in fiscalyear 2011 and thereafter. In the first quarter of 2009, we recorded a taxbenefit of $4.0 million related to the enactment of this legislation whichrepresents a reduction in our net deferred tax liabilities due to a lowereffective state tax rate.

 

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**Liquidity andCapital Resources**

 

As of March 28,2009, our primary source of liquidity consisted of cash and cash equivalentstotaling $30.7 million and $80.0 million of available borrowings under ourrevolving credit facility, described below. Working capital at March 28,2009 was $169.0 million. We believe that our existing cash, plus the amounts weexpect to generate from operations and amounts available through our revolvingcredit facility, will be sufficient to meet our operating needs for the nexttwelve months, including working capital requirements, capital expenditures,and debt and interest repayment obligations. While we currently believe that wewill be able to meet all of our financial covenants imposed by our SeniorSecured Credit Facility, there is no assurance that we will in fact be able todo so or that, if we do not, we will be able to obtain from our lenders waiversof default or amendments to the Senior Secured Credit Facility in the future.We and our subsidiaries, affiliates or significant shareholders (includingBlackstone and its affiliates) may from time to time, in our or their solediscretion, purchase, repay, redeem or retire any of our outstanding debt orequity securities (including any publicly issued debt securities), in privatelynegotiated or open market transactions, by tender offer or otherwise.

 

A summary ofthe changes in our cash and cash equivalents for the three months ended March 28,2009 and March 29, 2008 is as follows:

 
| ** **                                                    | ** ** | **Three Months Ended**   | ** ** |
|---------------------------------------------------------------|------------|--------------------------|------------|
| ** **                                                    | ** ** | **March 28,  2009** | ** ** | **March 29,  2008** | ** ** |
| Cash provided by operating activities                         |       | $                        | 17,608     |   | $ | 7,433 |   |
| Cash used in investing activities                             |       | (11,913                  | )          | (4,491 | ) |
| Cash used in financing activities                             |       | (4,095                   | )          | (108 | ) |
| Effect of exchange rate changes on cash and  cash equivalents |       | (1,339                   | )          | 1,389 |   |
| Net increase in cash and cash equivalents                     |       | $                        | 261        |   | $ | 4,223 |   |

 

***Cash Flows***

 

Operating activities provided cash of $17.6million and $7.4 million for the three months ended March 28, 2009 and March 29,2008, respectively. Cash provided by operating activities for the three monthsended March 28, 2009 primarily reflected our net income after adjustmentfor non-cash charges and favorable net change in operating assets andliabilities. Cash provided by operating activities for the three months ended March 29,2008 primarily reflects a positive net change in operating assets andliabilities partially offset by our net loss. Cash paid for interest was$3.6 million and $0.1 million for the three months ended March 28, 2009and March 29, 2008, respectively.

 

Investingactivities used $11.9 million and $4.5 million of cash for the threemonths ended March 28, 2009 and March 29, 2008, respectively. Cashused in investing activities for the three months ended March 28, 2009primarily consisted of purchases of property and equipment totaling $8.2million, including $1.2 million for our new ERP system, and the acquisition ofbusinesses for a total of $3.9 million, net of cash. Cash used in investingactivities for the three months ended March 29, 2008 was primarily usedfor purchases of property and equipment amounting to $4.3 million.

 

Financingactivities used $4.1 million and $0.1 million of cash for the three months endedMarch 28, 2009 and March 29, 2008, respectively. Cash used infinancing activities for the three months ended March 28, 2009 and thethree months ended March 29, 2008 represented net payments of $4.1 millionand $0.1 million, respectively, on long-term debt and revolving lines ofcredit.

 

For the remainder of 2009, weexpect to spend total cash of approximately $179.6 million for the following:

 

·    approximately $70.2 million for scheduled principaland estimated interest payments on our senior secured credit facility;

 

·    approximately$86.0 million for scheduled interest payments on our senior notes; and

 

·    approximately$23.4 million for capital expenditures, including $4.5 million for our ERPsystem.

 

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In addition, we expect to spend up toan additional $27.7million implementing our new ERP system capital project over approximately thenext two years.

 

***Indebtedness***

 

As of March 28,2009, we had approximately $1,840.0 million in aggregate indebtednessoutstanding.

* *

*Senior Secured Credit Facility*

* *

*Overview.* The Senior Secured Credit Facility provides senior secured financing of$1,165.0 million, consisting of a $1,065.0 million term loan facilityand a $100.0 million revolving credit facility. We issued the term loanfacility of the Senior Secured Credit Facility at a 1.2% discount, resulting innet proceeds of $1,052.4 million. In addition, we are permitted, subjectto receipt of additional commitments from participating lenders and certainother conditions, to incur up to an additional $150.0 million ofborrowings under the Senior Secured Credit Facility.

* *

*Interest Rate and Fees.*  Borrowings under the Senior Secured CreditFacility bear interest at a rate equal to an applicable margin plus, at ouroption, either (a) a base rate determined by reference to the higher of (1) 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.

