**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

** **

**FORM 10-K**

** **

**(Mark One)**

**ý****   ANNUALREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For thefiscal year ended December 31, 2004**

 

**or**

 

**o****   TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For thetransition period from               to               .**

 

**Commissionfile number 001-16757**

** **
| **DJ ORTHOPEDICS, INC.**                                                     |
|------------------------------------------------------------------------------|
| (Exact name of  Registrant as specified in its charter)                      |
|                                                                         |   |   |
| **Delaware**                                                                 | ** ** | **33-0978270** |
| (State or other  jurisdiction of  Incorporation or organization)             |   | (I.R.S. Employer  Identification Number) |
|                                                                         |   |   |
| **2985  Scott Street**                                                       | ** ** | ** ** |
| **Vista,  California**                                                       | ** ** | **92081** |
| (Address of principal  executive offices)                                    | ** ** | (Zip Code) |
| ** **                                                                   | ** ** | ** ** |
| Registrant’s telephone  number, including area code: **(800) 336-5690** |
| ** **                                                                   | ** ** | ** ** |
| **Securities  registered pursuant to Section 12(b) of the Act:**             |

 
| **Title  of Each Class**           | ** ** | **Name  of Each Exchange on  Which Registered** |
|------------------------------------|------------|-------------------------------------------------|
| **Common  Stock, $0.01 Par Value** | ** ** | **New  York Stock Exchange**                    |

 
| Securities registered pursuant  to Section 12(g) of the Act: |
|--------------------------------------------------------------|
| **None**                                                     |

 

**Indicate by check mark whether the Registrant (1)has filed all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports), and (2)has been subject to such filing requirements for the past 90 days.**

**Yes ****ý  No ****o**

 

**Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K is notcontained herein, and will not be contained, to the best of registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment to this Form 10-K. ****ý**

 

**Indicatedby check mark whether the Registrant is an accelerated filer (as defined inExchange Act Rule 12b-2).**

**Yes ****ý  No ****o**

 

**Theaggregate market value of all outstanding common equity held by non-affiliatesof the Registrant based on the closing price of common stock as reported on theNew York Stock Exchange on June 25, 2004 was $295,089,277.**

 

**Thenumber of shares of the Registrant’s common stock outstanding at February 25,2005 was 21,639,520 shares.**

 

**Documents Incorporated by Reference**

 

**Portionsof the Proxy Statement for the Registrant’s 2005 Annual Meeting of Stockholdersto be filed with the Commission on or before April 30, 2005 are incorporated byreference in Part III of this Annual Report on Form 10-K.  With the exception of those portions that arespecifically incorporated by reference in this Annual Report on Form 10-K, suchProxy Statement shall not be deemed filed as part of this Report orincorporated by reference herein.**

 

 

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**DJORTHOPEDICS, INC.**

**FORM10-K**

**TABLE OFCONTENTS**

 
| PART I     |
|------------|
| Item 1.    | Business |   |
| Item 2.    | Properties |   |
| Item 3.    | Legal Proceedings |   |
| Item  4.   | Submission  of Matters to a Vote of Security Holders |   |
|       | Executive Officers of the Registrant |   |
|       |   |   |
| PART II    |
| Item  5.   | Market  for the Registrant’s Common Equity, Related Stockholder Matters and Issuer  Purchases of Equity Securities |   |
| Item 6.    | Selected Financial  Data |   |
| Item  7.   | Management’s  Discussion and Analysis of Financial Condition and Results of Operations |   |
| Item 7A.   | Quantitative and Qualitative Disclosures About  Market Risk |   |
| Item 8.    | Financial Statements and Supplementary Data |   |
| Item  9.   | Changes  in and Disagreements with Accountants on Accounting and Financial Disclosure |   |
| Item 9A.   | Controls and  Procedures |   |
| Item 9B.   | Other Information |   |
|       |   |   |
| PART  III  |
| Item  10.  | Directors  and Executive Officers of the Registrant |   |
| Item 11.   | Executive Compensation |   |
| Item  12.  | Security  Ownership of Certain Beneficial Owners and Management |   |
| Item  13.  | Certain  Relationships and Related Transactions |   |
| Item  14.  | Principal  Accountant Fees and Services |   |
|       |   |   |
| PART IV    |
| Item  15.  | Exhibits,  Financial Statement Schedules |   |
|       |   |   |
| SIGNATURES |   |

 

***ExplanatoryNotes***

 

Unless the context requires otherwise, in this annualreport the terms “we,” “us” and “our” refer to dj Orthopedics, Inc., djOrthopedics, LLC, a wholly-owned subsidiary of dj Orthopedics, Inc., and ourother wholly-owned and indirect subsidiaries. When we refer to “we,” “us” and “our” for dates prior to November 20,2001, the date of our reorganization, the terms are meant to refer to ourpredecessor, DonJoy, L.L.C.  In November2003, we acquired the bone growth stimulation device business of OrthoLogicCorp. We refer to this business as our “Regeneration” business, formerly knownas our Regentek business, the acquisition as the “Regeneration acquisition” andthe products we acquired as our bone growth stimulation (BGS) products.  In this annual report, pro forma revenue datafor the year ended December 31, 2003 give effect to the Regenerationacquisition as if it had occurred on January 1, 2003.

 

This annual report includes market share and industrydata and forecasts that we obtained from industry publications and surveys,primarily by Frost & Sullivan, and internal company surveys. Frost &Sullivan was commissioned by us to provide certain industry and market data.Industry publications, surveys and forecasts generally state that theinformation contained therein has been obtained from sources believed to bereliable, but there can be no assurance as to the accuracy or completeness ofincluded information. We have not independently verified any of the data fromthird-party sources nor have we ascertained the underlying economic assumptionsrelied upon therein. While we are not aware of any misstatements regarding theindustry and market data presented herein, such data involve risks anduncertainties and are subject to change based on various factors, includingthose discussed under the heading “Risk Factors” in this annual report.

 

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***Noteon Forward-Looking Information***

 

This annual report on Form 10-K contains, in additionto historical information, statements by us with respect to our expectationsregarding future financial results and other aspects of our business thatinvolve risks and uncertainties and may constitute forward-looking statementswithin the meaning of Section 27A of the Securities Act andSection 21E of the Exchange Act. These statements reflect our current views and are based on certain assumptions.Actual results could differ materially from those currently anticipated as aresult of a number of factors, including, in particular, risks anduncertainties associated with the Regeneration business, the growth of the bonegrowth stimulation market and other material risks discussed under the heading “RiskFactors” in this annual report.  If theexpectations or assumptions underlying our forward-looking statements proveinaccurate or if risks or uncertainties arise, actual results could differ materiallyfrom those predicted in any forward-looking statement.

 

**Part I**

 

**Item 1. Business**

 

**Overview**

 

We are a global medical device company specializing inrehabilitation and regeneration products for the non-operative orthopedic andspine markets.  We believe that we have aleading market share in the non-operative orthopedic and spine markets that wetarget.  From 2003 to 2004, our pro formacombined revenues grew 6.5% to $256.0 million.

 

Our broad range of over 600 rehabilitation products,including rigid knee braces, soft goods and pain management products, are usedto prevent injury, to treat chronic conditions and to aid in recovery aftersurgery or injury.  Our regenerationproducts consist of bone growth stimulation devices that are used to treat nonunionfractures and as an adjunct therapy after spinal fusion surgery.

 

We sell our products in the United States and in morethan 40 other countries through networks of agents, distributors and our directsales force that market our products to orthopedic and spine surgeons,podiatrists, orthopedic and prosthetic centers, third-party distributors,hospitals, surgery centers, physical therapists, athletic trainers and otherhealthcare professionals.  We believethat we have one of the largest distribution networks for non-operativeorthopedic products.  We believe thatthis distribution network, along with our recognized brand name, reputation forquality, innovation and customer service, and our strong relationships withorthopedic professionals have contributed to our leading market position.

 

We were incorporated in Delaware in August 2001.  We are the successor to DonJoy, Inc., abusiness started in 1978 in Carlsbad, California.  In 1987, DonJoy was acquired by Smith &Nephew, Inc. and on June 30, 1999, DonJoy consummated a recapitalizationpursuant to which J.P. Morgan DJ Partners, LLC obtained a controlling interestin DonJoy from Smith & Nephew. Concurrently with the completion of our initial public offering onNovember 20, 2001, DonJoy merged with us through a series of transactions.  Our headquarters are located at 2985 ScottStreet, Vista, California 92081.  Ourtelephone number is (800) 336-5690.  Ourwebsite address is *www.djortho.com*.

 

We file annual reports, such as this Form 10-K, aswell as quarterly reports on Form 10-Q and current reports on Form    8-K, with the U.S. Securities and ExchangeCommission (SEC).  We make these reportsavailable free of charge on our website under the investor relations page.  These reports can be accessed the same daythey are filed with the SEC.  All suchreports were made available in this fashion during 2004.

 

4TITUDE®, Defiance®, dj Ortho®,DonJoy®, FourcePointTM, IceMan®, OfficeCare®,ProCare®, SpinaLogic®, UltraSling®, LegendTM,UltraSling ERTM, Knee GuaranteeTM, OL1000TM,OL1000 SCTM, and DonJoy Pain Control DeviceTM arecertain of our registered trademarks and trademarks for which we haveapplications pending or common law rights. All other brand names, trademarks and service marks appearing in thisannual report are the property of their respective holders.

 

**Common Stock Offering and Redemption of Notes**

 

On February 24, 2004, we completed an offering of8,625,000 shares of our common stock, of which 3,162,500 shares of common stockwere sold by us at $19.00 per share for net proceeds, after underwriters’commissions and other costs, of $56.5 million. In June 2004, we used the proceeds of the offering, along with cash onhand, to redeem all of our $75 million of outstanding senior subordinated notespursuant to the terms of the indenture governing the notes. We redeemed all ofthe outstanding notes for $79.7 million, including a redemption premium of $4.7million. As a result of the redemption, we recorded a charge of $7.8 million in2004, including the redemption premium and unamortized debt issuance costs andoriginal issue discounts.

 

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**Integration ofRegeneration Business**

** **

Following theRegeneration acquisition in November 2003, we operated the Regeneration businessas a stand alone division in Tempe, Arizona with a sales force separate fromour domestic rehabilitation product sales force.  In August 2004, we began the integration ofthe former Regeneration sales force into our domestic rehabilitation sales organization,and we took the first steps towards integrating most of the other Regenerationoperations into our corporate facility in Vista, California. By the end of2004, we completed the integration of most of the Regeneration operationsexcept for the assembly and calibration operations which we expect to move toVista in the first quarter of 2005 following site approval of the U.S. Food andDrug Administration. One of the principal objectives of the integration is toenhance the sales and distribution activities of the Regeneration business tocapture additional growth opportunities in the regeneration market.  In addition, we believe the integration willenable us to reduce both costs of goods sold and operating expenses as apercentage of net revenues in future periods, after the related costs of theintegration have been incurred.  The accompanyingconsolidated statement of operations for the year ended December 31, 2004include restructuring charges of approximately $3.8 million ($2.4 million netof tax), related to the Regeneration integration. The costs of the integrationwere primarily severance, recruiting and training.

 

**Our Strategy**

 

Our strategy is toincrease revenue and profitability and enhance cash flow by strengthening ourmarket leadership position.  Our keyinitiatives to implement this strategy include:

 

•                  *Grow Our Regeneration Business.* We haveintegrated the sales force for our OL1000 Regeneration product into ourdomestic rehabilitation sales organization, which will provide an increasednumber of BGS specialists who we believe will be able to use the establishedrelationships of our DonJoy sales representatives to enhance sales of theOL1000 product.  We have alsorestructured our distribution arrangement with DePuy Spine to permit us to sellthe SpinaLogic product directly or through other independent salesrepresentatives in those geographical parts of the country where sales are notmeeting our expectations.  We believethat this focus on Regeneration products will drive faster growth for thisbusiness.

 

•                  *Further Penetrate Our Existing Customer Base.*  We are focused on increasing the number andvariety of products sold to our existing customers.  We believe that our OfficeCare programprovides us with a strong platform for selling additional products to ourexisting customers because of the amount of contact our sales representativeshave with the orthopedic practices who participate in the program.  We also believe that the addition of the BGSproducts to our existing product lines will further this goal by providingsignificant cross-selling opportunities.

 

•                  *Continue to Introduce NewProducts and Product Enhancements.*  We have a history of developingand introducing innovative products into the marketplace, and are committed tocontinuing that tradition by introducing new products across our productplatform.  In the year ended December 31,2004, we launched 25 new products.  Webelieve that product innovation through effective and focused research anddevelopment will provide a sustainable competitive advantage.  We believe we are currently a technologyleader in several product categories and we intend to continue to develop nextgeneration technologies.

 

•                  *Expand Our OfficeCare Channel.*  OurOfficeCare channel currently includes over 650 physician offices encompassingover 2,500 physicians.  We believe thatour OfficeCare channel serves a growing need among orthopedic practices to havea number of products readily available for immediate distribution to patientsand represents an opportunity for sales growth. We intend to expand our OfficeCare channel into more “high-volume”orthopedic offices, thereby increasing the number of potential customers towhom we sell our products.  In the yearended December 31, 2004, we added approximately 100 net new offices to ourOfficeCare channel.

 

•                  *Maximize Existing and SecureAdditional National Accounts.*  We plan to capitalize on the growing practicein healthcare in which hospitals and other large healthcare providers seek toconsolidate their purchasing activities to national buying groups.  Contracts with these national accountsrepresent a significant opportunity for sales growth. We believe that our broadrange of products are well suited to the goals of these buying groups andintend to aggressively pursue these contracts.

 

•                  *Expand Product Offerings for theSpine*.  Our SpinaLogic product is used as an adjuncttherapy following spinal fusion surgery. SpinaLogic was our first product thattargeted the spine market.  According toFrost & Sullivan, back pain is the number one cause of healthcareexpenditure in the United States.  As aresult, we believe that expanding our product offerings in this marketrepresents a significant growth opportunity. In 2004, we launched a new

 

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compression back brace to address the spinemarket.

 

•                  *Pursue Selective StrategicAcquisitions.* We believe thatstrategic acquisitions represent an attractive and efficient means to broadenour product lines and increase our revenue. The BGS products acquired in theRegeneration acquisition, for example, which generated revenues of$49.7 million during the twelve months ended December 31, 2004, enabled usto enter the regeneration market, which is predicted to grow faster than therehabilitation market. We intend to pursue acquisition opportunities thatenhance sales growth, are accretive to earnings, increase customer penetrationand/or provide geographic diversity.  Inparticular, we intend to focus on international opportunities that will opennew markets or offer new products.

 

•                  *Expand International Sales*. International sales have historically represented less than 15% of ourrevenues. Although our presence outside the United States has been limited, wehave successfully established direct distribution capabilities in majorinternational markets.  On August30, 2004, we acquired the outstanding stock of KD Innovation A/S, ourindependent distributor in Denmark. The acquired company, renamed djOrthopedics Nordic ApS, has direct responsibility for sales, marketing anddistribution of our products in Denmark, Finland, Norway and Sweden.  Webelieve that sales to foreign markets continue to represent a significantgrowth opportunity and we intend to continue to develop direct distributioncapabilities in selected foreign markets.

 

•                  *Expand Low Cost Manufacturing Capabilities*. We plan tocontinue to expand our low cost manufacturing capabilities in Mexico to reduceour costs of goods sold and improve our gross margins. At the end of 2002 wemoved the manufacturing of our off-the-shelf rigid knee braces and theremaining manufacturing of our soft goods products from Vista, California toTijuana, Mexico, resulting in a significant reduction in our costs of goodssold. This improved our gross margins beginning in 2003. In August 2004, wecompleted construction of a new 200,000 square foot leased facility in Tijuana,Mexico, to replace three separate facilities we operated in the same area andto provide further opportunities to expand our Mexico manufacturingoperations.  As of October 2004, all ofour existing Mexico facilities had been moved to this new facility.  In the fourth quarter of 2004, we completedthe relocation of the manufacturing of our cold therapy products and machine shopactivities from Vista, California to the new Mexico plant.  We recorded restructuring charges of $0.9million ($0.5 million net of tax) in 2004 related to these manufacturing moves,including primarily severance and moving costs. We also intend to use ourexpanded Mexico facilities in the future to vertically integrate themanufacturing of certain components we purchase and further reduce our costs ofgoods sold.

 

**Rehabilitation Products**

** **

*Rigid Knee Bracing*

 

We design, manufacture and market a broad range ofrigid knee braces, including ligament braces, which are designed to providesupport for knee ligament instabilities, post-operative braces, which aredesigned to provide both knee immobilization and a protected range of motion,and osteoarthritic braces, which are designed to provide relief of knee paindue to osteoarthritis. These products are generally prescribed to a patient byan orthopedic physician or provided by athletic trainers for use in preventinginjury. Our rigid knee braces are either customized braces, utilizing basicframes which are then custom-manufactured to fit a patient’s particularmeasurements, or are standard braces which are available “off-the-shelf” invarious sizes and can be easily adjusted to fit the patient in the orthopedicprofessional’s office.  Sales of rigidknee braces represented approximately 32% of our revenues for 2004.

 

*Ligament Braces.*Ligament bracesare designed to provide durable support for moderate to severe knee ligamentinstabilities to help patients regain range of motion capability so they cansuccessfully complete rehabilitation and resume daily activities after kneesurgery or injury. Ligament braces are generally prescribed six to eight weeksafter knee surgery, often after use of a more restrictive post-operative brace.Our ligament braces can also be used to support the normal functioning of theknee to prevent injury. Our ligament bracing product line includes customizedbraces generally designed for strenuous athletic activity and off-the-shelf bracesgenerally designed for use in less rigorous activity.  In 2001, we introduced the Knee Guaranteeprogram in connection with our Defiance ligament brace. The Knee Guaranteeprogram will, in specified instances, cover a patient’s insurance deductible upto $1,000, or give uninsured patients $1,000 towards surgery, should an ACLre-injury occur while wearing the Defiance ligament brace. We believe that weare the only orthopedic company in the United States that provides such aguarantee.  Since we introduced thisguarantee, claims under the program have been minimal.

 

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*Post-operativeBraces.*Post-operative braces are designed to limit apatient’s range of motion after knee surgery and protect the repaired ligamentsand/or joints from stress and strain that would slow or prevent a healthyhealing process. The products within this line provide both immobilization anda protected range of motion, depending on the rehabilitation protocolprescribed by the orthopedic surgeon. Our post-operative bracing product lineincludes a range of premium to lower priced off-the-shelf braces and accessoryproducts.

 

*OsteoarthriticBraces.*Osteoarthritic braces are used to treatpatients suffering from osteoarthritis of the knee. Our line of customized andoff-the-shelf osteoarthritic braces is designed to redistribute weight throughthe knee, providing additional stability and reducing pain, and in some casesmay serve as a cost-efficient alternative to total knee replacement.  Frost & Sullivan estimates that sales ofosteoarthritic braces are expected to grow at a 12.9% annual rate between 2002and 2006.

 

*SoftGoods*

 

Our soft goods product line originally consisted ofsimple neoprene braces for the knee, thigh, elbow and ankle.  We now have over 550 soft goods products thatoffer immobilization and support from head to toe.  Our soft goods products representedapproximately 41% of our revenues for 2004.

 

*Soft Bracing. *These products are generally constructed from fabricor neoprene materials and are designed to provide support, immobilizationand/or heat retention and compression of the knee, ankle, back and upperextremities, including the shoulder, elbow, neck and wrist.  We currently offer products ranging fromsimple neoprene knee sleeves to more advanced products that incorporatematerials and features such as air-inflated cushions and metal alloy hingecomponents.

 

*Lower ExtremityFracture Boots.*These products are boots that fit on apatient’s foot and provide comfort and stability for ankle and foot injuriesranging from ankle sprains, soft tissue injuries and stress fractures in thelower leg to stable fractures of the ankle. Fracture boots are used as an alternative to traditional casts. We alsosell a line of fracture boots designed for patients suffering frompre-ulcerative and ulcerative foot conditions, primarily related tocomplications from diabetes.

 

*Shoulder and ElbowBraces.*We offer a line of shoulder and elbow bracesand slings, which are designed for immobilization after surgery and allow forcontrolled motion. For example, the UltraSling is a durable oversized sling,which offers immobilization and support for mild shoulder sprains and strains.We recently introduced the UltraSling ER that externally rotates the injuredshoulder for improved healing of certain conditions.

 

*Pain ManagementProducts*

 

Our portfolio of pain management products includescold therapy products to assist in the reduction of pain and swelling and asystem that employs ambulatory infusion pumps for the delivery of localanesthetic to a surgical site.  Our painmanagement products accounted for approximately 8% of our revenues for 2004.

 

*Cold TherapyProducts.**Cold therapyproducts*are designed to *help reduce swelling, minimize the need for post-operative painmedications and generally accelerate the rehabilitation process. *We manufacture, market andsell the IceMan****device, as well as other coldtherapy products such as ice packs and wraps. The IceMan product is a portabledevice used after surgery or injury.  Theproduct consists of a durable quiet pump and control system used to circulatecold water from a reservoir to a pad designed to fit the injured area, such asthe ankle, knee or shoulder. The IceMan product uses a patented circulationsystem to provide constant fluid flow rates, thereby minimizing temperaturefluctuations. We also offer a manual cold therapy product that involves asimple, gravity based means of applying cold therapy.

 

*AmbulatoryInfusion Pumps.**Ambulatory infusion pumps*are designed to provide acontinuous infusion of local anesthetic dispensed by a physician directly intoa surgical site following surgical procedures. We are the exclusive North American distributor of a pain managementsystem manufactured by McKinley Medical, LLLP called the DonJoy Pain ControlDevice.  This portable device consists ofa range of introducer needles, catheters for easy insertion and connectionduring surgery and pumps for continuous infusion for up to 72 hours. The paincontrol systems are intended to provide direct pain relief, reduce hospitalstays and allow earlier and greater ambulation. Our exclusive distributionrights for this product continue until 2007 and may be extended thereafter.

 

**RegenerationProducts**

 

BGS devices are designed to promote the healing ofmusculoskeletal bone and tissue through electromagnetic field technology.  The BGS products we offer utilize proprietarycombined magnetic field technology to deliver a highly specific, low-energysignal. The OL1000 product is used for the non-invasive treatment of anestablished nonunion fracture, which are fractures that do not show signs ofhealing within 90 days.  Approximately3-5% of fractures become nonunion.  TheSpinaLogic product is

 

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used as an adjunct therapy after primary lumbar spinal fusion surgeryfor at-risk patients.  Patients areconsidered at-risk when the natural healing process of the bone may becompromised by other health conditions of the patient, such as diabetes,smoking habits, weight, age and the severity and location of the fracture.  Our BGS products accounted for approximately19% of our revenues for 2004.

 

Patients using BGS devices generally receive aprescription for the product from their physician.  After insurance approval, the patientreceives the device and starts therapy, typically at home.  The patient is usually instructed to wear ourbone growth stimulators for only 30 minutes each day, a significantly shorterperiod than most competing products, which may require up to 24 hours of dailytherapy.  We believe the reducedtreatment time leads to increased patient compliance with treatmentprotocol.  The length of therapy with ourproducts varies, but usually is between 25 and 40 weeks.

 

In 2003, the Technology You Can Trust program wasintroduced in connection with our BGS products. If a patient has a nonunionfracture that fails to heal while using a BGS product, the Technology You CanTrust program will, if the patient meets the specified requirements of theprogram, refund the costs for treatment using the BGS product.

