Table of Contents

 

 

 

**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 periodended July 3, 2010**

 

**or**

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

 

**For the transition periodfrom               to               **

 

**Commission File Number:333-142188**

 

**DJO FinanceLLC**

(Exact name of Registrant asspecified in its charter)

 

| **State of Delaware**                                           | ** ** | **20-5653965**                          |
|-----------------------------------------------------------------|------------|-----------------------------------------|
| (State or other jurisdiction of

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

 

Registrant’s telephonenumber, including area code:

**(800) 336-5690**

 

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

 

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

 

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

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

 

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

 

As of August 6, 2010, 100% of the issuer’s membership interestswere owned by DJO Holdings, LLC.  

 

 

 

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**DJO FinanceLLC**

**INDEX**

 
| ** ** | ** **                                                                                                                              | **Page  Number** |
|------------|-----------------------------------------------------------------------------------------------------------------------------------------|------------------|
| ** ** | **PART I—FINANCIAL INFORMATION**                                                                                              |             |
|       |                                                                                                                                    |             |
| Item  1.   | Financial Statements                                                                                                                    |             |
|       | Unaudited Condensed Consolidated Balance Sheets as of  July 3, 2010 and December 31, 2009                                | 1                |
|       | Unaudited Condensed Consolidated Statements of  Operations for the three and six months ended July 3, 2010 and  June 27, 2009 | 2                |
|       | Unaudited Condensed Consolidated Statements of Cash  Flows for the six months ended July 3, 2010 and  June 27, 2009 | 3                |
|       | Notes to Unaudited Condensed Consolidated Financial  Statements                                                                         | 4                |
| Item 2.    | Management’s Discussion and  Analysis of Financial Condition and Results of Operations                                             | 27               |
| Item 3.    | Quantitative and  Qualitative Disclosures About Market Risk                                                                             | 43               |
| Item 4.    | Controls and Procedures                                                                                                                 | 44               |
| ** ** | **PART II—OTHER  INFORMATION**                                                                                                |             |
|       |                                                                                                                                    |             |
| Item 1.    | Legal Proceedings                                                                                                                       | 45               |
| Item 1A.   | Risk Factors                                                                                                                            | 46               |
| Item 6.    | Exhibits                                                                                                                                | 47               |

 

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**DJO FinanceLLC**

**Unaudited Condensed Consolidated Balance Sheets**

**(in thousands)**

 
| ** **                                             | ** ** | **July 3,  2010** | ** ** | **December 31,  2009** | ** ** |
|--------------------------------------------------------|------------|------------------------|------------|-----------------------------|------------|
| **Assets**                                             |       |                   |       |                        |       |
| Current assets:                                        |       |                   |       |                        |       |
| Cash and cash equivalents                              |       | $                      | 34,084     |                        | $          | 44,611 |   |
| Accounts receivable, net                               |       | 146,852                |       | 146,212                     |       |
| Inventories, net                                       |       | 100,478                |       | 95,880                      |       |
| Deferred tax assets, net                               |       | 39,742                 |       | 40,448                      |       |
| Prepaid expenses and other current assets              |       | 24,912                 |       | 14,725                      |       |
| Total current assets                                   |       | 346,068                |       | 341,876                     |       |
| Property and equipment, net                            |       | 83,069                 |       | 86,714                      |       |
| Goodwill                                               |       | 1,183,253              |       | 1,191,497                   |       |
| Intangible assets, net                                 |       | 1,145,853              |       | 1,187,677                   |       |
| Other assets                                           |       | 38,668                 |       | 42,415                      |       |
| Total assets                                           |       | $                      | 2,796,911  |                        | $          | 2,850,179 |   |
|                                                   |       |                   |       |                        |       |
| **Liabilities and Equity**                             |       |                   |       |                        |       |
| Current liabilities:                                   |       |                   |       |                        |       |
| Accounts payable                                       |       | $                      | 50,678     |                        | $          | 42,144 |   |
| Accrued interest                                       |       | 12,760                 |       | 10,968                      |       |
| Current portion of debt and capital lease  obligations |       | 12,470                 |       | 15,926                      |       |
| Other current liabilities                              |       | 92,474                 |       | 90,608                      |       |
| Total current liabilities                              |       | 168,382                |       | 159,646                     |       |
| Long-term debt and capital lease obligations           |       | 1,797,959              |       | 1,796,944                   |       |
| Deferred tax liabilities, net                          |       | 296,852                |       | 321,131                     |       |
| Other long-term liabilities                            |       | 16,655                 |       | 14,089                      |       |
| Total liabilities                                      |       | 2,279,848              |       | 2,291,810                   |       |
|                                                   |       |                   |       |                        |       |
| Commitments and contingencies                          |       |                   |       |                        |       |
| Equity:                                                |       |                   |       |                        |       |
| DJO Finance LLC membership equity:                     |       |                   |       |                        |       |
| Member capital                                         |       | 829,470                |       | 827,617                     |       |
| Accumulated deficit                                    |       | (305,690               | )          | (272,275                    | )          |
| Accumulated other comprehensive income (loss)          |       | (9,049                 | )          | 518                         |       |
| Total membership equity                                |       | 514,731                |       | 555,860                     |       |
| Noncontrolling interests                               |       | 2,332                  |       | 2,509                       |       |
| Total equity                                           |       | 517,063                |       | 558,369                     |       |
| Total liabilities and equity                           |       | $                      | 2,796,911  |                        | $          | 2,850,179 |   |

 

See accompanying notes tounaudited condensed consolidated financial statements.

 

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**DJO FinanceLLC**

**Unaudited Condensed Consolidated Statements of Operations**

**(in thousands)**

 
| ** **                                                                                                                                                                                                                                        | ** ** | **Three Months Ended**       | ** ** | **Six Months Ended**          | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-------------------------------|------------|
| ** **                                                                                                                                                                                                                                        | ** ** | **July 3,********2010** | ** ** | **June 27,********2009** | ** ** | **July 3,********2010** | ** ** | **June 27,********2009** | ** ** |
|                                                                                                                                                                                                                                              |       |                         |       |                          |       |   |   |   |   |
| Net sales                                                                                                                                                                                                                                         |       | $                            | 242,527    |                          | $          | 235,112 |   | $ | 482,603 |   | $ | 452,765 |   |
| Cost of sales (exclusive  of amortization of intangible assets of $9,062 and $17,981 for  the three and six months ended July 3, 2010 and $9,506 and $19,004  for the three and six months ended June 27, 2009, respectively) |       | 84,565                       |       | 82,156                        |       | 171,919 |   | 161,156 |   |
| Gross profit                                                                                                                                                                                                                                      |       | 157,962                      |       | 152,956                       |       | 310,684 |   | 291,609 |   |
| Operating expenses:                                                                                                                                                                                                                               |       |                         |       |                          |       |   |   |   |   |
| Selling, general and  administrative                                                                                                                                                                                                              |       | 115,715                      |       | 108,605                       |       | 226,241 |   | 209,205 |   |
| Research and development                                                                                                                                                                                                                          |       | 5,460                        |       | 6,162                         |       | 11,031 |   | 11,965 |   |
| Impairment of assets  held for sale                                                                                                                                                                                                               |       | 1,147                        |       | —                        |       | 1,147 |   | — |   |
| Amortization of  intangible assets                                                                                                                                                                                                                |       | 19,671                       |       | 19,171                        |       | 38,725 |   | 38,302 |   |
|                                                                                                                                                                                                                                              |       | 141,993                      |       | 133,938                       |       | 277,144 |   | 259,472 |   |
| Operating income                                                                                                                                                                                                                                  |       | 15,969                       |       | 19,018                        |       | 33,540 |   | 32,137 |   |
| Other income (expense):                                                                                                                                                                                                                           |       |                         |       |                          |       |   |   |   |   |
| Interest expense                                                                                                                                                                                                                                  |       | (37,450                      | )          | (39,555                       | )          | (78,162 | ) | (78,146 | ) |
| Interest income                                                                                                                                                                                                                                   |       | 322                          |       | 202                           |       | 675 |   | 538 |   |
| Other income (expense),  net                                                                                                                                                                                                                      |       | (2,837                       | )          | 2,967                         |       | (3,617 | ) | 1,587 |   |
|                                                                                                                                                                                                                                              |       | (39,965                      | )          | (36,386                       | )          | (81,104 | ) | (76,021 | ) |
| Loss from continuing  operations before income taxes                                                                                                                                                                                              |       | (23,996                      | )          | (17,368                       | )          | (47,564 | ) | (43,884 | ) |
| Income tax benefit                                                                                                                                                                                                                                |       | 24,560                       |       | 4,995                         |       | 14,792 |   | 16,932 |   |
| Income (loss) from  continuing operations                                                                                                                                                                                                         |       | 564                          |       | (12,373                       | )          | (32,772 | ) | (26,952 | ) |
| Loss from discontinued  operations, net of tax                                                                                                                                                                                                    |       | —                       |       | (577                          | )          | — |   | (167 | ) |
| Net income (loss)                                                                                                                                                                                                                                 |       | 564                          |       | (12,950                       | )          | (32,772 | ) | (27,119 | ) |
| Net income attributable  to noncontrolling interests                                                                                                                                                                                              |       | 321                          |       | 135                           |       | 643 |   | 274 |   |
| Net income (loss)  attributable to DJO Finance LLC                                                                                                                                                                                                |       | $                            | 243        |                          | $          | (13,085 | ) | $ | (33,415 | ) | $ | (27,393 | ) |

 

See accompanying notes tounaudited condensed consolidated financial statements.

 

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**DJO FinanceLLC**

**Unaudited Condensed Consolidated Statements of Cash Flows**

**(in thousands)**

 
| ** **                                                                                          | ** ** | **Six Months Ended**   | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                                                          | ** ** | **July 3,  2010** | ** ** | **June 27,  2009** | ** ** |
| **OPERATING ACTIVITIES:**                                                                           |       |                   |       |   |   |
| Net loss                                                                                            |       | $                      | (32,772    | ) | $ | (27,119 | ) |
| Adjustments to reconcile net loss to net cash  provided by operating activities:                    |       |                   |       |   |   |
| Depreciation                                                                                        |       | 13,105                 |       | 12,969 |   |
| Amortization of intangible assets                                                                   |       | 38,725                 |       | 38,302 |   |
| Amortization of debt issuance costs and non-cash  interest expense                                  |       | 7,193                  |       | 6,457 |   |
| Stock-based compensation expense                                                                    |       | 865                    |       | 1,426 |   |
| Loss on disposal of assets, net                                                                     |       | 660                    |       | 253 |   |
| Deferred income tax benefit                                                                         |       | (17,547                | )          | (18,109 | ) |
| Provision for doubtful accounts and sales returns                                                   |       | 17,388                 |       | 17,375 |   |
| Inventory reserves                                                                                  |       | 2,840                  |       | 2,157 |   |
| Impairment of assets held for sale                                                                  |       | 1,147                  |       | — |   |
| Gain on disposal of discontinued operations                                                         |       | —                 |       | (458 | ) |
| Changes in operating assets and liabilities, net  of acquired assets and liabilities:               |       |                   |       |   |   |
| Accounts receivable                                                                                 |       | (19,341                | )          | (15,061 | ) |
| Inventories                                                                                         |       | (8,619                 | )          | (206 | ) |
| Prepaid expenses and other assets                                                                   |       | (11,941                | )          | (2,952 | ) |
| Accrued interest                                                                                    |       | 1,792                  |       | 9,922 |   |
| Accounts payable and other current liabilities                                                      |       | 16,658                 |       | (299 | ) |
| Net cash provided by operating activities                                                           |       | 10,153                 |       | 24,657 |   |
| **INVESTING ACTIVITIES:**                                                                           |       |                   |       |   |   |
| Purchases of property and equipment                                                                 |       | (14,495                | )          | (11,605 | ) |
| Cash paid in connection with acquisitions, net of  cash acquired                                    |       | (810                   | )          | (4,046 | ) |
| Proceeds received upon disposition of discontinued  operations, net                                 |       | —                 |       | 21,846 |   |
| Other investing activities, net                                                                     |       | (498                   | )          | 369 |   |
| Net cash provided by (used in) investing  activities                                                |       | (15,803                | )          | 6,564 |   |
| **FINANCING ACTIVITIES:**                                                                           |       |                   |       |   |   |
| Proceeds from issuance of debt                                                                      |       | 118,130                |       | 55,072 |   |
| Repayments of debt and capital lease obligations                                                    |       | (121,835               | )          | (73,996 | ) |
| Payment of debt issuance costs                                                                      |       | (3,348                 | )          | — |   |
| Investment by parent                                                                                |       | 988                    |       | — |   |
| Dividend by subsidiary to noncontrolling interests                                                  |       | (529                   | )          | — |   |
| Net cash used in  financing activities                                                              |       | (6,594                 | )          | (18,924 | ) |
| Effect of exchange rate changes on cash and cash  equivalents                                       |       | 1,717                  |       | (911 | ) |
| **Net increase (decrease) in cash  and cash equivalents**                                           |       | (10,527                | )          | 11,386 |   |
| Cash and cash equivalents at beginning of period                                                    |       | 44,611                 |       | 30,483 |   |
| **Cash and cash equivalents at  end of period**                                                     |       | $                      | 34,084     |   | $ | 41,869 |   |
| **Supplemental disclosures of  cash flow information:**                                             |       |                   |       |   |   |
| Cash paid for interest                                                                              |       | $                      | 71,041     |   | $ | 61,653 |   |
| Cash paid for taxes, net                                                                            |       | $                      | 2,659      |   | $ | 15 |   |
| **Non-cash investing and  financing activities:**                                                   |       |                   |       |   |   |
| Increases in property and equipment and other  liabilities in connection with capitalized ERP costs |       | $                      | 500        |   | $ | 1,889 |   |

 

See accompanying notes tounaudited condensed consolidated financial statements.

 

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**DJO Finance LLC**

**Notes to Unaudited Condensed Consolidated FinancialStatements**

 

**1.  SUMMARY OFSIGNIFICANT ACCOUNTING PRINCIPLES**

 

**Basis of Presentation and Principles of Consolidation.**  We are a global provider of high-qualityorthopedic devices, with a broad range of products used for rehabilitation,pain management and physical therapy.  Wealso develop, manufacture and distribute a broad range of surgical reconstructiveimplant products.  We believe that weoffer healthcare 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 products are used by orthopedicspecialists, 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 ournon-surgical medical devices and related accessories are used by athletes andpatients for injury prevention and at-home physical therapy treatment.

 

Our current business activities are the result of a combination ofReAble Therapeutics, Inc. (“ReAble”), which was acquired by an affiliate ofBlackstone Capital Partners V L.P. (“Blackstone”), and DJO OpcoHoldings, Inc. (“DJO Opco”), formerly named DJO Incorporated.  On November 20, 2007, ReAble acquired DJOOpco through a merger transaction (the “DJO Merger”).  ReAble then changed its name to DJOIncorporated (“DJO”) and continues to be owned primarily by affiliates ofBlackstone.  As a result of the DJOMerger, DJO Opco became a subsidiary of DJO Finance LLC (“DJOFL”), the entityfiling this Quarterly Report on  Form 10-Q, which is itself asubsidiary of DJO Incorporated.

 

In the second quarter of 2010, we changed how we report our segmentfinancial information to senior management. Prior to the second quarter of 2010, our Bracing and Supports andRecovery Sciences businesses were reported together within the DomesticRehabilitation Segment.  During thesecond quarter, as a result of our recent sales and marketing leadershipreorganization, these businesses are now separately evaluated and managed.  Segment information for all periods presentedhas been restated to reflect this change.

 

We market and distribute ourproducts through four operating segments, Bracing and Supports, RecoverySciences, Surgical Implant, and International. Our Bracing and Supports Segment offers to customers in the UnitedStates, orthopedic soft goods; rigid knee braces; cold therapy devices andvascular systems which include products intended to prevent deep veinthrombosis following surgery.  OurRecovery Sciences Segment offers to customers in the United States,non-invasive medical products that are used before and after surgery to assistin the repair and rehabilitation of soft tissue and bone, and to protectagainst further injury; electrotherapy devices and accessories used to treatpain and restore muscle function; iontophoretic devices and accessories used todeliver medication; clinical therapy tables, traction equipment and otherclinical therapy equipment; and orthotic devices used to treat joint and spineconditions. Our Surgical Implant Segment offers a comprehensive suite ofreconstructive joint products to customers in the United States. OurInternational segment offers all of our products to customers outside theUnited States.

 

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

 

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

 

Our unaudited condensed consolidated financial statements have beenprepared in accordance with accounting principles generally accepted in theUnited States (“GAAP”) for interim financial information. Accordingly, they donot include all of the information and disclosures required by GAAP forcomplete financial statements. These unaudited condensed consolidated financialstatements should be read in conjunction with our consolidated financialstatements and notes thereto included in our Annual Report on Form 10-Kfor the year ended December 31, 2009. Our unaudited 

 

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condensedconsolidated financial statements have been prepared on the same basis as theaudited consolidated financial statements and include all adjustmentsconsisting of normal recurring adjustments which, in the opinion of management,are necessary for a fair presentation of the financial position, results ofoperations, and cash flows as of and 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.

 

We operate our business on a manufacturing calendar, with our fiscalyear always ending on December 31. Each quarter is 13 weeks, consisting oftwo four-week periods and one five-week period. Our first and fourth quartersmay have more or less operating days from year to year based on the days of theweek on which holidays and December 31 fall. The three months ended July 3,2010 and June 27, 2009 each included 64 days. The six months ended July 3,2010 and June 27, 2009 included 129 and 125 days, respectively.

 

**Use of Estimates.**  The preparation of financial statements inconformity with GAAP requires management to make certain estimates andassumptions that affect the reported amounts of assets and liabilities, thedisclosure of contingent assets and liabilities at the date of the financialstatements and the reported amounts of revenues and expenses during thereporting period. On an ongoing basis, management evaluates its estimates,including those related to contractual allowances, doubtful accounts,inventories, rebates, product returns, warranty obligations, self insurance,income taxes, goodwill and intangible assets and stock-based compensation. Webase our estimates on historical experience and on various other assumptionsthat we believe are reasonable under the circumstances, the results of whichform the basis for making judgments about the carrying values of assets andliabilities that are not readily apparent from other sources. Actual resultscould differ from those estimates.

 

**Cash and Cash Equivalents.**  Cash consists of deposits with financialinstitutions. We consider all short-term, highly liquid investments andinvestments in money market funds and commercial paper with original maturitiesof less than three months at the time of purchase to be cash equivalents.

 

**Computer Software Costs.**  Software is stated at costless accumulated amortization and is amortized using the straight-line methodover its estimated useful life ranging from three to seven years. In accordancewith ASC Topic 350 (formerly American Institute of Certified Public AccountantsStatement of Position (“SOP”) 98-1, “Accounting for the Costs of Computersoftware Developed or Obtained for Internal Use”), we capitalize costs ofinternally developed software during the development stage, including externalconsulting costs, cost of software licenses, and internal payroll andpayroll-related costs for employees who are directly associated with a softwareproject.  These assets are reviewed forimpairment when events or circumstances indicate that the carrying value maynot be recoverable over the remaining estimated useful lives of the assets.Upgrades and enhancements are capitalized if they result in addedfunctionality.  In 2008, we beganimplementing a new ERP system, which has resulted in approximately $17.6million of capitalized software costs as of July 3, 2010.

 

**Derivative Financial Instruments.**  We account for derivatives pursuant to ASCTopic 815 (formerly Financial Accounting Standards Board (“FASB”) Statements ofFinancial Accounting Standards (“SFAS”) No. 133, “Accounting forDerivative Instruments and Hedging”), and related amendments, which requiresthat all derivative instruments be recognized in the financial statements andmeasured at fair value regardless of their purpose or intent.

 

*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 entering into a derivative instrument tohedge a specific risk, potential natural hedges are evaluated.  While our foreign exchange contracts act aseconomic hedges, we have not designated such instruments as hedges under ASCTopic 815. We determine the fair value of our foreign forward contracts inaccordance with ASC Topic 820 (formerly SFAS No. 157, “Fair ValueMeasurement”).  The classification ofgains and losses resulting from changes in the fair values of derivatives isdependent on the intended use of the derivative and its resulting designation.The change in fair value of our derivatives is recorded in other income(expense), net, within the unaudited condensed consolidated statements ofoperations.  At July 3, 2010, thefair value of our foreign exchange forward contracts was an asset of $0.1million and was determined through the use of models that consider variousassumptions, including time value, yield curves, as well as other relevanteconomic measures, which are inputs that are classified as Level 2 in thevaluation hierarchy.