 

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% in an effort to hedge ourexposure to fluctuating interest rates related to a portion of our SeniorSecured Credit Facility (see Note 13). The swap agreement amortizesthrough December 2009. As of March 28, 2009, the remaining notionalamount of the swap was $ 470.0 million. In February 2009, we entered intotwo interest rate swap agreements. The first is for a notional amount of $550.0million at a fixed LIBOR rate of 1.04% beginning February 2009 through December 2009.The second is for a notional amount of $750.0 million at a fixed LIBOR rate of1.88% beginning January 2010 through December 2010. As of March 28,2009, our weighted average interest rate for all borrowings under the SeniorSecured Credit Facility 3.9%.

 

In addition topaying interest on outstanding principal under the Senior Secured CreditFacility, we are required to pay a commitment fee to the lenders under therevolving credit facility in respect of the unutilized commitments thereunder.The initial commitment fee rate is 0.50% per annum. The commitment fee rate maybe reduced subject to us attaining certain leverage ratios. We must also paycustomary letter of credit fees.

* *

*Amortization.* We are required to pay annual amortization (payable in equal quarterlyinstallments) on the loans under the term loan facility in an amount equal to1.00% of the funded total principal amount during the first six years and threemonths following the closing of the Senior Secured Credit Facility, with theremaining amount payable at maturity, which is six and one-half years from thedate of the closing of the Senior Secured Credit Facility. Principal amountsoutstanding under the revolving credit facility are due and payable in full atmaturity, which is six years from the date of the closing of the Senior SecuredCredit 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 additional indebtedness;

 

·                  create liens on assets;

 

·                  change fiscal years;

 

·                  enter into sale and leasebacktransactions;

 

·                  engage in mergers or consolidations;

 

·                  sell assets;

 

·                  pay dividends and make otherrestricted payments;

 

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·                  make investments, loans or advances;

 

·                  repay subordinated indebtedness;

 

·                  make certain acquisitions;

 

·                  engage in certain transactions withaffiliates;

 

·                  restrict the ability of restrictedsubsidiaries that are not Guarantors to pay dividends or make distributions;

 

·                  amend material agreements governingour subordinated indebtedness; and

 

·                  change our lines of business.

 

Pursuant tothe terms of the credit agreement relating to the Senior Secured CreditFacility, we are required to maintain a ratio of consolidated senior debt toAdjusted EBITDA (or senior leverage ratio) starting at a maximum of 5.1:1 andstepping down over time to 3.25:1 by the end of 2011. Adjusted EBITDArepresents net income (loss) plus 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 andthe Indentures (“Adjusted EBITDA”). As of March 28, 2009, we were requiredto maintain a senior leverage ratio not to exceed 4.65:1. At March 28,2009 our senior leverage ratio was 4.13:1.

 

*10.875% Senior Notes and 11.75% SeniorSubordinated Notes*

 

The Indenturesgoverning the $575.0 million principal amount of 10.875% Notes and the$200.0 million principal amount of 11.75% Notes limit our (and most or allof our subsidiaries’) ability to:

 

·                  incur additional debt or issuecertain preferred shares;

 

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

 

·                  make certain investments;

 

·                  sell certain assets;

 

·                  create liens on certain assets tosecure debt;

 

·                  consolidate, merge, sell or otherwisedispose of all or substantially all of our assets;

 

·                  enter into certain transactions withour affiliates; and

 

·                  designate our subsidiaries asunrestricted subsidiaries.

 

Under theIndentures governing our 10.875% Notes and our 11.75% Notes, our ability toincur additional debt, subject to specified exceptions, is tied to improvingour Adjusted EBITDA to fixed charges ratio or having a ratio of at least 2.00:1on a pro forma basis after giving effect to such incurrence. Additionally, ourability to make certain restricted payments is also tied to having an AdjustedEBITDA to fixed charge ratio of at least 2.00:1 on a pro forma basis. Our ratioof Adjusted EBITDA to fixed charges for the twelve months ended March 28,2009, measured on that date, was 1.64:1. Notwithstanding these limitations, theaggregate amount of term loan increases and revolving commitment increasesshall not exceed the greater of (i) $150.0 million and (ii) theadditional aggregate amount of secured indebtedness which would be permitted tobe incurred as of any date of determination (assuming for this purpose that thefull amount of any revolving credit increase had been utilized as of such date)such that, after giving pro forma effect to such incurrence (and any othertransactions consummated on such date), the senior secured leverage ratio forthe immediately preceding test period would not be greater than 4.0:1. Fixedcharges is defined in the Indentures as consolidated interest expense plus allcash dividends or other distributions paid on any series of preferred stock ofany restricted subsidiary and all dividends or other distributions accrued onany series of disqualified stock.