 

*OL1000.  *The OL1000product is a FDA approved device that comprises two magnetic field treatmenttransducers, or coils, and a microprocessor-controlled signal generator thatdelivers a highly specific, low-energy signal to the injured area.  This signal is designed to stimulate bonegrowth and healing.  This unique systemhas a micro-controller that tracks the patient’s daily treatmentcompliance.  The OL1000 is used for thenon-invasive treatment of an established nonunion fracture in all major longbones, such as the tibia, femur and humerus.

 

The OL1000 device is designed to be attached to thepatient’s arm, leg or other area where there is a nonunion fracture.  The OL1000 is designed to evenly distribute amagnetic field over the patient’s injured area. Because of the even distribution of the fields, specific placement ofthe device over the nonunion fracture is not as critical for product efficacyas it is for some competing products.

 

The OL1000 SC product is a FDA approved single coildevice, which utilizes the same combined magnetic field as the OL1000.  This product is available in three sizes andis designed to be more comfortable for patients with certain types offractures, such as clavicle and hip fractures, where only a single coil can beapplied.

 

*SpinaLogic*.  The SpinaLogic product is a FDA approved,portable, non-invasive, electromagnetic bone growth stimulator that is designedto enhance the healing process as an adjunct therapy after spinal fusionsurgery. With the SpinaLogic product, the patient attaches the device to thelumbar injury location where it is designed to provide localized magnetic fieldtreatment to the fusion site.  Similar tothe OL1000 product, the SpinaLogic device contains a micro-controller thattracks the patient’s daily treatment compliance and can be checked by thesurgeon during follow-up visits.

 

**Sales, Marketing andDistribution**

** **

We distribute our products through four sales channels:DonJoy, ProCare, OfficeCare and International. Our products are distributed in the United States and internationalmarkets primarily through networks of agents and distributors.  These agents and distributors sell toorthopedic and spine surgeons, podiatrists, orthopedic and prosthetic centers,third-party distributors, hospitals, surgery centers, physical therapists,athletic trainers and other healthcare professionals.  Our DonJoy, ProCare and OfficeCare channelsare managed by five regional general managers who are responsible for managingthe sale of all of our products across these channels, one general manager whois responsible for managing the sale of our Regeneration products in the U.S.and one vice president who is responsible for managing the sale of our ProCareproducts in the U.S.  In addition, ourSpinaLogic product is marketed in the U.S. by Johnson & Johnson’s DePuySpine on an exclusive basis in certain regions of the country and anon-exclusive basis elsewhere.  Ourinternational channel consists of sales by our wholly-owned foreignsubsidiaries and foreign independent distributors.  For the year ended December 31, 2004, nosingle customer represented more than 10% of our revenues.

 

*DonJoy*

 

The DonJoy sales channel,which is responsible for sales of rigid knee braces, pain management products,Regeneration products (effective August 2004) and certain soft goods, accountedfor approximately 58% of our revenues for 2004 (39% DonJoy segment and 19%Regeneration segment). The channel consists of approximately 300 independentcommissioned sales representatives who are employed by approximately 40independent sales agents and a few of our direct sales representatives andapproximately 100 sales representatives dedicated to selling our OL1000 product,of which approximately 43 are employed by us. The DonJoy channel is primarilydedicated to the sale of our products to orthopedic surgeons, podiatrists,orthopedic and prosthetic centers, hospitals, surgery centers, physicaltherapists, athletic trainers and other healthcare professionals.  Because the DonJoy product lines generallyrequire customer education on the application and use of the product, our salesrepresentatives are technical specialists who receive extensive training bothfrom us and the agent and use their

 

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expertise to help fit the patient with the product and assist theorthopedic professional in choosing the appropriate product to meet the patient’sneeds.

 

The SpinaLogic product was,until the end of 2004, sold by DePuy Spine in the U.S. under an exclusive salesagreement, which can be unilaterally terminated by DePuy Spine with four monthsnotice and expires by its terms in 2010. The agreement requires DePuy Spine to meet annual sales minimums inorder to maintain exclusivity.  InJanuary 2005, we amended the agreement with DePuy Spine to divide the U.S. intoterritories in which DePuy Spine has exclusive sales rights and non-exclusiveterritories in which we intend to engage in our own sales efforts or retainanother sales agent. Following this amendment, the annual sales minimums applyonly with respect to the exclusive territories.

 

After a salesrepresentative receives a product order, we generally ship and bill the productdirectly to the orthopedic professional, paying a sales commission to theagent. For most BGS products and certain custom rigid braces, we sell directlyto the patient and bill a third-party payor, if applicable, on behalf of thepatient.  We enjoy long-standingrelationships with most of most of our agents and sales representatives. Underthe arrangements with the agents, each agent is granted an exclusive geographicterritory for sales of our products and is not permitted to market products, orrepresent competitors who sell or distribute products, that compete with ourexisting products. The agents receive a commission, which varies based on thetype of product being sold. If an agent fails to achieve specified salesquotas, we may terminate the agent.

 

*ProCare*

 

The ProCare channelemploys approximately 36 direct and independent representatives that manageover 310 dealers focused on primary and acute facilities.  This channel accounted for approximately 20%of our revenues for 2004.  Products inthis channel consist primarily of our soft goods line, which are generally soldin non-exclusive territories to third-party distributors. These distributorsinclude large, national third-party distributors such as Owens & MinorInc., McKesson/HBOC, Allegiance Healthcare and Physican Sales and Service Inc.,regional medical surgical dealers, and medical products buying groups thatconsist of a number of dealers who make purchases through the buyinggroup.  These distributors generallyresell the products to large hospital chains, hospital buying groups, primarycare networks and orthopedic physicians for use by the patients. Unlike rigidknee bracing products, our soft goods products generally do not requiresignificant customer education for their use.

 

In response to theemergence of managed care and the formation of buying groups, nationalpurchasing contracts and various bidding procedures imposed by hospitals andbuying groups, we have entered into national contracts primarily for the saleof soft goods products, but often also covering our other product categories,with large healthcare providers and buying groups, such as AmeriNet Inc., USGovernment/Military hospitals, National Purchasing Alliance, Magnet, ManagedHealthcare Associates, Inc., Broadlane and Premier. Under these contracts, weprovide favorable pricing to the buying group and, as a result, are generallydesignated a preferred purchasing source for the members of the buying groupfor specified products.  Members,however, are not obligated to purchase our products. We are also a supplier forHealthTrust Purchasing Group, Magnet, Managed Healthcare Associates, Inc. andNovation.  As part of our strategy, weseek to secure additional national contracts with other healthcare providersand buying groups in the future.

 

*OfficeCare*

 

Through OfficeCare, wemaintain an inventory of product (mostly soft goods) on hand at orthopedicpractices for immediate distribution to the patient.  For these products, we arrange billing to thepatient or third-party payor after the product is provided to the patient. Asof December 31, 2004, the OfficeCare program was located at over 650 physicianoffices throughout the United States.  Wehave contracts with over 500 third-party payors for our OfficeCare products.The OfficeCare sales channel accounted for approximately 11% of our revenuesfor 2004.

 

We currently outsourcemost of the revenue cycle portion of this program, from billing to collecting,to an independent third-party contractor. As a result of the growth of this program,our working capital needs have increased due to higher levels of accountsreceivable and inventories necessary to operate the program. The collectionperiod for these receivables as compared to other portions of our business issignificantly longer.

 

*International*

 

We market our products inover 40 countries outside the United States, primarily countries in Europe aswell as in Australia, Canada and Japan. International sales are currently madethrough two distinct channels: independent third-party distributors and throughwholly-owned foreign subsidiaries in Germany and the United Kingdom (in eachcase since January 1, 2002), Canada (since May 2002), France (since October2003) and Denmark (since August 2004). The International sales channel accountedfor approximately 11% of our revenues for 2004.

 

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We believe that futureopportunities for sales growth within international markets aresignificant.  To this end, we establisheddirect distributorship subsidiaries in foreign countries in each of the lastthree years.  These wholly-ownedsubsidiaries have enabled us to obtain higher gross margins on our productsthan we would have obtained on sales through third-party distributors.  In addition, we believe that more directcontrol of the distribution network in these countries will allow us toaccelerate the launch of new products and product enhancements.

 

**Manufacturing**

** **

Nearly all of ourrehabilitation products are manufactured in Tijuana, Mexico.  In August 2004, we completed construction ofa new 200,000 square foot leased facility in Tijuana, Mexico, to replace threeseparate facilities we operated in the same area and to provide furtheropportunities to expand our Mexico manufacturing operations.  As of October 2004, all of our existingMexico operations had been moved to this new facility.  In the fourth quarter of 2004, we completedthe relocation of the manufacturing of our cold therapy products and machineshop activities from Vista, California to the new Mexico plant.  Our only products that are still manufacturedin Vista, California consist of our custom rigid knee bracing products, whichremain in the U.S. primarily to facilitate quick turn-around on custom orders.  Assembly and calibration of our Regenerationproduct lines is currently being performed in Tempe, Arizona but will be movedto our Vista facility as the final step of the Regeneration integration.  That move is expected to be completed inearly 2005 after FDA site approval of our Vista facility is received.  Within our Vista and Tijuana facilities, weoperate a vertically integrated manufacturing and cleanroom packaging operationand are capable of producing a majority of our subassemblies and componentsin-house. These include metal stamped parts, injection molding components andfabric-strapping materials. We also have extensive in-house tool and diefabrication capabilities, which provide savings in the development of typicallyexpensive tools and molds as well as flexibility to respond to and capitalizeon market opportunities as they are identified.

 

Our Vista, California facility has achieved ISO 9001certification, EN46001 certification and certification to the Canadian MedicalDevice Regulation (ISO 13485) and the European Medical Device Directive.Our Tijuana, Mexico facility has achieved ISO 9001 and ISO 13485 certification.These certifications are internationally recognized quality standards formanufacturing and assist us in marketing our products in certain foreignmarkets.

 

Most of the raw materials that we use in themanufacture of our products are available from more than one source and aregenerally readily available on the open market. We source some of our finishedproducts from manufacturers in China as well as other third-partymanufacturers.

 

**Research and Development**

** **

Our internal research and development program is aimedat developing and enhancing products, processes and technologies.  The research and development activities forour rehabilitation products are conducted in our Vista, California facility bya group of product engineers and designers who have substantial experience indeveloping and designing products using advanced technologies, processes andmaterials. The research and development team uses computational tools andcomputer aided design, or CAD, systems during the development process thatallow a design to be directly produced on computer-based fabrication equipment,reducing both production time and costs. Our current research and developmentactivities are focused on using new materials, innovative designs and state ofthe art manufacturing processes to develop new products and to enhance ourexisting products.

 

We have developed and maintain close relationshipswith a number of widely recognized orthopedic surgeons and professionals whoassist in product research, development and marketing. These professionalsoften become product proponents, speaking about our products at medicalseminars, assisting in the training of other professionals in the use andfitting of our products and providing us with feedback on the industry’sacceptance of our new products.  Some ofthese surgeons and specialists who participate in the design of products orprovide consulting services have contractual relationships with us under whichthey receive royalty payments or consultant fees in connection with thedevelopment of particular products with which they have been involved. Ourmedical advisory board, consisting of five orthopedic surgeons, also assists inour product development by advising us on technological advances inorthopedics, along with competitive and reimbursement updates within theorthopedic industry.

 

We maintain a clinical education research laboratoryin our Vista, California facility, which is used by orthopedic surgeons toevaluate soft tissue repair products in a simulated surgical setting andpractice surgical technique. These surgeons often provide us with feedback,which assists us in the development and enhancement of our products. Inaddition, we utilize our biomechanical laboratory in our Vista, Californiafacility to test the effectiveness of our products. U.S. based andinternational surgeons and researchers collaborate with our research staff toperform biomechanical testing. The tests are designed to demonstrate thefunctionality of new products and the effectiveness of new surgicalprocedures.  Mechanical models are usedto simulate behavior of normal, injured and osteoarthritic knees and observethe performance of new product designs as well as

 

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competitive products. We host numerous orthopedic professionals at ourbiomechanical and surgical technique laboratories, which allows theprofessionals to practice procedures and measure the effectiveness of thoseprocedures.

 

In addition to our internal research and developmentefforts, we have entered into a number of technology licensing arrangementswith third-parties that provide us innovative technologies and processes forthe manufacture and development of our products.  Finally, we act as the distributor of anumber of products that are manufactured by others.

 

**Competition**

** **

The non-operative orthopedic and spine markets arehighly competitive and fragmented. Our competitors include several large, diversifiedorthopedic companies and numerous smaller niche companies. Some of ourcompetitors are part of corporate groups that have significantly greaterfinancial, marketing and other resources than we do. Our primary competitors inthe rigid knee bracing market include companies such as Orthofix International,N.V., Bledsoe Brace Systems, Innovation Sports Incorporated, Generation II USA,Inc. and Townsend Industries Inc. In the soft goods products market, ourcompetitors include Aircast Inc., Biomet, Inc., DeRoyal Industries, EncoreMedical Corporation, Royce Medical Co. and Zimmer Holdings, Inc.  In the pain management products market, ourcompetitors include Aircast, I-Flow Corp., Orthofix and StrykerCorporation.  In the bone growthstimulation market, our competitors include Orthofix, Biomet and Smith &Nephew. Several competitors have initiated stock and bill programs similar toour OfficeCare program.

 

Competition in the rigid knee brace market isprimarily based on product technology, quality and reputation, relationshipswith customers, service and price. Competition in the soft goods market is lessdependent on innovation and technology and is primarily based on product range,quality, service and price. Competition in bone growth stimulation devices ismore limited as higher regulatory thresholds provide a barrier to marketentry.  International competition isprimarily from foreign manufacturers whose costs may be lower due to theirability to manufacture products within their respective countries.

 

We believe that our extensive product lines, advancedproduct design, strong distribution networks, reputation with leadingorthopedic professionals and customer service provide us with an advantage overour competitors. In particular, we believe that our broad product lines provideus with a competitive advantage over the smaller companies, while ourestablished distribution networks and relationship-based selling effortsprovide us with a competitive advantage over larger manufacturers.

 

**Intellectual Property**

** **

Our most significant intellectual property rights areour patents and trademarks, including our brand names, and proprietaryknow-how.

 

We own or have licensing rights to approximately 238U.S. and foreign patents and approximately 131 pending patent applications. Weanticipate that we will apply for additional patents in the future as wedevelop new products and product enhancements. One of our most significantpatents, which was registered only in the United States, involved the bracingtechnology and design called the “Four Points of Leverage” system. A majorityof our ligament bracing products and certain of our osteoarthritic braces havebeen designed using the “Four Points of Leverage” system which exerts a forceon the upper portion of the tibia, which, in turn, reduces strain on thedamaged, reconstructed or torn ligament. Our patent covering the “Four Pointsof Leverage” system expired in January 2005. Revenues generated from sales of products using our “Four Points ofLeverage” system in the U.S. accounted for approximately 15%, 22% and 23% ofour historical net revenues for 2004, 2003, and 2002, respectively.  We have secured additional patents in recentyears that cover several component parts or functions of our line of kneebraces, including the FourcePointTM hinge, anti-migration straps and others.

 

Our other significant patents include the customcontour measuring instrument, which serves as an integral part of themeasurement process for patients using our customized ligament and osteoarthriticbraces.  In addition, we own patentscovering a series of hinges for our rigid knee braces, as well as pneumatic paddesign and production technologies (which utilize air inflatable cushions thatallow the patient to vary the location and degree of support) used in rigidknee braces such as the Defiance ligament brace.  We also have patents relating to ourosteoarthritic braces and specific mechanisms in a number of our products, andwe license patents covering the combined magnetic field technology used in ourBGS products.

 

In addition to these patents, we rely on non-patentedknow-how, trade secrets, processes and other proprietary information, which weprotect through a variety of methods, including confidentiality agreements andproprietary information agreements with vendors, employees, consultants andothers who have access to our proprietary information.  We believe that our patents, trademarks andother proprietary rights are important to the development and conduct of ourbusiness and the marketing of our products. As a result, we intend to continueto aggressively protect our intellectual property rights.

 

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# ***Employees***

# * *

As of December 31, 2004,we had approximately 1,500 employees. Approximately 52% of our employees work in Mexico. Our employees are notunionized.  We have not experienced anystrikes or work stoppages, and management considers its relationships with ouremployees to be good.

 

**Government Regulation**

** **

*MedicalDevice Regulation*

 

*UnitedStates. *Ourproducts and operations are subject to regulation by the FDA, state authoritiesand comparable authorities in foreign jurisdictions.  The FDA regulates the research, testing,manufacturing, safety, labeling, storage, recordkeeping, premarket clearance orapproval, promotion, distribution and production of medical devices in theUnited States to ensure that medical products distributed domestically are safeand effective for their intended uses. In addition, the FDA regulates the export of medical devicesmanufactured in the United States to international markets.

 

Under the Federal Food, Drug, and Cosmetic Act, orFFDCA, medical devices are classified into one of three classes—Class I,Class II or Class III—depending on the degree of risk associated with eachmedical device and the extent of control needed to ensure safety andeffectiveness.  Our currently marketedrehabilitation products are all Class I or Class II medical devices.  Our currently marketed bone growthstimulation products are Class III medical devices.

 

Class I devices are those for which safety andeffectiveness can be assured by adherence to a set of guidelines called GeneralControls, including compliance with the applicable portions of the FDA’sQuality System Regulation, or QSR, facility registration and product listing,reporting of adverse medical events, and appropriate, truthful andnon-misleading labeling, advertising, and promotional materials.

 

Class II devices also are subject to the GeneralControls, and most require premarket demonstration of adherence to certainperformance standards or other special controls and clearance by the FDA.  Premarket review and clearance by the FDA forthese devices may be accomplished through the 510(k) premarket notification procedure.  When a 510(k) is required, the manufacturermust submit to the FDA a premarket notification submission demonstrating thatthe device is “substantially equivalent” to either a device that was legallymarketed prior to May 28, 1976 (the date upon which the Medical DeviceAmendments of 1976 were enacted) or another commercially available, similardevice that was subsequently cleared through the 510(k) process.  If the FDA determines that the device, or itsintended use, is not “substantially equivalent” to a previously-cleared deviceor use, the FDA will place the device, or the particular use of the device,into Class III, and the device sponsor must then fulfill more rigorouspremarketing requirements.

 

A Class III device is a product which has a newintended use or uses advanced technology that is not substantially equivalentto a use or technology with respect to a legally marketed device.  The safety and efficacy of Class III devicescannot be assured solely by the General Controls and the other requirementsdescribed above.  These devices almostalways require formal clinical studies to demonstrate safety andeffectiveness.  Submission and FDAapproval of a premarket approval application, or PMA, is required beforemarketing of a Class III product can proceed. A PMA application, which is intended to demonstrate that the device issafe and effective, must be supported by extensive data, including data frompreclinical studies and human clinical trials. The FDA  review of a PMAapplication often occurs over a significant period of time and can take up toseveral years.  In approving a PMAapplication or clearing a 510(k) application, the FDA may also require someform of post-market surveillance when necessary to protect the public health orto provide additional safety and effectiveness data for the device.

 

Medical devices can be marketed only for theindications for which they are cleared or approved.  Modifications to a previously cleared orapproved device that could significantly affect its safety or effectiveness orthat would constitute a major change in its intended use, design or manufacturerequire a 510(k) clearance, premarket approval supplement or new premarketapproval.  We have modified variousaspects of our devices in the past and determined that new approvals,clearances or supplements were not required or we filed a PMA supplement.  Nonetheless, the FDA may disagree with ourconclusion that clearances or approvals were not required for particularproducts and may require approval or clearances for such past or any futuremodifications or to obtain new indications for our existing products.  Such submissions may require the submissionof additional clinical or preclinical data and may be time consuming andcostly, and may not ultimately be cleared or approved by the FDA.

 

Our manufacturing processes are required to complywith the applicable portions of the QSR, which covers the methods anddocumentation of the design, testing, production, processes, controls, qualityassurance, labeling, packaging and shipping of our products.  Our domestic facility records andmanufacturing processes are subject to periodic unscheduled inspections by theFDA.  Our Mexican facilities, whichexport products to the United States, may also be inspected by the FDA.  Based on internal

 

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audits of our domestic and Mexican facilities, we believe that ourfacilities are in substantial compliance with the applicable QSRregulations.  We also are required to reportto the FDA if our products cause or contribute to a death or serious injury ormalfunction in a way that would likely cause or contribute to death or seriousinjury were the malfunction to recur. Although medical device reports have been submitted in the past 5 years,none have resulted in a recall of our products or other regulatory action bythe FDA.  The FDA and authorities inother countries can require the recall of products in the event of materialdefects or deficiencies in design or manufacturing.  The FDA can also withdraw or limit ourproduct approvals or clearances in the event of serious, unanticipated healthor safety concerns.

 

The FDA has broad regulatory and enforcementpowers.  If the FDA determines that wehave failed to comply with applicable regulatory requirements, it can impose avariety of enforcement actions from public warning letters, fines, injunctions,consent decrees and civil penalties to suspension or delayed issuance ofapprovals, seizure or recall of our products, total or partial shutdown ofproduction, withdrawal of approvals or clearances already granted, and criminalprosecution.  The FDA can also require usto repair, replace or refund the cost of devices that we manufactured ordistributed.  If any of these events wereto occur, it could materially adversely affect us.

 

Legal restrictions on the export from the UnitedStates of any medical device that is legally distributed in the United Statesare limited.  However, there arerestrictions under U.S. law on the export from the United States of medicaldevices that cannot be legally distributed in the United States.  If a Class I or Class II devicedoes not have 510(k) clearance, and the manufacturer reasonably believes thatthe device could obtain 510(k) clearance in the United States, then the devicecan be exported to a foreign country for commercial marketing without thesubmission of any type of export request or prior FDA approval, if it satisfiescertain limited criteria relating primarily to specifications of the foreignpurchaser and compliance with the laws of the country to which it is beingexported (Importing Country Criteria). We believe that all of our current products which are exported toforeign countries currently comply with these restrictions.