 

*Interest Rate Swap Agreements*.  We make use of debt financing as a source offunds and are therefore exposed to interest rate fluctuations in the normalcourse of business. Our credit facilities are subject to floating interestrates. We manage the risk of unfavorable movements in interest rates by hedginga portion of the outstanding loan balance, thereby 

 

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locking in a fixed rate on a portion of the principal, reducing theeffect of possible rising interest rates and making interest expense morepredictable over the term of the credit facilities. We have designated theseinterest rate swap agreements as cash flow hedges and account for our interestrate swap agreements in accordance with ASC Topic 815.  At July 3, 2010, the fair value of ourinterest rate swap agreements was a liability of $10.9 million and wasdetermined through the use of models that consider various assumptions,including time value, yield curves, as well as other relevant economicmeasures, which are inputs that are classified as Level 2 in the valuationhierarchy.

 

**Foreign Currency Translation and Transactions.**  The financial statements of our internationalsubsidiaries, where the local currency is the functional currency, aretranslated into U.S. dollars using period-end exchange rates for assets andliabilities and average exchange rates during the period for revenues andexpenses. Cumulative translation gains and losses are excluded from results ofoperations and recorded as a separate component of accumulated othercomprehensive income (loss) within equity. Gains and losses resulting fromforeign currency transactions (transactions denominated in a currency otherthan the entity’s local currency) are included in the unaudited condensedconsolidated statements of operations.

 

Comprehensive loss consists of the following for the three and sixmonths ended July 3, 2010 (in thousands):

 
| ** **                                                         | ** ** | **Three Months** | ** ** | **Six Months**                   | ** ** |
|--------------------------------------------------------------------|------------|------------------|------------|----------------------------------|------------|
| ** **                                                         | ** ** | **DJOFL**        | ** ** | **Non-  controlling  Interests** | ** ** | **Total** | ** ** | **DJOFL** | ** ** | **Non-  controlling  Interests** | ** ** | **Total** | ** ** |
| Net income (loss), as reported                                     |       | $                | 243        |                             | $          | 321 |   | $ | 564 |   | $ | (33,415 | ) | $ | 643 |   | $ | (32,772 | ) |
| Foreign currency  translation adjustments, net of tax              |       | (2,459           | )          | —                           |       | (2,459 | ) | (9,765 | ) | — |   | (9,765 | ) |
| Change in fair value of  interest rate swap agreements, net of tax |       | 580              |       | —                           |       | 580 |   | 198 |   | — |   | 198 |   |
| Comprehensive loss                                                 |       | $                | (1,636     | )                                | $          | 321 |   | $ | (1,315 | ) | $ | (42,982 | ) | $ | 643 |   | $ | (42,339 | ) |

 

Comprehensiveloss consists of the following for the three and six months endedJune 27, 2009 (in thousands):

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

 

**Reclassifications.**  The financial statements and notes theretoreflect certain reclassifications to prior year amounts to conform to thecurrent year presentation.

 

**Recent Accounting Pronouncements.**  In January 2010, we adopted ASC Topic810 (formerly SFAS No. 167, “Amendments to FASB Interpretation No. 46(R)”).  ASC Topic 810 amends certainrequirements of FASB Interpretation No. 46, “Consolidation of VariableInterest Entities” (“FIN 46”), including the addition of entities previouslyconsidered qualifying special-purpose entities. The adoption of ASC Topic 815had no impact on our consolidated financial statements.

 

InJanuary 2010, we adopted ASC Topic 860 (formerly SFAS No. 166, “Accountingfor the Transfers of Financial Assets as amendment of FASB StatementNo. 140” (“SFAS 166”) which amends SFAS No. 140, “Accounting forTransfers and Servicing of Financial Assets” (“SFAS 140”).  SFAS 166 makes the following amendments toSFAS 140: 1) removes concept of qualifying special-purpose entities from SFAS140; 2) modifies the financial components approach used and limits thecircumstances in which a transferor has not transferred the original financialasset to an entity that is not consolidated with the transferor in thefinancial statements; 3) establishes conditions for reporting a transfer of aportion of a financial asset as a sale; 4) redefines a participating interest;5) clarifies that an entity must consider all arrangements or agreements madecontemporaneously with, or in contemplation of, a transfer, even if not enteredinto at the time of the transfer; 6) clarifies that the transferor mustevaluate whether it, its consolidated affiliates included in the financialstatements being presented, or its agency effectively control the transferredfinancial 

 

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assetdirectly or indirectly; 7) requires that the transferor recognize and initiallymeasure at fair value all assets obtained and liabilities incurred as a resultof the a transfer of an entire asset or group of financial assets accounted foras a sale; 8) removes special provisions for guaranteed mortgagesecuritizations to require them to be treated the same as any other transfer offinancial assets; 9) Removes fair value practicability exception from measuringthe proceeds received by a transferor in a transfer that meets the conditionsfor sale accounting at fair value; and 10) requires enhanced disclosures. Theadoption of ASC Topic 860 had no impact on our consolidated financialstatements.

 

InSeptember 2009, the FASB issued ASU 2009-13, which amends ASC Topic 605(formerly Emerging Issues Task Force (“EITF”) Issue No. 08-1, “RevenueArrangements with Multiple Deliverables.”). ASU 2009-13 provides guidanceconcerning (1) the determination of whether an arrangement involvingmultiple deliverables contains more than one unit of accounting, and(2) the manner in which consideration should be measured and allocated tothe separate units of accounting in the multiple-element arrangement, and iseffective for fiscal years beginning on or after June 15, 2010. We arecurrently evaluating the impact, if any, this issue will have on ourconsolidated financial statements. However, we do not expect that this issuewill result in a change in current practice.

 

**2.  ACCOUNTS RECEIVABLE RESERVES**

 

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

 
| ** **                                        | ** ** | **Six Months Ended**   | ** ** |
|---------------------------------------------------|------------|------------------------|------------|
| ** **                                        | ** ** | **July 3,  2010** | ** ** | **June 27,  2009** | ** ** |
| Balance, beginning of period                      |       | $                      | 48,306     |   | $ | 36,521 |   |
| Provision for doubtful accounts and sales returns |       | 17,388                 |       | 17,375 |   |
| Write-offs, net of recoveries                     |       | (17,468                | )          | (9,345 | ) |
| Balance, end of period                            |       | $                      | 48,226     |   | $ | 44,551 |   |

 

**3.  INVENTORIES**

 

Inventories consist of thefollowing (in thousands):

 
| ** **                    | ** ** | **July 3,  2010** | ** ** | **December 31,  2009** | ** ** |
|-------------------------------|------------|------------------------|------------|-----------------------------|------------|
| Components and raw materials  |       | $                      | 27,097     |                        | $          | 29,967 |   |
| Work in process               |       | 5,619                  |       | 3,745                       |       |
| Finished goods                |       | 56,289                 |       | 50,558                      |       |
| Inventory held on consignment |       | 22,347                 |       | 24,121                      |       |
|                          |       | 111,352                |       | 108,391                     |       |
| Less inventory reserves       |       | (10,874                | )          | (12,511                     | )          |
|                          |       | $                      | 100,478    |                        | $          | 95,880 |   |

 

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

 
| ** **                         | ** ** | **Six Months Ended**   | ** ** |
|------------------------------------|------------|------------------------|------------|
| ** **                         | ** ** | **July 3,  2010** | ** ** | **June 27,  2009** | ** ** |
| Balance, beginning of period       |       | $                      | 12,511     |   | $ | 17,798 |   |
| Provision charged to cost of sales |       | 2,840                  |       | 2,157 |   |
| Write-offs, net of recoveries      |       | (4,477                 | )          | (4,908 | ) |
| Balance, end of period             |       | $                      | 10,874     |   | $ | 15,047 |   |

 

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

 

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**4.  GOODWILL AND INTANGIBLE ASSETS**

 

Changes in the carrying amount of goodwill for the six months endedJuly 3, 2010 are as follows (in thousands):

 
| Balance, beginning of period             |   | $      | 1,191,497 |   |
|------------------------------------------|--------|--------|-----------|--------|
| Foreign currency translation adjustments |   | (8,244 | )         |
| Balance, end of period                   |   | $      | 1,183,253 |   |

 

Identifiableintangible assets consisted of the following as of July 3, 2010 (inthousands):

 
| ** **                                      | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net  Carrying  Amount** | ** ** |
|-------------------------------------------------|------------|-----------------------------|------------|-------------------------------|------------|---------------------------|------------|
| Intangible assets subject to amortization, net: |       |                        |       |                          |       |                      |       |
| Technology-based                                |       | $                           | 458,150    |                          | $          | (112,366                  | )          | $ | 345,784 |   |
| Customer-based                                  |       | 488,442                     |       | (117,087                      | )          | 371,355                   |       |
|                                            |       | $                           | 946,592    |                          | $          | (229,453                  | )          | 717,139 |   |
| Indefinite-lived intangible assets:             |       |                        |       |                          |       |                      |       |
| Trademarks and trade names                      |       |                        |       |                          |       | 428,269                   |       |
| Foreign currency translation adjustments        |       |                        |       |                          |       | 445                       |       |
|                                            |       |                        |       |                          |       | $                         | 1,145,853  |   |

 

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

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

 

Our intangible assets with finite useful lives are being amortizedusing the straight-line method over their estimated useful lives ranging fromone to 20 years. Based on our amortizable intangible asset balances as of July 3,2010, we estimate that amortization expense will be as follows for the nextfive years and thereafter (in thousands):

 
| Remaining 2010 |   | $       | 38,491  |   |
|----------------|--------|---------|---------|--------|
| 2011           |   | 75,675  |    |
| 2012           |   | 74,441  |    |
| 2013           |   | 69,189  |    |
| 2014           |   | 67,368  |    |
| Thereafter     |   | 391,975 |    |
|           |   | $       | 717,139 |   |

 

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**5.  OTHERCURRENT LIABILITIES**

 

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

 
| ** **                                   | ** ** | **July 3,  2010** | ** ** | **December 31,  2009** | ** ** |
|----------------------------------------------|------------|------------------------|------------|-----------------------------|------------|
| Wages and related expenses                   |       | $                      | 24,064     |                        | $          | 20,668 |   |
| Other accrued liabilities                    |       | 18,103                 |       | 17,933                      |       |
| Commissions and royalties                    |       | 12,063                 |       | 12,953                      |       |
| Accrued product liability insurance premiums |       | 8,737                  |       | —                      |       |
| Professional fees                            |       | 6,076                  |       | 5,529                       |       |
| Interest rate swap derivative                |       | 5,540                  |       | 9,701                       |       |
| Rebates                                      |       | 5,477                  |       | 4,482                       |       |
| Taxes payable                                |       | 4,264                  |       | 3,061                       |       |
| Accrued product liability claims             |       | 2,514                  |       | 1,988                       |       |
| Warranties                                   |       | 2,219                  |       | 1,714                       |       |
| Accrued ERP costs                            |       | 1,852                  |       | 5,800                       |       |
| Integration costs                            |       | 1,565                  |       | 6,779                       |       |
|                                         |       | $                      | 92,474     |                        | $          | 90,608 |   |

 

**6.  DEBT ANDCAPITAL LEASE OBLIGATIONS**

 

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

 
| ** **                                                                                                                                                                                                      | ** ** | **July 3,  2010** | ** ** | **December 31,  2009** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------------|------------|
| Term loan under Senior Secured Credit Facility,  net of unamortized original issue discount ($7.6 million and  $9.3 million at July 3, 2010 and December 31, 2009,  respectively) |       | $                      | 927,828    |                        | $          | 1,034,427 |   |
| 10.875% Senior Notes, net of unamortized original  issue premium ($4.7 million at July 3, 2010)                                                                                                  |       | 679,661                |       | 575,000                     |       |
| 11.75% Senior Subordinated Notes                                                                                                                                                                                |       | 200,000                |       | 200,000                     |       |
| Notes payable for acquisitions                                                                                                                                                                                  |       | 2,828                  |       | 2,860                       |       |
| Capital lease obligations                                                                                                                                                                                       |       | 112                    |       | 228                         |       |
| Other                                                                                                                                                                                                           |       | —                 |       | 355                         |       |
| Total debt and capital lease obligations                                                                                                                                                                        |       | 1,810,429              |       | 1,812,870                   |       |
| Current maturities                                                                                                                                                                                              |       | (12,470                | )          | (15,926                     | )          |
| Long-term debt and capital lease obligations                                                                                                                                                                    |       | $                      | 1,797,959  |                        | $          | 1,796,944 |   |

 

*Senior Secured Credit Facility*

 

On November 20, 2007, we entered into the Senior Secured CreditFacility which consisted of a $1,065.0 million term loan facility maturingMay 2014 and a $100.0 million revolving credit facility maturingNovember 2013. We issued the term loan facility at a 1.2% discount,resulting in net proceeds of $1,052.4 million. The original$12.6 million discount was being amortized as additional interest expense,using the effective interest method over the term of the term loan facilityincreasing the reported outstanding balance accordingly. In the first quarterof 2010, we made a voluntary prepayment of $101.5 million towards the aggregateprincipal amount of our term loan under the Senior Secured Credit Facility. Inaddition, based on annual excess cash flow, as defined, for the year endedDecember 31, 2009, we were required to make a prepayment of the termloan outstanding under our Senior Secured Credit Facility of approximately $2.0million, which we paid in March 2010. As a result of our prepayments, weaccelerated the amortization associated with our unamortized original issuediscount by approximately $0.8 million, relating to the portion of the termloans that were repaid.

 

The market value of our term loan facility was approximately $893.3million as of July 3, 2010 and was determined using trading prices for ourterm loan on or near that date. As of July 3, 2010, no amounts were drawnrelated to our revolving credit facility.

 

*Interest Rate and Fees.*  Borrowings under the Senior Secured CreditFacility bear interest at a rate equal to an applicable margin plus, at ouroption, either (a) a base rate determined by reference to the higher of(1) the prime rate of Credit Suisse and (2) the federal funds rateplus 0.50% or (b) the Eurodollar rate determined by reference to the costsof funds for deposits in U.S. dollars for the interest period relevant to eachborrowing adjusted for required reserves. The initial applicable margin forborrowings under the term loan facility and the revolving credit facility is2.00% with respect to base rate borrowings and 3.00% with respect to Eurodollarborrowings. The applicable margin for borrowings under the term loan facilityand the revolving credit facility may be reduced subject to our attaining certainleverage ratios.

 

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We use interest rate swap agreements in an effort to hedge our exposureto fluctuating interest rates related to a portion of our Senior Secured CreditFacility (See Note 14).  OnNovember 20, 2007, we entered into an interest rate swap agreement for anotional amount of $515.0 million at a fixed LIBOR rate of 4.205% whichexpired at December 31, 2009. In February 2009, we entered into twonon-amortizing interest rate swap agreements. One agreement was for a notionalamount of $550.0 million at a fixed LIBOR rate of 1.04% beginningFebruary 2009 and expired at December 31, 2009. The other agreementwas for a notional amount of $750.0 million at a fixed LIBOR rate of 1.88%beginning January 2010 through December 2010.  In August 2009, we entered into fournon-amortizing interest rate swap agreements with notional amounts aggregating$300.0 million. Each of the four agreements has a term beginningJanuary 2011 through December 2011. The four agreements are at aweighted average fixed LIBOR rate of 2.5825%. As of July 3, 2010, our weighted average interest rate for allborrowings under the Senior Secured Credit Facility was 4.58%.

 

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

 

*Principal Payments.*  We are required to pay annual payments inequal quarterly installments on the loans under the term loan facility in anamount equal to 1.00% of the funded total principal amount throughFebruary 2014, with any remaining amount payable in May 2014.Principal amounts outstanding under the revolving credit facility are due andpayable 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 attainingcertain leverage ratios) of our annual excess cash flow, as defined;(2) 100% of the net cash proceeds above an annual amount of $25.0 millionfrom non-ordinary course asset sales (including insurance and condemnation proceeds)by DJOFL and its restricted subsidiaries, subject to certain exceptions to beagreed upon, including a 100% reinvestment right if reinvested or committed toreinvest within 15 months of such sale or disposition so long asreinvestment is completed within 180 days thereafter; and (3) 100% ofthe net cash proceeds from issuances or incurrences of debt by DJOFL and itsrestricted subsidiaries, other than proceeds from debt permitted to be incurredunder the Senior Secured Credit Agreement. Any mandatory prepayments areapplied to the term loan facilities in direct order of maturity.  Based on excess cash flows, as defined, forthe year ended December 31, 2009, we were required to make a prepayment ofthe term loan outstanding under our Senior Secured Credit Facility ofapproximately $2.0 million, which we paid in March 2010. We expect toreinvest the net proceeds from our 2009 asset sales during 2010 as permitted byour credit agreement and, as such, our calculation of 2009 excess cash flowsexcluded those net proceeds. We may voluntarily prepay outstanding loans underthe Senior Secured Credit Facility at any time without premium or penalty,provided that voluntary prepayments of Eurodollar loans made on a date otherthan the last day of an interest period applicable thereto shall be subject tocustomary breakage costs.  InJanuary 2010, we issued $100 million of new 10.875% Senior Notes and usedthe net proceeds, along with cash on hand, to make a voluntary prepayment of$101.5 million towards the aggregate principal amount of our term loan underthe Senior Secured Credit Facility.

 

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

 

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

 

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

 

·                  incur additionalindebtedness,

·                  create liens on assets,

·                  change fiscal years,

·                  enter into sale andleaseback transactions,

·                  engage in mergers orconsolidations,

·                  sell assets,

·                  pay dividends and otherrestricted payments,

·                  make investments, loans oradvances,

·                  repay subordinatedindebtedness,

·                  make certain acquisitions,

·                  engage in certaintransactions with affiliates,

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

·                  amend material agreementsgoverning our subordinated indebtedness; and

·                  change our lines ofbusiness.

 

In addition, the Senior Secured Credit Facility requires us to maintaina maximum senior secured leverage ratio of 4.00:1 for the trailing twelvemonths ended July 3, 2010, stepping down over time to 3.25:1 by the end of2011. The Senior Secured Credit Facility also contains certain customaryaffirmative covenants and events of default. As of July 3, 2010, ourmaximum senior secured leverage ratio was within the covenant level, and wewere in compliance with all other applicable covenants.

 

*10.875% Senior Notes*

 

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

 

On January 20, 2010, we issued $100.0 million aggregate principalamount of new 10.875% Senior Notes, pursuant to the 10.875% Indenture that alsogoverns our existing 10.875% Notes due 2014. The net proceeds of the issuance(excluding approximately $2.0 million of interest accrued fromNovember 15, 2009 to January 19, 2010, which was included in theinterest payment we made to noteholders on May 15, 2010), along with cashon hand, were used to repay $101.5 million aggregate principal amount ofexisting term loans under the Senior Secured Credit Facility. In connectionwith the issuance of these notes, we received a premium of $5.0 million, whichis being amortized over the term of the note, as a reduction to interestexpense in our unaudited condensed consolidated statements of operations.  Collectively, the new 10.875% Senior Notesand the existing 10.875% Notes are referred to as the 10.875% Notes.

 

The 10.875% Notes require semi-annual interest payments ofapproximately $36.7 million each May 15 and November 15 and are dueNovember 15, 2014. The market value of the 10.875% Notes was approximately$703.7 million as of July 3, 2010 and was determined using tradingprices for the 10.875% Notes on or near that date. We believe the tradingprices reflect certain differences between prevailing market terms andconditions and the actual terms of our 10.875% Notes.

 

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

 

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

 

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

 

*11.75% Senior Subordinated Notes*

 

The Issuers issued $200.0 million aggregate principal amount of11.75% senior subordinated notes in November 2006 (the “11.75% Notes”).The 11.75% Notes require semi-annual interest payments of approximately$11.8 million each May 15 and November 15 and are dueNovember 15, 2014.

 

The market value of the 11.75% Notes was approximately $205.0 millionas of July 3, 2010 and was determined using trading prices for the 11.75%Notes on or near that date. We believe the trading prices reflect certaindifferences between prevailing market terms and conditions and the actual termsof our 11.75% Notes.

 

The 11.75% Notes contain similar provisions as the 10.875% Notes withrespect to change of control and covenant requirements. Under the Indenturegoverning the 11.75% Notes (the “11.75% Indenture”), prior to November 15,2010, the Issuers have the option to redeem some or all of the 11.75% Notes forcash at a redemption price equal to 100% of the then outstanding principalbalance plus an applicable make-whole premium plus accrued and unpaid interest.Beginning on November 15, 2010, the Issuers may redeem some or all of the11.75% Notes at a redemption price of 105.875% of the then outstandingprincipal balance plus accrued and unpaid interest on the 11.75% Notes. Theredemption price decreases to 102.938% and 100% of the then outstandingprincipal balance at November 2011 and November 2012, respectively.Additionally, from time to time, before November 15, 2009, the Issuers mayredeem up to 35% of the 11.75% Notes at a redemption price equal to 111.75% ofthe principal amount then outstanding, in each case, with proceeds we raise, ora direct or indirect parent company raises, in certain offerings of equity ofDJOFL or its direct or indirect parent companies, as long as at least 65% ofthe aggregate principal amount of the notes issued remains outstanding.