 

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* *

*Covenant Compliance*

 

The following is a summary of our covenant requirements and pro formaratios as of March 28, 2009:

 
| ** **                                                                                                       | ** ** | **Covenant  Requirements** | ** ** | **Actual  Ratios** | ** ** |
|------------------------------------------------------------------------------------------------------------------|------------|----------------------------|------------|--------------------|------------|
| **Senior Secured Credit Facility**                                                                               |       |                       |       |               |       |
| Maximum ratio of consolidated net senior  secured debt to Adjusted EBITDA                                        |       | 4.65:1                     |       | 4.13:1             |       |
| **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                     |       | 1.64:1             |       |

 

 

As describedabove, our Senior Secured Credit Facility consisting of a $1,065.0 millionterm loan facility and a $100.0 million revolving credit facility and theIndentures governing the $575.0 million of senior notes and the$200.0 million of senior subordinated notes represent significantcomponents of our capital structure. Under our Senior Secured Credit Facility,we are required to maintain specified senior secured leverage ratios, whichbecome more restrictive over time, and which are determined based on ourAdjusted EBITDA. If we fail to comply with the senior secured leverage ratiounder our Senior Secured Credit Facility, we would be in default under thecredit facility. Upon the occurrence of an event of default under the SeniorSecured Credit Facility, the lenders could elect to declare all amountsoutstanding under the Senior Secured Credit Facility to be immediately due andpayable and terminate all commitments to extend further credit. If we wereunable to repay those amounts, the lenders under the Senior Secured CreditFacility could proceed against the collateral granted to them to secure thatindebtedness. We have pledged a significant portion of our assets as collateralunder the Senior Secured Credit Facility. Any acceleration under the SeniorSecured Credit Facility would also result in a default under the Indenturesgoverning the notes, which could lead to the noteholders electing to declarethe principal, premium, if any, and interest on the then outstanding notesimmediately due and payable. In addition, under the Indentures governing thenotes, our ability to engage in activities such as incurring additionalindebtedness, making investments, refinancing subordinated indebtedness, payingdividends and entering into certain merger transactions is governed, in part,by our ability to satisfy tests based on Adjusted EBITDA.

 

AdjustedEBITDA is defined as net income (loss) plus interest expense, net, provision(benefit) for income taxes and depreciation and amortization, further adjustedfor non-cash items, non-recurring items and other adjustment items permitted incalculating covenant compliance under our Senior Secured Credit Facility 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.

 

AdjustedEBITDA should not be considered as an alternative to net income or otherperformance measures presented in accordance with GAAP, or as an alternative tocash flow from operations as a measure of our liquidity. Adjusted EBITDA doesnot represent net loss or cash flow from operations as those terms are definedby GAAP and does not necessarily indicate whether cash flows will be sufficientto fund cash needs. In particular, the definition of Adjusted EBITDA in theIndentures and our Senior Secured Credit Facility allows us to add back certainnon-cash, extraordinary, unusual or non-recurring charges that are deducted incalculating net loss. However, these are expenses that may recur, vary greatlyand are difficult to predict. While Adjusted EBITDA and similar measures arefrequently used as measures of operations and the ability to meet debt servicerequirements, Adjusted EBITDA is not necessarily comparable to other similarlytitled captions of other companies due to the potential inconsistencies in themethod of calculation.

 

Our ability tomeet the covenants specified above will depend on future events, many of whichare beyond our control, and we cannot assure you that we will meet thosecovenants. A breach of any of these covenants in the future could result in adefault under our Senior Secured Credit Facility and the Indentures, at whichtime the lenders could elect to declare all amounts outstanding under ourSenior Secured Credit Facility to be immediately due and payable. Any suchacceleration would also result in a default under the Indentures.

 

The followingtable provides a reconciliation from our net loss to Adjusted EBITDA for thethree and twelve months ended March 28, 2009. The terms and relatedcalculations are defined in the credit agreement relating to our Senior SecuredCredit Facility and the Indentures.

 

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| **(in thousands)**                                                                           | ** ** | **Three Months  Ended  March 28, 2009** | ** ** | **Twelve Months  Ended  March 28, 2009** | ** ** |
|----------------------------------------------------------------------------------------------|------------|----------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                                                   | ** ** | **(unaudited)**                              | ** ** |
| Net loss                                                                                     |       | $                                            | (14,308    | )                                             | $          | (87,932 | ) |
| Interest expense, net                                                                        |       | 38,255                                       |       | 165,155                                       |       |
| Income tax benefit                                                                           |       | (11,471                                      | )          | (49,487                                       | )          |
| Depreciation and amortization                                                                |       | 25,166                                       |       | 122,940                                       |       |
| Non-cash items (a)                                                                           |       | 597                                          |       | 1,367                                         |       |
| Non-recurring items (b)                                                                      |       | 7,908                                        |       | 43,392                                        |       |
| Other adjustment items, before cost savings  (c)                                             |       | 3,361                                        |       | 21,145                                        |       |
| Other adjustment items—future cost savings  applicable for twelve month period only (d) |       | NA                                           |       | 33,857                                        |       |
| Adjusted EBITDA                                                                              |       | $                                            | 49,508     |                                          | $          | 250,437 |   |

 

(a)           Non-cashitems are comprised of the following:

 
| **(in thousands)**         | ** ** | **Three Months  Ended  March 28, 2009** | ** ** | **Twelve Months  Ended  March 28, 2009** | ** ** |
|----------------------------|------------|----------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                 | ** ** | **(unaudited)**                              | ** ** |
| Stock compensation expense |       | $                                            | 569        |                                          | $          | 1,339 |   |
| Loss on disposal of assets |       | 28                                           |       | 28                                            |       |
| Total non-cash items       |       | $                                            | 597        |                                          | $          | 1,367 |   |