 

*International. **In many of the foreign countries in which we market our products, weare subject to regulations affecting, among other things, product standards,packaging requirements, labeling requirements, import restrictions, tariffregulations, duties and tax requirements. Many of the regulations applicable to our devices and products in suchcountries are essentially similar to those of the FDA, including those inGermany, our largest foreign market.  Theregulation of our products in Europe falls primarily within the EuropeanEconomic Area, which consists of the fifteen member states of the EuropeanUnion as well as Iceland, Liechtenstein and Norway.  The legislative bodies of the European Unionhave adopted directives in order to harmonize national provisions regulatingthe design, manufacture, clinical trials, labeling and adverse event reportingfor medical devices and the member states of the European Economic Area haveimplemented the directives into their respective national law.  Medical devices that comply with theessential requirements of the national provisions and the directives will beentitled to bear a CE marking.  Unless anexemption applies, only medical devices which bear a CE marking may be marketedwithin the European Economic Area.  TheEuropean Commission has adopted numerous guidelines relating to the medicaldevices directives to ensure their uniform application.  The method of assessing conformity variesdepending on the class and type of the medical device and can involve a combinationof self-assessment by the manufacturer and a third-party assessment by aNotified Body, which is an independent and neutral institution appointed by themember states to conduct the conformity assessment.  This third-party assessment may consist of anaudit of the manufacturer’s quality system and specific testing of themanufacturer’s devices.  An assessment bya Notified Body in one country within the European Economic Area is generallyrequired in order for a manufacturer to commercially distribute the productthroughout the European Economic Area.*

 

*The European Standardization Committees haveadopted numerous harmonized standards for specific types of medicaldevices.  Compliance with relevantstandards establishes the presumption of conformity with the essentialrequirements for a CE marking.  Ourquality system relating to the development, production and distribution ofrigid and soft orthopedic bracing, cold therapy products and orthopedicfixation devices/instruments is certified to international standards throughJuly 14, 2006 for our two facilities in Vista, California and our facility inTijuana, Mexico.  Our quality systemrelating to the manufacturing of leg contour measuring devices and anglereference bending tools in our facilities in Vista, California has beencertified and the existing certificate is currently in the process of beingextended. The existing certificate remains valid until the issue of a newcertificate.*

 

*In many countries, the national health or socialsecurity organizations require our products to be qualified before they can bemarketed with the benefit of reimbursement eligibility.  To date, we have not experienced difficultyin complying with these regulations.  Dueto the movement towards harmonization of standards in the European Union, weexpect a changing regulatory environment in Europe characterized by a shiftfrom a country-by-country regulatory system to a European Union-wide singleregulatory system.  The timing of this harmonizationand its effect on us cannot currently be predicted.*

 

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*FederalPrivacy and Transaction Law and Regulations*

 

Other federal legislation requires major changes inthe transmission and retention of health information by us.  The Health Insurance Portability andAccountability Act of 1996, or HIPAA, mandates, among other things, theadoption of standards for the electronic exchange of health information thatmay require significant and costly changes to current practices.  Sanctions for failure to comply with HIPAAinclude civil and criminal penalties. The U.S. Department of Health and Human Services, or HHS, has releasedthree rules to date mandating the use of new standards with respect to certainhealthcare transactions and health information. The first rule requires the use of uniform standards for commonhealthcare transactions, including healthcare claims information, planeligibility, referral certification and authorization, claims status, planenrollment and disenrollment, payment and remittance advice, plan premiumpayments, and coordination of benefits. The second rule released by HHS imposesnew standards relating to the privacy of individually identifiable healthinformation. These standards not only require our compliance with rulesgoverning the use and disclosure of protected health information, but they alsorequire us to obtain satisfactory assurances that any business associate ofours to whom such information is disclosed will safeguard the information. Thethird rule released by HHS establishes minimum standards for the security ofelectronic health information. We were required to comply with the transactionstandards by October 16, 2003 and the privacy standards by April 14,2003, and are required to comply with the security standards by April 21,2005.

 

*Third-PartyReimbursement*

 

*Our products generally are prescribed by physiciansand are eligible for third-party reimbursement. An important consideration forour business is whether third-party payment amounts will be adequate, sincethis is a factor in our customers’ selection of our products.  We believe that third-party payors willcontinue to focus on measures to contain or reduce their costs through managedcare and other efforts.  Medicarepolicies are important to our business because third-party payors often modeltheir policies after the Medicare program’s coverage and reimbursementpolicies.*

 

Healthcare reform legislation in the Medicare area hasfocused on containing healthcare spending. Most recently, on December 8, 2003, President *Bush* signed the Medicare Prescription Drug,Improvement and Modernization Act of 2003, or the Modernization Act, whichprovides for revisions to payment methodologies and other standards for itemsof durable medical equipment and orthotic devices under the Medicareprogram.  First, beginning in 2004through 2008, the payment amounts for orthotic devices (2004 through 2006) anddurable medical equipment (2004 through 2008) will no longer be increased on anannual basis.  The freeze does not affectClass III devices such as bone growth stimulators, however.  Second, beginning in 2007, a competitivebidding program will be phased in to replace the existing fee schedule paymentmethodology.  Off-the-shelf orthoticdevices and other non-Class III devices are subject to the program.  The competitive bidding program will begin inten high population metropolitan statistical areas and in 2009 will be expandedto 80 metropolitan statistical areas (and additional areas thereafter).  Payments in regions not subject tocompetitive bidding may also be adjusted using payment information from regionssubject to competitive bidding.  Third,supplier quality standards are to be established which will be applied by independentaccreditation organizations.  Fourth,clinical conditions for payment will be established for certain products.  Fifth, the Modernization Act mandated thatthe Government Accountability Office (GAO) make a recommendation to Medicare in2006 regarding the 2007 fee schedule update for bone growth stimulators.  GAO is gathering information from bone growthstimulator manufacturers in 2005 to develop their recommendation.

 

In recent years, efforts to control Medicare costshave included the heightened scrutiny of reimbursement codes and paymentmethodologies.  Under Medicare, certaindevices used by outpatients are classified using reimbursement codes, which inturn form the basis for each device’s Medicare payment levels.  Changes to the reimbursement codes describingour products can result in reduced payment levels or a reduction in the breadthof products for which reimbursement can be sought under recognized codes.  In January 2003, Medicare introduced a newreimbursement code relating to tibial ankle-foot fracture boot products, which providedfor a lower payment value on the applicable devices.

 

On February 11, 2003, the Centers for Medicare andMedicaid Services, or CMS, made effective an interim final regulationimplementing ‘‘inherent reasonableness’’ authority, which allows the agency andcontractors to adjust payment amounts by up to 15% per year for certain itemsand services when the existing payment amount is determined to be grosslyexcessive or grossly deficient.  CMS maymake a larger adjustment each year if it undertakes prescribed procedures.  The regulation remains in effect after theModernization Act, although the use of inherent reasonableness authority isprecluded for devices provided under competitive bidding.  We do not know what impact inherentreasonableness and competitive bidding would have on us or the reimbursement ofour products.

 

Beyond changes in reimbursement codes and paymentmethodologies, the movement, both domestically and in foreign countries, towardhealthcare reform and managed care may continue to result in downward pressureon product pricing.  Net revenues fromthird-party reimbursement accounted for approximately 31%, 19% and 17% of ourhistorical net revenues for the years ended December 31, 2004, 2003 and 2002,respectively.  Medicare reimbursementconsisted of approximately 16% of our

 

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historical net revenues from third-party reimbursement or approximately5% of our total historical net revenues for the year ended December 31, 2004.

 

*Fraudand Abuse*

 

We are subject to various federal and state lawspertaining to healthcare fraud and abuse, including anti-kickback laws andphysician self-referral laws.  Violationsof these laws are punishable by criminal and civil sanctions, including, insome instances, exclusion from participation in federal and state healthcareprograms, including Medicare, Medicaid, Veterans Administration health programsand TRICARE.  We believe that ouroperations are in material compliance with such laws.  However, because of the far-reaching natureof these laws, there can be no assurance that we would not be required to alterone or more of our practices to be in compliance with these laws.  In addition, there can be no assurance thatthe occurrence of one or more violations of these laws or regulations would notresult in a material adverse effect on our financial condition and results ofoperations.

 

*Anti-kickback andFraud Laws. *Ouroperations are subject to federal and state anti-kickback laws.  Certain provisions of the Social SecurityAct, which are commonly known collectively as the Medicare Fraud and AbuseStatute, prohibit persons from knowingly and willfully soliciting, receiving,offering or providing remuneration directly or indirectly to induce either thereferral of an individual, or the furnishing, recommending, or arranging for agood or service, for which payment may be made under a federal healthcareprogram such as Medicare and Medicaid. The definition of “remuneration” has been broadly interpreted to includeanything of value, including such items as gifts, discounts, waiver ofpayments, and providing anything at less than its fair market value.  HHS has issued regulations, commonly known assafe harbors, that set forth certain provisions which, if fully met, willassure healthcare providers and other parties that they will not be prosecutedunder the Medicare Fraud and Abuse Statute. The penalties for violating the Medicare Fraud and Abuse Statute includeimprisonment for up to five years, fines of up to $25,000 per violation andpossible exclusion from federal healthcare programs such as Medicare andMedicaid.  Many states have adoptedprohibitions similar to the Medicare Fraud and Abuse Statute, some of whichapply to the referral of patients for healthcare services reimbursed by anysource, not only by the Medicare and Medicaid programs.

 

Our OfficeCare program is a stock and bill arrangementthrough which we make our products and services available in the offices ofphysicians or other providers.  In conjunctionwith the OfficeCare program, we may pay participating physicians a fee forrental space and support services provided by such physicians to us.  In a Special Fraud Alert issued by HHS’Office of Inspector General, or OIG, in February 2000, the OIG indicated thatit may scrutinize stock and bill programs involving excessive rental paymentsor rental space for possible violation of the Medicare Fraud and Abuse Statute,but noted that legitimate arrangements, including fair market value rental arrangements,will not be considered violations of the statute.  We believe we have structured the OfficeCareprogram to comply with the Medicare Fraud and Abuse Statute.

 

HIPAA created two new federal crimes: healthcare fraudand false statements relating to healthcare matters.  The healthcare fraud statute prohibitsknowingly and willfully executing or attempting to execute a scheme or artificeto defraud any healthcare benefit program, including private payors.  The false statements statute prohibitsknowingly and willfully falsifying, concealing or covering up a material factor making any materially false, fictitious or fraudulent statement orrepresentation in connection with the delivery of or payment for healthcarebenefits, items or services.  This statuteapplies to any health benefit plan, not just Medicare and Medicaid.  Additionally, HIPAA granted expandedenforcement authority to HHS and the U.S. Department of Justice, orDOJ, and provided enhanced resources to support the activities andresponsibilities of the OIG and DOJ by authorizing large increases in fundingfor investigating fraud and abuse violations relating to healthcare deliveryand payment.  In addition, HIPAA mandatesthe adoption of standards for the electronic exchange of health information.

 

*PhysicianSelf-Referral Laws. *Weare also subject to federal and state physician self-referral laws.  Federal physician self-referral legislation(commonly known as the Stark Law) prohibits, subject to certain exceptions,physician referrals of Medicare and Medicaid patients to an entity providingcertain “designated health services” if the physician or an immediate familymember has any financial relationship with the entity.  The Stark Law also prohibits the entityreceiving the referral from billing any good or service furnished pursuant toan unlawful referral, and any person collecting any amounts in connection withan unlawful referral is obligated to refund such amounts.  A person who engages in a scheme tocircumvent the Stark Law’s referral prohibition may be fined up to $100,000 foreach such arrangement or scheme.  Thepenalties for violating the Stark Law also include civil monetary penalties ofup to $15,000 per referral and possible exclusion from federal healthcareprograms such as Medicare and Medicaid. Various states have corollary laws to the Stark Law, including laws thatrequire physicians to disclose any financial interest they may have with ahealthcare provider to their patients when referring patients to thatprovider.  Both the scope and exceptionsfor such laws vary from state to state.

 

*False ClaimsLaws. *Underseparate statutes, submission of claims for payment that are “not provided asclaimed” may lead to civil money penalties, criminal fines and imprisonment,and/or exclusion from participation in Medicare, Medicaid and other federallyfunded state health programs.  Thesefalse claims statutes include the federal False Claims Act, which prohibits the

 

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knowing filing of a false claim or the knowing use of false statementsto obtain payment from the federal government. When an entity is determined to have violated the False Claims Act, itmust pay three times the actual damages sustained by the government, plusmandatory civil penalties of between $5,500 and $11,000 for each separate falseclaim.  Suits filed under the FalseClaims Act, known as “qui tam” actions, can be brought by any individual onbehalf of the government and such individuals (known as “relators” or, morecommonly, as “whistleblowers”) may share in any amounts paid by the entity tothe government in fines or settlement. In addition, certain states have enacted laws modeled after the federalFalse Claims Act.  Qui tam actions haveincreased significantly in recent years, causing greater numbers of healthcarecompanies to have to defend a false claim action, pay fines or be excluded fromthe Medicare, Medicaid or other federal or state healthcare programs as aresult of an investigation arising out of such action.

 

*GovernmentalAudits*

 

Because weparticipate in governmental programs as a supplier of medical devices, ouroperations are subject to periodic surveys and audits by governmental entitiesor contractors to assure compliance with Medicare and Medicaid standards andrequirements. To maintain our billing privileges, we are required to complywith certain supplier standards, including, by way of example, licensure anddocumentation requirements for our claims submissions.  From time to time in the ordinary course ofbusiness, we, like other healthcare companies, are audited by or receive claimsdocumentation requests from governmental entities, which may identify certaindeficiencies based on our alleged failure to comply with applicable supplierstandards or other requirements. We review and assess such audits or reportsand attempt to take appropriate corrective action. We also are subject tosurveys of our physical location for compliance with supplier standards.  The failure to effect corrective action toaddress identified deficiencies, or to obtain, renew or maintain any of therequired regulatory approvals, certifications or licenses could adverselyaffect our business, results of operations or financial condition and couldresult in our inability to offer our products and services to patients insuredby the programs.

 

**Risk Factors**

 

*Our ability to achieve our operating and financial goals is subject toa number of risks, including risks relating to our business operations, ourdebt level, and government regulations. If any of the following risks actually occur, our business, operatingresults, prospects or financial condition could be materially and adverselyaffected.  The risks described below arenot the only ones that we face. Additional risks not presently known to us orthat we currently deem immaterial may also affect our business operations.*

* *

***Risks Related to Our Business***

*** ***

**Prior to the Regeneration acquisition, we did nothave experience operating in the regeneration segment of the non-operativeorthopedic and spine markets.**

 

Historically, our principal focus has been the marketfor orthopedic rehabilitation products. Accordingly, prior to our acquisition of the bone growth stimulationdevice business from OrthoLogic in November 2003, we did not have anyexperience operating in the regeneration segment of the non-operativeorthopedic and spine markets.  Theregeneration segment of the non-operative orthopedic and spine markets hasdifferent competitive characteristics from those we have experienced in themarket for our rehabilitation products. In addition, the products we acquired from OrthoLogic are subject toClass III Food and Drug Administration, or FDA, review.  This level of review is more stringent thanthat required for our rehabilitation products.

 

In addition, we did not have existing relationshipswith spine surgeons that could facilitate our ability to market and sell theSpinaLogic bone growth stimulator. Furthermore, DePuy Spine acts as theexclusive distributor of the SpinaLogic device in significant portions of theU.S. and can unilaterally terminate its arrangement with us on four monthsnotice.  If this were to occur, we maynot be able to find a replacement distribution channel for this product in atimely manner.

 

**As a result of these factors, we cannot assure youthat we will be successful in operating in the regeneration segment of thenon-operative orthopedic and spine markets.**

** **

**We recently completed theintegration of the Regeneration sales force into our domestic rehabilitationsales force and we may be unsuccessful in our strategy relative to thisintegration.**

** **

We completed the Regeneration acquisition inNovember 2003.  As part of ourinitial strategy relative to this acquisition, we retained the existingRegeneration sales force and management and sought to expand the bone growthstimulation product sales, particularly the OL1000 product, through ourexisting distribution channels for our domestic rehabilitation products. InAugust 2004 we announced our intention to integrate fully the Regenerationbusiness sales force and sales management into our

 

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DonJoy sales organization, and that integration has been completed.This integration may not prove successful and is subject to a variety offactors, many of which are beyond our control, including the following:

 

•                  ourexisting customers may not have a need for bone growth stimulation products ormay have existing relationships with our competitors for similar products;

 

•                  competitiveproducts or technologies in fracture repair or spinal fusion surgery mayundermine our sales and profitability goals;

 

•                  ourrehabilitation product distribution channel is unfamiliar with BGS products andmay not be as effective as the established channels for BGS products;

 

In addition, part of our integration plan consisted of hiring asignificant number of additional BGS specialists and encouraging ourindependent sales agents to hire a similar number of specialists.  However, we may have difficulty training andretaining that number of product specialists.

 

Because of these and other factors, we may not be successful inimplementing our strategy relative to the integration of the Regeneration salesforce. Furthermore, the implementation of our strategy may not improve oursales or operating results.

 

**We may beunsuccessful in obtaining the synergies and expense reduction we seek from theintegration of the operations and administrative functions of the Regenerationbusiness into our Vista operations.**

 

Part of our Regeneration integration plan was to combine theadministrative functions of the Regeneration business with our existingfunctions in Vista and to move the assembly and calibration operations for BGSproducts from Tempe, Arizona to Vista.  We have completed the integration of theadministrative functions and expect to move the production operations in thefirst quarter of 2005 following FDA site approval.  Our ability to obtain synergies and expensereductions through this strategy is subject to risks, including the following:

 

•                  wemay incur unexpected expense or delay in obtaining FDA approval;

 

•                  wemay experience difficulty in the billing and collection functions for BGSproducts since our work force is newly hired; and

 

•                  wemay not be able to successfully replace the former Regeneration businessemployees who did not relocate to Vista with equally qualified personnel.

 

As a result of these risks, we cannot be certain we will realize thefinancial benefits and operating synergies that we anticipated as a part of theRegeneration integration.

 

**If we do not effectively manage our growth, ourexisting infrastructure may become strained, and we may be unable to increasesales of our products or generate revenue growth.**

 

In connection with the Regeneration integration, wehired approximately 50 new employees, many of whom are sales specialistslocated around the country.  The growththat we have experienced, and in the future may experience, may provide challengesto our organization, requiring us to expand our personnel, manufacturing anddistribution operations.  Future growthmay strain our infrastructure, operations, product development and othermanagerial and operating resources.  Ifour business resources become strained, we may be unable to increase sales ofour products or generate revenue growth.

 

**We have outsourced certain administrativefunctions relating to our OfficeCare sales channel to a third-party contractorand this arrangement may not prove successful.**

 

Our OfficeCare sales channel maintains an inventory ofproducts (mostly soft goods) on hand at orthopedic practices for immediatedistribution to patients.  For theseproducts, we arrange billing to a patient or third-party payor after theproduct is provided to the patient.  InMarch 2003, we began outsourcing the revenue cycle of this program, frombilling to collections, to an independent third-party contractor with anobjective to reduce collection time and increase collection amounts. Thisprovider may not be successful in achieving or maintaining these goals andthere can be no assurance that we will not have to resume these administrativefunctions in the future.

 

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**We rely on intellectualproperty to develop and manufacture our products and our business could beadversely affected if and when we lose our intellectual property rights.**

** **

We hold or license U.S. and foreign patents relatingto a number of our components and products and have patent applications pendingwith respect to other components and products. We also expect to apply foradditional patents as we deem appropriate.

 

The U.S. patent for our “Four Points of Leverage”system has expired in January 2005. Revenues generated from the sale ofproducts in the U.S. using our “Four Points of Leverage” system representedapproximately 15%, 22% and 23% of our historical net revenues for 2004, 2003and 2002, respectively. The majority of our anterior cruciate ligament, or ACL,braces, including Defiance, Legend and 4TITUDE, and certain of ourosteoarthritic braces use this system. We believe a number of our competitorswill introduce ligament braces that incorporate aspects of our “Four Points ofLeverage” system now that the patent has expired.  In such event, our competitors may be able tosell products that are similar to ours at lower prices than we currently sellour products, which could adversely affect our revenue and profitability.

 

We believe that several of our additional existingpatents are, and will continue to be, extremely important to our success.  These include the patents relating to our:

 

•                  kneeligament bracing product lines, including components and features such as frameconstruction and shape, strap attachment systems, anti-migration paddingsystems and extreme sport features;

 

•                  customcontour measuring system, which serves as an integral part of the measurementprocess for patients ordering our customized ligament and osteoarthriticbraces;

 

•                  seriesof hinges for our rigid braces, including the FourcePointTM hinge;

 

•                  pneumaticpad design and production technologies which utilize air inflatable cushionsthat allow the patient to vary the location and degree of support provided bybraces such as the Defiance knee ligament brace;

 

•                  osteoarthritisbracing concepts;

 

•                  anklebracing, both rigid and soft;

 

•                  rigidshoulder bracing; and

 

•                  combinedmagnetic field technology, which is used in our bone growth stimulationproducts.

 

However, we cannot assure you that:

 

•                  ourexisting or future patents, if any, will afford us adequate protection;

 

•                  ourpatent applications will result in issued patents; or

 

•                  ourpatents will not be circumvented or invalidated.

 

Our success also depends on non-patented proprietaryknow-how, trade secrets, processes and other proprietary information. We employvarious methods to protect our proprietary information, includingconfidentiality agreements and proprietary information agreements with vendors,employees, consultants and others who have access to our proprietary information.However, these methods may not provide us with adequate protection. Ourproprietary information may become known to, or be independently developed by,competitors, or our proprietary rights in intellectual property may bechallenged, any of which could have an adverse effect on our business.

 

**The direct distributionof our products in selected foreign countries involves financial andoperational risks.**

** **

We have implemented a strategy to selectively replaceour third-party international distributors with wholly-owneddistributorships.  In 2002, we began todistribute our products in Germany/Austria, the United Kingdom and Canadathrough wholly-owned subsidiaries.  Weestablished a wholly-owned distributorship in France in September 2003 and onein the Nordic countries in August 2004. The creation of direct distribution capabilities in foreign marketsrequires additional financial and

 

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operational controls.  We cannotassure you that we will be able to successfully maintain organizational changesand controls or that our international strategy will result in increasedrevenues or profitability.

 

**If we are not able todevelop, license or acquire and market new products or product enhancements wemay not remain competitive.**

** **

Our future success and the ability to grow ourrevenues and earnings require the continued development, licensing oracquisition of new products and the enhancement of our existing products. Wemay not be able to:

 

•                  continueto develop or license successful new products and enhance existing products;

 

•                  obtainrequired regulatory clearances and approvals for such products;

 

•                  marketsuch products in a commercially viable manner; or

 

•                  gainmarket acceptance for such products.

 

We may pursue acquisitions of other companies orproduct lines to expand our product portfolio. Our ability to grow through acquisitions depends on our ability toidentify, negotiate, complete and integrate suitable acquisitions.  Even if we complete acquisitions we mayexperience:

 

•                  difficultiesin integrating any acquired companies, personnel and products into our existingbusiness;

 

•                  delaysin realizing the benefits of the acquired company or products;

 

•                  diversionof our management’s time and attention;

 

•                  highercosts of integration than we anticipated; or

 

•                  difficultiesin retaining key employees of the acquired business who are necessary to managethese acquisitions.

 

In addition, we may require additional debt or equityfinancing for future acquisitions.  Suchfinancing may not be available on favorable terms, if at all.  Finally, in the event we decide todiscontinue pursuit of a potential acquisition, we will be required toimmediately expense all costs incurred in pursuit of the possible acquisitionwhich could have an adverse effect on our results of operations in the periodin which the expense is recognized.

 

We may be unable to remain competitive if we fail todevelop, license or acquire and market new products and productenhancements.  In addition, if any of ournew or enhanced products contain undetected errors or design defects,especially when first introduced, our ability to market these products could besubstantially delayed, resulting in lost revenue, potential damage to ourreputation and/or delays in obtaining acceptance of the product by orthopedicand spine surgeons and other healthcare professionals.

 

**We rely heavily on ourrelationships with orthopedic professionals, agents and distributors formarketing our products and our failure to maintain these relationships couldadversely affect our business.**

** **

The sales of our products depend significantly on theprescription or recommendation of such products by orthopedic and spinesurgeons and other healthcare professionals. We have developed and maintain close relationships with a number ofwidely recognized orthopedic surgeons and specialists who assist in productresearch, development and marketing. Failure of our products to retain the support of these surgeons andspecialists, or the failure of our products to secure and retain similarsupport from leading surgeons and specialists, could have an adverse effect onour business.

 

Our success also depends largely upon arrangementswith independent agents and distributors and their relationships with thecustomers in the marketplace. Our failure to maintain relationships with agentsand distributors for marketing our products could have an adverse effect on ourbusiness.

 

**We operate in a verycompetitive business environment.**

** **

The non-operative orthopedic and spine markets arehighly competitive and fragmented.  Ourcompetitors include several large, diversified general orthopedic productscompanies and numerous smaller niche companies. Some of our competitors arepart

 

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of corporate groups that have significantly greater financial,marketing and other resources than we have. Accordingly, we may be at a competitive disadvantage with respect tothese competitors.