 

Our ability to continue to meet the covenants related to ourindebtedness specified above in future periods will depend, in part, on eventsbeyond our control, and we may not continue to meet those ratios. A breach ofany of these covenants in the future could result in a default under the SeniorSecured Credit Facility, the 11.75% Indenture and the 10.875% Indenture(collectively, the “Indentures”), at which time the lenders could elect todeclare all amounts outstanding under the Senior Secured Credit Facility to beimmediately due and payable. Any such acceleration would also result in adefault under the Indentures.

 

*Debt Issuance Costs*

 

We incurred $30.7 million, $27.7 million (including $3.3 millionincurred during the six months ended July 3, 2010 in connection with thesale of the new 10.875% Senior Notes), and $10.2 million of debt issuance costsin connection with the Senior Secured Credit Facility, the 10.875% Notes, andthe 11.75% Notes, respectively. These costs have been capitalized and areincluded in other non-current assets in the condensed consolidated balancesheets as of July 3, 2010 (unaudited) and December 31, 2009. Debt issuancecosts are being amortized over the terms of the respective debt instrumentsthrough November 2014. As a result of the prepayment of $101.5 million ofaggregate principal amount of existing term loans under the Senior SecuredCredit Facility in the first quarter of 2010, we recognized a loss ofapproximately $1.9 million, due to the write off of unamortized debt issuancecosts relating to the portion of the term loans that were repaid.

 

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

 

*2007 Stock Incentive Plan*

 

We have one active equity compensation plan,the DJO Incorporated 2007 Incentive Stock Plan (the “2007 Plan”), under whichwe are authorized to grant options up to 7,500,000 shares of Common Stock ofour indirect parent, DJO Incorporated, subject to adjustment in certain events.Options issued under the 2007 Plan can be either incentive stock options ornon-qualified stock options. The exercise price of stock options granted willnot be less than 100% of the fair market value of the underlying shares on thedate of grant, and will expire no more than ten years from the date of grant.We adopted a form of non-statutory stock option agreement (the “DJOForm Option Agreement”) for employee stock option awards under the 2007Plan. Under the DJO Form Option Agreement, one-third of stock options willvest over a specified period of time (typically five years) contingent solelyupon the awardees’ continued employment with us (“Time-Based Tranche”). Asinitially adopted, another one-third of stock options will vest over aspecified performance period (typically five years) from the date of grant uponthe achievement of certain pre-determined performance targets based on AdjustedEBITDA and free cash flow on an annual basis (“Performance-Based Tranche”), asdefined in the DJO Form Option Agreement. As amended in March 2009,the final one-third of stock options will vest based upon achieving a minimuminternal rate of return (“IRR”) and a minimum return of money on investedcapital (“MOIC”), as defined in the DJO Form Option Agreement; eachmeasured with respect to Blackstone’s aggregate investment in our capital stock,to be achieved by Blackstone following a liquidation of all or a portion of itsinvestment in our capital stock (“Enhanced Market-Return Tranche”).

 

In March 2010, the Compensation Committee approved furthermodifications to the terms of the outstanding options and the DJOForm Option Agreement. The Time-Based Tranche and Enhanced Market-ReturnTranche terms remain the same as discussed above. The financial performancetargets for the future years of the Performance-Based Tranche were replaced bytargets with different financial metrics. These new targets are similar to theEnhanced Market-Return Tranche as they require achievement of a minimum IRR andMOIC, each measured with respect to Blackstone’s aggregate investment in ourcapital stock, to be achieved by Blackstone following a liquidation of all or aportion of its investment in our capital stock (referred to herein as the “Market-ReturnTranche”). As a result of this modification, the Market-Return Tranche has botha performance component and a market condition component.

 

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

 

*Employee Stock Options*

 

During the six months ended July 3, 2010 we granted 483,550 stockoptions under the 2007 Plan to senior management, and certain other employees.

 

We recorded non-cash compensation expense of approximately $0.4 millionand $0.9 million for the three and six months ended July 3, 2010,respectively, associated with stock options issued under the 2007 Plan. Werecorded non-cash compensation expense of approximately $0.8 million and $1.3million for the three and six months ended June 27, 2009, respectively,associated with stock options issued under the 2007 Plan. We recordcompensation expense for awards with a service or market condition ratably overthe service period. We record compensation expense for awards with aperformance condition only to the extent deemed probable of achievement.  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. To date, no amount has beenrecorded for the Market Return or the Enhanced Market-Return Tranches, asachievement of the performance component is not deemed probable at this time.

 

The fair value of each option is estimated on the date of grant, usingthe Black-Scholes-Merton option pricing model for service awards and a binomialmodel for market based awards. In estimating fair value for new options issuedunder the 2007 Plan, expected volatility was based completely on historicalvolatility of comparable publicly-traded companies. As our historical shareoption exercise experience does not provide a reasonable basis upon which toestimate the expected term, we used the simplified approach to calculate theexpected term. Expected life is calculated in two tranches based on theemployment level defined as executive or employee. The risk-free rate used incalculating fair value of service and performance-based stock options forperiods within the expected term of the option is based on the U.S. Treasuryyield bond curve in effect at the time of grant. As a result of the 2009 and2010 modifications, we will no longer use the original grant date fair value tomeasure compensation cost related to the Market-Return and Enhanced Market-Returntranches, and have re-assessed the assumptions used to determine the fair valueof options at the date of modification and at subsequent grant dates.

 

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The assumptions used to calculate the fair value of options granted areevaluated and revised, as necessary, to reflect market conditions andexperience. The following table presents the assumptions we used in calculatingthe fair value of employee stock options for the six months ended July 3,2010 and June 27, 2009:

 
| ** **                                                  | ** ** | **Six Months Ended**   | ** ** |
|-------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                  | ** ** | **July 3,  2010** | ** ** | **June 27,  2009** | ** ** |
| Assumptions used to estimate fair value of awards  granted: |       |                   |       |   |   |
| Expected volatility                                         |       | 34.2 – 34.5       | %          | 34.4 | % |
| Risk—free interest rate                                |       | 2.8 – 3.0         | %          | 2.3 | % |
| Expected term                                               |       | 6.4 – 7.0 years   |       | 6.3 years |   |
| Expected dividend yield                                     |       | none                   |       | none |   |

 

*Non-Employee Stock Options*

 

During the six months ended July 3, 2010 we granted 1,200 stockoptions under the 2007 Plan to non-employees, with an exercise price of $16.46per share, which is equal to 100% of the estimated fair market value of thestock. Non-cash compensation expense was $0.1 million for each of the three andsix month periods ended July 3, 2010 and June 27, 2009, respectively.

 

**8.  MEMBERSHIPEQUITY**

 

In June 2010, DJO Incorporated, our indirect parent, sold 62,748shares of its common stock, at $16.46 per share in an offering to certainaccredited investors comprised of employees, directors and independent salesagents, subject to the execution of a stockholders agreement including certainrights and restrictions. The proceeds were contributed to us as an additionalinvestment, and were included in member capital in our unaudited condensedconsolidated balance sheet as of July 3, 2010. The investment ofapproximately $1.0 million (after deducting issuance costs) will be used forworking capital purposes.  In addition,subsequent to July 3, 2010, 24,304 additional shares were issued pursuantto this offering.  The offeringterminated as of July 31, 2010.

 

**9. SEGMENT AND GEOGRAPHIC INFORMATION**

 

We provide a broad array of orthopedic rehabilitation and regenerationproducts, as well as surgical implants to customers in the United States andabroad.  In the second quarter of 2010,we changed how we report our segment financial information to senior management.Prior to the second quarter of 2010, our Bracing and Supports and RecoverySciences businesses were reported together within the Domestic RehabilitationSegment.  During the second quarter, as aresult of our recent sales and marketing leadership reorganization, thesebusinesses are now separately evaluated and managed. Segment information forall periods presented has been restated to reflect this change.  We currently develop, manufacture anddistribute our products through the following four operating segments:

 

***Bracing and Supports Segment***

 

Our Bracing and Supports Segment, which generates its revenues in theUnited States, offers our DonJoy, ProCare and Aircast products, including rigidknee bracing, orthopedic soft goods, cold therapy products, and vascularsystems.  This segment also includes ourOfficeCare business, through which we maintain an inventory of soft goods andother products at healthcare facilities, primarily orthopedic practices, forimmediate distribution to patients.

 

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***Recovery Sciences Segment***

 

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

 

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

 

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

 

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

 

·                  *AthleteDirect.*  Our Athlete Direct businessunit offers our Compex electrostimulation device to consumers, which range frompeople interested in improving their fitness to competitive athletes, to assistin athletic training programs through muscle development and to acceleratemuscle recovery after training sessions.

 

***Surgical Implant Segment***

 

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

 

***International Segment***

 

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

 

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

 
| ** **                                           | ** ** | **Three Months Ended**  | ** ** | **Six Months Ended**     | ** ** |
|------------------------------------------------------|------------|-------------------------|------------|--------------------------|------------|
| ** **                                           | ** ** | **July 3,********2010** | ** ** | **June 27,********2009** | ** ** | **July 3,********2010** | ** ** | **June 27,********2009** | ** ** |
| **Net sales:**                                       |       |                    |       |                     |       |   |   |   |   |
| Bracing and Supports                                 |       | $                       | 78,915     |                     | $          | 74,789 |   | $ | 153,931 |   | $ | 142,836 |   |
| Recovery Sciences                                    |       | 87,273                  |       | 84,816                   |       | 171,477 |   | 163,973 |   |
| Surgical Implant                                     |       | 15,214                  |       | 16,378                   |       | 32,176 |   | 31,681 |   |
| International                                        |       | 61,125                  |       | 59,129                   |       | 125,019 |   | 114,275 |   |
|                                                 |       | $                       | 242,527    |                     | $          | 235,112 |   | $ | 482,603 |   | $ | 452,765 |   |
|                                                 |       |                    |       |                     |       |   |   |   |   |
| **Gross profit:**                                    |       |                    |       |                     |       |   |   |   |   |
| Bracing and Supports                                 |       | $                       | 43,983     |                     | $          | 41,728 |   | $ | 85,344 |   | $ | 78,602 |   |
| Recovery Sciences                                    |       | 66,409                  |       | 64,471                   |       | 129,020 |   | 123,785 |   |
| Surgical Implant                                     |       | 10,813                  |       | 12,864                   |       | 24,275 |   | 24,762 |   |
| International                                        |       | 37,671                  |       | 34,706                   |       | 75,400 |   | 66,211 |   |
| Expenses not allocated to segments and  eliminations |       | (914                    | )          | (813                     | )          | (3,355 | ) | (1,751 | ) |
|                                                 |       | $                       | 157,962    |                     | $          | 152,956 |   | $ | 310,684 |   | $ | 291,609 |   |
|                                                 |       |                    |       |                     |       |   |   |   |   |
| **Operating income:**                                |       |                    |       |                     |       |   |   |   |   |
| Bracing and Supports                                 |       | $                       | 17,605     |                     | $          | 18,262 |   | $ | 33,240 |   | $ | 30,890 |   |
| Recovery Sciences                                    |       | 29,466                  |       | 27,133                   |       | 54,479 |   | 48,247 |   |
| Surgical Implant                                     |       | 1,396                   |       | 3,717                    |       | 4,144 |   | 6,177 |   |
| International                                        |       | 15,717                  |       | 12,868                   |       | 31,035 |   | 22,931 |   |
| Expenses not allocated to segments and  eliminations |       | (48,215                 | )          | (42,962                  | )          | (89,358 | ) | (76,108 | ) |
|                                                 |       | $                       | 15,969     |                     | $          | 19,018 |   | $ | 33,540 |   | $ | 32,137 |   |

 

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

 

**Geographic Area**

 

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

 
| ** **                                   | ** ** | **Three Months Ended**  | ** ** | **Six Months Ended**          | ** ** |
|----------------------------------------------|------------|-------------------------|------------|-------------------------------|------------|
| ** **                                   | ** ** | **July 3,********2010** | ** ** | **June 27,********2009** | ** ** | **July 3,********2010** | ** ** | **June 27,********2009** | ** ** |
| **Net sales:**                               |       |                    |       |                          |       |   |   |   |   |
| United States                                |       | $                       | 175,240    |                          | $          | 170,725 |   | $ | 347,744 |   | $ | 332,743 |   |
| Germany                                      |       | 18,249                  |       | 17,953                        |       | 39,321 |   | 34,700 |   |
| Other Europe, Middle East, & Africa |       | 25,796                  |       | 32,779                        |       | 51,602 |   | 61,393 |   |
| Asia Pacific                                 |       | 6,914                   |       | 3,798                         |       | 13,147 |   | 6,848 |   |
| Other                                        |       | 16,328                  |       | 9,857                         |       | 30,789 |   | 17,081 |   |
|                                         |       | $                       | 242,527    |                          | $          | 235,112 |   | $ | 482,603 |   | $ | 452,765 |   |

 

**10.  INCOMETAXES**

 

Income taxes for the interim periods presented have been included inour unaudited condensed consolidated financial statements on the basis of anestimated annual effective tax rate, adjusted for discrete items. The incometax benefit for these periods differed from the amount which would have beenrecorded using the U.S. statutory tax rate due primarily to the impact ofnondeductible expenses, foreign taxes, deferred taxes on the assumedrepatriation of foreign earnings, and the existence of valuation allowances inforeign jurisdictions. Based on changes in our annual 2010 financial projectionas of July 3, 2010, the income tax benefit recorded for the three months endedJuly 3, 2010 was $24.6 million on a pre-tax loss of $24.0 million, resulting inan effective tax rate of 102%. This tax benefit included the reversal ofcertain tax expense amounts recorded for the three months ended April 3, 2010,bringing our year-to-date tax benefit to $14.8 million, reflecting an effectivetax rate of 31.1% of our year-to-date pretax loss. Given the relationshipbetween fixed dollar tax items and pre-tax financial results, the projectedannual effective tax rate can change materially based on small variations ofincome.

 

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For the three and six months ended June 27, 2009, we recorded incometax benefits of approximately $5.0 million and $16.9 million,respectively, on pre-tax losses of approximately $17.4 million and $43.9million, resulting in effective tax rates of 28.7% and 38.5%, respectively. Thedifference in the tax benefit recorded during the three and six months endedJuly 3, 2010 and the three and six months ended June 27, 2009 is primarily dueto differences in the projected annualized effective tax rates for each year asdetermined by the Company.  In addition, a beneficial impact of a tax lawchange was recorded during the first quarter of 2009 as a discrete item.

 

We and our subsidiaries file income tax returns in the U.S. federaljurisdiction and various states and foreign jurisdictions. With few exceptions,we are no longer subject to U.S. federal, state and local, or non-U.S. incometax examinations by tax authorities for years before 2005. The Internal RevenueService (“IRS”) completed its field examination of the 2005 and 2006 tax yearsduring the three months ended July 3, 2010. The IRS has proposed material adjustments related to transaction cost,stock option, and bad debt deductions included in our 2006 tax return.  We intend to appeal each of the proposedadjustments vigorously through the IRS appeals process.  However, should the IRS’ proposed adjustmentsbe upheld in appeals, a material reduction in our currently unreserved netoperating losses could result.  AtDecember 31, 2009, our gross unrecognized tax benefits were $19.1million.  For the six months ended July3, 2010, we increased our gross unrecognized tax benefits by $0.7 million. Ourtotal gross unrecognized tax benefits were $19.8 million at July 3, 2010,including a cumulative $2.0 million related to interest and penalties.  There is a reasonable possibility that theclosing of the IRS appeals process could result in a material reduction to ourunrecognized tax benefits within the next twelve months.  Due to the fact that the appeals process hasnot been finalized, the amount of the unrecognized tax benefits that may bereduced cannot be reasonably estimated. Due to our adoption of ASC Topic 805 (formerly SFAS No. 141R, “BusinessCombinations”) on January 1, 2009, all unrecognized tax benefits willimpact our effective tax rate upon recognition. We believe that it isreasonably possible that an increase of $0.2 million in unrecognized taxbenefits related to various immaterial state exposures may be necessary withinthe next twelve months.

 

**11.  RESTRUCTURING ANDRELATED CHARGES**

 

In June 2009, we announced our plans to close our Chattanoogamanufacturing and distribution facility, located in Hixson, Tennessee, and tointegrate the operations of the Chattanooga site into our other existing sites.The transition of Chattanooga activities to our existing facilities occurredduring the first half of 2010. A summary of the activity relating to the restructuringfor the six months ended July 3, 2010 is as follows (in thousands):

 
| ** **                   | ** ** | **Severance &  Employee  Retention** | ** ** | **Other** | ** ** | **Total** | ** ** |
|------------------------------|------------|------------------------------------------|------------|-----------|------------|-----------|------------|
| Balance at December 31, 2009 |       | 4,049                                    |       | 405       |       | 4,454     |       |
| Expensed during period       |       | 1,111                                    |       | 123       |       | 1,234     |       |
| Payments made during period  |       | (4,317                                   | )          | (444      | )          | (4,761    | )          |
| Balance at July 3, 2010      |       | $                                        | 843        |      | $          | 84        |       | $ | 927 |   |
|                              |            |                                          |            |           |            |           |            |  |  |  |

 

Total severance and employee retentionrelated expenses incurred to date as a result of the transition of ourChattanooga activities are $6.6 million, and are included within selling,general and administrative, and research and development expenses in ourunaudited condensed consolidated statements of operations. We do not expect toincur additional material severance and employee retention expenses in conjunctionwith the Chattanooga integration.

 

As a result of ourintegration of the operations of our Chattanooga division, we exited thefacilities in Hixson, and listed the buildings for sale during the six monthsended July 3, 2010. Due to a decline in the fair market value of the buildings,we recorded an impairment charge of $1.1 million during the six months endedJuly 3, 2010, which has been reflected as impairment of assets held for sale inour unaudited condensed consolidated statements of operations. The fair marketvalue of the buildings held for sale is approximately $2.8 million, and isincluded in other current assets in our unaudited condensed consolidatedbalance sheet at July 3, 2010.

 

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**12.  COMMITMENTS ANDCONTINGENCIES**

 

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

 

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

 

We are currently named asone of several defendants in approximately 100 product liability cases,including a lawsuit in Canada seeking class action status, related to a disposabledrug infusion pump product manufactured by two third party manufacturers thatwe distributed through our Bracing and Supports segment. We discontinued oursale of these products in the second quarter of 2009. These cases have beenbrought against the manufacturers and certain distributors of these pumps, andin some cases, the manufacturers of the anesthetics used in these pumps. All ofthese lawsuits allege that the use of these pumps with certain anesthetics incertain shoulder surgeries over prolonged periods have resulted in cartilagedamage to the plaintiffs. We have sought indemnity and tendered the defense ofthese cases to the two manufacturers who supplied these pumps to us, to theirproducts liability carriers and to our products liability carriers. Althoughboth manufacturers have rejected our tenders of indemnity, we are indiscussions with both to reach a resolution of the indemnity issue. Theproducts liability carriers for both manufacturers have accepted coverage forour defense of these claims.  The basepolicy for one of the manufacturers has been exhausted and the excess liabilitycarriers for that manufacturer are not obligated to provide a defense until a$5 million self-insured retention has been paid and our underlying insurancehas been exhausted.  Our productsliability carrier has accepted coverage of these cases, subject to areservation of the right to deny coverage for customary matters, includingpunitive damages and off-label promotion. The lawsuits allege damages rangingfrom unspecified amounts to claims between $1.0 million and $10.0 million.These cases are in varying stages from initial pleading and discovery topre-trial preparation. We could be exposed to material liabilities if ourinsurance coverage is not available or inadequate and the resources of the twomanufacturers, including their respective products liability insurancepolicies, are unavailable or insufficient to pay the defense costs andsettlements or judgments in these cases.

 

On August 2, 2010, wewere served with a subpoena under the Health Insurance Portability andAccountability Act (“HIPAA”) seeking numerous documents related to ouractivities involving the infusion pumps discussed above. The subpoena which wasissued by the United States Attorney’s Office, Central District of California,refers to an official investigation of Federal health care offenses. We arereviewing the subpoena, but do not have any additional information regardingthe focus of the investigation. We believe that our actions related to ourprior distribution of these infusion pumps have been in compliance withapplicable legal standards. We can make no assurance as to the resources thatwill be needed to respond to the subpoena or the final outcome of anyinvestigation or further action.