** **

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

 
| **(in  thousands)**                   | ** ** | **Three Months  Ended  March 28, 2009** | ** ** | **Twelve Months  Ended  March 28, 2009** | ** ** |
|---------------------------------------|------------|--------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                            | ** ** | **(unaudited)**                                        | ** ** |
| Employee severance and relocation (1) |       | $                                                      | 681        |                                                    | $          | 10,858 |   |
| Integration expense (2)               |       | 2,996                                                  |       | 23,056                                                  |       |
| ERP Implementation                    |       | 4,231                                                  |       | 9,478                                                   |       |
| Total non-recurring items             |       | $                                                      | 7,908      |                                                    | $          | 43,392 |   |

 

----

(1)           Employee severance and relocation for thethree months ended March 28, 2009 included $0.3 million of severancepayments made to employees in connection with restructuring at ourinternational locations and $0.4 million of severance payments made toemployees in connection with integration activities following the DJOMerger.   Employee severance andrelocation for the twelve months ended March 28, 2009, included $2.8million of separation expense in connection with the termination of one of theCompany’s executive officers and $8.1 million of employee severance incurred inconnection with the DJO Merger, certain other acquisitions, and restructuringat our international locations.

 

(2)           Integration expense for the three monthsended March 28, 2009 included $3.9 million and $4.9 million of integrationcosts incurred in connection with restructuring at our international locationsand the DJO Merger, respectively, partially offset by a $6.0 million reversalof an accrual made in 2008 for alleged reimbursement claims due to thefavorable settlement of the dispute. Integration expense for the twelve months ended March 28, 2009included $23.9 million, $1.5 million, and $3.9 million of integration costsincurred in connection with the DJO Merger, restructuring at our internationallocations and certain other smaller acquisitions, respectively, partiallyoffset by a $6.0 million reversal of an accrual made in 2008 for allegedreimbursement claims due to the favorable settlement of the dispute.

 

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

 
| **(in  thousands)**                                | ** ** | **Three Months  Ended  March 28, 2009** | ** ** | **Twelve Months  Ended  March 28, 2009** | ** ** |
|----------------------------------------------------|------------|--------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                         | ** ** | **(unaudited)**                                        | ** ** |
| Blackstone monitoring fee                          |       | $                                                      | 1,750      |                                                    | $          | 7,000 |   |
| Other transaction fees                             |       | 62                                                     |       | 525                                                     |       |
| Noncontrolling interest                            |       | 139                                                    |       | 988                                                     |       |
| Pre-acquisition EBITDA(1)                          |       | —                                                 |       | 1,432                                                   |       |
| Other(2)                                           |       | 1,410                                                  |       | 11,200                                                  |       |
| Total other adjustment items, before cost  savings |       | $                                                      | 3,361      |                                                    | $          | 21,145 |   |

 

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(1)   Represents pre-acquisition adjusted EBITDA for the acquisitionof DJO Australia.

 

(2)   Other adjustment items for the three months ended March 28,2009 included net foreign currency transaction (gains) losses.  Other adjustment items for the twelve monthsended March 28, 2009 included net foreign currency transaction losses of$12.3 million partially offset by a favorable $1.1 million settlement of alitigation contingency.

 

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

 

**Critical Accounting Policies and Estimates**

 

Our management’sdiscussion and analysis of financial condition and results of operations isbased upon our financial statements, which have been prepared in accordancewith accounting principles generally accepted in the United States. Thepreparation of these financial statements requires us to make estimates and judgmentsthat affect the reported amounts of assets, liabilities, revenues and expenses,and related disclosure of contingent assets and liabilities. On an on-goingbasis, we evaluate our estimates, including those related to reserves forcontractual allowances, doubtful accounts, rebates, product returns and rentalcredits, goodwill and intangible assets, deferred tax assets and liabilities,and inventory. We base our estimates on historical experience and on variousother assumptions that are believed to be reasonable under the circumstances,the results of which form the basis for making judgments about the carryingvalues of assets and liabilities that are not readily apparent from othersources. To the extent that actual events differ from our estimates andassumptions, there could be a material impact on our financial statements.

 

We believe thefollowing critical accounting policies affect our more significant judgmentsand estimates used in the preparation of our condensed consolidated financialstatements and this discussion and analysis of our financial condition andresults of operations.

 

***Reserves forContractual Allowances, Doubtful Accounts, Rebates, Product Returns and RentalCredits***

 

We have established reserves to account forcontractual allowances, doubtful accounts, rebates, product returns and rentalcredits. Significant management judgment must be used and estimates must bemade in connection with establishing these reserves.

 

We maintain provisions for estimatedcontractual allowances for reimbursement amounts from our third party payorcustomers based on negotiated contracts and historical experience fornon-contracted payors. We report these allowances as reductions in our grossrevenue. We estimate the amount of the reduction based on historical experienceand invoices generated in the period, and we consider the impact of newcontract terms or modifications of existing arrangements with our customers. Wehave contracts with certain third party payors for our third partyreimbursement billings, which call for specified reductions in reimbursement ofbilled amounts based upon contractual reimbursement rates. For the three monthsended March 28, 2009 and March 29, 2008, we reserved for and reducedgross revenues from third party payors by 31% and 34%, respectively, forestimated allowances related to these contractual reductions.