 

In the rehabilitation market, our primary competitorsin the rigid knee bracing product line include Orthofix International, N.V.,Bledsoe Brace Systems, Innovation Sports Incorporated, Generation II USA, Inc.and Townsend Industries Inc.  Ourcompetitors in the soft goods products segment include Aircast Inc., Biomet,Inc., DeRoyal Industries, Encore Medical Corporation, Royce Medical Co. andZimmer Holdings, Inc.  Our primarycompetitors in the pain management products market include I-Flow Corp.,Aircast, Orthofix and Stryker Corporation.

 

In the regeneration market, our primary competitorsselling bone growth stimulation products approved by the FDA for the treatmentof  nonunion fractures are Orthofix,Biomet, Inc. and Smith & Nephew. Biomet and Orthofix also sell bone growth stimulation products for useby spinal fusion patients.  We estimatethat Biomet has a dominant share of the market for bone growth stimulationproducts for nonunion fractures in the United States and a dominant share ofthe market for use of its product as an adjunct therapy after spinal fusionsurgery.

 

**Our quarterly operatingresults are subject to substantial fluctuations and you should not rely on themas an indication of our future results.**

** **

Our quarterly operating results may vary significantlydue to a combination of factors, many of which are beyond our control.  These factors include:

 

•                  thenumber of business days in each quarter;

 

•                  demandfor our products, which historically has been higher in the fourth quarter whenscholastic sports and ski injuries are more frequent;

 

•                  ourability to meet the demand for our products;

 

•                  thedirect distribution of our products in foreign countries;

 

•                  thenumber, timing and significance of new products and product introductions andenhancements by us and our competitors, including delays in obtaininggovernment review and clearance of medical devices;

 

•                  ourability to develop, introduce and market new and enhanced versions of ourproducts on a timely basis;

 

•                  theimpact of any acquisitions that occur in a quarter;

 

•                  theimpact of any changes in generally accepted accounting principles;

 

•                  changesin pricing policies by us and our competitors and reimbursement rates bythird-party payors, including government healthcare agencies and privateinsurers;

 

•                  theloss of any of our distributors;

 

•                  changesin the treatment practices of orthopedic and spine surgeons and their alliedhealthcare professionals; and

 

•                  thetiming of significant orders and shipments.

 

Accordingly, our quarterly sales and operating resultsmay vary significantly in the future and period-to-period comparisons of ourresults of operations may not be meaningful and should not be relied upon asindications of future performance.  Wecannot assure you that our sales will increase or be sustained in future periodsor that we will be profitable in any future period.

 

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**Our business plan relieson certain assumptions for the market for our products, which, if incorrect,may adversely affect our profitability.**

** **

We**believe thatvarious demographics and industry specific trends will help drive growth in therehabilitation and regeneration markets, including:

 

•                  agrowing elderly population with broad medical coverage, increased disposableincome and longer life expectancy;

 

•                  agrowing emphasis on physical fitness, leisure sports and conditioning, whichhas lead to increased injuries, especially among women; and

 

•                  theincreasing awareness and use of non-invasive devices for prevention, treatmentand rehabilitation purposes.

 

**These demographics and trends are beyond ourcontrol.  The projected demand for ourproducts could materially differ from actual demand if our assumptionsregarding these factors prove to be incorrect or do not materialize or ifalternative treatments to those offered by our products gain widespreadacceptance.**

** **

**Our business, operatingresults and financial condition could be adversely affected if we becomeinvolved in litigation regarding our patents or other intellectual propertyrights.**

** **

The orthopedic products industry has experiencedextensive litigation regarding patents and other intellectual property rights.We or our products may become subject to patent infringement claims orlitigation or interference proceedings declared by the U.S. Patent andTrademark Office, or USPTO, or the foreign equivalents thereto to determine thepriority of inventions. The defense and prosecution of intellectual propertysuits, USPTO interference proceedings or the foreign equivalents thereto andrelated legal and administrative proceedings are both costly and timeconsuming. An adverse determination in litigation or interference proceedingsto which we may become a party could:

 

•                  subjectus to significant liabilities to third-parties;

 

•                  requiredisputed rights to be licensed from a third-party for royalties that may besubstantial; or

 

•                  requireus to cease using such technology.

 

Any one of these outcomes could have an adverse effecton us.  Furthermore, we may not be ableto obtain necessary licenses on satisfactory terms, if at all. Accordingly,adverse determinations in a judicial or administrative proceeding or ourfailure to obtain necessary licenses could prevent us from manufacturing andselling our products, which would have a material adverse effect on ourbusiness, operating results and financial condition. Moreover, even if we aresuccessful in such litigation, the expense of defending such claims could bematerial.

 

In addition, we have from time to time needed to, andmay in the future need to, litigate to enforce our patents, to protect ourtrade secrets or know-how or to determine the enforceability, scope andvalidity of the proprietary rights of others. Such enforcement of ourintellectual property rights could involve counterclaims against us. Any futurelitigation or interference proceedings will result in substantial expense to usand significant diversion of effort by our technical and management personnel.

 

**We have limited suppliersfor some of our components and products which makes us susceptible to supplyshortages and could disrupt our operations.**

** **

Some of our important suppliers are in China and otherparts of Asia and provide us predominately finished soft goods products.  In fiscal year 2004, we obtainedapproximately 12% of our total purchased materials from suppliers in China andother parts of Asia. Political and economic instability and changes ingovernment regulations in these areas could affect our ability to continue toreceive materials from our suppliers there. The loss of our suppliers in Chinaand other parts of Asia, any other interruption or delay in the supply of ourrequired materials or our inability to obtain these materials at acceptableprices and within a reasonable amount of time could impair our ability to meetscheduled product deliveries to our customers and could hurt our reputation andcause customers to cancel orders.

 

In addition, we purchase the microprocessor used inthe OL1000 and SpinaLogic devices from a single manufacturer. Although thereare feasible alternate microprocessors that might be used immediately, all areproduced by a single supplier.  Inaddition, there are single suppliers for other components used in the OL1000and SpinaLogic devices and only two suppliers for

 

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the magnetic field sensor employed in them.  Establishment of additional or replacementsuppliers for these components cannot be accomplished quickly.

 

**Our international salesand profitability may be adversely affected by foreign currency exchangefluctuations and other risks.**

** **

We sell products in foreign currency through ourforeign subsidiaries.  The U.S. dollarequivalent of international sales denominated in foreign currencies in fiscalyears 2004, 2003 and 2002 were favorably impacted by foreign currency exchangerate fluctuations with the weakening of the U.S. dollar against the foreigncurrencies of our subsidiaries.  The U.S.dollar equivalent of the related costs denominated in these foreign currencieswas unfavorably impacted during the same periods.  In addition, the costs associated with ourMexico-based manufacturing operations are incurred in Mexican pesos.  As we continue to distribute and manufactureour products in selected foreign countries, we expect that future sales andcosts associated with our activities in these markets will continue to bedenominated in the applicable foreign currencies, which could cause currencyfluctuations to materially impact our operating results.

 

We occasionally engage in hedging transactions and mayobtain in the future one or more forms of currency protection – in the form offorward exchange contracts, options or similar agreements – to “hedge” againstthe possible negative effects of exchange rate fluctuations.  However, we cannot assure you that anyhedging will adequately relieve the adverse effects of exchange rate changes orthat counterparties under these agreements will honor their obligationsthereunder.  In addition, we may besubject to risks of default by hedging counterparties.

 

We are also subject to other risks inherent ininternational operations such as political and economic conditions, foreignregulatory requirements, exposure to different legal requirements andstandards, exposure to different approaches to treating injuries, potentialdifficulties in protecting intellectual property, import and exportrestrictions, increased costs of transportation or shipping, currencyfluctuations, difficulties in staffing and managing international operations,labor disputes, difficulties in collecting accounts receivable and longercollection periods and potentially adverse tax consequences.  For example, in Germany, our largest foreignmarket, orthopedic professionals began re-using our bracing devices on multiplepatients during 2004, which adversely impacted our sales of these devices inthis market in 2004.  As we continue toexpand our international business, our success will be dependent, in part, onour ability to anticipate and effectively manage these and other risks.  If we are unable to do so, these and otherfactors may have an adverse effect on our international operations.

 

**Our lack of manufacturingoperations outside North America may cause our products to be less competitivein international markets.**

** **

We currently have no manufacturing operations in anyforeign country other than Mexico. For our international sales to third-partydistributors, the cost of transporting our products to foreign countries iscurrently borne by our third-party distributors who are also often required topay foreign import duties on our products. As a result, the cost of ourproducts to our third-party distributors is often greater than productsmanufactured by our competitors in that country. In addition, foreignmanufacturers of competitive products may receive various local tax concessionsthat lower their overall manufacturing costs. In order to compete successfullyin international markets, we may be required to open or acquire manufacturingoperations abroad, which would be costly to implement and would increase ourexposure to the risks of doing business in foreign countries. We may not beable to successfully operate offshore manufacturing operations.

 

**Product liability claimsmay harm our business if our insurance proves inadequate or the number ofclaims increases significantly.**

** **

We face an inherent business risk of exposure toproduct liability claims in the event that the use of our technology orproducts is alleged to have resulted in adverse effects. We have, from time totime, been subject to product liability claims. In addition, we have operated a Knee Guarantee program since 2001 inrelation to our Defiance knee brace.  TheKnee Guarantee program will, in specified instances, cover a patient’sinsurance deductible up to $1,000, or give uninsured patients $1,000, towardssurgery should an ACL re-injury occur while wearing the brace.  In 2003, the Technology You Can Trust programwas introduced in connection with our BGS products. If a patient has a nonunionfracture that fails to heal while using a BGS product, the Technology You CanTrust program will, if the patient meets the specified requirements of theprogram, refund the costs for treatment using the BGS product. If there is asignificant increase in claims under these programs, our business could beadversely affected.

 

We maintain product liability insurance with coverageof an annual aggregate maximum of $20 million.  The policy is provided on a claims made basisand is subject to annual renewal. There can be no assurance that liabilityclaims will not exceed the coverage limit of such policy or that such insurancewill continue to be available on commercially reasonable terms or at all.  If we do not or cannot maintain sufficientliability insurance, our ability to market our products may be significantlyimpaired.

 

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**We may be adversely affected if welose the services of any member of our senior management team.**

 

**We are dependent on the continued services of oursenior management team, who have made significant contributions to our growthand success.  Leslie H. Cross, ourPresident and Chief Executive Officer, for example, has worked for us for 15years and helped lead our 1999 recapitalization and transition from ownershipby Smith & Nephew to a stand-alone company. The loss of any one or more members of our senior management team couldhave a material adverse effect on us.**

** **

**Any claims relating toour improper handling, storage or disposal of wastes could be time consumingand costly.**

** **

**Our facilities and operations are subject tofederal, state and local environmental and occupational health and safetyrequirements of the United States and foreign countries, including thoserelating to discharges of substances to the air, water, and land, the handling,storage and disposal of wastes and the cleanup of properties affected bypollutants.  In the future, federal,state, local or foreign governments could enact new or more stringent laws orissue new or more stringent regulations concerning environmental and workerhealth and safety matters that could affect our operations.  Also, contamination may be found to exist atour current, former or future facilities, including the facility in Tempe,Arizona that we occupied following the Regeneration acquisition, or off-sitelocations where we have sent wastes.  Wecould be held liable for such contamination, which could have a materialadverse effect on our business or financial condition.  In addition, changes in environmental andworker health and safety requirements or liabilities from newly discoveredcontamination could have a material effect on our business or financialcondition.**

** **

**If a natural or man-madedisaster strikes our manufacturing facilities, we will be unable to manufactureour products for a substantial amount of time and our sales will decline.**

** **

Nearly all of our rehabilitation products aremanufactured in our new facility in Tijuana, Mexico.    The products that are still manufactured inVista, California consist of our custom rigid bracing products, which remain inthe U.S. to facilitate quick turn-around on custom orders and, if FDA siteapproval is received, the Regeneration product line. These facilities and themanufacturing equipment we use to produce our products would be difficult torepair or replace.  Our facilities may beaffected by natural or man-made disasters. If one of our facilities were affected by a disaster, we would be forcedto rely on third-party manufacturers or shift production to another manufacturingfacility.  In addition, our insurance maynot be sufficient to cover all of our potential losses and may not continue tobe available to us on acceptable terms, or at all.

 

**Because we have variousmechanisms in place to discourage takeover attempts, a change in control of ourcompany that a stockholder may consider favorable could be prevented.**

** **

Provisions of our certificate of incorporation andbylaws may discourage, delay or prevent a change in control of our company thata stockholder may consider favorable. These provisions could also discourageproxy contests and make it more difficult for stockholders to elect directorsand take other corporate actions. These provisions include:

 

•                  authorizingthe issuance of “blank check” preferred stock by our board of directors toincrease the number of outstanding shares and thwart a takeover attempt;

 

•                  aclassified board of directors with staggered, three-year terms, which maylengthen the time required to gain control of the board of directors;

 

•                  prohibitingcumulative voting in the election of directors, which would otherwise allowless than a majority of stockholders to elect director candidates;

 

•                  requiringsupermajority voting to effect particular amendments to our certificate ofincorporation and bylaws;

 

•                  limitationson who may call special meetings of stockholders;

 

•                  prohibitingstockholder action by written consent, thereby requiring all actions to betaken at a meeting of the stockholders; and

 

•                  establishingadvance notice requirements for the nomination of candidates for election tothe board of directors or for proposing matters that can be acted upon bystockholders at stockholder meetings.

 

In addition, Section 203 of the Delaware GeneralCorporation Law prohibits a publicly held Delaware corporation from engaging ina business combination with an interested stockholder, generally defined as aperson that together with its affiliates

 

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owns or within the last three years has owned 15% of the corporation’svoting stock, for a period of three years after the date of the transaction inwhich the person became an interested stockholder, unless the businesscombination is approved in a prescribed manner. Accordingly, Section 203may discourage, delay or prevent a change in control of our company.

 

As a result, these provisions could limit the pricethat investors are willing to pay in the future for shares of our common stock.

 

***Risks Related to our Debt***

*** ***

**Our debt agreementscontain operating and financial restrictions, which restrict our business andfinancing activities.**

** **

The operating and financial restrictions and covenantsin our credit agreement and any future financing agreements may adverselyaffect our ability to finance future operations, meet our capital needs orengage in our business activities. Currently, our existing credit agreementrestricts our ability to:

 

•                  incuradditional indebtedness;

 

•                  issueredeemable equity interests and preferred equity interests;

 

•                  paydividends or make distributions, repurchase equity interests or make otherrestricted payments;

 

•                  redeemsubordinated indebtedness;

 

•                  createliens;

 

•                  enterinto certain transactions with affiliates;

 

•                  makeinvestments;

 

•                  sellassets; or

 

•                  enterinto mergers or consolidations.

 

With respect to mergers or acquisitions, our creditagreement limits our ability to finance acquisitions through additionalborrowings.  In addition, our creditagreement prohibits us from acquiring assets or the equity of another companyunless:

 

•                  weare not in default under the credit agreement;

 

•                  aftergiving pro forma effect to the transaction, we remain in compliance with thefinancial covenants contained in the credit agreement;

 

•                  ifthe acquisition price is greater than $5 million and our leverage is greaterthan 3.0 to 1.0, the company we are acquiring has positive earnings beforeinterest, taxes, depreciation and amortization, or EBITDA;

 

•                  theacquisition price is less than $20 million individually and less than $30million in the aggregate with all other permitted acquisitions consummatedduring the same fiscal year; and

 

•                  ifthe acquisition involves assets outside the United States, the acquisitionprice is less than $15 million individually and less than $25 million in theaggregate with all other permitted acquisitions consummated outside the UnitedStates during the term of the agreement.

 

Restrictions contained in our credit agreement could:

 

•                  limitour ability to plan for or react to market conditions or meet capital needs orotherwise restrict our activities or business plans; and

 

•                  adverselyaffect our ability to finance our operations, acquisitions, investments orstrategic alliances or other capital needs or to engage in other businessactivities that would be in our interest.

 

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A breach of any of these covenants, ratios, tests orother restrictions could result in an event of default under the creditagreement. Upon the occurrence of an event of default under the credit agreement,the lenders could elect to declare all amounts outstanding under the creditagreement, together with accrued interest, to be immediately due and payable.If we were unable to repay those amounts, the lenders could proceed against thecollateral granted to them to secure such indebtedness. If the lenders underthe credit agreement accelerate the payment of the indebtedness, there can beno assurance that our assets would be sufficient to repay in full suchindebtedness and our other indebtedness.

 

**We may not be able to generate sufficient cash toservice our indebtedness, which could require us to reduce our expenditures,sell assets, restructure our indebtedness or seek additional equity capital.**

 

We may not have sufficient cash to service ourindebtedness. Our ability to satisfy our obligations will depend upon, amongother things:

 

•                  ourfuture financial and operating performance, which will be affected byprevailing economic conditions and financial, business, regulatory and otherfactors, many of which are beyond our control; and

 

•                  thefuture availability of borrowings under our revolving credit facility or anysuccessor facility, the availability of which depends or may depend on, amongother things, our complying with covenants in the credit agreement.

 

If we cannot service our indebtedness, we will beforced to take actions such as reducing or delaying acquisitions, investments,strategic alliances and/or capital expenditures, selling assets, restructuringor refinancing our indebtedness, or seeking additional equity capital orbankruptcy protection. We cannot assure you that any of these remedies can beeffected on satisfactory terms, if at all. In addition, the terms of existingor future debt agreements may restrict us from adopting any of thesealternatives.

 

***Risks Related to Government Regulation***

*** ***

**Our failure to complywith regulatory requirements or receive regulatory clearance or approval forour products or operations in the United States or abroad would adverselyaffect our revenues and potential for future growth.**

** **

Our products are medicaldevices that are subject to extensive regulation in the United States by theFood and Drug Administration, or FDA, and by respective authorities in foreigncountries where we do business.  The FDAregulates virtually all aspects of a medical device’s testing, manufacture,safety, labeling, storage, recordkeeping, reporting, promotion anddistribution.  The FDA also regulates theexport of medical devices to foreign countries. Failure to comply with the regulatory requirements of the FDA and otherapplicable U.S. regulatory requirements may subject a company to administrativeor judicially imposed sanctions which could have a material adverse effect onour business, financial condition and results of operations.  These sanctions include:

 

•                                          warningletters;

 

•                                          civilpenalties;

 

•                                          criminalpenalties;

 

•                                          injunctions;

 

•                                          productseizure or detention;

 

•                                          productrecalls; and

 

•                                          totalor partial suspension of production.

 

Unless an exemption applies, a medical device mustreceive either approval or premarket clearance from the FDA before it can bemarketed in the United States.  The FDA’s510(k) clearance process for Class II devices usually takes from three totwelve months, but may take significantly longer.  The premarket approval process for Class IIIdevices generally takes from one to three years from the time the applicationis filed with the FDA, but also can be significantly longer.  Premarket approval typically requiresextensive clinical data and can be significantly longer, more expensive andmore uncertain than the 510(k) clearance process.  Despite the time, effort and expenseexpended, there can be no assurance that a particular device will be approvedor cleared by the FDA through either the 510(k) clearance process or thepremarket approval process.

 

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*Modifications*

 

Medical devices may only be marketed for theindications for which they are approved or cleared.  We may be required to obtain additional newpremarket approvals, premarket approval supplements or 510(k) clearances tomarket additional products or for new indications for or modifications to ourexisting products.  We cannot be certainthat we would obtain additional premarket approvals or 510(k) clearances in atimely manner or at all.  Modificationsto a previously cleared or approved device that could significantly affect itssafety or effectiveness or that would constitute a major change in its design,intended use or manufacturing require a premarket approval, a premarketapproval supplement, or a 510(k) clearance. The FDA requires device manufacturers themselves to make and document adetermination of whether or not a modification requires an approval, supplementor clearance; however, the FDA can review a manufacturer’s decision.  We have modified various aspects of ourdevices in the past and we determined that new approvals, supplements orclearances either were not required or we filed a PMA supplement.  The FDA may not agree with our decisions notto seek approvals, supplements or clearances for particular devicemodifications.  If the FDA requires us toobtain premarket approvals, supplement approvals or 510(k) clearances for anymodification to a previously cleared or approved device, we may be required tocease manufacturing and marketing the modified device or to recall suchmodified device until we obtain FDA clearance or approval and we may be subjectto significant regulatory fines or penalties. In addition, there can be no assurance that the FDA will clear orapprove such submissions in a timely manner, if at all.

 

We currently have new products, new indications, orproduct modifications under development or under review by the FDA.  Our failure to obtain FDA clearance or approvalsof new products, new indications or product modifications that we develop inthe future, any limitations imposed by the FDA on such products’ development oruse, or the costs of obtaining FDA clearance or approvals could have a materialadverse effect on our business.

 

*International Regulation*

 

In many of the foreign countries in which we marketour products, we are subject to extensive regulations essentially the same asthose of the FDA, including those in Germany, our largest foreign market.  The regulation of our products in Europefalls primarily within the European Economic Area, which consists of thefifteen member states of the European Union, as well as Iceland, Liechtensteinand Norway.  The Council of the EuropeanUnion (formerly the Council of the European Communities) and the Council of theEuropean Parliament have adopted three directives in order to harmonizenational provisions regulating the design, manufacture, clinical trials,labeling and adverse event reporting for medical devices to ensure that medicaldevices marketed are safe and effective for their intended uses.  The member states of the European EconomicArea have implemented the directives into their respective national law.  Medical devices that comply with theconformity requirements of the national provisions and the directives will beentitled to bear a CE marking.  Unless anexemption applies, only medical devices which bear a CE marking may be marketedwithin the European Economic Area. Switzerland also allows the marketing of medical devices that bear a CEmarking.  Failure to receive, or delaysin the receipt of, relevant foreign qualifications, such as the CE marking,could have a material adverse effect on our international operations.

 

The European Standardization Committees CEN (EuropeanCommittee for Standardization), CENELEC (European Committee forElectrotechnical Standardization) and ETSI (European TelecommunicationsStandards Institute) have adopted numerous harmonized standards for specifictypes of medical devices.  Although theapplication by a company of such standards remains voluntary, complianceestablishes the presumption of conformity with the essential requirements for aCE marking.  In the event ofnon-compliance with the standards, we must demonstrate to independent andneutral institutions appointed by the member states of the European EconomicArea the conformity of our products with the essential requirements by othermeans, such as displaying adherence to established technical specifications.  Non-compliance with the conformity assessmentin the European Economic Area or other foreign countries could adversely affectour international product sales.

 

Post market surveillance of medical devices in theEuropean Economic Area is generally conducted on a country-by-countrybasis.  The requirement within the memberstates of the European Economic Area vary. Due to the movement towards harmonization of standards in the EuropeanUnion and the expansion of the European Union, we expect a changing regulatoryenvironment in Europe characterized by a shift from a country-by-countryregulatory system to a European Union-wide single regulatory system.  The timing of this harmonization and itseffect on us cannot currently be predicted. Any such developments could have a material adverse effect on ourbusiness, financial condition and results of operations.

 

**Our products are subjectto recalls even after receiving FDA clearance or approval, or after receivingCE-markings, which would harm our reputation and business.**

** **

We are subject to medical device reporting regulationsthat require us to report to the FDA or respective governmental authorities inother countries if our products cause or contribute to a death or seriousinjury or malfunction in a way that would be reasonably likely to contribute todeath or serious injury if the malfunction were to recur.  The FDA and similar governmental authoritiesin other countries have the authority to require the recall of our products inthe event of material deficiencies or defects

 

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in design or manufacturing, and we have been subject to product recallsin the past.  A government mandated, orvoluntary, recall by us could occur as a result of component failures,manufacturing errors or design defects, including defects in labeling.  Any recall would divert managerial andfinancial resources and could harm our reputation with customers.  There can be no assurance that there will notbe product recalls in the future or that such recalls would not have a materialadverse effect on our business.