 

We maintain product liability insurance that is subject to annualrenewal. Our current policy covers claims reported between July 1, 2010and June 30, 2011.  No carriers wereprepared to cover claims for this reporting period arising out of the pain pumpproduct described above and therefore our current policies exclude coverage forthose products.  For the current policyyear, we maintain coverage limits (together with excess policies) of up to $50million, with self-insured retentions of $500,000 per claim for claims relatingto the IceMan cold therapy unit, $500,000 per claim for claims relating toinvasive products, $75,000 per claim for claims relating to non-invasiveproducts other than the IceMan device, and an aggregate self-insured retentionof $2.25 million.  We purchasedsupplemental extended reporting period (“SERP”) coverage for our $80 millionlimit product liability program that expired on June 30, 2010, and thissupplemental coverage is limited to pain pump claims.  Except for the additional excess coveragementioned below, this SERP coverage does not provide additional limits to theaggregate $80 million limit on the expiring program but does provide that theexisting limits of the expiring program will remain available for claims reportedfor an extended period of time. Specifically, pain pump claims may be reportedunder the $10 million base policy for an indefinite period of time and for aperiod of five years under the excess layers. We also purchased additionalcoverage of $25 million excess of $80 million with a five year reportingperiod. Thus, the SERP coverage has a total limit of $105 million (less amountspaid for claims reported under the expiring program). This coverage is subjectto a self-insured retention of $500,000 per claim for claims related to painpumps, with an aggregate self-insured retention of $1.0 million for allproducts liability claims under either the expiring program or the SERPprogram. In addition, the layer of $25 million excess over $55 million has aseparate self-insured retention of $50,000 per claim.  Our two products liability programs prior tothe program that expired on June 30, 2010 cover claims reported betweenJuly 1, 2007 and February 15, 2008 and between February 15, 2008and July 1, 2009, respectively.  The2007-2008 policy provides for coverage (together with excess policies) of up toa limit of $20 million and the 2008-2009 policy provides for coverage (togetherwith excess policies) of up to a limit of $25 million.  Certain of the pain pump cases describedabove were reported under and are covered by these two policies as well as theexpiring program.

 

If a products liability claim or series of claims is brought against usfor uninsured liabilities or in excess of our insurance coverage, our businesscould suffer materially. In addition, in certain instances, a productsliability claim could also result in our having to recall some of our products,which could result in significant costs to us. Our condensed consolidatedbalance sheets as of July 3, 2010 (unaudited) and December 31, 2009,include accrued liabilities of approximately $2.5 million and $2.0 million,respectively, for expenses related to products liability claims for productsother than our pain pump products.  Theamounts 

 

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accruedare based upon previous claims experience in part due to the fact that in 2003we exceeded the coverage limits in effect at that time for certain historicalproduct liability claims involving one of our discontinued surgical implantproducts and such products are excluded from coverage under our currentpolicies. In addition, our unaudited condensed consolidated balance sheet as ofJuly 3, 2010 includes accrued liabilities of $8.7 million for the SERP forproduct claims related to our discontinued pain pump products.

 

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

 

**13.  RELATEDPARTY TRANSACTIONS**

 

Blackstone Management Partners V L.L.C. (“BMP”), an affiliate of ourmajor shareholder, provides certain monitoring, advisory and consultingservices to us for an annual monitoring fee equal to the greater of$7.0 million or 2% of consolidated EBITDA as defined in the Transactionand Monitoring Fee Agreement, payable in the first quarter of each year. Themonitoring fee agreement will continue until the earlier of the twelfthanniversary of the date of the agreement or such date as DJOFL and BMP maymutually determine. DJOFL will agree to indemnify BMP and its affiliates,directors, officers, employees, agents and representatives from and against allliabilities relating to the services contemplated by the Transaction and MonitoringFee Agreement and the engagement of BMP pursuant to, and the performance of BMPand its affiliates of the services contemplated by, the Transaction and MonitoringFee Agreement. At any time in connection with or in anticipation of a change ofcontrol of DJOFL, a sale of all or substantially all of DJOFL’s assets or aninitial public offering of common stock of DJOFL, BMP may elect to receive, inlieu of remaining annual monitoring fee payments, a single lump sum cashpayment equal to the then-present value of all then-current and future annualmonitoring fees payable under the transaction and monitoring fee agreement,assuming a hypothetical termination date of the agreement to be the twelfthanniversary of such election. For each of the three and six month periodspresented, we recognized $1.75 million and $3.5 million, respectively, relatedto the monitoring fee, which is recorded as a component of selling, general andadministrative expense in our unaudited condensed consolidated statements ofoperations.

 

**14.  DERIVATIVEINSTRUMENTS**

 

We operate internationally and are therefore exposed to foreigncurrency exchange rate fluctuations in the normal course of our business, inparticular to changes in the Mexican Peso (“MXP”) due to our Mexico-basedmanufacturing operations that incur costs that are largely denominated in MXP.As part of our risk management strategy, we use derivative instruments to hedgeportions of our exposure. While our foreign exchange forward contracts act aseconomic hedges, we have not designated such instruments as hedges under ASCTopic 815.  Before acquiring a derivativeinstrument to hedge a specific risk, potential natural hedges are evaluated.Derivative instruments are only utilized to manage underlying exposures thatarise from our business operations. Factors considered in the decision to hedgean underlying market exposure include the materiality of the risk, thevolatility of the market, the duration of the hedge, and the availability,effectiveness and cost of derivative instruments.  At July 3, 2010, we had foreign exchangeforward 

 

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contracts,with a notional amount of MXP 228.0 million, or approximately $17.1 million.These foreign exchange forward contracts expire weekly throughout the fiscalyear 2010.

 

Additionally, we make use of debt financing as a source of funds andare therefore exposed to interest rate fluctuations in the normal course ofbusiness. Our credit facilities are subject to floating interest rates. Wemanage the risk of unfavorable movements in interest rates by hedging a portionof the outstanding loan balance, thereby locking in a fixed rate on a portionof the principal, reducing the effect of possible rising interest rates andmaking interest expense more predictable over the term of the creditfacilities. 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% which expired onDecember 31, 2009.  InFebruary 2009, we entered into two non-amortizing interest rate swapagreements.  One agreement was for anotional amount of $550.0 million at a fixed LIBOR rate of 1.04% beginning inFebruary 2009 which expired on December 31, 2009.  The other agreement was for a notional amountof $750.0 million at a fixed LIBOR rate of 1.88% with a term beginningJanuary 2010 through December 2010. In August 2009, we entered into four non-amortizing interest rateswap agreements with notional amounts aggregating $300.0 million. Each of thefour agreements has a term beginning January 2011 throughDecember 2011. The four agreements are at a weighted average fixed LIBORrate of 2.5825%.  We have designatedthese interest rate swap agreements as cash flow hedges under ASC Topic 815.

 

In accordance with ASC Topic 820, we follow the three levels of thefair value hierarchy for disclosure of the inputs to valuation. This hierarchyprioritizes the inputs into three broad levels as follows. Level 1 inputsare quoted prices (unadjusted) in active markets for identical assets orliabilities. Level 2 inputs are quoted prices for similar assets andliabilities in active markets or inputs that are observable for the asset orliability, either directly or indirectly through market corroboration, forsubstantially the full term of the financial instrument. Level 3 inputsare unobservable inputs based on our own assumptions used to measure assets andliabilities at fair value. A financial asset or liability’s classificationwithin the hierarchy is determined based on the lowest level input that issignificant to the fair value measurement. At July 3, 2010, the fair value ofour interest rate swap agreements and our foreign currency exchange forwardcontracts were determined through the use of models that consider various assumptions,including time value, yield curves, as well as other relevant economicmeasures, which are inputs that are classified as Level 2 in the valuationhierarchy.

 

The following table summarizes the fair value of our derivativeinstruments as of July 3, 2010 (unaudited) and December 31, 2009 (inthousands):

 
| ** **                               | ** ** | **July 3,  2010** | ** ** | **December 31,  2009** | ** ** |
|------------------------------------------|------------|-------------------|------------|------------------------|------------|
| **Current derivative assets:**           | ** ** | ** **        | ** ** | ** **             | ** ** |
| Foreign exchange forward contracts       |       | $                 | 113        |                   | $          | 89 |   |
| ** **                               | ** ** | ** **        | ** ** | ** **             | ** ** |
| **Derivative liabilities:**              | ** ** | ** **        | ** ** | ** **             | ** ** |
| Current portion of interest rate swaps   |       | $                 | 5,540      |                   | $          | 9,701 |   |
| Long-term portion of interest rate swaps |       | 5,380             |       | 1,543                  |       |
|                                     |       | $                 | 10,920     |                   | $          | 11,244 |   |

 

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

 
| ** **                         | ** ** | ** **                   | ** ** | **Three Months Ended**  | ** ** | **Six Months Ended**     | ** ** |
|------------------------------------|------------|------------------------------|------------|-------------------------|------------|--------------------------|------------|
| ** **                         | ** ** | **Location of gain (loss)**  | ** ** | **July 3,********2010** | ** ** | **June 27,********2009** | ** ** | **July 3,********2010** | ** ** | **June 27,********2009** | ** ** |
| Foreign exchange forward contracts |       | Other  income (expense), net |       | $                       | 113        |                     | $          | (366 | ) | $ | 1,241 |   | $ | (3,372 | ) |
| Interest rate swaps                |       | Interest  expense            |       | (2,998                  | )          | (4,251                   | )          | (6,193 | ) | (7,628 | ) |
|                               |       |                         |       | $                       | (2,885     | )                        | $          | (4,617 | ) | $ | (4,952 | ) | $ | (11,000 | ) |

 

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

 

DJOFL and its direct wholly-owned subsidiary, Finco, issued the 10.875%Notes with aggregate principal amounts of $575.0 million and $100.0million on November 20, 2007 and January 20, 2010, respectively. OnNovember 3, 2006, DJOFL and Finco issued the 11.75% Notes with anaggregate principal amount of $200.0 million. Finco was formed solely toact as a co-issuer of the notes, has only nominal assets and does not conductany operations. The Indentures generally prohibit Finco from holding anyassets, becoming liable for any obligations, or engaging in any businessactivity. The 10.875% Notes are jointly and severally, fully andunconditionally guaranteed, on an unsecured senior basis by all of the DJOFL’sdomestic subsidiaries (other than the co-issuer) that are 100% owned, directlyor indirectly, by DJOFL (the “Guarantors”). The 11.75% Notes are jointly andseverally, fully and unconditionally guaranteed, on an unsecured seniorsubordinated basis by the Guarantors. Our foreign subsidiaries (the “Non-Guarantors”)do not guarantee the notes. The Guarantors also unconditionally guarantee theSenior Secured Credit Facility.

 

The following tables present the financial position, results ofoperations and cash flows of DJOFL, the Guarantors, the Non-Guarantors andcertain eliminations as of July 3, 2010 and December 31, 2009 and forthe three and six months ended July 3, 2010 and June 27, 2009,respectively.

 

**DJO FinanceLLC**

**UnauditedCondensed Consolidating Balance Sheets**

**As of July 3,2010**

(inthousands)

 
| ** **                                             | ** ** | **DJOFL** | ** ** | **Guarantors** | ** ** | **Non —  Guarantors** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|--------------------------------------------------------|------------|-----------|------------|----------------|------------|----------------------------|------------|------------------|------------|------------------|------------|
| **Assets**                                             |       |      |       |           |       |                       |       |             |       |             |       |
| Current assets:                                        |       |      |       |           |       |                       |       |             |       |             |       |
| Cash and cash equivalents                              |       | $         | 3,972      |           | $          | 13,069                     |       | $                | 17,043     |             | $          | — |   | $ | 34,084 |   |
| Accounts receivable, net                               |       | —    |       | 114,716        |       | 32,136                     |       | —           |       | 146,852          |       |
| Inventories, net                                       |       | —    |       | 84,095         |       | 24,765                     |       | (8,382           | )          | 100,478          |       |
| Deferred tax assets, net                               |       | —    |       | 36,025         |       | 3,863                      |       | (146             | )          | 39,742           |       |
| Prepaid expenses and other current assets              |       | 73        |       | 21,517         |       | 3,322                      |       | —           |       | 24,912           |       |
| Total current assets                                   |       | 4,045     |       | 269,422        |       | 81,129                     |       | (8,528           | )          | 346,068          |       |
| Property and equipment, net                            |       | —    |       | 74,319         |       | 12,990                     |       | (4,240           | )          | 83,069           |       |
| Goodwill                                               |       | —    |       | 1,108,702      |       | 102,468                    |       | (27,917          | )          | 1,183,253        |       |
| Intangible assets, net                                 |       | —    |       | 1,111,154      |       | 34,699                     |       | —           |       | 1,145,853        |       |
| Investment in subsidiaries                             |       | 1,297,702 |       | 1,659,562      |       | 32,124                     |       | (2,989,388       | )          | —           |       |
| Intercompany receivables                               |       | 1,007,613 |       | —         |       | —                     |       | (1,007,613       | )          | —           |       |
| Other non-current assets                               |       | 36,460    |       | 754            |       | 1,424                      |       | 30               |       | 38,668           |       |
| Total assets                                           |       | $         | 2,345,820  |           | $          | 4,223,913                  |       | $                | 264,834    |             | $          | (4,037,656 | ) | $ | 2,796,911 |   |
|                                                   |       |      |       |           |       |                       |       |             |       |             |       |
| **Liabilities and Equity**                             |       |      |       |           |       |                       |       |             |       |             |       |
| Current liabilities:                                   |       |      |       |           |       |                       |       |             |       |             |       |
| Accounts payable                                       |       | $         | —     |           | $          | 43,901                     |       | $                | 6,777      |             | $          | — |   | $ | 50,678 |   |
| Current portion of debt and capital lease  obligations |       | 9,594     |       | 50             |       | 2,826                      |       | —           |       | 12,470           |       |
| Other current liabilities                              |       | 23,599    |       | 61,829         |       | 19,806                     |       | —           |       | 105,234          |       |
| Total current liabilities                              |       | 33,193    |       | 105,780        |       | 29,409                     |       | —           |       | 168,382          |       |
| Long-term debt and capital lease obligations           |       | 1,797,896 |       | 63             |       | —                     |       | —           |       | 1,797,959        |       |
| Deferred tax liabilities, net                          |       | —    |       | 283,333        |       | 13,519                     |       | —           |       | 296,852          |       |
| Intercompany payables, net                             |       | —    |       | 913,179        |       | 94,434                     |       | (1,007,613       | )          | —           |       |
| Other long-term liabilities                            |       | —    |       | 15,183         |       | 1,472                      |       | —           |       | 16,655           |       |
| Total liabilities                                      |       | 1,831,089 |       | 1,317,538      |       | 138,834                    |       | (1,007,613       | )          | 2,279,848        |       |
| Noncontrolling interests                               |       | —    |       | —         |       | 2,332                      |       | —           |       | 2,332            |       |
| Total membership equity                                |       | 514,731   |       | 2,906,375      |       | 123,668                    |       | (3,030,043       | )          | 514,731          |       |
| Total liabilities and equity                           |       | $         | 2,345,820  |           | $          | 4,223,913                  |       | $                | 264,834    |             | $          | (4,037,656 | ) | $ | 2,796,911 |   |

 

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**DJO FinanceLLC**

**UnauditedCondensed Consolidating Statements of Operations**

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

(inthousands)

 
| ** **                                                                                    | ** ** | **DJOFL** | ** ** | **Guarantors** | ** ** | **Non-  Guarantors** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|-----------------------------------------------------------------------------------------------|------------|-----------|------------|----------------|------------|----------------------|------------|------------------|------------|------------------|------------|
| Net sales                                                                                     |       | $         | —     |           | $          | 205,053              |       | $                | 32,765     |             | $          | 4,709 |   | $ | 242,527 |   |
| Cost of sales (exclusive of amortization of  intangible assets of $9,062 included below) |       | —    |       | 74,732         |       | 7,280                |       | 2,553            |       | 84,565           |       |
| Gross profit                                                                                  |       | —    |       | 130,321        |       | 25,485               |       | 2,156            |       | 157,962          |       |
| Operating expenses:                                                                           |       |      |       |           |       |                 |       |             |       |             |       |
| Selling, general and administrative                                                           |       | —    |       | 96,052         |       | 19,663               |       | —           |       | 115,715          |       |
| Research and development                                                                      |       | —    |       | 4,542          |       | 918                  |       | —           |       | 5,460            |       |
| Impairment of assets held for sale                                                            |       | —    |       | 1,147          |       | —               |       | —           |       | 1,147            |       |
| Amortization of intangible assets                                                             |       | —    |       | 18,716         |       | 955                  |       | —           |       | 19,671           |       |
|                                                                                          |       | —    |       | 120,457        |       | 21,536               |       | —           |       | 141,993          |       |
| Operating income                                                                              |       | —    |       | 9,864          |       | 3,949                |       | 2,156            |       | 15,969           |       |
| Other income (expense):                                                                       |       |      |       |           |       |                 |       |             |       |             |       |
| Interest expense                                                                              |       | (37,124   | )          | (10,464        | )          | (863                 | )          | 11,001           |       | (37,450          | )          |
| Interest income                                                                               |       | 9,205     |       | 1,970          |       | 148                  |       | (11,001          | )          | 322              |       |
| Other income (expense), net                                                                   |       | 28,162    |       | 4,683          |       | (2,211               | )          | (33,471          | )          | (2,837           | )          |
|                                                                                          |       | 243       |       | (3,811         | )          | (2,926               | )          | (33,471          | )          | (39,965          | )          |
| Income (loss) before income taxes                                                             |       | 243       |       | 6,053          |       | 1,023                |       | (31,315          | )          | (23,996          | )          |
| Income tax provision (benefit)                                                                |       | —    |       | (25,863        | )          | 1,303                |       | —           |       | (24,560          | )          |
| Net income (loss)                                                                             |       | 243       |       | 31,916         |       | (280                 | )          | (31,315          | )          | 564              |       |
| Net income attributable to noncontrolling  interests                                          |       | —    |       | —         |       | 321                  |       | —           |       | 321              |       |
| Net income (loss) attributable to DJO Finance LLC                                             |       | $         | 243        |           | $          | 31,916               |       | $                | (601       | )                | $          | (31,315 | ) | $ | 243 |   |

 

**DJO FinanceLLC**

**UnauditedCondensed Consolidating Statements of Operations**

**For the SixMonths Ended July 3, 2010**

(inthousands)

 
| ** **                                                                                     | ** ** | **DJOFL** | ** ** | **Guarantors** | ** ** | **Non-  Guarantors** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|------------------------------------------------------------------------------------------------|------------|-----------|------------|----------------|------------|----------------------|------------|------------------|------------|------------------|------------|
| Net sales                                                                                      |       | $         | —     |           | $          | 415,864              |       | $                | 103,114    |             | $          | (36,375 | ) | $ | 482,603 |   |
| Cost of sales (exclusive of amortization of  intangible assets of $17,981 included below) |       | —    |       | 158,296        |       | 50,968               |       | (37,345          | )          | 171,919          |       |
| Gross profit                                                                                   |       | —    |       | 257,568        |       | 52,146               |       | 970              |       | 310,684          |       |
| Operating expenses:                                                                            |       |      |       |           |       |                 |       |             |       |             |       |
| Selling, general and administrative                                                            |       | —    |       | 186,147        |       | 40,094               |       | —           |       | 226,241          |       |
| Research and development                                                                       |       | —    |       | 9,274          |       | 1,757                |       | —           |       | 11,031           |       |
| Impairment of assets held for sale                                                             |       | —    |       | 1,147          |       | —               |       | —           |       | 1,147            |       |
| Amortization of intangible assets                                                              |       | —    |       | 36,793         |       | 1,932                |       | —           |       | 38,725           |       |
|                                                                                           |       |      |       | 233,361        |       | 43,783               |       | —           |       | 277,144          |       |
| Operating income                                                                               |       | —    |       | 24,207         |       | 8,363                |       | 970              |       | 33,540           |       |
| Other income (expense):                                                                        |       |      |       |           |       |                 |       |             |       |             |       |
| Interest expense                                                                               |       | (77,466   | )          | (21,251        | )          | (1,796               | )          | 22,351           |       | (78,162          | )          |
| Interest income                                                                                |       | 19,955    |       | 2,773          |       | 298                  |       | (22,351          | )          | 675              |       |
| Other income (expense), net                                                                    |       | 24,096    |       | (20,825        | )          | (2,942               | )          | (3,946           | )          | (3,617           | )          |
|                                                                                           |       | (33,415   | )          | (39,303        | )          | (4,440               | )          | (3,946           | )          | (81,104          | )          |
| Income (loss) before income taxes                                                              |       | (33,415   | )          | (15,096        | )          | 3,923                |       | (2,976           | )          | (47,564          | )          |
| Income tax provision (benefit)                                                                 |       | —    |       | (17,079        | )          | 2,287                |       | —           |       | (14,792          | )          |
| Net income (loss)                                                                              |       | (33,415   | )          | 1,983          |       | 1,636                |       | (2,976           | )          | (32,772          | )          |
| Net income attributable to noncontrolling  interests                                           |       | —    |       | —         |       | 643                  |       | —           |       | 643              |       |
| Net income (loss) attributable to DJO Finance LLC                                              |       | $         | (33,415    | )              | $          | 1,983                |       | $                | 993        |             | $          | (2,976 | ) | $ | (33,415 | ) |

 