 

Our reserve for doubtful accounts is basedupon estimated losses from customers who are billed directly and the portion ofthird party reimbursement billings that ultimately become the financialresponsibility of the end user patients. Direct-billed customers representedapproximately 68% and 72% of our net revenues for the three months ended March 28,2009 and March 29, 2008, respectively, and approximately 62% and 65% ofour net accounts receivable for the three months ended March 28, 2009 and March 29,2008, respectively. We experienced write-offs of less than 1% of related netrevenues for the three months ended March 28, 

 

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2009 and March 29, 2008, respectively. Our third partyreimbursement customers including insurance companies, managed care companiesand 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 March 28, 2009 and March 29, 2008, respectively, andapproximately 38% and 35% of our net accounts receivable for the three monthsended March 28, 2009 and March 29, 2008, respectively. For the threemonths ended March 28, 2009 and March 29, 2008, we estimate bad debtexpense to be approximately 8% and 5%, respectively, of gross revenues fromthese third party reimbursement customers. If the financial condition of ourcustomers were to deteriorate resulting in an impairment of their ability tomake payments or if third party payors were to deny claims for late filings,incomplete information or other reasons, additional provisions may be required.Additions to this reserve are reflected as selling, general and administrativeexpense.

 

Our reserve for rebates accounts forincentives that we offer to certain of our distributors. These rebatesgenerally are attributable to sales volume, sales growth and to reimburse thedistributor for certain discounts. We record estimated reductions to revenuefor customer rebate programs based upon historical experience and estimatedrevenue levels.

 

Our reserve for product returns accounts forestimated customer returns of our products after purchase. These returns aremainly attributable to a third party payor’s refusal to provide reimbursementfor the product or the inability of the product to adequately address thepatient’s condition. We provide for this reserve by reducing gross revenuebased on our historical rate of returns.

 

Our reserve for rental credit recognizes atiming difference between billing for a sale and processing a rental creditassociated with some of our rehabilitation devices. Many insurance providersrequire patients to rent our rehabilitation devices for a period of one to threemonths prior to purchase. If the patient has a long-term need for the device,these insurance companies may authorize purchase of the device after such timeperiod. When the device is purchased, most providers require that rentalpayments previously made on the device be credited toward the purchase price.These credits are processed at the time the payment is received for thepurchase of the device, which creates a time lag between billing for a sale andprocessing the rental credit. Our rental credit reserve estimates unprocessedrental credits based on the number of devices converted to purchase. Thereserve is calculated by first assessing the number of our products beingrented during the relevant period and our historical conversion rate of rentalsto sales, and then reducing our revenue by the applicable amount. We providefor these reserves by reducing our gross revenue. The cost to refurbish rentedproducts is expensed as incurred as part of cost of sales.

 

***Inventory Reserves***

 

We providereserves for estimated excess and obsolete inventories equal to the differencebetween the costs of inventories on hand plus future purchase commitments andthe estimated market value based upon assumptions about future demand. Iffuture demand is less favorable than currently projected by management,additional inventory write-downs may be required. We also provide reserves fornewer product inventories, as appropriate, based on any minimum purchasecommitments and our level of sales of the new products.

 

We consign aportion of our inventory to allow our products to be immediately dispensed topatients. This requires a large amount of inventory to be on hand for theproducts we sell through consignment arrangements. It also increases thesensitivity of these products to obsolescence reserve estimates. As thisinventory is not in our possession, we maintain additional reserves forestimated shrinkage of these inventories based on the results of periodicinventory counts and historical trends.

 

***Goodwill andIntangible Assets***

 

In accordance with 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 

 

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failure to meet the performance projections included in our forecastsof future operating results. We estimated the fair values of our reportingunits primarily using the income approach valuation methodology that includesthe discounted cash flow method, taking into consideration the market approachand certain market multiples as a validation of the values derived using thediscounted cash flow methodology. The discounted cash flows for each reportingunit were based on discrete financial forecasts developed by management forplanning purposes. Cash flows beyond the discrete forecasts were estimatedusing a terminal value calculation, which incorporated historical andforecasted financial trends for each identified reporting unit and consideredlong-term earnings growth rates for publicly traded peer companies. Future cashflows were discounted to present value by incorporating the present valuetechniques discussed in FASB Concepts Statement 7, “Using Cash Flow Information and Present Value in AccountingMeasurements,” or Concepts Statement 7. Specifically, the incomeapproach valuations included reporting unit cash flow discount rates rangingfrom 10.8% to 11.6% and terminal value growth rates of 3%. Publicly availableinformation regarding the market capitalization was also considered inassessing the reasonableness of the cumulative fair values of our reportingunits estimated using the discounted cash flow methodology.  Significant management judgment is requiredin the forecasts of future operating results that are used in the discountedcash flow method of valuation. The estimates we have used are consistent withthe plans and estimates that we use to manage our business. It is possible,however, that the plans may change and estimates used may prove to beinaccurate. If our actual results, or the plans and estimates used in futureimpairment analyses, are lower than the original estimates used to assess therecoverability of these assets, we could incur significant impairment charges.