 

**If we fail to comply with the FDA’s Quality SystemRegulation, our manufacturing could be delayed, and our product sales andprofitability could suffer.**

** **

Our manufacturing processes are required to complywith the FDA’s Quality System Regulation, which covers the proceduresconcerning (and documentation of) the design, testing, production processes,controls, quality assurance, labeling, packaging, storage and shipping of ourdevices.  We also are subject to staterequirements and licenses applicable to manufacturers of medical devices.  In addition, we must engage in extensiverecordkeeping and reporting and must make available our manufacturingfacilities and records for periodic unscheduled inspections by governmentalagencies, including the FDA, state authorities and comparable agencies in othercountries.  Moreover, failure to pass aQuality System Regulation inspection or to comply with these and otherapplicable regulatory requirements could result in disruption of our operationsand manufacturing delays.  Failure totake adequate corrective action could result in, among other things,significant fines, suspension of approvals, seizures or recalls of products,operating restrictions and criminal prosecutions.  We have previously received warning lettersand untitled letters from the FDA regarding regulatory non-compliance.  We cannot assure you that the FDA or othergovernmental authorities would agree with our interpretation of applicableregulatory requirements or that we have in all instances fully complied withall applicable requirements.  Any failureto comply with applicable requirements could adversely affect our product salesand profitability.

 

**Changes in U.S.reimbursement policies for our products by third-party payors or reductions inreimbursement rates for our products could adversely affect our business andresults of operations.**

** **

Our products are sold to healthcare providers andphysicians who may receive reimbursement for the cost of our products fromprivate third-party payors and, to a lesser extent, from Medicare, Medicaid andother governmental programs.  In certaincircumstances, such as for our OfficeCare program, we submit claims tothird-party payors for reimbursement. Our ability to sell our productssuccessfully will depend in part on the purchasing and practice patterns ofhealthcare providers and physicians, who are influenced by cost containmentmeasures taken by third-party payors. Limitations or reductions in third-party reimbursement for our productscan have a material adverse effect on our sales and profitability.

 

Congress and state legislatures consider reforms inthe healthcare industry that may modify reimbursement methodologies andpractices, including controls on healthcare spending of the Medicare and Medicaidprograms.  It is not clear at this timewhat proposals, if any, will be adopted or, if adopted, what effect theproposals would have on our business. Many private health insurance plans model their coverage andreimbursement policies after Medicare policies. Congressional or regulatory measures that reduce Medicare reimbursementrates could cause private health insurance plans to reduce their reimbursementrates for our products, which could have an adverse effect on our ability tosell our products or cause our orthopedic professional customers to prescribeless expensive products introduced by us and our competitors.

 

With the passage of the Medicare Prescription Drug,Improvement, and Modernization Act of 2003, or Modernization Act, a number ofchanges have been mandated to the Medicare payment methodology and conditionsfor coverage for our orthotic devices and durable medical equipment, includingour bone growth stimulators.  Thesechanges include a freeze in payments for certain medical devices from 2004through 2008, competitive bidding requirements, new clinical conditions forpayment and quality standards.  Thechanges affect our products generally, although specific products may beaffected by some but not all of the Modernization Act’s provisions.  Our Class III bone growth stimulator devices,for example, are not affected by the payment freeze and are not subject tocompetitive bidding.  Off-the-shelforthotic devices are subject to competitive bidding.  Off-the-shelf orthotics are products requiringminimal self-adjustment for appropriate use and do not require expertise intrimming, bending, molding, assembling, or customizing to fit the patient.  Under competitive bidding, which will bephased in beginning in 2007, Medicare will change its approach to reimbursingcertain items and services covered by Medicare from the current fee scheduleamount to an amount established through a bidding process between thegovernment and suppliers.  Competitivebidding may reduce the number of suppliers providing certain items and servicesto Medicare beneficiaries and the amounts paid for such items andservices.  Also, Medicare payments inregions not subject to competitive bidding may be reduced using payment informationfrom regions subject to competitive bidding. Any payment reductions or the inclusion of certain of our orthoticdevices in competitive bidding, in addition to the other changes to Medicarereimbursement and standards contained in the Modernization Act, could have amaterial adverse effect on our results of operations.

 

In addition, on February 11, 2003, the Centersfor Medicare and Medicaid Services, or CMS, the agency responsible forimplementing the Medicare program, made effective an interim final regulationimplementing “inherent reasonableness” authority, which allows adjustments topayment amounts for certain items and services covered by Medicare when theexisting payment

 

26

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amount is determined to be grossly excessive orgrossly deficient.  The regulation listsfactors that may be used to determine whether an existing reimbursement rate isgrossly excessive or grossly deficient and to determine what is a realistic andequitable payment amount.  Also, underthe regulation, a payment amount will not be considered grossly excessive orgrossly deficient if an overall payment adjustment of less than fifteen percentwould be necessary to produce a realistic and equitable payment amount.  The regulation remains in effect after theModernization Act, although the new legislation precludes the use of inherentreasonableness authority for devices subject to competitive bidding.  When using the inherent reasonablenessauthority, CMS may reduce reimbursement levels for certain items and services,which could have a material adverse effect on our results of operations.

 

We cannot assure you that third-party reimbursementfor our products will continue to be available or at what rate such productswill be reimbursed.  Failure by users ofour products to obtain sufficient reimbursement from third-party payors for ourproducts or adverse changes in governmental and private payors’ policies towardreimbursement for our products could have a material adverse effect on ourresults of operations.

 

**Changes in internationalregulations regarding reimbursement for our products could adversely affect ourbusiness and results of operations.**

** **

Similar to our domestic business, our success ininternational markets also depends upon the eligibility of our products forreimbursement through government sponsored healthcare payment systems andthird-party payors, the portion of cost subject to reimbursement, and the costallocation between the patient and government sponsored healthcare paymentsystems and third-party payors. Reimbursement practices vary significantly by country, with certaincountries requiring products to undergo a lengthy regulatory review in order tobe eligible for third-party reimbursement. In addition, healthcare cost containment efforts similar to those weface in the United States are prevalent in many of the foreign countries inwhich our products are sold, and these efforts are expected to continue in thefuture, possibly resulting in the adoption of more stringent standards.  For example, in Germany, our largest foreignmarket, effective since January 1, 2004, each German adult patient mustpay between five and ten Euros for each medical technical deviceprescribed.  The exact amount of theco-payment is defined as 10% of the price of the device if it falls within thepayment corridor.  Patients may beexempted from this co-payment obligation if the aggregate co-payments in thecourse of a calendar year exceeds 2% (1% for chronically ill) of the untaxedincome of the patient.  This new formulareplaces the former co-payment rule which imposed a 20% contribution on thepatient.

 

In Italy, our rigid knee bracing products and coldtherapy *products,*among others, are no longer eligible for reimbursement.  In the United Kingdom, while reimbursementfor our products through the National Health Service, or NHS, is currentlyavailable, the cost of our products is not reimbursed by private healthinsurance plans and orthopedic professionals are being pressured by the NHS toreduce or eliminate the number of rigid knee braces prescribed for orthopedicpatients.  Any developments in ourforeign markets that eliminate or reduce reimbursement rates for our productscould have an adverse effect on our ability to sell our products or cause ourorthopedic professional customers to use less expensive products in thesemarkets.

 

**Medicare laws mandatingnew supplier standards and conditions for coverage could adversely impact ourbusiness.**

** **

Medicare regulations require entities or individualssubmitting claims and receiving payment to obtain a supplier number, which inturn is predicated on compliance with a number of supplier standards.  Under the Modernization Act, any entity orindividual that bills Medicare for durable medical equipment and orthotics andthat has a supplier number for submission of such bills will be subject to newquality standards as a condition of receiving payment from the Medicareprogram.  The new standards are to be metby suppliers of orthotics and durable medical equipment, such as bone growthstimulators.  New standards are to bedeveloped by CMS and applied by independent accreditation organizations.  The Modernization Act also authorizes CMS toestablish clinical conditions for payment for durable medical equipment.  These new supplier standards and clinicalconditions for payment could limit or reduce the number of individuals who canfit, sell or provide our products and could restrict coverage for ourproducts.  In addition, because we are aMedicare supplier, and therefore also subject to any new supplier standards,our failure to meet any new supplier standards could affect our ability tobill, and therefore could have a material adverse effect on our business,financial condition and results of operations.

 

**Healthcare reform, managedcare and buying groups have put downward pressure on the prices of ourproducts.**

** **

Within the United States, healthcare reform andmanaged care have changed and continue to affect the dynamics of the healthcareindustry in responding to rising healthcare costs.  As a result of healthcare reform, the U.S.healthcare industry has seen a rapid expansion of managed careorganizations.  The development ofmanaged care programs in which the providers contract to provide comprehensivehealthcare to a patient population at a fixed cost per person (referred to ascapitation) has put pressure on, and is expected to continue to cause,healthcare providers to lower costs.  Theadvent of managed care has also resulted in greater attention to the tradeoffbetween patient need and product cost, so-called demand matching, wherepatients are evaluated as to age, need for mobility and other parameters andare then matched with an orthopedic product that is cost effective in light ofsuch evaluation.  One result of demandmatching has been, and is expected to continue to be, a shift toward lowerpriced products, and

 

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any such shift in our product mix to lower margin,off-the-shelf products could have an adverse impact on our operatingresults.  For example, in our rigidknee-bracing segment, we and many of our competitors are offering lower priced,off-the-shelf products in response to managed care customers.

 

A further result of managed care and the relatedpressure on costs has been the advent of buying groups in the UnitedStates.  Such buying groups enter intopreferred supplier arrangements with one or more manufacturers of orthopedic orother medical products in return for price discounts.  The extent to which such buying groups areable to obtain compliance by their members with such preferred supplieragreements varies considerably depending on the particular buying groups.  In response to the organization of new buyinggroups, we have entered into national contracts with selected groups andbelieve that the high levels of product sales to such groups and theopportunity for increased market share have the potential to offset thefinancial impact of discounting.  Webelieve that our ability to maintain our existing arrangements will beimportant to our future success and the growth of our revenues.  In addition, we may not be able to obtain newpreferred supplier commitments for major buying groups, in which case we couldlose significant potential sales, to the extent these groups are able tocommand a high level of compliance by their members.  On the other hand, if we receive preferredsupplier commitments from particular groups which do not deliver high levels ofcompliance, we may not be able to offset the negative impact of lower per unitprices or lower margins with any increases in unit sales or in market share.

 

In international markets, where the movement towardhealthcare reform and the development of managed care are generally not asadvanced as in the United States, we have experienced downward pressure onproduct pricing and other effects of healthcare reform similar to that which wehave experienced in the United States. We expect healthcare reform and managed care to continue to develop inour primary international markets, which we expect will result in furtherdownward pressure in product pricing. The timing and effects on us of healthcare reform and the development ofmanaged care in international markets cannot currently be predicted.

 

**Proposed laws that wouldlimit the types of orthopedic professionals who can fit, sell or seekreimbursement for our products could, if adopted, adversely affect ourbusiness.**

** **

In response to pressure from mostly orthopedicpractitioners, Congress and state legislatures have from time to timeconsidered proposals that limit the types of orthopedic professionals who canfit and/or sell our orthotic device products or who can seek reimbursement forthem.  Several states have adopted legislationwhich imposes certification or licensing requirements on the measuring, fittingand adjusting of certain orthotic devices. Some of these laws have exemptions for manufacturers’representatives.  Other laws apply to theactivities of such representatives. Other states may be considering similar legislation.  Such laws could limit our potential customersin those jurisdictions in which such legislation or regulations are enacted bylimiting the measuring and fitting of these devices to certain licensedindividuals.  We may not be successful inopposing their adoption and, therefore, such laws could have a material adverseeffect on our business. In addition, efforts have been made to establish suchrequirements at the federal level for the Medicare program.  Most recently, in 2000 Congress passed theMedicare, Medicaid, and SCHIP Benefits Improvement and Protection Act of 2000(BIPA).  BIPA contained a provisionrequiring as a condition for payment by the Medicare program that certaincertification or licensing requirements be met for individuals and suppliersfurnishing certain, but not all, custom-fabricated orthotic devices.  CMS is in the process of implementing thisrequirement, and we cannot predict the effect its implementation orimplementation of other such laws will have on our businees.

 

**We may need to change ourbusiness practices to comply with healthcare fraud and abuse laws andregulations.**

** **

We are subject to various federal and state lawspertaining to healthcare fraud and abuse, including anti-kickback laws andphysician self-referral laws.  Violationsof these laws are punishable by criminal and/or civil sanctions, including, insome instances, imprisonment and exclusion from participation in federal andstate healthcare programs, including Medicare, Medicaid, Veterans Administrationhealth programs and TRICARE.  Because ofthe far-reaching nature of these laws, we may be required to alter one or moreof our practices.  Healthcare fraud andabuse regulations are complex and even minor, inadvertent irregularities insubmissions can potentially give rise to claims that a fraud and abuse law orregulation has been violated.  Anyviolations of these laws or regulations could result in a material adverseeffect on our business, financial condition and results of operations.  If there is a change in law, regulation oradministrative or judicial interpretations, we may have to change our businesspractices or our existing business practices could be challenged as unlawful.

 

**Audits or denials of ourclaims by government agencies could reduce our revenue or profits.**

** **

As part of our business structure, we submit claimsdirectly to and receive payments directly from the Medicare and Medicaidprograms.  Therefore, we are subject toextensive government regulation, including requirements for maintaining certaindocumentation to support our claims. Medicare contractors and Medicaid agencies periodically conduct pre- andpost-payment review and other audits of claims, and are under increasingpressure to scrutinize more closely healthcare claims and supportingdocumentation generally.  We periodicallyreceive requests for documentation during the governmental audits of individualclaims

 

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either on a pre-payment or post-payment basis.  We cannot assure you that review and/or otheraudits of our claims will not result in material delays in payment, as well asmaterial recoupments or denials, which could reduce our revenue or profits.

 

**Item 2. Properties**

 

We are headquartered in Vista, California and operatemanufacturing locations in Vista, California and Tijuana, Mexico. In October2004 we signed a 15-year lease for a 110,000 square foot built-to-suit facilityto be constructed in Vista, California, and we intend to consolidate our Vistaoperations in that facility when completed, which is estimated to be in thefirst half of 2006. Our manufacturing facilities located in Tijuana, Mexico arewithin 100 miles of Vista and consist of a 200,000 square foot built-to-suitfactory which we occupied in late 2004. In December 2003, we established a pilot east coast distribution centerin Lansing, Michigan and we have signed a lease for a distribution facility inIndianapolis, Indiana to which we will relocate our east coast distributionoperation.  We also lease warehouse andoffice space in Germany, Canada, France, the United Kingdom and Denmark.  All of our facilities are leased; none areowned. The following table summarizes the properties we lease.

 

 
| **Location**                 | ** ** | **Use**                                                                             | ** ** | **Owned/Leased** | ** ** | **Lease Termination  Date**               | ** ** | **Size (Square Feet)** | ** ** |
|------------------------------|------------|-------------------------------------------------------------------------------------|------------|------------------|------------|-------------------------------------------|------------|------------------------|------------|
| Vista, California            |       | Corporate  Headquarters Research & Development Manufacturing & Distribution |       | Leased           |       | February  2008                            |       | 266,041                |       |
| Vista, California            |       | New  Corporate Headquarters Under Construction                                      |       | Leased           |       | 15  years from completion of construction |       | 110,000                |       |
|                         |       |                                                                                |       |             |       |                                      |       |                   |       |
| Tijuana, Mexico              |       | Manufacturing  Facility                                                             |       | Leased           |       | September 2014                            |       | 200,000                |       |
|                         |       |                                                                                |       |             |       |                                      |       |                   |       |
| Neudrossenfeld, Germany      |       | Office &  Distribution                                                          |       | Leased           |       | December 2007                             |       | 14,300                 |       |
|                         |       |                                                                                |       |             |       |                                      |       |                   |       |
| Surrey, United  Kingdom      |       | Office &  Distribution                                                          |       | Leased           |       | November 2011                             |       | 3,111                  |       |
|                         |       |                                                                                |       |             |       |                                      |       |                   |       |
| Mississauga, Ontario, Canada |       | Office &  Distribution                                                          |       | Leased           |       | January 2010                              |       | 8,628                  |       |
|                         |       |                                                                                |       |             |       |                                      |       |                   |       |
| Tournes, France              |       | Office &  Distribution                                                          |       | Leased           |       | January 2012                              |       | 3,470                  |       |
|                         |       |                                                                                |       |             |       |                                      |       |                   |       |
| Horsholm,  Denmark           |       | Office &  Distribution                                                          |       | Leased           |       | December 2005                             |       | 2,500                  |       |
|                         |       |                                                                                |       |             |       |                                      |       |                   |       |
| Indianapolis,  Indiana       |       | Distribution                                                                        |       | Leased           |       | April 2010                                |       | 41,600                 |       |

 

**Item 3. Legal Proceedings**

 

From time to time, we are involved in lawsuits arisingin the ordinary course of business. This includes patent and other intellectualproperty disputes between our various competitors and us.  With respect to these matters, we believethat we have adequate insurance coverage or have made adequate accruals forrelated costs, and we may also have effective legal defenses. We are not awareof any pending lawsuits that could have a material adverse effect on ourbusiness, financial condition and results of operations.

 

**Item 4. Submission of Matters toa Vote of Security Holders**

 

No matters were submittedto a vote of security holders during the quarter ended December 31, 2004.

 

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** **

**Executive Officers**

 

The following table setsforth information with respect to our executive officers:

 
| **Name**          | ** ** | **Age** | ** ** | **Position with dj Orthopedics**                                       |
|-------------------|------------|---------|------------|------------------------------------------------------------------------|
|              |       |    |       |                                                                   |
| Leslie H. Cross   |       | 54      |       | President, Chief  Executive Officer and Director                       |
| Vickie L. Capps   |       | 43      |       | Senior Vice President,  Finance, Chief Financial Officer and Treasurer |
| Luke T. Faulstick |       | 41      |       | Senior Vice President,  Operations                                     |
| Louis T. Ruggiero |       | 45      |       | Senior Vice President,  Sales and Marketing                            |
| Donald M. Roberts |       | 56      |       | Vice President, General  Counsel and Secretary                         |

 

*Leslie H.Cross* has been our Chief Executive Officer and President anda member of our board of directors since our incorporation in August 2001. Heserved as the Chief Executive Officer and a Manager of DonJoy, L.L.C., ourpredecessor, from June 1999 until November 2001, and has served as President ofdj Orthopedics, LLC, our wholly owned operating subsidiary, or its predecessor,the Bracing & Support Systems division of Smith & Nephew, Inc. sinceJune 1995.  From 1990 to 1994,Mr. Cross held the position of Senior Vice President of Marketing andBusiness Development of the Bracing & Support Systems division of Smith& Nephew. He was a Managing Director of two different divisions ofSmith & Nephew from 1982 to 1990. Prior to that time, he worked atAmerican Hospital Supply Corporation. Mr. Cross earned a diploma inmedical technology from Sydney Technical College in Sydney, Australia andstudied business at the University of Cape Town in Cape Town, South Africa.

 

*Vickie L.Capps* joined us in July 2002 and serves as our Senior VicePresident, Finance, Chief Financial Officer and Treasurer.  From September 2001 until July 2002, Ms.Capps was employed by AirFiber, a privately held provider of broadband wirelesssolutions, where she served as Senior Vice President, Finance andAdministration and Chief Financial Officer. From July 1999 to July 2001, Ms. Capps served as Vice President ofFinance and Administration and Chief Financial Officer for MaxwellTechnologies, Inc., a publicly traded technology company.  From 1992 to 1999, Ms. Capps served invarious positions, including Chief Financial Officer, with Wavetek WandelGoltermann, Inc., a multinational communications equipment company.  Ms. Capps also served as a senior audit andaccounting professional for Ernst & Young LLP from 1982 to 1992. Ms. Cappsis a California Certified Public Accountant and also serves on the board ofdirectors for Targeted Molecules Corporation of San Diego, a privately heldbiotechnology company. Ms. Capps received a B.S. degree in businessadministration/accounting from San Diego State University.

 

*Luke T.Faulstick* currently serves as our Senior Vice President,Operations. He joined us as Vice President of Manufacturing in June of2001.  From 1998 to June 2001, Mr.Faulstick served as General Manager for Tyco Healthcare. From 1996 to 1998, Mr.Faulstick served as Plant Manager for Mitsubishi Consumer Electronics. In 1994,he started a contract manufacturing business that supplied products to themedical, electronic and photographic industries. Mr. Faulstick began his careerin 1985 working for Eastman Kodak Company in Rochester New York where he heldvarious positions in Engineering, Marketing, and Product Research andDevelopment.  He currently serves on theboard of directors of Power Partners, Inc., a privately held power transmissionmanufacturer. Mr. Faulstick received a B.S. in engineering from Michigan StateUniversity and an M.S. in engineering from Rochester Institute of Technology.

 

*Louis T.Ruggiero* joined us as Senior Vice President, Sales andMarketing in August 2003.  Mr. Ruggierobrings more than 20 years of sales experience in medical devices, with morethan half of his tenure in management roles. From 2000 to 2003, Mr. Ruggieroserved as President and Chief Executive Officer of Titan Scan Technologies, asubsidiary of Titan Corporation, a leader in electron beam technology formedical device sterilization, mail sanitization and industrial processes. From1990 to 2000, Mr. Ruggiero was employed by GE Medical Systems, a global leaderin medical diagnostic imaging, healthcare IT, productivity solutions, servicesand financing. He most recently served as director of corporate alliances.Prior to 1990, Mr. Ruggiero was employed by Davol, Inc., a division of C.R.Bard, Inc., where he served as sales manager in the northeast district. He hasalso held field sales positions with American V. Mueller, a division ofAmerican Hospital Supply, and Proctor & Gamble. Mr. Ruggiero received hisundergraduate degree in interpersonal communication/political science from St.John’s University and his M.B.A. from the J.L. Kellogg School of Management,Northwestern University.

 

*Donald M.Roberts* joined us in December 2002 and currently serves asVice President, General Counsel and Secretary. From 1994 to December 2002, Mr. Roberts served as Vice President,Secretary and General Counsel for Maxwell Technologies, Inc., a publicly heldtechnology company. Previous to that, he was with the Los Angeles-based lawfirm of Parker, Milliken, Clark, O’Hara & Samuelian for 21 years.  Mr. Roberts was a shareholder in the firm,having served as partner in a predecessor partnership. Mr. Roberts received hisundergraduate degree in political science from Yale University and earned hisJ.D. at the University of California, Berkeley, Boalt Hall School of Law.

 

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**PART II**

** **

**Item 5.   Market for the Registrant’s Common Equity,Related Stockholder Matters and Issuer Purchases of Equity Securities**

 

Our common stock islisted on the New York Stock Exchange under the symbol DJO. The following tablesets forth, for the calendar quarters indicated, the high and low sales pricesper share of our common stock as reported on the New York Stock Exchange:

 
| ** **                         | ** ** | **High** | ** ** | **Low** | ** ** |
|------------------------------------|------------|----------|------------|---------|------------|
|                               |       |     |       |    |       |
| **Year  ended December 31, 2004:** |       |     |       |    |       |
| First Quarter                      |       | $        | 27.25      |    | $          | 17.35 |   |
| Second Quarter                     |       | 27.60    |       | 20.60   |       |
| Third Quarter                      |       | 24.90    |       | 16.59   |       |
| Fourth Quarter                     |       | 22.50    |       | 16.28   |       |
|                               |       |     |       |    |       |
| **Year  ended December 31, 2003:** |       |     |       |    |       |
| First Quarter                      |       | $        | 4.22       |    | $          | 3.50 |   |
| Second Quarter                     |       | 11.40    |       | 3.87    |       |
| Third Quarter                      |       | 14.15    |       | 10.23   |       |
| Fourth Quarter                     |       | 29.30    |       | 13.54   |       |

 

As of February 25, 2005,there were approximately 15 stockholders of record of our common stock.