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**DJO Finance LLC**

**UnauditedCondensed Consolidating Statements of Cash Flows**

**For the SixMonths Ended July 3, 2010**

(inthousands)

 
| ** **                                                                                                    | ** ** | **DJOFL** | ** ** | **Guarantors** | ** ** | **Non-  Guarantors** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|---------------------------------------------------------------------------------------------------------------|------------|-----------|------------|----------------|------------|----------------------|------------|------------------|------------|------------------|------------|
| **OPERATING ACTIVITIES:**                                                                                     |       |      |       |           |       |                 |       |             |       |             |       |
| Net income (loss)                                                                                             |       | $         | (33,415    | )              | $          | 1,983                |       | $                | 1,636      |             | $          | (2,976 | ) | $ | (32,772 | ) |
| Adjustments to reconcile net income (loss)  to net cash provided by (used in) operating activities: |       |      |       |           |       |                 |       |             |       |             |       |
| Depreciation                                                                                                  |       | —    |       | 10,811         |       | 2,358                |       | (64              | )          | 13,105           |       |
| Amortization of intangible assets                                                                             |       | —    |       | 36,793         |       | 1,932                |       | —           |       | 38,725           |       |
| Amortization of debt issuance costs and non-cash  interest expense                                            |       | 7,193     |       | —         |       | —               |       | —           |       | 7,193            |       |
| Stock-based compensation expense                                                                              |       | —    |       | 865            |       | —               |       | —           |       | 865              |       |
| Loss on disposal of assets, net                                                                               |       | —    |       | 709            |       | 129                  |       | (178             | )          | 660              |       |
| Deferred income tax benefit                                                                                   |       | —    |       | (17,409        | )          | (138                 | )          | —           |       | (17,547          | )          |
| Non-cash income from subsidiaries                                                                             |       | (21,332   | )          | 513,115        |       | 20,877               |       | (512,660         | )          | —           |       |
| Provision for doubtful accounts and sales returns                                                        |       | —    |       | 17,054         |       | 334                  |       | —           |       | 17,388           |       |
| Inventory reserves                                                                                            |       | —    |       | 2,472          |       | 368                  |       | —           |       | 2,840            |       |
| Impairment of assets held for sale                                                                            |       | —    |       | 1,147          |       | —               |       | —           |       | 1,147            |       |
| Changes in operating assets and liabilities:                                                                  |       |      |       |           |       |                 |       |             |       |             |       |
| Accounts receivable                                                                                           |       | —    |       | (18,733        | )          | (608                 | )          | —           |       | (19,341          | )          |
| Inventories                                                                                                   |       | —    |       | (3,993         | )          | (2,392               | )          | (2,234           | )          | (8,619           | )          |
| Prepaid expenses and other assets                                                                             |       | 92        |       | 11,954         |       | (23,987              | )          | —           |       | (11,941          | )          |
| Accounts payable and other current liabilities                                                                |       | 1,632     |       | 18,345         |       | (1,527               | )          | —           |       | 18,450           |       |
| Net cash provided by (used in)  operating activities                                                     |       | (45,830   | )          | 575,113        |       | (1,018               | )          | (518,112         | )          | 10,153           |       |
| **INVESTING ACTIVITIES:**                                                                                     |       |      |       |           |       |                 |       |             |       |             |       |
| Cash paid in connection with acquisitions, net of  cash acquired                                              |       | —    |       | (810           | )          | —               |       | —           |       | (810             | )          |
| Purchases of property and equipment                                                                           |       | —    |       | (12,904        | )          | (3,096               | )          | 1,505            |       | (14,495          | )          |
| Other investing activities, net                                                                               |       | —    |       | 69             |       | (567                 | )          | —           |       | (498             | )          |
| Net cash used in investing activities                                                                    |       | —    |       | (13,645        | )          | (3,663               | )          | 1,505            |       | (15,803          | )          |
| **FINANCING ACTIVITIES:**                                                                                     |       |      |       |           |       |                 |       |             |       |             |       |
| Intercompany                                                                                                  |       | 49,449    |       | (566,251       | )          | 195                  |       | 516,607          |       | —           |       |
| Proceeds from issuance of debt                                                                                |       | 118,000   |       | —         |       | 130                  |       | —           |       | 118,130          |       |
| Repayments of debt and capital lease obligations                                                              |       | (121,298  | )          | (525           | )          | (12                  | )          | —           |       | (121,835         | )          |
| Payment of debt issuance costs                                                                                |       | (3,348    | )          | —         |       | —               |       | —           |       | (3,348           | )          |
| Investment by parent                                                                                          |       | —    |       | 988            |       | —               |       | —           |       | 988              |       |
| Dividend by subsidiary to noncontrolling interests                                                            |       | —    |       | —         |       | (529                 | )          | —           |       | (529             | )          |
| Net cash provided by (used in) financing  activities                                                          |       | 42,803    |       | (565,788       | )          | (216                 | )          | 516,607          |       | (6,594           | )          |
| Effect of exchange rate changes on cash  and cash equivalents                                            |       | —    |       | —         |       | 1,717                |       | —           |       | 1,717            |       |
| **Net increase (decrease) in cash  and cash equivalents**                                                |       | (3,027    | )          | (4,320         | )          | (3,180               | )          | —           |       | (10,527          | )          |
| Cash and cash equivalents at beginning of period                                                              |       | 6,999     |       | 17,389         |       | 20,223               |       | —           |       | 44,611           |       |
| Cash and cash equivalents at end of period                                                                    |       | $         | 3,972      |           | $          | 13,069               |       | $                | 17,043     |             | $          | — |   | $ | 34,084 |   |

 

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**DJO Finance LLC**

**CondensedConsolidating Balance Sheets**

**As of December 31,2009**

(inthousands)

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

 

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**DJOFinance LLC**

**UnauditedCondensed Consolidating Statements of Operations**

**For theThree Months Ended June 27, 2009**

(inthousands)

 
| ** **                                                                                    | ** ** | **DJOFL** | ** ** | **Guarantors** | ** ** | **Non-  Guarantors** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|-----------------------------------------------------------------------------------------------|------------|-----------|------------|----------------|------------|----------------------|------------|------------------|------------|------------------|------------|
| Net sales                                                                                     |       | $         | —     |           | $          | 194,514              |       | $                | 67,771     |             | $          | (27,173 | ) | $ | 235,112 |   |
| Cost of sales (exclusive of amortization of  intangible assets of $9,506 included below) |       | —    |       | 69,537         |       | 44,833               |       | (32,214          | )          | 82,156           |       |
| Gross profit                                                                                  |       | —    |       | 124,977        |       | 22,938               |       | 5,041            |       | 152,956          |       |
| Operating expenses:                                                                           |       |      |       |           |       |                 |       |             |       |             |       |
| Selling, general and administrative                                                           |       | —    |       | 89,428         |       | 19,177               |       | —           |       | 108,605          |       |
| Research and development                                                                      |       | —    |       | 5,428          |       | 734                  |       | —           |       | 6,162            |       |
| Amortization of intangible assets                                                             |       | —    |       | 18,639         |       | 532                  |       | —           |       | 19,171           |       |
|                                                                                          |       | —    |       | 113,495        |       | 20,443               |       | —           |       | 133,938          |       |
| Operating income                                                                              |       | —    |       | 11,482         |       | 2,495                |       | 5,041            |       | 19,018           |       |
|                                                                                          |       |      |       |           |       |                 |       |             |       |             |       |
| Other income (expense):                                                                       |       |      |       |           |       |                 |       |             |       |             |       |
| Interest income                                                                               |       | 4,657     |       | 749            |       | 150                  |       | (5,354           | )          | 202              |       |
| Interest expense                                                                              |       | (39,410   | )          | (4,689         | )          | (801                 | )          | 5,345            |       | (39,555          | )          |
| Other income, net                                                                             |       | 21,668    |       | 15,073         |       | 1,217                |       | (34,991          | )          | 2,967            |       |
|                                                                                          |       | (13,085   | )          | 11,133         |       | 566                  |       | (35,000          | )          | (36,386          | )          |
| Income (loss) from continuing operations before  income taxes                            |       | (13,085   | )          | 22,615         |       | 3,061                |       | (29,959          | )          | (17,368          | )          |
| Income tax benefit (expense)                                                                  |       | —    |       | 6,388          |       | (1,393               | )          | —           |       | 4,995            |       |
| Loss from discontinued operations, net                                                        |       | —    |       | (577           | )          | —               |       | —           |       | (577             | )          |
| Net income (loss)                                                                             |       | (13,085   | )          | 28,426         |       | 1,668                |       | (29,959          | )          | (12,950          | )          |
| Net income attributable to noncontrolling  interests                                          |       | —    |       | —         |       | 135                  |       | —           |       | 135              |       |
| Net income (loss) attributable to DJO Finance LLC                                             |       | $         | (13,085    | )              | $          | 28,426               |       | $                | 1,533      |             | $          | (29,959 | ) | $ | (13,085 | ) |

 

**DJOFinance LLC**

**UnauditedCondensed Consolidating Statements of Operations**

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

(inthousands)

 
| ** **                                                                                | ** ** | **DJOFL** | ** ** | **Guarantors** | ** ** | **Non-  Guarantors** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|-------------------------------------------------------------------------------------------|------------|-----------|------------|----------------|------------|----------------------|------------|------------------|------------|------------------|------------|
| Net sales                                                                                 |       | $         | —     |           | $          | 381,296              |       | $                | 128,750    |             | $          | (57,281 | ) | $ | 452,765 |   |
| Cost of sales (exclusive of amortization of  intangible assets of $19,004 included below) |       | —    |       | 138,633        |       | 84,399               |       | (61,876          | )          | 161,156          |       |
| Gross profit                                                                              |       | —    |       | 242,663        |       | 44,351               |       | 4,595            |       | 291,609          |       |
| Operating expenses:                                                                       |       |      |       |           |       |                 |       |             |       |             |       |
| Selling, general and administrative                                                       |       | —    |       | 169,641        |       | 39,564               |       | —           |       | 209,205          |       |
| Research and development                                                                  |       | —    |       | 10,490         |       | 1,475                |       | —           |       | 11,965           |       |
| Amortization of intangible assets                                                         |       | —    |       | 37,278         |       | 1,024                |       | —           |       | 38,302           |       |
|                                                                                      |       | —    |       | 217,409        |       | 42,063               |       | —           |       | 259,472          |       |
| Operating income                                                                          |       | —    |       | 25,254         |       | 2,288                |       | 4,595            |       | 32,137           |       |
| Other income (expense):                                                                   |       |      |       |           |       |                 |       |             |       |             |       |
| Interest income                                                                           |       | 9,386     |       | 1,437          |       | 481                  |       | (10,766          | )          | 538              |       |
| Interest expense                                                                          |       | (77,840   | )          | (9,465         | )          | (1,604               | )          | 10,763           |       | (78,146          | )          |
| Other income, net                                                                         |       | 41,061    |       | 8,629          |       | 442                  |       | (48,545          | )          | 1,587            |       |
|                                                                                      |       | (27,393   | )          | 601            |       | (681                 | )          | (48,548          | )          | (76,021          | )          |
| Income (loss) from continuing operations before  income taxes                        |       | (27,393   | )          | 25,855         |       | 1,607                |       | (43,953          | )          | (43,884          | )          |
| Income tax (benefit) provision                                                            |       | —    |       | (17,490        | )          | 558                  |       | —           |       | (16,932          | )          |
| Loss from discontinued operations, net                                                    |       | —    |       | (167           | )          | —               |       | —           |       | (167             | )          |
| Net income (loss)                                                                         |       | (27,393   | )          | 43,178         |       | 1,049                |       | (43,953          | )          | (27,119          | )          |
| Net income attributable to noncontrolling  interests                                      |       | —    |       | —         |       | 274                  |       | —           |       | 274              |       |
| Net income (loss) attributable to DJO Finance LLC                                         |       | $         | (27,393    | )              | $          | 43,178               |       | $                | 775        |             | $          | (43,953 | ) | $ | (27,393 | ) |

 

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**DJOFinance LLC**

**UnauditedCondensed Consolidating Statements of Cash Flows**

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

(inthousands)

 
| ** **                                                                                                         | ** ** | **DJOFL** | ** ** | **Guarantors** | ** ** | **Non-  Guarantors** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|--------------------------------------------------------------------------------------------------------------------|------------|-----------|------------|----------------|------------|----------------------|------------|------------------|------------|------------------|------------|
| **OPERATING ACTIVITIES:**                                                                                          |       |      |       |           |       |                 |       |             |       |             |       |
| Net income (loss)                                                                                                  |       | $         | (27,393    | )              | $          | 43,178               |       | $                | 1,049      |             | $          | (43,953 | ) | $ | (27,119 | ) |
| Adjustments to reconcile net income (loss)  to net cash provided by (used in) operating activities: |       |      |       |           |       |                 |       |             |       |             |       |
| Depreciation                                                                                                       |       | —    |       | 10,850         |       | 2,334                |       | (215             | )          | 12,969           |       |
| Amortization of intangible assets                                                                                  |       | —    |       | 37,278         |       | 1,024                |       | —           |       | 38,302           |       |
| Amortization of debt issuance costs and non-cash  interest expense                                                 |       | 6,457     |       | —         |       | —               |       | —           |       | 6,457            |       |
| Stock-based compensation expense                                                                                   |       | —    |       | 1,426          |       | —               |       | —           |       | 1,426            |       |
| Loss on disposal of assets                                                                                         |       | —    |       | 145            |       | 206                  |       | (98              | )          | 253              |       |
| Gain on disposal of discontinued operations                                                                        |       | —    |       | (458           | )          | —               |       | —           |       | (458             | )          |
| Deferred income tax (benefit) expense                                                                              |       | —    |       | (20,381        | )          | 123                  |       | 2,149            |       | (18,109          | )          |
| Non-cash income (loss) from subsidiaries                                                                           |       | (41,061   | )          | 16,254         |       | 3                    |       | 24,804           |       | —           |       |
| Provision for doubtful accounts and sales returns                                                                  |       | —    |       | 16,961         |       | 414                  |       | —           |       | 17,375           |       |
| Inventory reserves                                                                                                 |       | —    |       | 1,703          |       | 454                  |       | —           |       | 2,157            |       |
| Changes in operating assets and liabilities,  net of acquired assets and liabilities:                         |       |      |       |           |       |                 |       |             |       |             |       |
| Accounts receivable                                                                                                |       | —    |       | (12,873        | )          | (2,188               | )          | —           |       | (15,061          | )          |
| Inventories                                                                                                        |       | —    |       | 2,420          |       | (2,471               | )          | (155             | )          | (206             | )          |
| Prepaid expenses and other assets                                                                                  |       | 229       |       | (5,888         | )          | 3,045                |       | (338             | )          | (2,952           | )          |
| Accounts payable and other current liabilities                                                                     |       | 9,613     |       | (888           | )          | 642                  |       | 256              |       | 9,623            |       |
| Net cash provided by (used in) operating  activities                                                               |       | (52,155   | )          | 89,727         |       | 4,635                |       | (17,550          | )          | 24,657           |       |
| **INVESTING ACTIVITIES:**                                                                                          |       |      |       |           |       |                 |       |             |       |             |       |
| Cash paid in connection with acquisitions, net of  cash acquired                                                   |       | —    |       | (2,417         | )          | (1,629               | )          | —           |       | (4,046           | )          |
| Purchases of property and equipment                                                                                |       | —    |       | (8,785         | )          | (2,854               | )          | 34               |       | (11,605          | )          |
| Proceeds received upon disposition of discontinued  operations, net                                                |       | —    |       | 21,846         |       | —               |       | —           |       | 21,846           |       |
| Other investing activities, net                                                                                    |       | —    |       | 369            |       | —               |       | —           |       | 369              |       |
| Net cash provided by (used in)  investing activities                                                          |       | —    |       | 11,013         |       | (4,483               | )          | 34               |       | 6,564            |       |
| **FINANCING ACTIVITIES:**                                                                                          |       |      |       |           |       |                 |       |             |       |             |       |
| Intercompany                                                                                                       |       | 70,819    |       | (87,783        | )          | (552                 | )          | 17,516           |       | —           |       |
| Proceeds from issuance of debt                                                                                     |       | 54,999    |       | (3             | )          | 76                   |       | —           |       | 55,072           |       |
| Repayments of debt and capital lease obligations                                                                   |       | (73,663   | )          | 23             |       | (356                 | )          | —           |       | (73,996          | )          |
| Net cash provided by (used in) financing  activities                                                               |       | 52,155    |       | (87,763        | )          | (832                 | )          | 17,516           |       | (18,924          | )          |
| Effect of exchange rate changes on cash and cash  equivalents                                                      |       | —    |       | —         |       | (911                 | )          | —           |       | (911             | )          |
| **Net increase (decrease) in cash  and cash equivalents**                                                     |       | —    |       | 12,977         |       | (1,591               | )          | —           |       | 11,386           |       |
| Cash and cash equivalents at beginning of period                                                                   |       | —    |       | 14,373         |       | 16,110               |       | —           |       | 30,483           |       |
| Cash and cash equivalents at end of period                                                                         |       | $         | —     |           | $          | 27,350               |       | $                | 14,519     |             | $          | — |   | $ | 41,869 |   |

 

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**ITEM2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIALCONDITION AND RESULTS OF OPERATIONS**

 

**Forward Looking Statements**

 

The following management’s discussion and analysis contains “forwardlooking statements” within the meaning of Section 27A of the SecuritiesAct of 1933, as amended, and Section 21E of the Securities Exchange Act of1934, as amended, that represent our expectations or beliefs concerning futureevents, including, but not limited to, statements regarding growth in sales ofour products, profit margins and the sufficiency of our cash flow for futureliquidity and capital resource needs. These forward-looking statements arefurther qualified by important factors that could cause actual results todiffer materially from those in the forward-looking statements. The sectionentitled “Risk Factors” of our 2009 Annual Report on Form 10-K filedwith the Securities and Exchange Commission (“SEC”) on March 5, 2010,describes these and other important risk factors that may affect our business,financial condition, results of operations, and/or liquidity. Results actuallyachieved may differ materially from expected results included in thesestatements as a result of these or other factors.

 

**Introduction**

 

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

 

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

 

**Overview of Business**

 

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

 

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

 

***Bracing and Supports Segment***

 

Our Bracing and Supports Segment, which generates its revenues in theUnited States, offers our DonJoy, ProCare and Aircast products, including rigidknee bracing, orthopedic soft goods, cold therapy products, and vascularsystems.  This segment also includes ourOfficeCare business, through which we maintain an inventory of soft goods andother products at healthcare facilities, primarily orthopedic practices, forimmediate distribution to patients.

 

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***Recovery Sciences Segment***

 

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

 

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

 

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

 

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

 

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

 

***Surgical Implant Segment***

 

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

 

***International Segment***

 

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

 

Our four operating segments enable us to reach a diverse customer basethrough multiple distribution channels and give us the opportunity to provide awide range of orthopedic devices and related products to orthopedic specialistsoperating in a variety of patient treatment settings. These four segmentsconstitute our reportable segments. See Note 9 to our unaudited condensedconsolidated financial statements for additional information regarding oursegments.

 

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Set forth below is net sales, gross profit andoperating income information for our reportable segments for the three and sixmonths ended July 3, 2010 and June 27, 2009. This informationexcludes intersegment and certain expenses not allocated to segments, primarilygeneral corporate expenses and non-recurring charges related to our integrationactivities.  All prior periods presentedhave been restated to reflect our current reportable segments.

 
| ** **                                               | ** ** | **Three Months Ended** | ** ** | **Six Months Ended**    | ** ** |
|----------------------------------------------------------|------------|------------------------|------------|-------------------------|------------|
| **($ in thousands)**                                | ** ** | **July 3,  2010** | ** ** | **June 27,  2009** | ** ** | **July 3,  2010** | ** ** | **June 27,  2009** | ** ** |
| **Bracing and Supports:**                                |       |                   |       |                    |       |   |   |   |   |
| Net sales                                                |       | $                      | 78,915     |                    | $          | 74,789 |   | $ | 153,931 |   | $ | 142,836 |   |
| Gross profit                                             |       | $                      | 43,983     |                    | $          | 41,728 |   | $ | 85,344 |   | $ | 78,602 |   |
| Gross profit margin                                      |       | 55.7                   | %          | 55.8                    | %          | 55.4 | % | 55.0 | % |
| Operating income                                         |       | $                      | 17,605     |                    | $          | 18,262 |   | $ | 33,240 |   | $ | 30,890 |   |
| Operating income as a percent of net  segment sales |       | 22.3                   | %          | 24.4                    | %          | 21.6 | % | 21.6 | % |
| **Recovery Sciences:**                                   |       |                   |       |                    |       |   |   |   |   |
| Net sales                                                |       | $                      | 87,273     |                    | $          | 84,816 |   | $ | 171,477 |   | $ | 163,973 |   |
| Gross profit                                             |       | $                      | 66,409     |                    | $          | 64,471 |   | $ | 129,020 |   | $ | 123,785 |   |
| Gross profit margin                                      |       | 76.1                   | %          | 76.0                    | %          | 75.2 | % | 75.5 | % |
| Operating income                                         |       | $                      | 29,466     |                    | $          | 27,133 |   | $ | 54,479 |   | $ | 48,247 |   |
| Operating income as a percent of net  segment sales |       | 33.8                   | %          | 32.0                    | %          | 31.8 | % | 29.4 | % |
| **Surgical Implant:**                                    |       |                   |       |                    |       |   |   |   |   |
| Net sales                                                |       | $                      | 15,214     |                    | $          | 16,378 |   | $ | 32,176 |   | $ | 31,681 |   |
| Gross profit                                             |       | $                      | 10,813     |                    | $          | 12,864 |   | $ | 24,275 |   | $ | 24,762 |   |
| Gross profit margin                                      |       | 71.1                   | %          | 78.5                    | %          | 75.4 | % | 78.2 | % |
| Operating income                                         |       | $                      | 1,396      |                    | $          | 3,717 |   | $ | 4,144 |   | $ | 6,177 |   |
| Operating income as a percent of net  segment sales |       | 9.2                    | %          | 22.7                    | %          | 12.9 | % | 19.5 | % |
| **International:**                                       |       |                   |       |                    |       |   |   |   |   |
| Net sales                                                |       | $                      | 61,125     |                    | $          | 59,129 |   | $ | 125,019 |   | $ | 114,275 |   |
| Gross profit                                             |       | $                      | 37,671     |                    | $          | 34,706 |   | $ | 75,400 |   | $ | 66,211 |   |
| Gross profit margin                                      |       | 61.6                   | %          | 58.7                    | %          | 60.3 | % | 57.9 | % |
| Operating income                                         |       | $                      | 15,717     |                    | $          | 12,868 |   | $ | 31,035 |   | $ | 22,931 |   |
| Operating income as a percent of net  segment sales |       | 25.7                   | %          | 21.8                    | %          | 24.8 | % | 20.1 | % |

 

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**Results of Operations**

 

We operate our business on a manufacturing calendar, with our fiscalyear always ending on December 31. Each quarter is 13 weeks, consisting oftwo four-week periods and one five-week period. Our first and fourth quartersmay have more or less operating days from year to year based on the days of theweek on which holidays and December 31 fall. The quarters ended July 3,2010 and June 27, 2009 each included 64 days. The six months ended July 3,2010 and June 27, 2009 included 129 and 125 days, respectively.