 

We perform an impairment analysis on ourgoodwill on an annual basis in the fourth quarter and in certain othercircumstances when impairment indicators are present. Our annual impairmenttest related to goodwill did not indicate any impairment.

 

Furthermore, SFAS 142 states thatintangible assets with indefinite lives should be tested annually in lieu ofbeing amortized.  This testwork comparesthe fair value of the intangible with its carrying amount.  To determine the fair value we applied therelief from royalty method (“RFR”). Under the RFR method, the value of the trade name is determined bycalculating the present value of the after-tax cost savings associated withowning the asset and therefore not being required to pay royalties for its useduring the asset’s indefinite life. Significant judgments inherent in this analysis include the selection ofappropriate discount rates, estimating future cash flows and the identificationof appropriate terminal growth rate assumptions.  Discount rate assumptions are based on anassessment of the risk inherent in the projected future cash generated by therespective intangible assets.  Alsosubject to judgment are assumptions about royalty rates, which are based on theestimated rates at which similar brands and trademarks are being licensed inthe marketplace.

 

***Deferred Tax AssetValuation Allowance***

 

We recognizedeferred tax assets and liabilities based on the differences between thefinancial statement carrying amount and the tax bases of assets, liabilitiesand net operating loss carryforwards. We establish valuation allowances whenthe recovery of a deferred tax asset is not likely based on historical income,projected future income, the expected timing of the reversals of temporarydifferences and the implementation of tax-planning strategies.

 

Our grossdeferred tax asset balance was approximately $180.0 million at March 28,2009 and primarily related to reserves for accounts receivable and inventory,accrued expenses, and net operating loss carryforwards (see Note 10 to ourunaudited condensed consolidated financial statements). As of March 28,2009, we maintained a valuation allowance of $7.1 million due touncertainties related to our ability to realize certain net operating losscarryforwards acquired in connection with prior year acquisitions.

 

**ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

We are exposedto certain market risks as part of our ongoing business operations, primarilyrisks from changing interest rates and foreign currency exchange rates thatcould impact our financial condition, results of operations, and cash flows.

 

***Interest Rate Risk***

 

Our primaryexposure is to changing interest rates. We have historically managed ourinterest rate risk by balancing the amounts of our fixed and variable debt. Forour fixed rate debt, interest rate changes may affect the market value of thedebt, but do not impact our earnings or cash flow. Conversely, for our variablerate debt, interest rate changes generally do not affect the fair market valueof the debt, but do impact future earnings and cash flow, assuming otherfactors are held constant. We are exposed to 

 

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interest rate risk as a resultof our borrowings under our Senior Secured Credit Facility, which bear interestat floating rates based on the LIBOR or the prime rate of Credit Suisse. As of March 28,2009, we had $1,054.4 million of borrowings under our Senior Secured CreditFacility. On November 20, 2007, we entered into an interest rate swapagreement related to the Senior Secured Credit Facility for a notional amountof $515.0 million at a fixed LIBOR rate of 4.205% amortizing through anexpiration date of December 2009 (the notional amount was $470.0 millionas of March 28, 2009). In February 2009, we entered into two interestrate swap agreements. The first is for a notional amount of $550.0 million at afixed LIBOR rate of 1.04% beginning February 2009 amortizing through December 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. Thefair value of our interest rate swap agreement recorded in the accompanyingcondensed consolidated balance sheets as of March 28, 2009 and December 31,2008 was a loss of approximately $18.8 million and $13.3 million,respectively, and is recorded in other current and non-current liabilities. Ahypothetical 1% increase in variable interest rates for the remaining portionof the Senior Secured Credit Facility not covered by the swaps would haveimpacted our earnings and cash flow, for the three months ended March 28,2009, by approximately $0.1 million. Our senior debt of approximately$775.0 million consisted of fixed rate debt at December 31, 2008. Wemay use additional derivative financial instruments where appropriate to manageour interest rate risk. However, as a matter of policy, we do not enter intoderivative or other financial investments for trading or speculative purposes.

 

***Foreign CurrencyRisk***

 

Due to the global reach of our business, weare exposed to market risk from changes in foreign currency exchange rates,particularly with respect to the U.S. dollar compared to the Euro and theMexican Peso. Our wholly owned foreign subsidiaries are consolidated into ourfinancial results and are subject to risks typical of an international businessincluding, but not limited to, differing economic conditions, changes inpolitical climate, differing tax structures, other regulations and restrictionsand foreign exchange volatility. To date, we have not used internationalcurrency derivatives to hedge against our investment in our Europeansubsidiaries or their operating results, which are converted into U.S. Dollarsat period-end and average rates, respectively. However, as we continue toexpand our business through acquisitions and organic growth, the sales of ourproducts that are denominated in foreign currencies has increased as well asthe costs associated with our foreign subsidiaries which operate in currenciesother than the U.S. dollar. Accordingly, our future results could be materiallyimpacted by changes in these or other factors. For the three months ended March 28,2009, our average monthly sales denominated in foreign currencies wasapproximately $16.0 million, of which $13.3 million was derived from Eurodenominated sales. In addition, our exposure to fluctuations in foreigncurrencies arises because certain of our subsidiaries enter into purchase orsale transactions using a currency other than its functional currency. OurMexico-based manufacturing operations incur costs that are largely denominatedin Mexican Pesos. Accordingly, our future results could be materially impactedby changes in foreign exchange rates or other factors. Occasionally, we seek toreduce the potential impact of currency fluctuations on our business throughhedging transactions. As of March 28, 2009, we had outstanding hedges inthe form of forward contracts to purchase Mexican Pesos aggregating a U.S.dollar equivalent of $16.5 million. For the three months ended March 28,2009, we recognized a loss in the statement of operations on Mexico Pesoforward contracts of approximately $3.0 million.  For the three months ended March 29,2008, we recognized a gain in the statement of operations on Mexico Pesoforward contracts of approximately $0.4 million.