 

We have not declared orpaid any cash dividends since our inception. We currently intend to retain ourfuture earnings, if any, to finance the further expansion and continued growthof our business. In addition, our ability to pay cash dividends on our commonstock is currently restricted under the terms of our credit agreement. Futuredividends, if any, will be determined by our board of directors.

 

On September 27, 2004, our board of directorsauthorized a program to repurchase up to $20 million of our common stock. Theshares may be repurchased at times and prices as determined by management andmay be completed through open market or privately negotiated transactions. Therepurchase program provides that repurchases will be made in accordance withapplicable state and federal law and in accordance with the terms and subjectto the restrictions of Rule 10b-18 under the Securities Exchange Act of 1934,as amended. Shares will be retired and cancelled upon repurchase. We obtainedan amendment to our credit agreement permitting the stock repurchaseprogram.  Through December 31, 2004, wehad repurchased 837,300 shares of our common stock at an average price of$17.62 per share, for an aggregate total cost of approximately $14.8million.  Details of the repurchases areas follows:

 
| **Fiscal Period**                               | ** ** | **Total  Number of  Shares  Purchased** | ** ** | **Average  Price Paid  per Share** | ** ** | **Total Number of  Shares  Purchased as  Part of Publicly  Announced  Plans or  Programs** | ** ** | **Approximate Dollar  Value of Shares that May  Yet Be Purchased Under  the Plans or Programs** | ** ** |
|-------------------------------------------------|------------|-----------------------------------------|------------|------------------------------------|------------|--------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------|------------|
| ** **                                      | ** ** | ** **                              | ** ** | ** **                         | ** ** | ** **                                                                                 | ** ** | **(in thousands)**                                                                              | ** ** |
| October 2004  (September 26 – October 30)  |       | 685,300                                 |       | $                                  | 17.77      |                                                                                       | 685,300    |                                                                                            | $          | 7,800 |   |
| November 2004  (October 31 – November 27)  |       | 152,000                                 |       | 16.96                              |       | 152,000                                                                                    |       | 5,200                                                                                           |       |
| December 2004  (November 28 – December 31) |       | —                                  |       | —                             |       | —                                                                                     |       | 5,200                                                                                           |       |
| Total                                           |       | 837,300                                 |       | $                                  | 17.62      |                                                                                       | 837,300    |                                                                                            | $          | 5,200 |   |

 

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**Item  6.Selected Financial Data**

 

The selected financialdata set forth below with respect to our consolidated financial statements hasbeen derived from our audited financial statements.  The data set forth below should be read inconjunction with “Management’s Discussion and Analysis of Financial Conditionand Results of Operations” and our audited financial statements and Notesthereto appearing elsewhere herein.

 
| ** **                                                                              | ** ** | **Years Ended December 31,**              | ** ** |
|-----------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                              | ** ** | **2004**                                  | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
| ** **                                                                              | ** ** | **(In thousands, except per share data)** | ** ** |
| **Statement  of Operations Data:**                                                      |       |                                      |       |   |   |   |   |   |   |   |   |
| Net revenues                                                                            |       | $                                         | 255,999    |   | $ | 197,939 |   | $ | 182,636 |   | $ | 169,170 |   | $ | 143,586 |   |
| Costs of goods  sold (a)                                                                |       | 95,164                                    |       | 85,927 |   | 95,878 |   | 83,079 |   | 69,129 |   |
| Gross profit                                                                            |       | 160,835                                   |       | 112,012 |   | 86,758 |   | 86,091 |   | 74,457 |   |
| Operating  expenses:                                                                    |       |                                      |       |   |   |   |   |   |   |   |   |
| Sales and  marketing (b)                                                                |       | 78,984                                    |       | 54,067 |   | 56,216 |   | 36,175 |   | 29,201 |   |
| General and  administrative                                                             |       | 27,727                                    |       | 21,767 |   | 26,414 |   | 25,042 |   | 19,829 |   |
| Research and  development                                                               |       | 5,627                                     |       | 4,442 |   | 2,922 |   | 2,285 |   | 2,898 |   |
| Amortization of  acquired intangibles                                                   |       | 4,731                                     |       | 464 |   | — |   | — |   | — |   |
| Impairment of  long-lived assets (c)                                                    |       | —                                    |       | — |   | 3,666 |   | — |   | — |   |
| Performance  improvement, restructuring and other  costs (d)                            |       | 4,693                                     |       | (497 | ) | 10,008 |   | — |   | 400 |   |
| Total operating  expenses                                                               |       | 121,762                                   |       | 80,243 |   | 99,226 |   | 63,502 |   | 52,328 |   |
| Income (loss)  from operations                                                          |       | 39,073                                    |       | 31,769 |   | (12,468 | ) | 22,589 |   | 22,129 |   |
| Prepayment  premium and other costs related to senior subordinated notes redemption (e) |       | (7,760                                    | )          | — |   | — |   | (4,669 | ) | — |   |
| Interest expense  and other, net                                                        |       | (8,276                                    | )          | (11,718 | ) | (12,088 | ) | (17,388 | ) | (16,970 | ) |
| Income (loss)  before income taxes                                                      |       | 23,037                                    |       | 20,051 |   | (24,556 | ) | 532 |   | 5,159 |   |
| Benefit  (provision) for income taxes (f)                                               |       | (9,022                                    | )          | (7,980 | ) | 9,361 |   | 55,958 |   | — |   |
| Net income  (loss)                                                                      |       | 14,015                                    |       | 12,071 |   | (15,195 | ) | 56,490 |   | 5,159 |   |
| Less: Preferred  unit dividends and accretion of preferred unit fees                    |       | —                                    |       | — |   | — |   | (5,667 | ) | (5,415 | ) |
| Net income  (loss) available to common stockholders                                     |       | $                                         | 14,015     |   | $ | 12,071 |   | $ | (15,195 | ) | $ | 50,823 |   | $ | (256 | ) |
|                                                                                    |       |                                      |       |   |   |   |   |   |   |   |   |
| Net income  (loss) per share available to common stockholders:                          |       |                                      |       |   |   |   |   |   |   |   |   |
| Basic                                                                                   |       | $                                         | 0.66       |   | $ | 0.67 |   | $ | (0.85 | ) | $ | 4.80 |   | N/A |   |
| Diluted                                                                                 |       | $                                         | 0.63       |   | $ | 0.64 |   | $ | (0.85 | ) | $ | 4.68 |   | N/A |   |
| Weighted average  shares outstanding:                                                   |       |                                      |       |   |   |   |   |   |   |   |   |
| Basic                                                                                   |       | 21,221                                    |       | 17,963 |   | 17,873 |   | 10,593 |   | N/A |   |
| Diluted                                                                                 |       | 22,209                                    |       | 18,791 |   | 17,873 |   | 10,858 |   | N/A |   |
| **Balance  Sheet Data (at end of period):**                                             |       |                                      |       |   |   |   |   |   |   |   |   |
| Cash                                                                                    |       | $                                         | 11,182     |   | $ | 19,146 |   | $ | 32,085 |   | $ | 25,814 |   | $ | 4,106 |   |
| Total assets                                                                            |       | 306,850                                   |       | 320,504 |   | 237,724 |   | 247,922 |   | 155,672 |   |
| Long-term  obligations                                                                  |       | 95,000                                    |       | 174,156 |   | 109,816 |   | 110,934 |   | 157,222 |   |
| Total  stockholders’/members’ equity (deficit)                                |       | 183,038                                   |       | 117,333 |   | 100,913 |   | 115,240 |   | (63,625 | ) |

 

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N/A-Asof December 31, 2000, we were organized as a limited liability company andaccordingly, had no shares outstanding.

 

(a)          Theyear ended December 31, 2002 included aggregate charges of $5.1 million toprovide reserves for excess inventories, substantially related to product linesthat we discontinued (see Note 4 of the notes to our consolidated financialstatements).

 

(b)         Theyear ended December 31, 2002 included an aggregate increase of $6.7 million inour estimated reserves for contractual allowances and bad debts related to ouraccounts receivable from third-party payor customers (see Note 4 of the notesto our consolidated financial statements).

 

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(c)          Theyear ended December 31, 2002 included $3.7 million in charges related toimpairment of certain of our long-lived assets (see Note 4 of the notes to ourconsolidated financial statements).

 

(d)         Theyear ended December 31, 2004 includes $4.7 million in restructuring chargesrelated to our Regeneration business integration and the relocation of certainmanufacturing operations to Mexico (see Note 4 of the notes to our consolidatedfinancial statements). The year ended December 31, 2002 includes $10.0 millionin charges related to our performance improvement program (see Note 4 of thenotes to our consolidated financial statements), including an accrual forestimated future net rent for vacated facilities. In 2003, we decided to retainthe vacant space for future expansion and reversed the remaining accrual of$0.5 million. We recorded $0.4 million of merger and integration costs in 2000associated with the consolidation of certain acquired operations into ourexisting facilities.

 

(e)          Theyear ended December 31, 2004 includes charges aggregating $7.8 million relatedto the redemption of all of our outstanding senior subordinated notes in June2004.  The $7.8 million charge includes aprepayment premium and unamortized debt issuance costs and original issuediscounts. The year ended December 31, 2001 included a charge of approximately$4.7 million for the write-off of unamortized deferred debt issuance costs,debt discount and a prepayment premium incurred as a result of an early redemptionof a portion of our senior subordinated notes.

 

(f)            Werecorded a tax benefit (provision) at an effective tax rate of 39.2%, 39.8% and(38.1%) on our income (loss) before income taxes for the years ended December31, 2004, 2003 and 2002, respectively, and at an effective tax rate of 40% onour income before income taxes for the period from November 20, 2001, the dateof our reorganization, to December 31, 2001. Because DonJoy, L.L.C. operated asa limited liability company from the date of its recapitalization in June 1999through November 20, 2001, the date on which the reorganization wasconsummated, in accordance with federal, state and local income tax regulationsthat provide that no income taxes are levied on U.S. limited liabilitycompanies as each member of the LLC is individually responsible for reportingthe member’s share of net income or loss, we did not provide for income taxesin our historical consolidated financial statements prior to thereorganization. In connection with the reorganization, we recorded a deferredtax benefit of $54.2 million related to the difference between the book and thetax bases of certain assets and liabilities of DonJoy at November 20, 2001.

 

**Item  7. Management’s Discussion and Analysis ofFinancial Condition and Results of Operations**

 

***Overview***

** **

We are a global medicaldevice company specializing in rehabilitation and regeneration products for thenon-operative orthopedic and spine markets. Our broad range of over 600 rehabilitation products, including rigidknee braces, soft goods, and pain management products, are used to preventinjury, to treat chronic conditions and to aid in recovery after surgery orinjury. Our regeneration products consist of bone growth stimulation devicesthat are used to treat nonunion fractures and as an adjunct therapy afterspinal fusion surgery. We sell our products in the United States and in morethan 40 other countries through networks of agents, distributors and our directsales force that market our products to orthopedic and spine surgeons,podiatrists, orthopedic and prosthetic centers, third-party distributors,hospitals, surgery centers, physical therapists, athletic trainers and otherhealthcare professionals.

 

# ***Acquisitions and Other RecentTransactions***

# * *

On November 26, 2003, weacquired the bone growth stimulation device business from OrthoLogic, which wenow call our Regeneration business. Following the Regeneration acquisition inNovember 2003, we operated the Regeneration business as a stand alone divisionin Tempe, Arizona with a sales force separate from our domestic rehabilitationproduct sales force.  In August 2004, webegan the integration of the former Regeneration sales force into our domesticrehabilitation sales organization, and we took the first steps towards integratingmost of the other Regeneration operations into our corporate facility in Vista,California. By the end of 2004, we completed the integration of most of theRegeneration operations except for the assembly and calibration operationswhich we expect to move to Vista in the first quarter of 2005 following siteapproval of the U.S. Food and Drug Administration. One of the principalobjectives of the integration is to enhance the sales and distributionactivities of the Regeneration business to capture more of the growthopportunities in the regeneration market. In addition, we believe the integration will enable us to reduce bothcosts of goods sold and operating expenses as a percentage of net revenues infuture periods, after the related costs of the integration have beenincurred.  The accompanying consolidatedstatement of operations for the year ended December 31, 2004 includesrestructuring charges totaling approximately $3.8 million ($2.4 million net oftax). The costs of the integration were primarily severance, recruiting andtraining.

 

In August 2004, wecompleted construction of a new 200,000 square foot leased facility in Tijuana,Mexico, to replace three separate facilities we operated in the same area andto provide further opportunities to expand our Mexico manufacturingoperations.  As of early October 2004,all of our existing Mexico facilities had been moved to this new facility.  In the fourth quarter of 2004, we completedthe relocation of the manufacturing of our cold therapy products and machineshop activities from

 

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Vista, California to thenew Mexico plant.  We recordedrestructuring charges of $0.9 million ($0.5 million net of tax) in 2004 relatedto these manufacturing moves, including primarily severance and moving costs.

 

On August 30, 2004, weacquired the outstanding stock of KD Innovation A/S (KDI), our independentdistributor in Denmark. The acquired company, renamed dj Orthopedics Nordic ApS(dj Nordic), has direct responsibility for sales, marketing and distribution ofour products in Denmark, Finland, Norway and Sweden.  The stock purchase agreement provided for thepurchase of all of the outstanding capital stock for KDI for an initial cashpurchase price of $0.7 million, paid in October 2004, plus amounts aggregatingup to an additional $0.5 million through 2006 if certain net operating incometargets are met.  The acquisition wasaccounted for using the purchase method of accounting whereby a total purchaseprice of approximately $1.0 million, including the portion of the contingentfuture payments that are deemed by management to be probable, was allocated totangible and intangible assets acquired and liabilities assumed based on theirestimated fair market values as of the acquisition date.

 

During the year endedDecember 31, 2004, we purchased rights to certain distributor territories inthe U.S., for amounts aggregating $1.9 million, in connection with areorganization of the distribution activities within such territories. Thesereorganizations are intended to achieve several objectives, includingimprovement of sales results within the affected territories and reduction ofour distribution costs within such territories for a defined period of time.  Purchase price aggregating $1.2 million wascapitalized as an intangible asset and will be amortized over the period ofcost reduction. Purchase price aggregating $0.7 million was recorded as notesreceivable and is included in other current or long-term assets, depending onmaturity, and will be repaid over periods ranging from three years to fiveyears.

 

In February 2004,we completed a public offering of 8,625,000 shares of our common stock.  The offering consisted of 3,162,500 shares ofcommon stock sold by us at $19.00 per share for net proceeds, afterunderwriters’ commissions and other costs, of $56.5 million, and 5,462,500shares sold by certain of our stockholders.

 

In June 2004, wecompleted a public offering of 3,072,379 shares of our common stock.  All of these shares were sold by certain ofour stockholders and we did not receive any of the net proceeds.  We incurred costs of $0.2 million related tothis offering, which were recorded as a reduction in our additional paid-incapital.

 

In June 2004, we redeemedall of our outstanding senior subordinated notes for $79.7 million, including aredemption premium of $4.7 million.  Wefunded the redemption with the net proceeds from our February 2004 sale ofcommon stock and existing cash.  As aresult of the redemption, we recorded a charge of $7.8 million, including theredemption premium and unamortized debt issuance costs and original issuediscounts.  Prior to the redemption, wehad received the consents necessary under our credit agreement to use theproceeds from the sale of shares by us and cash on hand to redeem the notes.

 

On September 27, 2004,our board of directors authorized a program to repurchase up to $20 million ofour common stock. The shares may be repurchased at times and prices asdetermined by management and may be completed through open market or privatelynegotiated transactions. The repurchase program provides that repurchases willbe made in accordance with applicable state and federal law and in accordancewith the terms and subject to the restrictions of Rule 10b-18 under theSecurities Exchange Act of 1934, as amended. Shares will be retired andcancelled upon repurchase. We obtained an amendment to our credit agreementpermitting the stock repurchase program. Through December 31, 2004, we had repurchased 837,300 shares of ourcommon stock at an average price of $17.62 per share, for an aggregate totalcost of approximately $14.8 million.

 

***2002Performance Improvement Program***

 

In 2002, we completed acompany-wide performance improvement program with the objective of increasingrevenues and reducing both costs of goods sold and operating expenses as apercentage of net revenues beginning in 2003. We retained the services of AlixPartners, LLC, a consulting firmspecializing in corporate performance enhancement, to assist with theperformance improvement program. With the objective of reducing costs bystreamlining our organization structure, our performance improvement programincluded the elimination of several senior management and other positions.  We also moved the manufacturing of all ourremaining soft goods and certain non-custom rigid braces manufactured in theUnited States to our manufacturing facilities in Mexico. Other focuses of theperformance improvement program included: reducing operating expenses;improving the profitability of sales to our third-party payor customers;improving working capital management; and improving our business processes andinformation systems.  We also refocusedour resources on our core rehabilitation business and discontinued themarketing of our surgical products and our knee replacement product in 2002.

 

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***Segments***

 

Our reportable segments,except for Regeneration, reflect our primary distribution channels.  Regeneration is considered a reportablesegment because of management’s separate focus on its growth and profitability.Our reportable segments are as follows:

 

•                  *DonJoy*, which is responsible for sales of rigid knee braces,pain management products, regeneration products (effective August 2004) andcertain soft goods.  The channel consistsof approximately 300 independent commissioned sales representatives who areemployed by approximately 40 independent sales agents and a few of our directsales representatives. Our sales representatives are primarily dedicated to thesale of our products to orthopedic surgeons, podiatrists, orthopedic andprosthetic centers, hospitals, surgery centers, physical therapists, athletictrainers and other healthcare professionals. Because the DonJoy product lines generally require customer education onthe application and use of the product, our sales representatives are technicalspecialists who receive extensive training both from us and the agent and usetheir expertise to help fit the patient with the product and assist theorthopedic professional in choosing the appropriate product to meet the patient’sneeds. After a product order is received by a sales representative, wegenerally ship the product directly to the orthopedic professional and pay asales commission to the agent based on sales of such products. Thesecommissions are reflected in sales and marketing expense in our consolidatedstatements of income;

 

•                  *ProCare*, in which products are sold by approximately 36 directand independent representatives that manage over 310 dealers focused on primaryand acute facilities. Products are sold primarily to national third-partydistributors, other regional medical supply dealers and medical product buyinggroups, generally at a discount from list prices. The majority of theseproducts are soft goods and pain management products requiring little or nopatient education. These distributors resell these products to large hospitalchains, hospital buying groups, primary care networks and orthopedic physiciansfor use by the patients;

 

•                  *Regeneration,*in which our OL1000 product is sold through acombination of our DonJoy segment direct sales representatives andapproximately 100 sales representatives dedicated to selling our OL1000product, of which approximately 43 are employed by us. The SpinaLogic product isalso included in this segment and was, until the end of 2004, sold by DePuySpine in the U.S. under an exclusive sales agreement. In January 2005, weamended the agreement with DePuy to divide the U.S. into territories in whichDePuy Spine has exclusive sales rights and non-exclusive territories in whichwe are permitted to engage in our own sales efforts or retain another salesagent.   These products are sold eitherdirectly to the patient or to independent distributors.  We arrange billing to the third-party payorsor patients, for products sold directly to the patient;

 

•                  *OfficeCare*, inwhich we maintain an inventory of product (mostly soft goods) on hand atorthopedic practices for immediate distribution to the patient. For theseproducts, we arrange billing to the patient or third-party payor after theproduct is provided to the patient. We outsource most OfficeCare billing andcollections activities to an independent third-party contractor. The OfficeCareprogram is also intended to facilitate the introduction of our products toorthopedic surgeons who had not previously been our customers.  As of December 31, 2004, the OfficeCareprogram was located at over 650 physician offices throughout the United States.We have contracts with over 500 third-party payors for our OfficeCare products;and

 

•                  *International*, in which our products are sold in foreigncountries through wholly-owned subsidiaries or independent distributors.  We sell our products in over 40 foreigncountries, primarily in Europe, Canada, Australia and Japan.

 

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Set forth below is netrevenue, gross profit and operating income (loss) information for our reportingsegments for the years ended December 31 (in thousands). This informationexcludes the impact of other expenses not allocated to segments, which arecomprised of (i) general corporate expenses for all periods presented, (ii) theimpairment of long-lived assets and certain performance improvement,restructuring, and other costs for 2002 and (iii) the restructuring costsassociated with the manufacturing move in 2004. Information for the Regenerationsegment includes operations for the period subsequent to the Regenerationacquisition on November 26, 2003 and includes the impact of purchase accountingand related amortization of acquired intangible assets.  For the years ended December 31, 2004 and2003, Regeneration income from operations was reduced by amortization ofacquired intangible assets amounting to $4.7 million and $0.5 million,respectively.   For the year endedDecember 31, 2004, Regeneration income from operations was also reduced byrestructuring charges of $3.8 million related to the integration of thebusiness operations of the segment.

 
| ** **                                            | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|-------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| **DonJoy:**                                           |       |     |       |     |       |     |       |
| Net revenues                                          |       | $        | 99,771     |     | $          | 95,353   |       | $ | 90,799 |   |
| Gross profit                                          |       | 58,498   |       | 53,824   |       | 53,380   |       |
| Gross profit  margin                                  |       | 58.6     | %          | 56.4     | %          | 58.8     | %          |
| Operating income                                      |       | 22,415   |       | 22,437   |       | 23,043   |       |
| Operating income  as a percent of net revenues        |       | 22.5     | %          | 23.5     | %          | 25.4     | %          |
| **ProCare:**                                          |       |     |       |     |       |     |       |
| Net revenues                                          |       | $        | 50,159     |     | $          | 47,858   |       | $ | 46,441 |   |
| Gross profit                                          |       | 19,294   |       | 19,805   |       | 11,320   |       |
| Gross profit  margin                                  |       | 38.5     | %          | 41.4     | %          | 24.4     | %          |
| Operating income                                      |       | 9,950    |       | 10,224   |       | 2,379    |       |
| Operating income  as a percent of net revenues        |       | 19.8     | %          | 21.4     | %          | 5.1      | %          |
| **Regeneration:**                                     |       |     |       |     |       |     |       |
| Net revenues                                          |       | $        | 49,658     |     | $          | 3,989    |       | — |   |
| Gross profit                                          |       | 43,032   |       | 3,145    |       | —   |       |
| Gross profit  margin                                  |       | 86.7     | %          | 78.8     | %          | —   |       |
| Operating income                                      |       | 7,836    |       | 537      |       | —   |       |
| Operating income  as a percent of net revenues        |       | 15.8     | %          | 13.5     | %          | —   |       |
| **OfficeCare:**                                       |       |     |       |     |       |     |       |
| Net revenues                                          |       | $        | 27,551     |     | $          | 25,631   |       | $ | 22,966 |   |
| Gross profit                                          |       | 22,408   |       | 20,162   |       | 16,829   |       |
| Gross profit  margin                                  |       | 81.3     | %          | 78.7     | %          | 73.3     | %          |
| Operating income  (loss)                              |       | 3,976    |       | 2,801    |       | (4,591   | )          |
| Operating income  (loss) as a percent of net revenues |       | 14.4     | %          | 10.9     | %          | (20.0    | )%         |
| **International:**                                    |       |     |       |     |       |     |       |
| Net revenues                                          |       | $        | 28,860     |     | $          | 25,108   |       | $ | 22,430 |   |
| Gross profit                                          |       | 17,603   |       | 15,076   |       | 10,325   |       |
| Gross profit  margin                                  |       | 61.0     | %          | 60.0     | %          | 46.0     | %          |
| Operating income                                      |       | 5,398    |       | 6,255    |       | 824      |       |
| Operating income  as a percent of net revenues        |       | 18.7     | %          | 24.9     | %          | 3.7      | %          |

 

# ***Domestic Sales***

# * *

Domestic sales, includingall sales of our DonJoy, ProCare, Regeneration and OfficeCare channels,accounted for approximately 89%, 87% and 88% of our net revenues in 2004, 2003and 2002, respectively.