 

The following table sets forth our statements of operations as apercentage of net sales for the periods presented ($ in thousands):

 
| ** **                                                                  | ** ** | **Three Months Ended** | ** ** | **Six Months Ended**    | ** ** |
|-----------------------------------------------------------------------------|------------|------------------------|------------|-------------------------|------------|
| ** **                                                                  | ** ** | **July 3,  2010** | ** ** | **June 27,  2009** | ** ** | **July 3,  2010** | ** ** | **June 27,  2009** | ** ** |
| Net  sales                                                                  |       | $                      | 242,527    |                    | 100.0      | % | $ | 235,112 |   | 100.0 | % | $ | 482,603 |   | 100.0 | % | $ | 452,765 |   | 100.0 | % |
| Cost  of sales (exclusive of amortization of intangible assets, see note 1) |       | 84,565                 |       | 34.9                    |       | 82,156 |   | 34.9 |   | 171,919 |   | 35.6 |   | 161,156 |   | 35.6 |   |
| Gross  profit                                                               |       | 157,962                |       | 65.1                    |       | 152,956 |   | 65.1 |   | 310,684 |   | 64.4 |   | 291,609 |   | 64.4 |   |
| Operating  expenses:                                                        |       |                   |       |                    |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Selling,  general and administrative                                        |       | 115,715                |       | 47.7                    |       | 108,605 |   | 46.2 |   | 226,241 |   | 46.9 |   | 209,205 |   | 46.2 |   |
| Research  and development                                                   |       | 5,460                  |       | 2.3                     |       | 6,162 |   | 2.6 |   | 11,031 |   | 2.3 |   | 11,965 |   | 2.6 |   |
| Impairment  of assets held for sale                                         |       | 1,147                  |       | 0.5                     |       | — |   | — |   | 1,147 |   | 0.2 |   | — |   | — |   |
| Amortization  of intangible assets                                          |       | 19,671                 |       | 8.1                     |       | 19,171 |   | 8.2 |   | 38,725 |   | 8.0 |   | 38,302 |   | 8.5 |   |
| Operating  income                                                           |       | 15,969                 |       | 6.6                     |       | 19,018 |   | 8.1 |   | 33,540 |   | 6.9 |   | 32,137 |   | 7.1 |   |
| Other  income (expense):                                                    |       |                   |       |                    |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest  expense                                                           |       | (37,450                | )          | (15.4                   | )          | (39,555 | ) | (16.8 | ) | (78,162 | ) | (16.2 | ) | (78,146 | ) | (17.3 | ) |
| Interest  income                                                            |       | 322                    |       | 0.1                     |       | 202 |   | 0.1 |   | 675 |   | 0.1 |   | 538 |   | 0.1 |   |
| Other  income (expense), net                                                |       | (2,837                 | )          | (1.2                    | )          | 2,967 |   | 1.3 |   | (3,617 | ) | (0.7 | ) | 1,587 |   | 0.4 |   |
| Loss  from continuing operations before income taxes                        |       | (23,996                | )          | (9.9                    | )          | (17,368 | ) | (7.4 | ) | (47,564 | ) | (9.9 | ) | (43,884 | ) | (9.7 | ) |
| Income  tax benefit                                                         |       | (24,560                | )          | (10.1                   | )          | (4,995 | ) | (2.1 | ) | (14,792 | ) | (3.1 | ) | (16,932 | ) | (3.7 | ) |
| Loss  from discontinued operations, net                                     |       | —                 |       | —                  |       | (577 | ) | (0.2 | ) | — |   | — |   | (167 | ) | (0.0 | ) |
| Net  income (loss)                                                          |       | 564                    |       | 0.2                     |       | (12,950 | ) | (5.5 | ) | (32,772 | ) | (6.8 | ) | (27,119 | ) | (6.0 | ) |
| Net  income attributable to noncontrolling interests                        |       | 321                    |       | 0.1                     |       | 135 |   | 0.1 |   | 643 |   | 0.1 |   | 274 |   | 0.1 |   |
| Net  income (loss) attributable to DJO Finance LLC                     |       | $                      | 243        |                    | 0.1        | % | $ | (13,085 | ) | (5.6 | )% | $ | (33,415 | ) | (6.9 | )% | $ | (27,393 | ) | (6.1 | )% |

 

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Note 1 — Cost of sales isexclusive of amortization of intangible assets of $9,062 and $17,981 for thethree and six months ended July 3, 2010 and $9,506 and $19,004 for thethree and six months ended June 27, 2009, respectively.

 

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***Three Months Ended July 3, 2010compared to Three Months Ended June 27, 2009***

 

*Net Sales.*  Our net sales for the three months endedJuly 3, 2010 were $242.5 million, representing an increase of 3.2% ascompared to $235.1 million for the three months ended June 27,2009.  This increase was driven byincreased sales across most business units, offset by $1.9 million ofunfavorable changes in foreign exchange rates compared to rates in effect forthe three months ended June 27, 2009.

 

For the three months ended July 3, 2010, we generated 25.2% of ournet sales from customers outside the United States as compared to 25.1% for thethree months ended June 27, 2009. Additionally, sales of new products,which include products that have been on the market less than one year, were$2.6 million for the three months ended July 3, 2010 compared to newproduct sales of $5.5 million for the three months ended June 27, 2009.

 

The following table sets forth the mix of our net sales for the threemonths ended July 3, 2010 compared to the three months ended June 27,2009 ($ in thousands):

 
| ** **            | ** ** | **Three Months Ended** | ** ** | ** **          | ** ** | ** **              | ** ** |
|-----------------------|------------|------------------------|------------|---------------------|------------|-------------------------|------------|
| ** **            | ** ** | **July 3,  2010** | ** ** | **% of Net  Sales** | ** ** | **June 27,  2009** | ** ** | **% of Net  Sales** | ** ** | **Increase  (Decrease)** | ** ** | **% Increase  (Decrease)** | ** ** |
| Bracing and Supports  |       | $                      | 78,915     |                | 32.5       | %                       | $          | 74,789 |   | 31.8 | % | $ | 4,126 |   | 5.5 | % |
| Recovery Sciences     |       | 87,273                 |       | 36.0                |       | 84,816                  |       | 36.1 |   | 2,457 |   | 2.9 |   |
| Surgical Implant      |       | 15,214                 |       | 6.3                 |       | 16,378                  |       | 7.0 |   | (1,164 | ) | (7.1 | ) |
| International Segment |       | 61,125                 |       | 25.2                |       | 59,129                  |       | 25.1 |   | 1,996 |   | 3.4 |   |
|                  |       | $                      | 242,527    |                | 100.0      | %                       | $          | 235,112 |   | 100.0 | % | $ | 7,415 |   | 3.2 | % |

 

Net sales in our Bracing and Supports Segment were $78.9 million forthe three months ended July 3, 2010, reflecting an increase of 5.5% fromnet sales of $74.8 million for the three months ended June 27, 2009. Theincrease was driven primarily by increased unit sales, sales of new productslaunched in the first quarter of 2010, and increased revenue under our new softgoods contract with the Novation group purchasing organization.

 

Net sales in our Recovery Sciences Segment increased to $87.3 millionfor the three months ended July 3, 2010 from $84.8 million for the threemonths ended June 27, 2009, representing a 2.9% increase over the sameperiod in the prior year. The increase is primarily due to continuedimprovement in sales in our Chattanooga business unit, as well as sales of newproducts in our Empi business unit, in the three months ended July 3, 2010as compared to the three months ended June 27, 2009, partially offset bythe impact of discontinuing certain Chattanooga products which contributedrevenue in 2009.

 

Net sales in our Surgical Implant Segment decreased to$15.2 million for the three months ended July 3, 2010 from $16.4million for the three months ended June 27, 2009, representing a 7.1%decrease over the same period in the prior year. The decrease was drivenprimarily by the sale of our non-core spinal product line in 2009, anddecreased sales of our hip and knee products, partially offset by increasedsales of our shoulder products.

 

Net sales in our International Segment for the three months endedJuly 3, 2010 were $61.1 million, reflecting an increase of 3.4% from netsales of $59.1 million for the three months ended June 27, 2009. Theincrease was driven primarily by strong sales of our bracing and supportsproducts, and the improving sales of our Chattanooga products, offset by $1.9million of unfavorable changes in foreign exchange rates compared to rates ineffect for the three months ended June 27, 2009, and by the impact ofdiscontinuing certain Chattanooga products which contributed revenue in 2009.

 

*Gross Profit.*  Consolidated gross profit as a percentage ofnet sales was 65.1%, for the three months ended July 3, 2010, consistentwith the three months ended June 27, 2009. Our gross profit margin for thethree months ended July 3, 2010 was impacted by a less favorable mix ofproducts sold and $1.3 million of unfavorable changes in foreign currencyexchange rates compared to the rates in effect for the prior year, partiallyoffset by cost savings achieved in connection with various integrationactivities.

 

Gross profit in our Bracing and Supports Segment as a percentage of netsales was 55.7% for the three months ended July 3, 2010 as compared to55.8% for the three months ended June 27, 2009. The decrease was primarilydue to a lower margin mix of products sold.

 

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Gross profit in our Recovery Sciences Segment as a percentage of netsales increased slightly to 76.1% for the three months ended July 3, 2010from 76.0% for the three months ended June 27, 2009. The increase wasprimarily driven by cost savings resulting from the integration of ourChattanooga business unit, partially offset by an unfavorable mix of productssold.

 

Gross profit in our Surgical Implant Segment as a percentage of netsales decreased to 71.1% for the three months ended July 3, 2010 from78.5% for the three months ended June 27, 2009. The decrease was primarilydriven by lower sales volume and certain non recurring costs.

 

Gross profit in our International Segment as a percentage of net salesincreased to 61.6% for the three months ended July 3, 2010 from 58.7% forthe three months ended June 27, 2009. The increase was primarily driven by a more favorable mix of productssold, and cost savings achieved in connection with the integration of ourChattanooga business operations, partially offset by $1.3 million ofunfavorable changes in foreign exchange rates.

 

*Selling, General and Administrative.*  Our selling, general and administrativeexpenses increased to $115.7 million for the three months ended July 3,2010 from $108.6 million for the three months ended June 27, 2009,primarily due to increased integration costs for the three months ended July 3,2010 as compared to the three months ended June 27, 2009.  We incurred the following expenses associatedwith our integration activities and the implementation of our new global ERPsystem during the periods presented (in thousands):

 
| ** **                                        | ** ** | **Three Months Ended** | ** ** |
|---------------------------------------------------|------------|------------------------|------------|
| ** **                                        | ** ** | **July 3,  2010** | ** ** | **June 27,  2009** | ** ** |
| Integration charges:                              |       |                   |       |   |   |
| Employee severance and relocation                 |       | $                      | 932        |   | $ | 2,144 |   |
| Chattanooga integration                           |       | 1,333                  |       | 1,058 |   |
| DJO Merger and other integration                  |       | 1,355                  |       | 4,077 |   |
| U.S Commercial Sales and Marketing reorganization |       | 3,415                  |       | — |   |
| International integration                         |       | 27                     |       | 759 |   |
| Litigation costs and settlements, net             |       | 998                    |       | — |   |
| Additional product liability insurance premiums   |       | 10,293                 |       | — |   |
| ERP implementation                                |       | 3,733                  |       | 7,846 |   |
|                                              |       | $                      | 22,086     |   | $ | 15,884 |   |

 

During the three monthsended July 3, 2010, we incurred $10.3 million of expenses related to additionalproduct liability insurance premiums, which were primarily attributable tosupplemental coverage for product liability claims related to our discontinuedpain pump products, for which annual insurance coverage was otherwise unavailablewhen our existing coverage expired on June 30, 2010.

 

*Research and Development.*  Our research and development expensedecreased to $5.5 million for the three months ended July 3, 2010 from$6.2 million for the three months ended June 27, 2009. As a percentage ofnet sales, research and development expense decreased slightly to 2.3% for thethree months ended July 3, 2010 from 2.6% in the three months ended June 27,2009, primarily reflecting cost savings from integration activities, andfavorable changes in foreign currency exchanges rates from the prior year.

 

*Amortization of Intangible Assets.*  Intangible assets are being amortized usingthe straight-line method over their estimated lives ranging from one to 20years. Amortization of intangible assets was $19.7 million and $19.2 millionfor the three months ended July 3, 2010 and June 27, 2009,respectively.

 

*Interest Expense.*  Our interest expense decreased to $37.5million for the three months ended July 3, 2010 from $39.6 millionfor the three months ended June 27, 2009, primarily due to lower weightedaverage interest rates on our outstanding debt.

 

*Other Income (Expense), Net.*  Other expense, net, was $2.8 million duringthe three months ended July 3, 2010 compared to $3.0 million of otherincome, net, during the three months ended June 27, 2009.  Results for both periods were primarily associatedwith foreign currency transaction gains and losses.

 

*Income Tax Benefit.*  For the three months ended July 3, 2010,we recorded an income tax benefit of approximately $24.6 million on a pre-taxloss of approximately $24.0 million, resulting in a 102% effective taxrate.  However, for the six months endedJuly 3, 2010, we recorded an income tax benefit of approximately $14.8million on a pre-tax loss of approximately $47.6 million, resulting in a 31.1%effective tax rate.  Based on changes inour annual financial projection as of July 3, 2010, the income tax benefitrecorded for the three months ended July 3, 2010 included 

 

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thereversal of certain tax expense amounts recorded for the three months ended April 3,2010.  Given the relationship betweenfixed dollar tax items and pre-tax financial results, our projected annualeffective tax rate can change materially based on small variations of income.

 

For the three months ended June 27, 2009, we recorded an incometax benefit of approximately $5.0 million on a pre-tax loss of approximately$17.4 million, resulting in a 28.7% effective tax rate. The difference in thetax benefit recorded during the three months ended July 3, 2010 and thethree months ended June 27, 2009 is primarily attributable to differencesin our projected annualized effective tax rates for each year.

 

***Six Months Ended July 3, 2010compared to Six Months Ended June 27, 2009***

 

*Net Sales.*  Our net sales for the six months endedJuly 3, 2010 were $482.6 million, representing an increase of 6.6% fromnet sales of $452.8 million for the six months ended June 27, 2009.  This increase was driven by increased salesacross all business units as well as $2.4 million of favorable changes inforeign exchange rates compared to rates in effect for the six months ended June 27,2009.  Net sales for the six months endedJuly 3, 2010 were also favorably impacted by the benefit of fouradditional shipping days as compared to the six months ended June 27,2009.

 

For the six months ended July 3, 2010, we generated 25.9% of ournet sales from customers outside the United States as compared to 25.2% for thesix months ended June 27, 2009. Additionally, sales of new products, whichinclude products that have been on the market less than one year, were $11.4million for the six months ended July 3, 2010 compared to new productsales of $8.6 million for the six months ended June 27, 2009.

 

The following table sets forth the mix of our net sales for the sixmonths ended July 3, 2010 compared to the six months ended June 27,2009 ($ in thousands):

 
| ** **           | ** ** | **Six Months Ended**   | ** ** | ** **          | ** ** | ** **              | ** ** |
|----------------------|------------|------------------------|------------|---------------------|------------|-------------------------|------------|
| ** **           | ** ** | **July 3,  2010** | ** ** | **% of Net  Sales** | ** ** | **June 27,  2009** | ** ** | **% of Net  Sales** | ** ** | **Increase** | ** ** | **%  Increase** | ** ** |
| Bracing and Supports |       | $                      | 153,931    |                | 31.9       | %                       | $          | 142,836 |   | 31.6 | % | $ | 11,095 |   | 7.8 | % |
| Recovery Sciences    |       | 171,477                |       | 35.5                |       | 163,973                 |       | 36.2 |   | 7,504 |   | 4.6 |   |
| Surgical Implant     |       | 32,176                 |       | 6.7                 |       | 31,681                  |       | 7.0 |   | 495 |   | 1.6 |   |
| International        |       | 125,019                |       | 25.9                |       | 114,275                 |       | 25.2 |   | 10,744 |   | 9.4 |   |
|                 |       | $                      | 482,603    |                | 100.0      | %                       | $          | 452,765 |   | 100.0 | % | $ | 29,838 |   | 6.6 | % |

 

Net sales in our Bracing and Supports Segment were $153.9 million forthe six months ended July 3, 2010, reflecting an increase of 7.8% from netsales of $142.8 million for the six months ended June 27, 2009. Theincrease was driven primarily by increased unit sales, sales of new productslaunched in the first quarter of 2010, and increased revenue under our new softgoods contract with the Novation group purchasing organization.  In addition, net sales were positivelyimpacted by the benefit of four additional shipping days in the first half of2010 as compared to the first half of 2009.

 

Net sales in our Recovery Sciences Segment increased to$171.5 million for the six months ended July 3, 2010 from $164.0million for the six months ended June 27, 2009, representing a 4.6%increase over the same period in the prior year. The increase is primarily dueto continued improvement in sales in our Chattanooga business unit, sales ofnew products in our Empi business unit, and the benefit of four additionalshipping days in the first half of 2010. These increases were partially offsetby the impact of discontinuing certain Chattanooga products which contributedrevenue in 2009.

 

Net sales in our Surgical Implant Segment increased to$32.2 million for the six months ended July 3, 2010 from $31.7million for the six months ended June 27, 2009, representing a 1.6%increase over the same period in the prior year. The increase was drivenprimarily by increased sales of our shoulder products and the benefit of fouradditional shipping days in the first half of 2010. These increases werepartially offset by decreased sales of our hip and knee products, and the saleof our non-core spinal product line in 2009.

 

Net sales in our International Segment for the six months endedJuly 3, 2010 were $125.0 million, reflecting an increase of 9.4% from netsales of $114.3 million for the six months ended June 27, 2009.  The increase was driven primarily by strongsales of our bracing and supports products, and the improving sales of ourChattanooga products, as well as $2.4 million of favorable changes in foreignexchange rates compared to rates in effect for the six months ended June 27,2009. In addition, net sales were positively impacted by the benefit of fouradditional shipping days in the first half of 2010 as compared to the firsthalf of 2009. These increases were partially offset by the impact ofdiscontinuing certain Chattanooga products which contributed revenue in 2009.

 

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*Gross Profit.*  Consolidated gross profit as a percentage ofnet sales was 64.4%, for the six months ended July 3, 2010 and June 27,2009. Our gross profit margin for the six months ended July 3, 2010 isconsistent with the prior year period as the impact of a less favorable mix ofproducts sold and certain integration related costs were offset by cost savingsresulting from integration activity, and $1.9 million of favorable changes inforeign exchange rates compared to rates in effect for the six months ended June 27,2009.

 

Gross profit in our Bracing and Supports Segment as a percentage of netsales was 55.4% for the six months ended July 3, 2010 compared to 55.0%for the six months ended June 27, 2009. The increase was primarily drivenby a higher margin mix of products sold.

 

Gross profit in our Recovery Sciences Segment as a percentage of netsales was 75.2% for the six months ended July 3, 2010 compared to 75.5%for the six months ended June 27, 2009. The decrease was primarily drivenby a lower margin mix of products sold, partially offset by cost savingsachieved in connection with the integration of our Chattanooga businessoperations.