 

**ITEM 4T. CONTROLS AND PROCEDURES**

 

***Disclosure Controlsand Procedures***

 

We maintaindisclosure controls and procedures (as the term is defined in Rules 13a-15(e) and15d-15(e) under the Securities Exchange Act of 1934, as amended (the “ExchangeAct”) that are designed to ensure that information required to be disclosed inour Exchange Act reports is recorded, processed, summarized and reported withinthe time periods specified in the Commission’s rules and forms, and thatsuch information is accumulated and communicated to our management, includingour Chief Executive Officer and Chief Financial Officer, as appropriate, toallow timely decisions regarding required disclosure.

 

Any controlsand procedures, no matter how well designed and operated, can provide onlyreasonable assurance of achieving the desired control objectives. Under thesupervision and with the participation of our management, including our ChiefExecutive Officer and our Chief Financial Officer, we conducted an evaluationof the effectiveness of our disclosure controls and procedures. Based on thisevaluation and subject to the foregoing, our Chief Executive Officer and ourChief Financial Officer concluded that, as of the end of the quarter covered bythis report, the design and operation of our disclosure controls and proceduresprovide reasonable 

 

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assurance that the disclosurecontrols and procedures are effective to accomplish their objectives at areasonable assurance level.

 

***Changes in InternalControl over Financial Reporting***

 

There has beenno change to our internal control over financial reporting (as that term isdefined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act)during our most recent fiscal quarter that has materially affected, or isreasonably likely to materially affect, our internal control over financialreporting.

 

**Part II. OTHER INFORMATION**

 

**ITEM 1. LEGAL PROCEEDINGS**

 

From time to time, we are plaintiffs ordefendants in various litigation matters in the ordinary course of ourbusiness, some of which involve claims for damages that are substantial inamount. We believe that the disposition of claims currently pending will nothave a material adverse effect on our financial position or results ofoperations.

 

Themanufacture and sale of orthopedic devices and related products exposes us tosignificant risks of product liability claims, lawsuits and product recalls.From time to time, we have been, and we are currently, the subject of a numberof product liability claims and lawsuits relating to our products. We arecurrently defendants in approximately 30 product liability cases related to adisposable drug infusion pump product manufactured by two third party manufacturersthat we distribute through our Bracing and Supports business unit of ourDomestic Rehabilitation segment. We intend to discontinue our sale of theseproducts in the second quarter of 2009. These cases have been brought againstthe manufacturers and certain distributors of these pumps, the manufacturers ofthe anesthetics used in these pumps, and the healthcare professionals involvedin providing the pumps to their patients. All of these lawsuits allege that theuse of these pumps with certain anesthetics in certain shoulder surgeries overprolonged periods have resulted in cartilage damage to the plaintiffs. We havesought indemnity and tendered the defense of these cases both to themanufacturers who have supplied these pumps to us and to our product liabilitycarrier. Both manufacturers have indicated they would accept our tender ofdefense in these cases.  The productliability carrier for both of the two manufacturers has accepted coverage forour defense of these claims.  Inaddition, our product liability carrier has accepted coverage of these cases,subject to customary reservations, and was providing us with the defense untilthe carrier for the manufacturers began providing a defense. The lawsuitsallege damages ranging from unspecified amounts to claims between$1.0 million and $10.0 million. These cases are in varying stages ofdiscovery.

 

We currently carry product liabilityinsurance up to a limit of $25.0 million, subject to a deductible of$50,000 on non-invasive products and a deductible of $250,000 on invasiveproducts and an aggregate deductible of $750,000 for all product liabilityclaims. Our insurance policy is subject to annual renewal. We believe ourcurrent product liability insurance coverage is adequate. In 2003, we exceededthe coverage limits in effect at that time for certain historical productliability claims involving one of our discontinued surgical implant productsand such products are excluded from coverage under our current policies. Theestimated exposure for these claims has been accrued for in our condensedconsolidated balance sheet as of that date. While we believe that our productliability coverage is adequate for the exposure we face today, future productliability claims that could be made against us could significantly exceed thecoverage limit of our policies or such insurance coverage may not continue tobe available on commercially reasonable terms or at all. Additionally, we arealso subject to the risk that our insurers will exclude from coverage claimsmade against us or the risk that insurers may become insolvent.