 

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# ***International***

# * *

International salesaccounted for approximately 11%, 13% and 12% of our net revenues, in 2004, 2003and 2002, respectively. The following table sets forth our international netrevenues as a percentage of our total net revenues, by country for the yearsended December 31:

 
| ** **                 | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|----------------------------|------------|----------|------------|----------|------------|----------|------------|
|                       |       |     |       |     |       |     |       |
| Germany                    |       | 4        | %          | 5        | %          | 4        | %          |
| Canada                     |       | 2        | %          | 2        | %          | 2        | %          |
| Australia                  |       | 1        | %          | 1        | %          | 2        | %          |
| Other countries            |       | 4        | %          | 5        | %          | 4        | %          |
| Total  international sales |       | 11       | %          | 13       | %          | 12       | %          |

 

The “Other countries”category consists primarily of sales in Italy, Belgium, the United Kingdom, theCzech Republic, Denmark, France, Japan and Spain.

 

International sales are made primarilythrough two distinct channels: independent third-party distributors and through our wholly-owned foreign subsidiaries.Through our wholly-owned international subsidiaries, we sell products in Euros,Pounds Sterling, Canadian Dollars and Danish Krones. The U.S. dollar equivalentof our international sales denominated in foreign currencies in 2004, 2003 and2002 were favorably impacted by foreign currency exchange rate fluctuationswith the weakening of the U.S. dollar against the foreign currencies of oursubsidiaries.  The U.S. dollar equivalentof the related costs denominated in these foreign currencies were unfavorablyimpacted during the same period.  Inaddition, the costs associated with our Mexico-based manufacturing operationsare incurred in Mexican pesos.  As wecontinue to distribute and manufacture our products in selected foreigncountries, we expect that future sales and costs associated with our activitiesin these markets will continue to be denominated in the applicable foreigncurrencies, which could cause currency fluctuations to materially impact ouroperating results. Occasionally we seek to reduce the potential impact ofcurrency fluctuations on our business through hedging transactions. At December31, 2004, we had no hedging transactions in place.

 

**Our Strategy**

 

Our strategy is toincrease revenue and profitability and enhance cash flow by strengthening ourmarket leadership position.  Our keyinitiatives to implement this strategy include:

 

•                  *Grow Our Regeneration Business.* We haveintegrated the sales force for our OL1000 Regeneration product into ourdomestic rehabilitation sales organization, which will provide an increasednumber of BGS specialists who we believe will be able to use the establishedrelationships of our DonJoy sales representatives to enhance sales of theOL1000 product.  We have alsorestructured our distribution arrangement with DePuy Spine to permit us to sellthe SpinaLogic product directly or through other independent salesrepresentatives in those geographical parts of the country where sales are notmeeting our expectations.  We believethat this focus on Regeneration products will drive faster growth for thisbusiness.

 

•                  *Further Penetrate Our Existing Customer Base.*  We are focused on increasing the number andvariety of products sold to our existing customers.  We believe that our OfficeCare programprovides us with a strong platform for selling additional products to ourexisting customers because of the amount of contact our sales representativeshave with the orthopedic practices who participate in the program.  We also believe that the addition of the BGSproducts to our existing product lines will further this goal by providingsignificant cross-selling opportunities.

 

•                  *Continue to Introduce New Productsand Product Enhancements.*  We have a history of developing andintroducing innovative products into the marketplace, and are committed tocontinuing that tradition by introducing new products across our productplatform.  In the year ended December 31,2004, we launched 25 new products.  Webelieve that product innovation through effective and focused research anddevelopment will provide a sustainable competitive advantage.  We believe we are currently a technologyleader in several product categories and we intend to continue to develop nextgeneration technologies.

 

•                  *Expand Our OfficeCare Channel.*  OurOfficeCare channel currently includes over 650 physician offices encompassingover 2,500 physicians.  We believe thatour OfficeCare channel serves a growing need among orthopedic practices to havea number of products readily available for immediate distribution to patientsand represents an opportunity for sales growth. We intend to expand our OfficeCare channel into more “high-volume”

 

37

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orthopedic offices, therebyincreasing the number of potential customers to whom we sell our products.  In the year ended December 31, 2004, we addedapproximately 100 net new offices to our OfficeCare channel.

 

•                  *Maximize Existing and SecureAdditional National Accounts.*  We plan to capitalize on the growing practicein healthcare in which hospitals and other large healthcare providers seek toconsolidate their purchasing activities to national buying groups.  Contracts with these national accountsrepresent a significant opportunity for sales growth. We believe that our broadrange of products are well suited to the goals of these buying groups andintend to aggressively pursue these contracts.

 

•                    *Expand Product Offerings for theSpine*.  Our SpinaLogic product is used as an adjuncttherapy following spinal fusion surgery. SpinaLogic was our first product thattargeted the spine market.  According toFrost & Sullivan, back pain is the number one cause of healthcare expenditurein the United States.  As a result, webelieve that expanding our product offerings in this market represents asignificant growth opportunity.  In 2004,we launched a new compression back brace to address the spine market.

 

•                  *Pursue Selective StrategicAcquisitions.* We believe thatstrategic acquisitions represent an attractive and efficient means to broadenour product lines and increase our revenue. The BGS products acquired in theRegeneration acquisition, for example, which generated revenues of$49.7 million during the twelve months ended December 31, 2004, enabled usto enter the regeneration market, which is predicted to grow faster than therehabilitation market. We intend to pursue acquisition opportunities thatenhance sales growth, are accretive to earnings, increase customer penetrationand/or provide geographic diversity. In particular, we intend to focus oninternational opportunities that will open new markets or offer new products.

 

•                  *Expand International Sales*. International sales have historically represented less than 15% of ourrevenues. Although our presence outside the United States has been limited, wehave successfully established direct distribution capabilities in majorinternational markets.  On August30, 2004, we acquired the outstanding stock of KD Innovation A/S, ourindependent distributor in Denmark. The acquired company, renamed djOrthopedics Nordic ApS, has direct responsibility for sales, marketing anddistribution of our products in Denmark, Finland, Norway and Sweden.  Webelieve that sales to foreign markets continue to represent a significantgrowth opportunity and we intend to continue to develop directdistribution capabilities in selected foreign markets.

 

•                  *Expand Low Cost Manufacturing Capabilities.* We plan tocontinue to expand our low cost manufacturing capabilities in Mexico to reduceour costs of goods sold and improve our gross margins. At the end of 2002 wemoved the manufacturing of our off-the-shelf rigid knee braces and theremaining manufacturing of our soft goods products from Vista, California toTijuana, Mexico, resulting in a significant reduction in our costs of goodssold. This improved our gross margins beginning in 2003. In August 2004, wecompleted construction of a new 200,000 square foot leased facility in Tijuana,Mexico, to replace three separate facilities we operated in the same area andto provide further opportunities to expand our Mexico manufacturingoperations.  As of October 2004, all ofour existing Mexico facilities had been moved to this new facility.  In the fourth quarter of 2004, we completedthe relocation of the manufacturing of our cold therapy products and machineshop activities from Vista, California to the new Mexico plant.  We recorded restructuring charges of $0.9 million($0.5 million net of tax) in 2004 related to these manufacturing moves,including primarily severance and moving costs. We also intend to use ourexpanded Mexico facilities in the future to vertically integrate themanufacturing of certain components we purchase and further reduce our costs ofgoods sold.

 

## ***Critical Accounting Policies andEstimates***

## * *

Our discussion and analysis of our financial conditionand results of operations is based upon our consolidated financial statements,which have been prepared in accordance with accounting principles generallyaccepted in the United States.  Thepreparation of these financial statements requires us to make estimates andjudgments that affect the reported amounts of assets, liabilities, revenues andexpenses, and related disclosure of contingent assets and liabilities.  On an on-going basis, we evaluate ourestimates including those related to contractual allowances, doubtful accounts,inventories, rebates, product returns, warranty obligations, income taxes,intangibles and investments.  We base ourestimates on historical experience and on various other assumptions that webelieve to be reasonable under the circumstances, the results of which form thebasis for making judgments about the carrying values of assets and liabilitiesthat are not readily apparent from other sources.  Actual results may differ from theseestimates under different assumptions or conditions.

 

We believe the following critical accounting policiesaffect our more significant judgments and estimates used in the preparation ofour consolidated financial statements and this discussion and analysis of ourfinancial condition and results of operations:

 

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*Provision for Contractual Allowances and DoubtfulAccounts.*We maintain provisions for contractual allowancesfor reimbursement amounts from our third-party payor customers based onnegotiated contracts and historical experience for non-contracted payors. Wealso maintain provisions for doubtful accounts for estimated losses resultingfrom the inability of our customers to make required payments. We havecontracts with certain third-party payors for our third-party reimbursementbillings, which call for specified reductions in reimbursement of billedamounts based upon contractual reimbursement rates. For 2004, we reserved forand reduced gross revenues from third-party payors by between 29% and 39% forallowances related to these contractual reductions, which is higher than ourhistorical rates of 22% to 33% of gross billed charges to third-partypayors.  Our contractual allowancespercentages increased in 2004 following increases in our current gross pricelevels.  For our Regeneration business,we record revenue net of actual contractual allowances and discounts from ourgross prices, which are determined on a specific identification basis andamount to approximately 29% to 34% of our gross prices for bone growthstimulation products.

 

Our reserve for doubtful accounts is based uponestimated losses from customers who are billed directly and the portion ofthird-party reimbursement billings that ultimately become the financialresponsibility of the end user patients. Direct-billed customers representapproximately 52% of our net accounts receivable at December 31, 2004 and wehave historically experienced write-offs of less than 2% of these accountsreceivable. Our third-party reimbursement customers include all of thecustomers of our OfficeCare business segment, the majority of our Regenerationbusiness segment and certain third-party payor customers of our DonJoy businesssegment, including insurance companies, managed care companies and certaingovernmental payors such as Medicare. Our third-party payor customersrepresented approximately 31% of our net revenue for the year ended December31, 2004 and 48% of our net accounts receivable at December 31, 2004 and weestimate bad debt expense to be approximately 4% to 10% of gross revenues fromthese third-party reimbursement customers. If the financial condition of ourcustomers were to deteriorate resulting in an impairment of their ability tomake payments or if third-party payors were to deny claims for late filings,incomplete information or other reasons, additional provisions may be required.

 

Historically, we relied heavily on third-party billingservice providers to provide information about the accounts receivable of ourthird-party payor customers, including the data utilized to determine reservesfor contractual allowances and doubtful accounts. During 2002, we enhanced theability of our systems to obtain and analyze the information processed by thesebilling service providers. Our increased ability to obtain and better analyzeinformation beginning in 2002 revealed that, as a result of historicalthird-party billing problems, we had experienced an increase in allowances andbad debts for accounts receivable from our third-party payor customers and weincreased our provisions for contractual allowances and doubtful accountsaccordingly in 2002. In March 2003, we completed the transition to a newthird-party insurance billing service provider. We continue to enhance ourability to analyze historical information, resolve issues related to ouraccounts receivable, and reduce our aging. Based on information currently available to us, we believe we haveprovided adequate reserves for our third-party payor accounts receivable. Ifclaims are denied, or amounts are otherwise not paid, in excess of ourestimates, the recoverability of our net accounts receivable could be reducedby a material amount. In addition, if our third-party insurance billing serviceprovider does not perform to our expectations we may be required to increaseour reserve estimates.

 

# *Reserve for Excess andObsolete Inventories.* We providereserves for estimated excess or obsolete inventories equal to the differencebetween the cost of inventories on hand plus future purchase commitments andthe estimated market value based upon assumptions about future demand.  If future demand is less favorable thancurrently projected by management, additional inventory write-downs may berequired.  In addition, reserves forinventories on hand in our OfficeCare locations are provided based on historicalshrinkage rates of approximately 12%.  Ifactual shrinkage rates differ from our estimated shrinkage rates, revisions tothe reserve may be required.  We alsoprovide reserves for newer product inventories, as appropriate, based on anyminimum purchase commitments and our level of sales of the new products. During the year endedDecember 31, 2004, we disposed of gross inventories aggregating $2.4 millionwhich had been fully reserved for in a previous year.

# * *

*Rebates.*  We offer certain of our distributors rebatesbased on 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.

 

*Returnsand Warranties.*  Weprovide for the estimated cost of returns and product warranties at the timerevenue is recognized based on historical trends.  While we engage in extensive product qualityprograms and processes, including actively monitoring and evaluating the qualityof our suppliers, our actual returns and warranty costs could differ from ourestimates.  If actual product returns,failure rates, material usage or service costs differ from our estimates,revisions to the estimated return and/or warranty liabilities may be required.

 

*ValuationAllowance for Deferred Tax Asset.* As of December 31, 2004, wehave approximately $54.0 million of net deferred tax assets on our balancesheet related primarily to tax deductible goodwill arising at the date of ourreorganization in 2001 and not recognized for book purposes and net lossesreported during 2002.  Realization of ourdeferred tax assets is

 

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dependent on our abilityto generate future taxable income prior to the expiration of our net operatingloss carryforwards.  Our managementbelieves that it is more likely than not that the deferred tax assets will berealized based on forecasted future taxable income.  However, there can be no assurance that wewill meet our expectations of future taxable income.  Management will evaluate the realizability ofthe deferred tax assets on a quarterly basis to assess any need for valuationallowances.

 

*Goodwill and Other Intangibles.*In 2002, Statement of Financial Accounting Standards No. 142, or SFAS No. 142, *Goodwill and Other Intangible Assets*became effective and as a result, we ceased amortization of goodwill.  In lieu of amortization, we are required toperform an annual review for impairment. Goodwill is considered to be impaired if we determine that the carryingvalue of the segment or reporting unit exceeds its fair value.   At October 1, 2004, our goodwill wasevaluated for impairment and we determined that no impairment existed at thatdate.  With the exception of goodwillrelated to our Regeneration acquisition of $39 million, we believe that thegoodwill acquired through December 31, 2004 benefits the entire enterprise andsince our reporting units share the majority of our assets, we compared thetotal carrying value of our consolidated net assets (including goodwill) to thefair value of the Company.  With respectto goodwill related to our Regeneration acquisition, we compared the carryingvalue of the goodwill related to the Regeneration segment to the fair value of theRegeneration segment.

 

At December 31, 2004, other intangibles were evaluatedfor impairment as required by SFAS No. 144, *Accountingfor Impairment or Disposal of Long-Lived Assets*.  The determination of the fair value ofcertain acquired assets and liabilities is subjective in nature and ofteninvolves the use of significant estimates and assumptions.  Determining the fair values and useful livesof intangible assets requires the exercise of judgment.  Upon initially recording certain of our otherintangible assets, including the intangible assets that were acquired inconnection with the Regeneration acquisition, we used independent valuationfirms to assist us in determining the appropriate values for these assets.  Subsequently, we have used the samemethodology and updated our assumptions. While there are a number of different generally accepted valuationmethods to estimate the value of intangible assets acquired, we primarily usedthe undiscounted cash flows expected to result from the use of the assets.  This method requires significant managementjudgment to forecast the future operating results used in the analysis.  In addition, other significant estimates arerequired such as residual growth rates and discount factors.  The estimates we have used are consistentwith the plans and estimates that we use to manage our business and are basedon available historical information and industry averages.

 

We recorded an impairmentcharge for certain long-lived assets in 2002 as a result of certain newproducts not achieving anticipated revenues and estimated recovery values ofassets being disposed of being less than anticipated.  The value of our goodwill and otherintangible assets is exposed to future impairments if we experience futuredeclines in operating results, if negative industry or economic trends occur orif our future performance is below our projections or estimates.

 

***Resultsof Operations***

 

We operate our businesson a manufacturing calendar, with our fiscal year always ending onDecember 31.  Each quarter is 13weeks, consisting of one five-week and two four-week periods.  The first and fourth quarters may have moreor less working days from year to year based on the days of the week on whichholidays and December 31 fall.

 

***Year Ended December31, 2004 Compared To Year Ended December 31, 2003***

 

Regeneration segment amounts in the tables belowinclude operations for the period subsequent to the Regeneration acquisition onNovember 26, 2003 and include the impact of the Regeneration purchaseaccounting and related amortization of acquired intangible assets.  For the years ended December 31, 2004 and2003, Regeneration income from operations was reduced by amortization ofacquired intangible assets amounting to $4.7 million and $0.5 million, respectively.   For the year ended December 31, 2004,Regeneration income from operations was also reduced by restructuring chargesrelated to the integration of the business operations of the segment of $3.8million.

 

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**Net Revenues*.***Set forth below arenet revenues for our reporting segments (in thousands):

 
| ** **                 | ** ** | **Years Ended**        | ** ** | ** **             | ** ** | ** **             | ** ** | ** **             | ** ** | **Pro Forma  Year ended** | ** ** |
|----------------------------|------------|------------------------|------------|------------------------|------------|------------------------|------------|------------------------|------------|---------------------------|------------|
| ** **                 | ** ** | **December 31,  2004** | ** ** | **% of Net  Revenues** | ** ** | **December 31,  2003** | ** ** | **% of Net  Revenues** | ** ** | **Increase**              | ** ** | **%  Increase** | ** ** | **December 31,  2003** | ** ** | **% of Net  Revenues** | ** ** |
| DonJoy                     |       | $                      | 99,771     |                   | 39.0       |                   | $          | 95,353                 |       | 48.2                      |       | $ | 4,418 |   | 4.6 |   | $ | 95,353 |   | 39.7 |   |
| ProCare                    |       | 50,159                 |       | 19.6                   |       | 47,858                 |       | 24.2                   |       | 2,301                     |       | 4.8 |   | 47,858 |   | 19.9 |   |
| Regeneration               |       | 49,658                 |       | 19.4                   |       | 3,989                  |       | 2.0                    |       | 45,669                    |       | 1,144.9 |   | 46,428 |   | 19.3 |   |
| OfficeCare                 |       | 27,551                 |       | 10.7                   |       | 25,631                 |       | 12.9                   |       | 1,920                     |       | 7.5 |   | 25,631 |   | 10.7 |   |
| International              |       | 28,860                 |       | 11.3                   |       | 25,108                 |       | 12.7                   |       | 3,752                     |       | 14.9 |   | 25,108 |   | 10.4 |   |
| Consolidated net  revenues |       | $                      | 255,999    |                   | 100.0      |                   | $          | 197,939                |       | 100.0                     |       | $ | 58,060 |   | 29.3 |   | $ | 240,378 |   | 100.0 |   |

 

Net revenues in our DonJoy segment increased primarilydue to the implementation of sales productivity initiatives, increased sales ofrigid knee braces into school athletic programs and sales of new products.  These increases were partially offset by anegative impact from recent changes in the California workers compensationsystem and reduced sales of certain of our pain management products.  Net revenues in our ProCare segment increaseddue to growth in sales related to national contracts.  On a pro forma basis, net revenue in our Regenerationsegment increased due to increased sales volumes, offset by a negative impactin the third quarter of 2004 caused by disruption from the integration of ourRegeneration sales organization into our DonJoy sales organization.  Revenues in our Regeneration segment werealso impacted during the third quarter of 2004 by a decline in sales of ourSpinaLogic product, which we believe was due partly to slow market conditionsand partly to weak sales performance in certain territories.  Net revenues in our OfficeCare segmentincreased due partly to the net addition of approximately 100 net newOfficeCare locations and price increases implemented in mid-2003, offset byprice reductions in our fracture boot products due to a change in the Medicarereimbursement code.  Internationalrevenues increased due partly to favorable changes in exchange rates comparedto the rates in effect in 2003. Excluding the impact of exchange rates, local currency internationalrevenue increased 8.6% in the year ended December 31, 2004 compared to the yearended December 31, 2003, due to the launch of new products and the addition ofour new direct sales subsidiary in the Nordic countries, effective September 1,2004.

 

**Gross Profit.**Set forth below is gross profit information for ourreporting segments (in thousands):

** **

* *
| ** **                 | ** ** | **Years Ended**        | ** ** | **Pro Forma  Year Ended** | ** ** |
|----------------------------|------------|------------------------|------------|---------------------------|------------|
| ** **                 | ** ** | **December 31,  2004** | ** ** | **% of Net  Revenues**    | ** ** | **December 31,  2003** | ** ** | **% of Net  Revenues** | ** ** | **Increase  (Decrease)** | ** ** | **%Increase  (Decrease)** | ** ** | **December 31,  2003** | ** ** | **% of Net  Revenues** | ** ** |
| DonJoy                     |       | $                      | 58,498     |                      | 58.6       |   | $ | 53,824 |   | 56.4 |   | $ | 4,674 |   | 8.7 |   | $ | 53,824 |   | 56.4 |   |
| ProCare                    |       | 19,294                 |       | 38.5                      |       | 19,805 |   | 41.4 |   | (511 | ) | (2.6 | ) | 19,805 |   | 41.4 |   |
| Regeneration               |       | 43,032                 |       | 86.7                      |       | 3,145 |   | 78.8 |   | 39,887 |   | 1,268.3 |   | 38,949 |   | 83.9 |   |
| OfficeCare                 |       | 22,408                 |       | 81.3                      |       | 20,162 |   | 78.7 |   | 2,246 |   | 11.1 |   | 20,162 |   | 78.7 |   |
| International              |       | 17,603                 |       | 61.0                      |       | 15,076 |   | 60.0 |   | 2,527 |   | 16.8 |   | 15,076 |   | 60.0 |   |
| Consolidated  gross profit |       | $                      | 160,835    |                      | 62.8       |   | $ | 112,012 |   | 56.6 |   | $ | 48,823 |   | 43.6 |   | $ | 147,816 |   | 61.5 |   |

 

The improvement in consolidated gross profit and grossprofit margin is primarily related to the favorable impact of higher grossmargins associated with the products sold in our Regeneration segment,continued manufacturing cost reduction initiatives and a reduction in expensesassociated with employee bonuses, partially offset by increased freight costs.Gross profit increased in the DonJoy segment primarily due to a favorableproduct mix, including increased sales in our DonJoy insurance channel, whichcarry a higher gross margin than sales in our DonJoy direct channel.  ProCare gross profit decreased due toincreased sales through our national contracts, which carry lower grossmargins.  On a pro forma basis and excludingthe impact of one-time purchase accounting adjustments, Regeneration grossprofit increased as a percentage of revenues due to reduced cost of goods soldfor these products and a higher mix of insurance sales, which have higheraverage selling prices and therefore generate higher gross margins than salesto wholesale customers. OfficeCare gross profit increased primarily due tocertain price increases implemented in mid-2003 in this segment offset by pricereductions due to a change in the Medicare reimbursement code for certainfracture boot products.  The increase inthe International gross profit is primarily related to the favorable impact ofchanges in exchange rates and the addition of the incremental in-market grossmargin on our direct sales in the Nordic countries since September 1, 2004.