 

Gross profit in our Surgical Implant Segment as a percentage of netsales decreased to 75.4% for the six months ended July 3, 2010 from 78.2%for the six months ended June 27, 2009. The decrease was primarily drivenby certain non recurring costs.

 

Gross profit in our International Segment as a percentage of net salesincreased to 60.3% for the six months ended July 3, 2010 from 57.9% forthe six months ended June 27, 2009. The increase was primarily driven by the impact of a more favorable mixof products sold, $1.9 million of favorable changes in foreign currencyexchange rates compared to rates in effect for the six months ended June 27,2009, and cost savings achieved in connection with the integration of ourChattanooga operations.

 

*Selling, General and Administrative.*  Our selling, general and administrativeexpenses increased to $226.2 million for the six months ended July 3, 2010from $209.2 million for the six months ended June 27, 2009, primarily dueto increased integration costs for the six months ended July 3, 2010 ascompared to the six months ended June 27, 2009.  We incurred the following expenses associatedwith our integration activities and the implementation of our new global ERPsystem for the periods presented (in thousands):

 
| ** **                                        | ** ** | **Six Months Ended**   | ** ** |
|---------------------------------------------------|------------|------------------------|------------|
| ** **                                        | ** ** | **July 3,  2010** | ** ** | **June 27,  2009** | ** ** |
| Integration charges:                              |       |                   |       |   |   |
| Employee severance and relocation                 |       | $                      | 2,356      |   | $ | 2,803 |   |
| Chattanooga integration                           |       | 6,570                  |       | 1,144 |   |
| DJO Merger and other integration                  |       | 2,881                  |       | 2,991 |   |
| U.S Commercial Sales and Marketing reorganization |       | 5,337                  |       | — |   |
| International integration                         |       | 40                     |       | 4,650 |   |
| Litigation costs and settlements, net             |       | 2,514                  |       | — |   |
| Additional product liability insurance premiums   |       | 11,139                 |       | — |   |
| ERP implementation                                |       | 7,010                  |       | 12,077 |   |
|                                              |       | $                      | 37,847     |   | $ | 23,665 |   |

 

During the six months ended July 3,2010, we incurred $11.1 million of expenses related to additional productliability insurance premiums, which were primarily attributable to supplementalextended coverage for product liability claims related to our discontinued painpump products, for which annual insurance coverage was otherwise unavailablewhen our existing coverage expired on June 30, 2010.

 

*Research and Development.*  Our research and development expensedecreased to $11.0 million for the six months ended July 3, 2010 from$12.0 million for the six months ended June 27, 2009. As a percentage ofnet sales, research and development expense decreased slightly to 2.3% for thesix months ended July 3, 2010 from 2.6% in the six months ended June 27,2009, primarily reflecting cost savings initiatives.

 

*Amortization of Intangible Assets.*  Intangible assets are being amortized usingthe straight-line method over their estimated lives ranging from one to 20years. Our amortization of intangible assets was $38.7 million and $38.3million for the six months ended July 3, 2010 and June 27, 2009,respectively.

 

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*Interest Expense.*  Our interest expense was $78.2 and $78.1million for the six months ended July 3, 2010 and June 27, 2009,respectively. Lower weighted average interest rates on our outstanding debt inthe six months ended July 3, 2010 were offset by accelerated amortizationof original issue discount and deferred financing costs in connection with the$101.5 million prepayment of our Senior Secured term loan in January 2010.

 

*Other Income (Expense), Net.*  Other expense, net, was $3.6 million for thesix months ended July 3, 2010 compared to $1.6 million of otherincome, net, for the six months ended June 27, 2009.  Results for both periods were primarily associatedwith foreign currency transaction gains and losses.

 

*Income Tax Benefit.* For the six months endedJuly 3, 2010, we recorded an income tax benefit of approximately $14.8million on a pre-tax loss of approximately $47.6 million, resulting in a 31.1% effectivetax rate.

 

For the six months ended June 27, 2009, we recorded an income taxbenefit of approximately $16.9 million on a pre-tax loss of approximately$43.9 million, resulting in a 38.5% effective tax rate.

 

The difference in the tax benefit recorded during the six months ended July 3,2010 and the six months ended June 27, 2009 is primarily attributable todifferences in our projected annualized effective tax rates for each year asdetermined by the Company.  In addition, a beneficial impact of a tax lawchange was recorded during the first quarter of 2009 as a discrete item. Giventhe relationship between fixed dollar tax items and pre-tax financial results, ourprojected annual effective tax rate can change materially based on smallvariations of income.

 

**Liquidity and Capital Resources**

 

As of July 3, 2010, our primary source of liquidity consisted ofcash and cash equivalents totaling $34.1 million and $100.0 million ofavailable borrowings under our revolving credit facility. Working capital atJuly 3, 2010 was $177.7 million. We believe that our existing cash, plusthe amounts we expect to generate from operations and amounts available throughour revolving credit facility, will be sufficient to meet our operating needsfor the next twelve months, including working capital requirements, capitalexpenditures, and debt and interest repayment obligations. While we currentlybelieve that we will be able to meet all of our financial covenants imposed byour Senior Secured Credit Facility, there is no assurance that we will in factbe able to do so or that, if we do not, we will be able to obtain from ourlenders waivers of default or amendments to the Senior Secured Credit Facilityin the future. We and our subsidiaries, affiliates or significant shareholders(including Blackstone and its affiliates) may from time to time, in our ortheir sole discretion, purchase, repay, redeem or retire any of our outstandingdebt or equity securities (including any publicly issued debt securities), inprivately negotiated or open market transactions, by tender offer or otherwise.

 

A summary of the changes in our cash and cash equivalents for the sixmonths ended July 3, 2010 and June 27, 2009 is as follows:

 
| ** **                                                    | ** ** | **Six Months Ended**   | ** ** |
|---------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                    | ** ** | **July 3,  2010** | ** ** | **June 27,  2009** | ** ** |
| Cash provided by operating activities                         |       | $                      | 10,153     |   | $ | 24,657 |   |
| Cash provided by (used in) investing activities               |       | (15,803                | )          | 6,564 |   |
| Cash used in financing activities                             |       | (6,594                 | )          | (18,924 | ) |
| Effect of exchange rate changes on cash and cash  equivalents |       | 1,717                  |       | (911 | ) |
| Net increase (decrease) in cash and cash  equivalents         |       | $                      | (10,527    | ) | $ | 11,386 |   |

 

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***Cash Flows***

 

Operatingactivities provided cash of $10.2 million and $24.7 million for the six monthsended July 3, 2010 and June 27, 2009, respectively. Cash provided byoperating activities for the six months ended July 3, 2010 primarilyreflected our net loss after adjustment for non-cash charges. Cash provided byoperating activities for the six months ended June 27, 2009 primarilyreflected our net loss after adjustment for non-cash charges and a favorablenet change in operating assets and liabilities.

 

Investing activities used$15.8 million of cash for the six months ended July 3, 2010 as compared to$6.6 million of cash provided for the six months ended June 27, 2009.Cash used in investing activities for the six months ended July 3, 2010primarily consisted of $14.5 million of purchases of property and equipment,including $9.3 million for our new ERP system, and a $0.8 million paymentrelated to an earn out provision associated with our 2009 Australianacquisition. Cash provided by investing activities for the six months ended June 27,2009 primarily consisted of $21.8 million of proceeds from the sales of assets,partially offset by purchases of property and equipment totaling $11.6 million,including $1.6 million for our new ERP system, and the acquisition ofbusinesses for a total of $4.0 million, net of cash acquired.

 

We used $6.6 million and$18.9 million of cash for financing activities during the six months endedJuly 3, 2010 and June 27, 2009, respectively. Cash used infinancing activities for the six months ended July 3, 2010 was primarilyrelated to net payments on long-term debt of $3.7 million and the payment of$3.3 million of debt issuance costs incurred in connection with the issuance ofour new 10.875% Senior Notes. In addition, during the six months ended July 3,2010, we received an additional investment of approximately $1.0 million fromour indirect parent, from the issuance of DJO Incorporated common stock tocertain accredited investors. Cash used in financing activities for the sixmonths ended June 27, 2009 represented net payments on long-term debt andrevolving lines of credit.

 

For the remainder of 2010, we expect to spend total cash ofapproximately $109.1 million for the following:

 

· $43.6 million forscheduled principal and estimated interest payments on our senior securedcredit facility,

· $48.5 million for scheduledinterest payments on our senior notes, and

· $17.0 million forcapital expenditures, including $6.6 million for our ERP system.

 

Inaddition, we expect to incur additional costs implementing our new ERP systemover the remainder of the project, which will be expensed as incurred in ourunaudited condensed consolidated statements of operations.

 

***Indebtedness***

 

As of July 3, 2010, we had approximately $1,810.4 million inaggregate indebtedness outstanding.

 

*Senior Secured Credit Facility*

 

*Overview.*  The Senior Secured Credit Facility originallyprovided senior secured financing of $1,165.0 million, consisting of a$1,065.0 million term loan facility, of which $927.8 million remainsoutstanding as of July 3, 2010, and a $100.0 million revolving creditfacility. We issued the term loan facility at a 1.2% discount, resulting in netproceeds of $1,052.4 million. In addition, we are permitted, subject toreceipt of additional commitments from participating lenders and certain otherconditions, to incur up to an additional $150.0 million of borrowingsunder the Senior Secured Credit Facility.

 

*Interest Rate and Fees.*  Borrowings under the Senior Secured CreditFacility bear interest at a rate equal to an applicable margin plus, at ouroption, either (a) a base rate determined by reference to the higher of(1) the prime rate of Credit Suisse and (2) the federal funds rateplus 0.50% or (b) the Eurodollar rate determined by reference to the costsof funds for deposits in U.S. dollars for the interest period relevant to eachborrowing adjusted for required reserves. The initial applicable margins forborrowings under the term loan facility and the revolving credit facility is2.00% with respect to base rate borrowings and 3.00% with respect to Eurodollarborrowings. The applicable margin for borrowings under the term loan facilityand the revolving credit facility may be reduced subject to us attainingcertain leverage ratios.

 

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We use interest rate swap agreements in an effort to hedge our exposureto fluctuating interest rates related to a portion of our Senior Secured CreditFacility (see note 14 to our unaudited condensed consolidated financialstatements).  On November 20, 2007,we entered into an interest rate swap agreement for a notional amount of$515.0 million at a fixed LIBOR rate of 4.205% which expired onDecember 31, 2009.  InFebruary 2009, we entered into two additional non-amortizing interest rateswap agreements. The first was for a notional amount of $550.0 million at afixed LIBOR rate of 1.04% beginning in February 2009 which expired onDecember 31, 2009. The second is for a notional amount of $750.0 millionat a fixed LIBOR rate of 1.88% beginning January 2010 throughDecember 2010.  In August 2009,we entered into four new non-amortizing interest rate swap agreements withnotional amounts aggregating $300.0 million. Each of the four agreements has aterm beginning January 2011 through December 2011. The fouragreements are at a weighted average fixed LIBOR rate of 2.5825%.  As of July 3, 2010, our weighted averageinterest rate for all borrowings under the Senior Secured Credit Facility was4.58%.

 

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

 

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

 

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

 

·                  incuradditional indebtedness,

·                  create liens onassets,

·                  change fiscalyears,

·                  enter into saleand leaseback transactions,

·                  engage inmergers or consolidations,

·                  sell assets,

·                  pay dividendsand make 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.

 

Pursuant to the terms of the credit agreement relating to the SeniorSecured Credit Facility, we are required to maintain a maximum senior securedleverage ratio consolidated senior debt to Adjusted EBITDA, of 4.00:1 for thetrailing 12 months ended July 3, 2010, stepping down over time to 3.25:1by the end of 2011. Adjusted EBITDA represents net income (loss) plus interestexpense, net, provision (benefit) for income taxes and depreciation and amortization,further adjusted for non-cash items, non-recurring items and other adjustmentitems permitted in calculating covenant compliance under our Senior SecuredCredit Facility and the Indentures (“Adjusted EBITDA”). As of July 3, 2010our actual senior secured leverage ratio was within the required ratio at3.34:1.

 

*10.875% Senior Notes and 11.75% Senior SubordinatedNotes*

 

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

 

·                  incuradditional debt or issue certain preferred shares,

·                  pay dividendson or make other distributions in respect of our capital stock or make otherrestricted payments,

·                  make certaininvestments,

·                  sell certainassets,

·                  create liens oncertain assets to secure debt,

 

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

·                  enter intocertain transactions with our affiliates, and

·                  designate oursubsidiaries as unrestricted subsidiaries.

 

Under the Indentures governing our 10.875% Notes and our 11.75% Notes,our ability to incur additional debt, subject to specified exceptions, is tiedto improving our Adjusted EBITDA to fixed charges ratio or having a ratio of atleast 2.00:1 on a pro forma basis after giving effect to such incurrence.Additionally, our ability to make certain restricted payments is also tied tohaving an Adjusted EBITDA to fixed charge ratio of at least 2.00:1 on a proforma basis. Our ratio of Adjusted EBITDA to fixed charges for the twelvemonths ended July 3, 2010, measured on that date, was 1.88:1.Notwithstanding these limitations, the aggregate amount of term loan increasesand revolving commitment increases shall not exceed the greater of(i) $150.0 million and (ii) the additional aggregate amount ofsecured indebtedness which would be permitted to be incurred as of any date ofdetermination (assuming for this purpose that the full amount of any revolvingcredit increase had been utilized as of such date) such that, after giving proforma effect to such incurrence (and any other transactions consummated on suchdate), the senior secured leverage ratio for the immediately preceding testperiod would not be greater than 4.00:1. Fixed charges is defined in theIndentures as consolidated interest expense plus all cash dividends or otherdistributions paid on any series of preferred stock of any restricted subsidiaryand all dividends or other distributions accrued on any series of disqualifiedstock.

 

*Covenant Compliance*

 

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

 
| ** **                                                                                                            | ** ** | **Covenant  Requirements** | ** ** | **Actual  Ratios** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------|------------|----------------------------|------------|--------------------|------------|
| **Senior Secured Credit Facility**                                                                                    |       |                       |       |               |       |
| Maximum ratio of consolidated net senior secured  debt to Adjusted EBITDA                                        |       | 4.00:1                     |       | 3.34:1             |       |
| **10.875% Senior Notes and 11.75%  Senior Subordinated Notes**                                                        |       |                       |       |               |       |
| Minimum ratio of Adjusted EBITDA to fixed charges  required to incur additional debt pursuant to ratio provision |       | 2.00:1                     |       | 1.88:1             |       |

 

As described above, our Senior Secured Credit Facility consisting of a$927.8 million term loan facility as of July 3, 2010, and a$100.0 million revolving credit facility and the Indentures governing the$675.0 million of senior notes and the $200.0 million of seniorsubordinated notes represent significant components of our capital structure.Under our Senior Secured Credit Facility, we are required to maintain specifiedsenior secured leverage ratios, which become more restrictive over time, andwhich are determined based on our Adjusted EBITDA. If we fail to comply withthe senior secured leverage ratio under our Senior Secured Credit Facility, wewould be in default under the credit facility. Upon the occurrence of an eventof default under the Senior Secured Credit Facility, the lenders could elect todeclare all amounts outstanding under the Senior Secured Credit Facility to beimmediately due and payable and terminate all commitments to extend furthercredit. If we were unable to repay those amounts, the lenders under the SeniorSecured Credit Facility could proceed against the collateral granted to them tosecure that indebtedness. We have pledged a significant portion of our assetsas collateral under the Senior Secured Credit Facility. Any acceleration underthe Senior Secured Credit Facility would also result in a default under theIndentures governing the notes, which could lead to the noteholders electing todeclare the principal, premium, if any, and interest on the then outstandingnotes immediately due and payable. In addition, under the Indentures governingthe notes, our ability to engage in activities such as incurring additionalindebtedness, making investments, refinancing subordinated indebtedness, payingdividends and entering into certain merger transactions is governed, in part,by our ability to satisfy tests based on Adjusted EBITDA.

 

Adjusted EBITDA is defined as net income (loss) attributable to DJOFinance LLC, plus loss from discontinued operations, interest expense, net,provision (benefit) for income taxes and depreciation and amortization, furtheradjusted for non-cash items, non-recurring items and other adjustment itemspermitted in calculating covenant compliance under our Senior Secured CreditFacility and Indentures. We believe that the presentation of Adjusted EBITDA isappropriate to provide additional information to investors about thecalculation of, and compliance with, certain financial covenants in our SeniorSecured Credit Facility and the Indentures. Adjusted EBITDA is a materialcomponent of these covenants.

 

Adjusted EBITDA should not be considered as an alternative to netincome or other performance measures presented in accordance with GAAP, or asan alternative to cash flow from operations as a measure of our liquidity.Adjusted EBITDA does not represent net loss or cash flow from operations asthose terms are defined by GAAP and does not necessarily indicate whether cashflows will be sufficient to fund cash needs. In particular, the definition of

 

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AdjustedEBITDA in the Indentures and our Senior Secured Credit Facility allows us toadd back certain non-cash, extraordinary, unusual or non-recurring charges thatare deducted in calculating net loss. However, these are expenses that mayrecur, vary greatly and are difficult to predict. While Adjusted EBITDA andsimilar measures are frequently used as measures of operations and the abilityto meet debt service requirements, Adjusted EBITDA is not necessarilycomparable to other similarly titled captions of other companies due to thepotential inconsistencies in the method of calculation.

 

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

 

The following table provides a reconciliation from our net income(loss) to Adjusted EBITDA for the three and twelve months ended July 3,2010 (in thousands). The terms and related calculations are defined in thecredit agreement relating to our Senior Secured Credit Facility and theIndentures.

 
| ** **                                                                                        | ** ** | **Three Months  Ended  July 3, 2010** | ** ** | **Twelve Months  Ended  July 3, 2010** | ** ** |
|---------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                        | ** ** | ** **                                 | ** ** |
| Net income (loss) attributable to DJO Finance LLC                                                 |       | $                                          | 243        |                                        | $          | (56,455 | ) |
| Loss from discontinued operations, net                                                            |       | —                                     |       | 152                                         |       |
| Interest expense, net                                                                             |       | 37,128                                     |       | 155,878                                     |       |
| Income tax benefit                                                                                |       | (24,560                                    | )          | (19,538                                     | )          |
| Depreciation and amortization                                                                     |       | 25,982                                     |       | 112,739                                     |       |
| Non-cash charges (a)                                                                              |       | 1,518                                      |       | 4,696                                       |       |
| Non-recurring and restructuring charges (b)                                                       |       | 22,086                                     |       | 61,964                                      |       |
| Other adjustment items, before cost savings (c)                                                   |       | 4,960                                      |       | 7,485                                       |       |
| Other adjustment items—future cost savings  applicable for twelve month period only (d) |       | —                                     |       | 400                                         |       |
| Adjusted EBITDA                                                                                   |       | $                                          | 67,357     |                                        | $          | 267,321 |   |

 

(a)          Non-cashcharges are comprised of the following (in thousands):

 
| ** **                             | ** ** | **Three Months  Ended  July 3, 2010** | ** ** | **Twelve Months  Ended  July 3, 2010** | ** ** |
|----------------------------------------|------------|--------------------------------------------|------------|---------------------------------------------|------------|
| ** **                             | ** ** | ** **                                 | ** ** |
| Impairment of assets held for sale (1) |       | $                                          | 1,147      |                                        | $          | 1,147 |   |
| Stock compensation expense             |       | 370                                        |       | 2,821                                       |       |
| Losses on disposal of assets, net      |       | 1                                          |       | 728                                         |       |
| Total non-cash charges                 |       | $                                          | 1,518      |                                        | $          | 4,696 |   |

 

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(1)          As a result ofour integration of the operations of our Chattanooga division, we exited thefacilities in Hixson, Tennessee and listed the buildings for sale during thesix months ended July 3, 2010. Due to a decline in the fair market valueof the buildings, we recorded a $1.1 million non-cash charge during the sixmonths ended July 3, 2010, which has been reflected as impairment ofassets held for sale.

 

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(b)         Non-recurring andintegration charges are comprised of the following (in thousands):

 
| ** **                                           | ** ** | **Three Months  Ended  July 3, 2010** | ** ** | **Twelve  Months  Ended  July 3, 2010** | ** ** |
|------------------------------------------------------|------------|--------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                           | ** ** | ** **                                 | ** ** |
| Integration charges:                                 |       |                                       |       |                                         |       |
| Employee severance and relocation                    |       | $                                          | 932        |                                         | $          | 8,199 |   |
| Chattanooga integration                              |       | 1,333                                      |       | 13,744                                       |       |
| DJO Merger and other integration                     |       | 1,355                                      |       | 4,516                                        |       |
| U.S Commercial Sales and Marketing reorganization    |       | 3,415                                      |       | 5.337                                        |       |
| International integration                            |       | 27                                         |       | 1,496                                        |       |
| Litigation costs and settlements, net                |       | 998                                        |       | 4,526                                        |       |
| Additional products liability insurance premiums (1) |       | 10,293                                     |       | 11,139                                       |       |
| ERP implementation                                   |       | 3,733                                      |       | 13,007                                       |       |
| Total non-recurring and integration charges          |       | $                                          | 22,086     |                                         | $          | 61,964 |   |

 

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(1)          Primarilyconsists of insurance premiums related to a supplemental extended reportingperiod for product liability claims related to our discontinued pain pumpproducts, for which annual insurance coverage was otherwise unavailable whenour existing coverage expired on June 30, 2010.