 

We are an authorized Medicare supplier andprovide a variety of our products directly to Medicare beneficiaries and seekreimbursement from the applicable Medicare Administrative Contractor. CIGNAGovernment Services is that contractor in the western region of the UnitedStates. As a Medicare supplier, we are subject to periodic audits of ouroperations, and, in November 2008, we were advised that as a result ofsuch an audit, CIGNA was asserting that we had been overpaid in the amount ofapproximately $6 million from January 1, 2006 to April 9, 2007. Thisfigure represented Medicare reimbursements for claims we submitted on behalf ofMedicare beneficiaries for our bone growth stimulator product during thatperiod of time. The reason asserted by CIGNA that Medicare was not obligated toprovide reimbursement on these claims is that we failed to maintain aCalifornia Home Medical Device Retail Exemptee License during such 15 monthperiod. We believe that this licensing program does not apply to our businessand appealed the assessment of the overpayment. In March 2009 we received a letter from CIGNA agreeing with ourposition and reversing the asserted overpayment entirely.  As a result, we reversed the $6.0 millionliability we had accrued in November 2008.

 

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On April 15, 2009, we became aware of a *Qui Tam*action filed in Federal Court in Boston, Massachusetts in March 2005 andamended in December 2007 that names as defendants us and each of the othercompanies that manufactures and sells external bone growth stimulators, as wellas our principal stockholder, The Blackstone Group, and the principalstockholder of one of the other companies in the bone growth stimulationbusiness.  The case was sealed whenoriginally filed and unsealed in March 2009.  The plaintiff, or relator, alleges that thedefendants have engaged in Medicare fraud and violated Federal and state falseclaims acts from the time of the original introduction of the devices by eachdefendant to the present by seeking reimbursement for bone growth stimulatorsas a purchased item rather than a rental item. The relator also alleges that the defendants are engaged in othermarketing practices constituting violations of the Federal and various stateantikickback statutes.  Shortly beforebecoming aware of the *Qui Tam* action,we were advised that our bone growth stimulator business was the subject of aninvestigation by the DOJ, and on April 10, 2009, we were served with asubpoena under the Health InsurancePortability and Accountability Act seeking numerous documents relatingto the marketing and sale by us of bone growth stimulators.  We believe that this subpoena is related tothe DOJ’s investigation of the allegations in the *Qui Tam*action, although the DOJ has not yet joined the *Qui Tam*action.  The Company believes that itsmarketing practices in the bone growth stimulation business are in compliancewith applicable legal standards and intends to defend this case vigorously.

 

**ITEM 1A. RISK FACTORS**

 

For adiscussion of the Company’s potential risks or uncertainties, please see Part I,Item IA, of the Company’s 2008 Annual Report on Form 10-K filed withthe Commission on March 11, 2009. There have been no material changes tothe risk factors disclosed in such Form 10-K.

 

**ITEM 5. OTHER INFORMATION**

 

(a)       *Changes to 2008 Option Awards*.  As previously disclosed in the CompensationDisclosure and Analysis section of the Company’s Form 10-K for the year endedDecember 31, 2008 and as described above in Note 8 to Unaudited CondensedConsolidated Financial Statements, which disclosure is incorporated herein bythis reference, during March 2009 the Company’s Compensation Committee mademodifications to the terms of the outstanding options under the 2007 IncentiveStock Plan and adopted a new form of stock option agreement to be used inconnection with future grants. The new Form of Nonstatutory Stock OptionAgreement under 2007 Incentive Stock Plan to be entered into in connection withfuture option grants and the Form of Amendment No. 1 to Nonstatutory StockOption Agreement to be entered into with the holders of outstanding options areattached to this Report as Exhibits 10.1 and 10.2, respectively.

 

(b)      None.

 

**ITEM 6. EXHIBITS**

 

(a)*       Exhibits*

 

 
| 3.1   |   | Certificate of Formation of DJOFL and  amendments thereto (incorporated by reference to Exhibit 3.1 to DJOFL’s  Annual Report on Form 10-K, filed on March 28, 2008).                      |
|-------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.2   |   | Limited Liability Company Agreement of  DJOFL (incorporated by reference to Exhibit 3.2 to DJOFL’s Registration  Statement on Form S-4, filed April 18, 2008 (File  No. 333-142188)). |
| 10.1+ |   | Form of Nonstatutory Stock Option  Agreement under 2007 Incentive Stock Plan.                                                                                                                             |
| 10.2+ |   | Form of Amendment No. 1 to  Nonstatutory Stock Option Agreement.                                                                                                                                     |
| 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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+              Filedherewith

 

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**SIGNATURES**

 

Pursuant tothe requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the registrant has duly caused this report to be signed on itsbehalf by the undersigned thereunto duly authorized.

 
| ** **             | **DJO FINANCE LLC** |
|------------------------|--------------------------|
|                   |                     |   |
| Date: May 6, 2009 | By:                      | /s/ LESLIE H. CROSS |
|                   |                     | Leslie H. Cross*President, Chief Executive Officer and Director*(Authorized Signatory) |
|                   |                     |   |
| Date: May 6, 2009 | By:                      | /s/ VICKIE L. CAPPS |
|                   |                     | Vickie L. Capps*Executive Vice President, Chief Financial Officer  and Treasurer*(Authorized Signatory) |

 

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