 

(c)                                  Otheradjustment items, before future cost savings, are comprised of the following(in thousands):

 
| ** **                                        | ** ** | **Three Months  Ended  July 3, 2010** | ** ** | **Twelve Months  Ended  July 3, 2010** | ** ** |
|---------------------------------------------------|------------|--------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                        | ** ** | ** **                                 | ** ** |
| Blackstone monitoring fee                         |       | $                                          | 1,750      |                                        | $          | 7,000 |   |
| Noncontrolling interests                          |       | 321                                        |       | 1,092                                       |       |
| Pre-acquisition EBITDA (1)                        |       | —                                     |       | 100                                         |       |
| Pre-disposition EBITDA (2)                        |       | —                                     |       | (200                                        | )          |
| Other (3)                                         |       | 2,889                                      |       | (507                                        | )          |
| Total other adjustment items, before cost savings |       | $                                          | 4,960      |                                        | $          | 7,485 |   |

 

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(1)          Pre-acquisitionAdjusted EBITDA for the twelve months ended July 3, 2010 related to twoCanadian subsidiaries acquired in August 2009.

 

(2)          Pre-dispositionAdjusted EBITDA for the twelve months ended July 3, 2010 related tocertain immaterial product lines sold in fiscal year 2009.

 

(3)          Otheradjustment items consist of costs and expenses which are individuallyinsignificant.

 

(d)                                 Future costsavings for the twelve month period ended July 3, 2010 relates to twoCanadian subsidiaries acquired in August 2009.

 

**CriticalAccounting Policies and Estimates**

 

Our management’s discussion and analysis of financial condition andresults of operations is based upon our financial statements, which have beenprepared in accordance with GAAP. The preparation of these financial statementsrequires us to make estimates and judgments that affect the reported amounts ofassets, liabilities, revenues and expenses, and related disclosure ofcontingent assets and liabilities. On an on-going basis, we evaluate ourestimates, including those related to reserves for contractual allowances,doubtful accounts, rebates, product returns and rental credits, goodwill andintangible assets, deferred tax assets and liabilities, and inventory. We baseour estimates on historical experience and on various other assumptions thatare believed to be reasonable under the circumstances, the results of whichform the basis for making judgments about the carrying values of assets and liabilitiesthat are not readily apparent from other sources. To the extent that actualevents differ from our estimates and assumptions, there could be a materialimpact on our financial statements.

 

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

 

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

 

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

 

We maintain provisions for estimated contractual allowances forreimbursement amounts from our third party payor customers based on negotiatedcontracts and historical experience for non-contracted payors. We report theseallowances as reductions to our gross revenue. We estimate the amount of thereduction based on historical experience and invoices generated in the period,and we consider the impact of new contract terms or modifications of existingarrangements with our customers. We have contracts with certain third partypayors for our third party reimbursement billings, which call for specifiedreductions in reimbursement of billed amounts based upon contractualreimbursement rates. For the six months ended July 3, 2010 and June 27,2009, we reserved for and reduced gross revenues from third party payors by 32%and 31%, respectively, for estimated allowances related to these contractualreductions.

 

Our reserve for doubtful accounts is based upon estimated losses fromcustomers who are billed directly and the portion of third party reimbursementbillings that ultimately become the financial responsibility of the end userpatients. Direct-billed customers represented approximately 68% and 67% of ournet revenues for the six months ended July 3, 2010 and June 27, 2009,and approximately 66% and 44% of our net accounts receivable for the six monthsended July 3, 2010 and June 27, 2009, respectively. We experiencedwrite-offs of less than 1% of related net revenues for the six months endedJuly 3, 2010 and June 27, 2009, 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 Bracing and Supports and Recovery Sciences Segments. Our third-partypayor customers represented approximately 32% and 33% of our net revenues forthe six months ended July 3, 2010 and June 27, 2009, respectively,and approximately 34% and 56% of our net accounts receivable as of July 3,2010 and June 27, 2009, respectively. For each of the six months endedJuly 3, 2010 and June 27, 2009, we estimate bad debt expense to beapproximately 7% of gross revenues from these third party reimbursement customers.If the financial condition of our customers were to deteriorate resulting in animpairment of their ability to make payments or if third party payors were todeny claims for late filings, incomplete information or other reasons,additional provisions may be required. Additions to this reserve are reflectedas selling, general and administrative expense in our unaudited condensedconsolidated statements of operations.

 

Our reserve for rebates accounts for incentives that we offer tocertain of our distributors. These rebates generally are substantiallyattributable to sales volume, sales growth and to reimburse the distributor forcertain discounts. We record estimated reductions to revenue for customerrebate programs based upon historical experience and estimated revenue levels.

 

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

 

Our reserve for rental credit recognizes a timing difference betweenbilling for a sale and processing a rental credit associated with some of ourrehabilitation devices. Many insurance providers require patients to rent ourrehabilitation devices for a period of one to three months prior to purchase.If the patient has a long-term need for the device, these insurance companiesmay authorize purchase of the device after such time period. When the device ispurchased, most providers require that rental payments previously made on thedevice be credited toward the purchase price. These credits are processed atthe time the payment is received for the purchase of the device, which createsa time lag between billing for a sale and processing the rental credit. Ourrental credit reserve estimates unprocessed rental credits based on the numberof devices converted to purchase. The reserve is calculated by first assessingthe number of our products being rented during the relevant period and ourhistorical conversion rate of rentals to sales, and then reducing our grossrevenue by the applicable amount. The cost to refurbish rented products isexpensed as incurred as part of cost of sales in our unaudited condensedconsolidated statements of operations.

 

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***Inventory Reserves***

 

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

 

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

 

***Goodwill and Intangible Assets***

 

In accordance with ASC Topic 350 (formerly SFAS No. 142, “Goodwilland Other Intangible Assets”), we do not amortize goodwill. In lieu ofamortization, we are required to perform an annual review for impairment.Goodwill is recorded as the difference, if any, between the aggregateconsideration paid for an acquisition and the fair value of the net tangibleand intangible assets acquired. The amounts and useful lives assigned tointangible assets acquired, other than goodwill, impact the amount and timingof future amortization, and the amount assigned to in-process research anddevelopment which is expensed immediately. The value of our intangible assets,including goodwill, could be impacted by future adverse changes such as:(i) any future declines in our operating results, (ii) a furtherdecline in the valuation of comparable company stocks, (iii) a furthersignificant slowdown in the worldwide economy or our industry or (iv) anyfailure to meet the performance projections included in our forecasts of futureoperating results. We estimated the fair values of our reporting unitsprimarily using the income approach valuation methodology that includes thediscounted cash flow method, taking into consideration the market approach andcertain 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. Specifically, the income approachvaluations included reporting unit cash flow discount rates ranging from 10.5%to 12.6% and terminal value growth rates of 3%. Publicly available informationregarding the market capitalization of publicly traded peer companies was alsoconsidered in assessing the reasonableness of the cumulative fair values of ourreporting units 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 our goodwill on an annual basis inthe fourth quarter and in certain other circumstances when impairmentindicators are present. Our 2009 annual impairment test related to goodwill didnot indicate any impairment.

 

Furthermore, ASC Topic 350 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 thisanalysis include the selection of appropriate discount rates, estimating futurecash flows and the identification of appropriate terminal growth rateassumptions.  Discount rate assumptionsare based on an assessment of the risk inherent in the projected future cashgenerated by the respective intangible assets. Also subject to judgment are assumptions about royalty rates, which arebased on the estimated rates at which similar brands and trademarks are beinglicensed in the marketplace. Our 2009 annual impairment test related toindefinite lived intangible assets resulted in an aggregate impairment chargeof $7.0 million to two of our tradenames.

 

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***Deferred Tax Asset ValuationAllowance***

 

We recognize deferred tax assets and liabilities based on thedifferences between the financial statement carrying amount and the tax basesof assets, liabilities and net operating loss carryforwards (“NOL’s”). Weestablish valuation allowances when the recovery of a deferred tax asset is notlikely based on historical income, projected future income, the expected timingof the reversals of temporary differences and the implementation oftax-planning strategies.

 

Our gross deferred tax asset balance was approximately $193.8 millionat July 3, 2010 and primarily related to reserves for accounts receivableand inventory, accrued expenses, and NOL’s (see Note 10 to our unauditedcondensed consolidated financial statements). As of July 3, 2010, wemaintained a valuation allowance of $6.2 million due to uncertainties relatedto our ability to realize certain NOL’s acquired in connection with prior yearacquisitions.

 

**ITEM3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKETRISK**

 

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

 

***Interest Rate Risk***

 

Our primary exposure is to changing interest rates. We havehistorically managed our interest rate risk by balancing the amounts of ourfixed and variable debt. For our fixed rate debt, interest rate changes mayaffect the market value of the debt but do not impact our earnings or cashflow. Conversely, for our variable rate debt, interest rate changes generallydo not affect the fair market value of the debt but do impact future earningsand cash flow, assuming other factors are held constant. We are exposed tointerest rate risk as a result of our borrowings under our Senior SecuredCredit Facility, which bear interest at floating rates based on the LIBOR orthe prime rate of Credit Suisse. As of July 3, 2010, we had $935.4 millionof borrowings under our Senior Secured Credit Facility. On November 20,2007, we entered into an interest rate swap agreement related to the SeniorSecured Credit Facility for a notional amount of $515.0 million at a fixedLIBOR rate of 4.205% which expired on December 31, 2009. InFebruary 2009, we entered into two non-amortizing interest rate swapagreements. One was for a notional amount of $550.0 million at a fixed LIBORrate of 1.04% beginning in February 2009 which expired onDecember 31, 2009. The other agreement was for a notional amount of $750.0million at a fixed LIBOR rate of 1.88% beginning January 2010 amortizingthrough December 2010.  InAugust 2009, we entered into four non-amortizing interest rate swapagreements with notional amounts aggregating $300.0 million. Each of the fouragreements has a term beginning January 2011 through December 2011.The four agreements are at a weighted average fixed LIBOR rate of 2.5825%. Thefair value of our interest rate swap agreement recorded in the accompanyingcondensed consolidated balance sheets as of July 3, 2010 (unaudited) andDecember 31, 2009 was a liability of approximately $10.9 million and$11.2 million, respectively, and is recorded in other current andnon-current liabilities. A hypothetical 1% increase in variable interest ratesfor the remaining portion of the Senior Secured Credit Facility not covered bythe swaps would have impacted our earnings and cash flow, for the six monthsended July 3, 2010, by approximately $0.9 million. Our senior notes ofapproximately $875.0 million principal consisted of fixed rate notes atJuly 3, 2010. We may use additional derivative financial instruments whereappropriate to manage our interest rate risk. However, as a matter of policy,we do not enter into derivative or other financial investments for trading orspeculative purposes.

 

***Foreign Currency Risk***

 

Due to the global reach of our business, we are exposed to market riskfrom changes in foreign currency exchange rates, particularly with respect tothe U.S. dollar compared to the Euro and the Mexican Peso (“MXP”).  Our wholly owned foreign subsidiaries areconsolidated into our financial results and are subject to risks typical of aninternational business including, but not limited to, differing economicconditions, changes in political climate, differing tax structures, otherregulations and restrictions and foreign exchange volatility. To date, we havenot used international currency derivatives to hedge against our investment inour European subsidiaries or their operating results, which are converted intoU.S. Dollars at period-end and average foreign exchange rates,respectively.  However, as we continue toexpand our business through acquisitions and organic growth, the sales of ourproducts that are denominated in foreign currencies has increased, as well asthe costs associated with our foreign subsidiaries which operate in currenciesother than the U.S. dollar. Accordingly, our future results could be materiallyimpacted by changes in these or other factors. For the three

 

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andsix months ended July 3, 2010, sales denominated in foreign currenciesaccounted for approximately 22.2% and 22.5% of our consolidated net sales,respectively, of which 16.6% and 17.2% respectively, were denominated in theEuro.  In addition, our exposure tofluctuations in foreign currencies arises because certain of our subsidiariesenter into purchase or sale transactions using a currency other than its functionalcurrency. Our Mexico-based manufacturing operations incur costs that arelargely denominated in MXP.  Accordingly,our future results could be materially impacted by changes in foreign exchangerates or other factors.  Occasionally, weseek to reduce the potential impact of currency fluctuations on our businessthrough hedging transactions. At July 3, 2010, we had foreign exchangeforward contracts with an aggregate notional amount of MXP 228.0 million, orapproximately $17.1 million, and an aggregate fair market value ofapproximately $0.1 million.  Thesecontracts expire weekly throughout the fiscal year 2010.  For the three and six months ended July 3,2010 we recognized unrealized gains of approximately $0.1 million and $1.2million, respectively, and for the three and six months ended June 27,2009, we recognized unrealized losses of approximately $0.4 million and $3.4million, respectively, related to these contracts, which are included in otherincome (expense), net, in our unaudited condensed consolidated statements ofoperations.

 

**ITEM4.  CONTROLS AND PROCEDURES**

 

***Disclosure Controls and Procedures***

 

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

 

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

 

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

 

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

 

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

 

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**Part II.OTHER INFORMATION**

 

**ITEM1.  LEGAL PROCEEDINGS**

 

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

 

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

 

We are currently named asone of several defendants in approximately 100 product liability cases,including a lawsuit in Canada seeking class action status, related to adisposable drug infusion pump product manufactured by two third partymanufacturers that we distributed through our Bracing and Supports segment. Wediscontinued our sale of these products in the second quarter of 2009. Thesecases have been brought against the manufacturers and certain distributors ofthese pumps, and in some cases, the manufacturers of the anesthetics used inthese pumps. All of these lawsuits allege that the use of these pumps withcertain anesthetics in certain shoulder surgeries over prolonged periods haveresulted in cartilage damage to the plaintiffs. We have sought indemnity and tenderedthe defense of these cases to the two manufacturers who supplied these pumps tous, to their products liability carriers and to our products liabilitycarriers. Although both manufacturers have rejected our tenders of indemnity,we are in discussions with both to reach a resolution of the indemnity issue.The products liability carriers for both manufacturers have accepted coveragefor our defense of these claims.  Thebase policy for one of the manufacturers has been exhausted and the excessliability carriers for that manufacturer are not obligated to provide a defenseuntil a $5 million self-insured retention has been paid and our underlyinginsurance has been exhausted.  Ourproducts liability carrier has accepted coverage of these cases, subject to areservation of the right to deny coverage for customary matters, includingpunitive damages and off-label promotion. The lawsuits allege damages rangingfrom unspecified amounts to claims between $1.0 million and $10.0 million.These cases are in varying stages from initial pleading and discovery topre-trial preparation. We could be exposed to material liabilities if ourinsurance coverage is not available or inadequate and the resources of the twomanufacturers, including their respective products liability insurancepolicies, are unavailable or insufficient to pay the defense costs andsettlements or judgments in these cases.

 

On August 2, 2010, wewere served with a subpoena under the Health Insurance Portability andAccountability Act (“HIPAA”) seeking numerous documents related to ouractivities involving the infusion pumps discussed above. The subpoena which wasissued by the United States Attorney’s Office, Central District of California,refers to an official investigation of Federal health care offenses. We arereviewing the subpoena, but do not have any additional information regardingthe focus of the investigation. We believe that our actions related to ourprior distribution of these infusion pumps have been in compliance withapplicable legal standards. We can make no assurance as to the resources thatwill be needed to respond to the subpoena or the final outcome of anyinvestigation or further action.

 

We maintain product liability insurance that is subject to annualrenewal. Our current policy covers claims reported between July 1, 2010and June 30, 2011.  No carriers wereprepared to cover claims for this reporting period arising out of the pain pumpproduct described above and therefore our current policies exclude coverage forthose products.  For the current policyyear, we maintain coverage limits (together with excess policies) of up to $50million, with self-insured retentions of $500,000 per claim for claims relatingto the IceMan cold therapy unit, $500,000 per claim for claims relating toinvasive products, $75,000 per claim for claims relating to non-invasiveproducts other than the IceMan device, and an aggregate self-insured retentionof $2.25 million.  We purchasedsupplemental extended reporting period (“SERP”) coverage for our $80 millionlimit product liability program that expired on June 30, 2010, and thissupplemental coverage is limited to pain pump claims. Except for the additionalexcess coverage mentioned below, this SERP coverage does not provide additionallimits to the aggregate $80 million limit on the expiring program but doesprovide that the existing limits of the expiring program will remain availablefor claims reported for an extended period of time. Specifically, pain pumpclaims may be reported under the $10 million base policy for an indefiniteperiod of time and for a period of five years under the excess layers. We alsopurchased additional coverage of $25 million excess of $80 million with a fiveyear reporting period. Thus, the SERP coverage has a total limit of $105million (less amounts paid for claims reported under the expiring program).This coverage is subject to a self-insured retention of $500,000 per claim forclaims related to pain pumps, with an aggregate self-insured retention of $1.0million for all products liability claims under either the expiring program orthe SERP program. In addition, the layer of $25 million excess over $55 millionhas a separate self-insured retention of $50,000 per claim.  Our two products liability programs prior to theprogram that expired on June 30, 2010 cover claims reported betweenJuly 1, 2007 and February 15, 2008 and between February 15, 2008and July 1, 2009, respectively.  The2007-2008 policy provides for coverage (together with excess policies) of up toa limit of $20 million and the 2008-2009 policy provides for coverage (togetherwith excess policies) of up to a limit of $25 million.  Certain of the pain pump cases describedabove were reported under and are covered by these two policies as well as theexpiring program.

 

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If a products liability claim or series of claims is brought against usfor uninsured liabilities or in excess of our insurance coverage, our businesscould suffer materially. In addition, in certain instances, a productsliability claim could also result in our having to recall some of our products,which could result in significant costs to us. Our condensed consolidatedbalance sheets as of July 3, 2010 (unaudited) and December 31, 2009,include accrued liabilities of approximately $2.5 million and $2.0 million,respectively, for expenses related to products liability claims for productsother than our pain pump products.  Theamounts accrued are based upon previous claims experience in part due to thefact that in 2003 we exceeded the coverage limits in effect at that time forcertain historical product liability claims involving one of our discontinuedsurgical implant products and such products are excluded from coverage underour current policies. In addition, our unaudited condensed consolidated balancesheet as of July 3, 2010 includes accrued liabilities of $8.7 million forthe SERP for product claims related to our discontinued pain pump products.

 

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

 

**ITEM1A.  RISK FACTORS**

 

For a discussion of theCompany’s potential risks or uncertainties, please see Part I, Item IA,of the Company’s Annual Report on Form 10-K for the fiscal year endedDecember 31, 2009 filed with the Commission on March 5, 2010.  There have been no material changes to therisk factors disclosed in such Form 10-K.

 

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**ITEM6.  EXHIBITS**

 

(a)*                   **Exhibits*

 
| 3.1   |   | Certificate  of Formation of DJOFL and amendments thereto (incorporated by reference to  Exhibit 3.1 to DJOFL’s Annual Report on Form 10-K, filed on  March 5, 2009).                      |
|-------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.2   |   | Limited  Liability Company Agreement of DJOFL (incorporated by reference to  Exhibit 3.2 to DJOFL’s Registration Statement on Form S-4, filed  April 18, 2008 (File No. 333-142188)). |
| 31.1+ |   | Certification  (pursuant to Securities Exchange Act Rule 13a-14a) by Chief Executive  Officer.                                                                                                            |
| 31.2+ |   | Certification  (pursuant to Securities Exchange Act Rule 13a-14a) by Chief Financial  Officer.                                                                                                            |
| 32.1+ |   | Section 1350—Certification  (pursuant to Section 906 of the Sarbanes-Oxley Act of 2002) by Chief  Executive Officer.                                                                            |
| 32.2+ |   | Section 1350—Certification  (pursuant to Section 906 of the Sarbanes-Oxley Act of 2002) by Chief  Financial Officer.                                                                            |

 

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+          Filed herewith

 

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**SIGNATURES**

 

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

 
| ** **                 | ** ** | **DJO FINANCE LLC** |
|----------------------------|------------|--------------------------|
|                       |       |                     |   |
| Date:  August 6, 2010 |       | By:                      | /s/  LESLIE H. CROSS |
|                       |       |                     | Leslie  H. Cross*President and Chief Executive Officer* |
|                       |       |                     |   |
| Date:  August 6, 2010 |       | By:                      | /s/  VICKIE L. CAPPS |
|                       |       |                     | Vickie  L. Capps*Executive Vice President, Chief Financial  Officer and Treasurer* |

 

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