 

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**OperatingExpenses.* ***Set forth below is operating expenseinformation (in thousands):

** **
| ** **                            | ** ** | **Years Ended**        | ** ** | **Pro Forma  Year Ended** | ** ** |
|---------------------------------------|------------|------------------------|------------|---------------------------|------------|
| ** **                            | ** ** | **December 31,  2004** | ** ** | **% of Net  Revenues**    | ** ** | **December 31,  2003** | ** ** | **% of Net  Revenues** | ** ** | **Increase** | ** ** | **%  Increase** | ** ** | **December 31,  2003** | ** ** | **% of Net  Revenues** | ** ** |
| Sales and  marketing                  |       | $                      | 78,984     |                      | 30.9       |   | $ | 54,067 |   | 27.3 |   | $ | 24,917 |   | 46.1 |   | $ | 72,924 |   | 30.3 |   |
| General and  administrative           |       | 27,727                 |       | 10.8                      |       | 21,767 |   | 11.0 |   | 5,960 |   | 27.4 |   | 25,870 |   | 10.8 |   |
| Research and  development             |       | 5,627                  |       | 2.2                       |       | 4,442 |   | 2.2 |   | 1,185 |   | 26.7 |   | 5,211 |   | 2.2 |   |
| Amortization of  acquired Intangibles |       | 4,731                  |       | 1.9                       |       | 464 |   | 0.2 |   | 4,267 |   | 919.6 |   | 4,808 |   | 2.0 |   |
| Restructuring  costs                  |       | 4,693                  |       | 1.8                       |       | (497 | ) | (0.2 | ) | 5,190 |   | 1,044.3 |   | (497 | ) | (0.2 | ) |
| Consolidated  operating Expenses      |       | $                      | 121,762    |                      | 47.6       |   | $ | 80,243 |   | 40.5 |   | $ | 41,519 |   | 51.7 |   | $ | 108,316 |   | 45.1 |   |

 

***Sales and MarketingExpenses. ***Theincrease in sales and marketing expenses is primarily attributed to $21.4million of expenses related to the Regeneration segment.  In addition, selling and marketing expensesincreased due to costs associated with increased commissions on increasedsales, additional sales personnel, increased advertising and marketing programsand the impact of unfavorable foreign exchange rate changes.  These increases were offset by a reduction inexpenses associated with employee bonuses. Our international segment also incurred increased expenses in 2004related to our new subsidiaries in France and Denmark, added in September 2003and September 2004, respectively, and a bi-annual trade exhibition in Europe.

 

***General andAdministrative Expenses.***The increase in general andadministrative expenses is primarily attributed to $4.3 million of expensesrelated to the Regeneration segment, increased professional fees related tocompliance with section 404 of the Sarbanes-Oxley Act, and legal costs,including the settlement of a contract dispute, offset by a reduction inexpenses associated with employee bonuses. General and administrative expenses also increased in our OfficeCaresegment in 2004 related to increased efforts to maximize cash collections inthis segment.

 

***Research andDevelopment Expenses.***The increase in research anddevelopment expense is attributed to $0.9 million of expenses related to theRegeneration segment and an increase in professional fees related to variouspatents and technology offset by a reduction in expenses associated withemployee bonuses.

 

***Amortization ofAcquired Intangibles. ***Amortizationof acquired intangibles relates to intangible assets acquired in connectionwith the Regeneration acquisition, which are being amortized over lives rangingfrom 4 months to 10 years.   On a proforma basis the amortization expense in the year ended December 31, 2004 isconsistent with the year ended December 31, 2003.

 

###### ***Restructuringcosts.***  In 2004,we recorded charges of$4.7 million related to our Regeneration integrationand manufacturing moves, including charges for severance, recruiting, trainingand other related exit costs.  In theyear ended December 31, 2003, we recorded a credit to restructuring costs ofapproximately $0.5 million as a reversal of an accrual recorded in 2002 relatedto future rent to be paid for vacated facilities, as we decided to retain thevacant space for future expansion.

###### ** **

###### **Income fromOperations.*** *Set forthbelow is income from operations information for our reporting segments (inthousands):

 
| ** **                                     | ** ** | **Years Ended**        | ** ** | ** **             | ** ** | ** **             | ** ** | **Pro Forma  Year Ended** | ** ** |
|------------------------------------------------|------------|------------------------|------------|------------------------|------------|------------------------|------------|---------------------------|------------|
| ** **                                     | ** ** | **December 31,  2004** | ** ** | **% of Net  Revenues** | ** ** | **December 31,  2003** | ** ** | **% of Net  Revenues**    | ** ** | **Increase  (Decrease)** | ** ** | **% Increase  (Decrease)** | ** ** | **December 31,  2003** | ** ** | **% of Net  Revenues** | ** ** |
| DonJoy                                         |       | $                      | 22,415     |                   | 22.5       |                   | $          | 22,437                    |       | 23.5 |   | $ | (22 | ) | (0.1 | ) | $ | 22,437 |   | 23.5 |   |
| ProCare                                        |       | 9,950                  |       | 19.8                   |       | 10,224                 |       | 21.4                      |       | (274 | ) | (2.7 | ) | 10,224 |   | 21.4 |   |
| Regeneration                                   |       | 7,836                  |       | 15.8                   |       | 537                    |       | 13.5                      |       | 7,299 |   | 1,359.2 |   | 8,268 |   | 17.8 |   |
| OfficeCare                                     |       | 3,976                  |       | 14.4                   |       | 2,801                  |       | 10.9                      |       | 1,175 |   | 41.9 |   | 2,801 |   | 10.9 |   |
| International                                  |       | 5,398                  |       | 18.7                   |       | 6,255                  |       | 24.9                      |       | (857 | ) | (13.7 | ) | 6,255 |   | 24.9 |   |
| Income from  operations of reportable segments |       | 49,575                 |       | 19.4                   |       | 42,254                 |       | 21.3                      |       | 7,321 |   | 17.3 |   | 49,985 |   | 20.8 |   |
| Expenses not  allocated to segments            |       | (10,502                | )          | (4.1                   | )          | (10,485                | )          | (5.3                      | )          | (17 | ) | 0.2 |   | (10,485 | ) | (4.4 | ) |
| Consolidated  income from operations           |       | $                      | 39,073     |                   | 15.3       |                   | $          | 31,769                    |       | 16.0 |   | $ | 7,304 |   | 23.0 |   | $ | 39,500 |   | 16.4 |   |

 

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Thedecrease in income from operations as a percentage of net revenue for theDonJoy segment is primarily due to an increased investment in sales andmarketing expense for personnel and programs. The slight decrease in income from operations in the ProCare segment isdue primarily to lower gross profit margins associated with revenue fromnational contracts.  The decrease inincome from operations, on a pro forma basis, for the Regeneration segment isprimarily the result of restructuring charges of $3.8 million in 2004,partially offset by increased revenues and higher gross margins.  The increase in income from operations forthe OfficeCare segment is primarily the result of increased revenue and highergross profit margins.  Income fromoperations in the International segment was reduced from the prior year dueprimarily to the investment we made in the start up activities of our newdirect sales subsidiaries in France and Denmark, as well as the expenses associatedwith a bi-annual European exhibition which occurred in the second quarter of2004.

 

**Interest Expense, Net of InterestIncome and Prepayment premium and other costs related to Senior SubordinatedNotes redemption.****Interestexpense, net of interest income, was $9.0 million in the year ended December31, 2004 compared to $12.2 million in the year ended December 31, 2003.  The decrease is due to the retirement of ourformer credit facility and the June 2004 redemption of our senior subordinatednotes, offset by interest related to the incremental outstanding debt weincurred in connection with the Regeneration acquisition. We incurred costs of$7.8 million in connection with the redemption of the notes, comprised of a$4.7 million redemption premium and write-offs of $2.3 million and $0.8 millionfor debt issuance costs and unamortized discounts, respectively.

 

**Other Income (Expense).****Other income (expense)for the year ended December 31, 2004 includes a net foreign exchangetransaction gain and a gain on the sale of an investment, partially offset by awrite-off of costs related to a potential acquisition. For the year endedDecember 31, 2003, other income (expense) includes a net foreign exchangetransaction gain.

 

**Provision for Income Taxes.****Our estimated worldwideeffective tax rate was 39.2% for the year ended December 31, 2004 and 39.8% forthe year ended December 31, 2003.  Thetax rate in 2004 was reduced compared to 2003 primarily due to a lowereffective state tax rate in 2004.

 

**NetIncome*.***Netincome was $14.0 million for the year ended December 31, 2004 compared to netincome of $12.1 million for the year ended December 31, 2003 as a result of thechanges discussed above.

 

***YearEnded December 31, 2003 Compared To Year Ended December 31, 2002***

 

Regeneration amounts inthe tables below include operations for the period subsequent to theRegeneration acquisition on November 26, 2003 and include the impact of theRegeneration purchase accounting and related amortization of acquiredintangible assets.  For the year endedDecember 31, 2003, Regeneration income from operations was reduced byamortization of acquired intangible assets amounting to $0.5 million.

 

**Net Revenues*.***Set forth below arenet revenues for our reporting segments (in thousands):

 
| ** **                 | ** ** | **Years Ended**        | ** ** | ** **             | ** ** | ** **             | ** ** | ** **             | ** ** |
|----------------------------|------------|------------------------|------------|------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                 | ** ** | **December 31,  2003** | ** ** | **% of Net  Revenues** | ** ** | **December 31,  2002** | ** ** | **% of Net  Revenues** | ** ** | **Increase** | ** ** | **%  Increase** | ** ** |
| DonJoy                     |       | $                      | 95,353     |                   | 48.2       |                   | $          | 90,799                 |       | 49.7 |   | $ | 4,554 |   | 5.0 |   |
| ProCare                    |       | 47,858                 |       | 24.2                   |       | 46,441                 |       | 25.4                   |       | 1,417 |   | 3.1 |   |
| Regeneration               |       | 3,989                  |       | 2.0                    |       | —                 |       | —                 |       | 3,989 |   | N/A |   |
| OfficeCare                 |       | 25,631                 |       | 12.9                   |       | 22,966                 |       | 12.6                   |       | 2,665 |   | 11.6 |   |
| International              |       | 25,108                 |       | 12.7                   |       | 22,430                 |       | 12.3                   |       | 2,678 |   | 11.9 |   |
| Consolidated net  revenues |       | $                      | 197,939    |                   | 100.0      |                   | $          | 182,636                |       | 100.0 |   | $ | 15,303 |   | 8.4 |   |

 

Sales in 2003 for the DonJoy segment increased $4.6million, or 5.0%, as compared to 2002 primarily due to increased sales of coldtherapy, osteoarthritic knee braces, shoulder and elbow bracing products.ProCare segment net revenues increased $1.4 million, or 3.1%, as compared to2002, reflecting an increase in sales to national accounts customers, includingthrough our contract with Broadlane, Inc. Sales in 2003 for the OfficeCaresegment increased by $2.7 million, or 11.6%, compared to 2002 primarilydue to certain price increases in this segment and the addition of newOfficeCare locations, offset by reductions due to a change in the Medicarereimbursement code for certain fracture boot products.  Sales in 2003 for the International segmentincreased by $2.7 million, or 11.9%, compared to 2002.  Net revenue in the International segment in2003 included a benefit from favorable changes in foreign exchange rates of$2.0 million compared to the rates in effect in 2002, but was negativelyaffected by a decrease of $3.5 million in sales in Australia, compared to2002, based on the discontinuation of our majority owned subsidiary inAustralia effective December 31, 2002. Without the impact of either thefavorable changes in foreign exchange rates, or sales in

 

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Australia,International segment revenues increased 23.3% in 2003 compared to 2002 due toincreased sales through our subsidiaries located in Germany, Canada and the UKand from our independent distributors.

 

Gross Profit. **Setforth below is gross profit information for our reporting segments (inthousands):**

* *
| ** **                                        | ** ** | **Years Ended**        | ** ** |
|---------------------------------------------------|------------|------------------------|------------|
| ** **                                        | ** ** | **December 31,  2003** | ** ** | **% of Net  Revenues** | ** ** | **December 31,  2002** | ** ** | **% of Net  Revenues** | ** ** | **Increase** | ** ** | **%  Increase** | ** ** |
| DonJoy                                            |       | $                      | 53,824     |   | 56.4 |   | $ | 53,380 |   | 58.8 |   | $ | 444 |   | 0.8 |   |
| ProCare                                           |       | 19,805                 |       | 41.4 |   | 11,320 |   | 24.4 |   | 8,485 |   | 75.0 |   |
| Regeneration                                      |       | 3,145                  |       | 78.8 |   | — |   | — |   | 3,145 |   | N/A |   |
| OfficeCare                                        |       | 20,162                 |       | 78.7 |   | 16,829 |   | 73.3 |   | 3,333 |   | 19.8 |   |
| International                                     |       | 15,076                 |       | 60.0 |   | 10,325 |   | 46.0 |   | 4,751 |   | 46.0 |   |
| Consolidated  gross profit of reportable segments |       | $                      | 112,012    |   | 56.6 |   | $ | 91,854 |   | 50.3 |   | $ | 20,158 |   | 21.9 |   |
| Expenses not  allocated to segments               |       | —                 |       | — |   | (5,096 | ) | (2.8 | ) | 5,096 |   | 100.0 |   |
| Consolidated  gross profit                        |       | $                      | 112,012    |   | 56.6 |   | $ | 86,758 |   | 47.5 |   | $ | 25,254 |   | 29.1 |   |

 

The increase in grossprofit and the improvement in gross profit margin from 2002 to 2003 isprimarily related to the successful move of a substantial portion of our U.S.manufacturing to Mexico in the fourth quarter of 2002, as well as thecompletion of other manufacturing cost reduction initiatives.  Gross profit for 2002 was also impacted byinventory charges of $5.1 million taken in connection with our performanceimprovement program. Although total gross profit was increased by ourmanufacturing move to Mexico, the reduced gross profit as a percentage of netrevenues in the DonJoy segment is primarily the result of a reallocation ofcertain U.S. manufacturing overhead expenses from products moved to Mexico toDonJoy custom rigid bracing products, which continue to be manufactured in theU.S.  The increase in gross profit in theProCare, OfficeCare and International segments is primarily related to themanufacturing move to Mexico. International gross profit in 2002 was also affected by sales of lowergross margin surgical products by our Australian subsidiary, which wasdiscontinued in December 2002. Gross profit in our Regeneration segment was78.8% of net revenue in the 2003 period subsequent to the Regenerationacquisition on November 26, 2003 and was negatively impacted by a charge tocosts of goods sold of $0.2 million related to a step up of certain acquiredinventory values.

 

**OperatingExpenses.* ***Set forth below is operating expenseinformation (in thousands):

 
| ** **                            | ** ** | **Years Ended**        | ** ** |
|---------------------------------------|------------|------------------------|------------|
| ** **                            | ** ** | **December 31,  2003** | ** ** | **% of Net  Revenues** | ** ** | **December 31,  2002** | ** ** | **% of Net  Revenues** | ** ** | **Increase  (Decrease)** | ** ** | **%Increase  (Decrease)** | ** ** |
| Sales and  marketing                  |       | $                      | 54,067     |   | 27.3 |   | $ | 56,216 |   | 30.8 |   | $ | (2,149 | ) | (3.8 | ) |
| General and  administrative           |       | 21,767                 |       | 11.0 |   | 26,414 |   | 14.4 |   | (4,647 | ) | (17.6 | ) |
| Research and  development             |       | 4,442                  |       | 2.2 |   | 2,922 |   | 1.6 |   | 1,520 |   | 52.0 |   |
| Amortization of  acquired intangibles |       | 464                    |       | 0.2 |   | — |   | — |   | 464 |   | N/A |   |
| Impairment of  long-lived assets      |       | —                 |       | — |   | 3,666 |   | 2.0 |   | (3,666 | ) | (100.0 | ) |
| Restructuring  costs                  |       | (497                   | )          | (0.2 | ) | 10,008 |   | 5.5 |   | (10,505 | ) | (105.0 | ) |
| Consolidated  operating expenses      |       | $                      | 80,243     |   | 40.5 |   | $ | 99,226 |   | 54.3 |   | $ | (18,983 | ) | (19.1 | ) |

 

***Sales and Marketing Expenses.***Salesand marketing expenses decreased in 2003 from 2002 partly due to lowercommissions expense, which was the result of a change in product mix andrevised commission programs initiated for sales to our third-party payorcustomers.  Also, bad debt expenserelated to our third-party payor customers was significantly less in 2003compared to 2002. Sales and marketing expenses related to our new Regenerationsegment were $1.4 million in 2003.

 

***General and AdministrativeExpenses.***General and administrative expenses decreasedboth in total and as a percentage of net revenues in 2003 from 2002 dueprimarily to lower expenses for legal activities and other professional feesand lower wages and benefits, which were partially offset by increasedinsurance costs and billing fees related to our third-party insurance billingservice provider.  General andadministrative expenses related to our new Regeneration segment were $0.6million in 2003.

 

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***Research and DevelopmentExpenses.***Research and development expenses increased intotal and as a percentage of net revenues in 2003 from 2002 primarily as aresult of increased spending in order to accelerate new product introductions.Research and development expenses related to our new Regeneration segment were$0.1 million in 2003.

 

***Amortization of AcquiredIntangibles.***Amortization of acquired intangibles was$0.5 million in 2003 and reflects amortization expense for intangible assetsacquired in the Regeneration acquisition on November 26, 2003.

 

***Impairment of Long-Lived Assets.*****During 2002, we recognized $3.7 million in charges relatedto impairment of certain of our long-lived assets, including intangible assetsassociated with certain discontinued product lines.

 

***Performance Improvement,Restructuring and Other Costs. ***In2002, we recorded charges of $10.0 million related to our performanceimprovement program, including charges for severance pay, consultants, movingcosts and accrued rent related to manufacturing facilities vacated in theUnited States. In connection with the manufacturing move, a portion of our U.S.manufacturing facilities was vacated, and we accrued an estimate of the futurenet rent that would be paid for the vacated facilities, in excess of estimatedsublease income. In 2003, we decided to retain the vacant space for futureexpansion and discontinued our efforts to sublease the vacant space.Accordingly, the remaining accrual for rent for the vacant space of $0.5million was reversed and credited to operating expenses in 2003.

 

***Interest Expense and Other, Net.***Interest expense and other, net, including interest expense and discontinuedacquisition costs, net of interest income and foreign exchange gains, was $11.7million in 2003 compared to $12.1 million in 2002.

 

***Benefit (Provision) for IncomeTaxes.***Our estimated worldwide effective tax rate was39.8% for 2003 as compared to approximately 38.1% for 2002.  The tax benefit rate in 2002 was reducedprimarily due to the disallowance by certain states of net operating losscarryforwards.

 

***NetIncome (Loss).***Net income was $12.1 million for 2003compared to net loss of $15.2 million for 2002 as a result of the changesdiscussed above.

 

***Liquidityand Capital Resources***

 

Our principal liquidity requirements are to serviceour debt and meet our working capital and capital expenditure needs.  Total indebtedness at December 31, 2004 was$95.0 million. Total cash and cash equivalents were $11.2 million atDecember 31, 2004.

 

Net cash provided byoperating activities were $39.5 million and $26.5 million for the yearsended December 31, 2004 and 2003, respectively. The increase in net cashprovided by operations in 2004 primarily reflects positive operating resultsand a decrease in net working capital. Net cash provided in 2003 was reduced by amounts paid for costs accruedin 2002 in connection with our performance improvement program.

 

Cashflows used in investing activities were $10.2 million and $105.5 millionfor the years ended December 31, 2004 and 2003, respectively.  Cash used in investing activities in 2004includes $6.0 million used for capital expenditures and $1.8 million related tothe final payment for the acquisition of certain patent licenses in 2003 andthe initial payment for the acquisition of a patent license in 2004.  In addition, as part of our 2004 salesinitiatives, we proactively reorganized certain territories within our DonJoysales channel by changing distributor partners or adding direct salesrepresentatives.  We paid $1.2 million in2004 to acquire distribution rights to facilitate this reorganization.  We also paid $0.7 million in 2004 to acquirethe outstanding stock of KD Innovation A/S (KDI), our independent distributorin Denmark.  We may be required to pay upto an additional $0.5 million through 2006, if certain net operating incometargets are met.

 

Cashused in investing activities in 2003 included $93.9 million for theRegeneration acquisition, $3.0 million for the acquisition of certain patentlicenses in connection with the settlement of a patent litigation matter, $2.9million for the DuraKold asset purchase and capital expenditures amounting to$5.3 million.

 

Cashflows (used in) provided by financing activities were $(37.5) million and $65.8million for the years ended December 31, 2004 and 2003, respectively.  Cash used in financing activities in 2004reflects $79.7 million used to redeem our senior subordinated notes and $5.0million used to repay our term loan, partially offset by the net proceeds,amounting to $56.3 million, from the sale of shares by us in stock offeringscompleted in 2004.  Also in 2004,proceeds of $5.9 million were received from the issuance of common stockthrough our Employee Stock Purchase Plan and the exercise of stock options and$0.3 million was received from collection of a note receivable.  On September 27, 2004, our board of directorsauthorized a program to repurchase

 

45

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up to $20 million of our common stock. The shares may be repurchased attimes and prices as determined by management and may be completed through openmarket or privately negotiated transactions. The repurchase program providesthat repurchases will be made in accordance with applicable state and federallaw and in accordance with the terms and subject to the restrictions of Rule10b-18 under the Securities Exchange Act of 1934, as amended. Shares will beretired and cancelled upon repurchase. We also obtained an amendment to ourcredit agreement, which was required prior to implementing the stock repurchaseprogram.  Through December 31, 2004we had repurchased 837,300 shares of our common stock at an average price of$17.62 per share, for an aggregate total cost of approximately $14.8 million,which is included in cash flows used in financing activities.

 

Cash provided by financing activities in 2003reflects the proceeds received from the issuance of the $100.0 million termloan received in connection with our new credit agreement, net of repayment ofour previous bank debt totaling approximately $35.8 million and debt issuancecosts of $2.6 million associated with the new credit agreement.

 

*Contractual Obligations and CommercialCommitments*

 

We entered into a new credit agreement in November 2003to finance the Regeneration acquisition and repay our prior bank debt.  Our new credit facility provided a term loanof $100.0 million, of which $95.0 million was outstanding as of December 31,2004. We also have available up to $30 million under a revolving creditfacility, which is available for working capital and general corporatepurposes, including financing acquisitions, investments and strategicalliances. As of December 31, 2004, we did not have any borrowed amountoutstanding under our revolving credit facility, but we were contingentlyliable for letters of credit issued under the facility aggregating $3.8million. Borrowings under the term loan and on the revolving credit facilitybear interest at variables rates plus an applicable margin. At December 31,2004, the weighted-average effective interest rate on the term loan was 4.32%.Outstanding letters of credit under the revolving credit facility bear interestat variable rates plus a fronting fee of 0.25%.

 

In addition to scheduled principal paymentsof $1.25 million per quarter, beginning in 2005 we are required to makeannual mandatory payments of the term loan in an amount equal to 50% of ourexcess cash flow (75% if our ratio of total debt to consolidated EBITDA exceeds3.00 to 1.00). Excess cash flow represents our net income adjusted forextraordinary gains or losses, depreciation, amortization and other non-cashcharges, changes in working capital, changes in deferred revenues, payments forcapital expenditures, repayment of certain indebtedness and payments forcertain common stock repurchases.  Inaddition, the term loan is subject to mandatory prepayments in an amount equalto (a) 100% of the net cash proceeds of certain equity (50% for certain qualifiedequity issuances) and debt issuances by us and (b) 100% of the net cashproceeds of certain asset sales or other dispositions of property by us, ineach case subject to certain exceptions. We had no excess cash flow for 2004 and we are not required to make anyrelated mandatory payments in 2005.

 

The credit agreement imposes certainrestrictions on us, including restrictions on our ability to incurindebtedness, incur or guarantee obligations, prepay other indebtedness oramend other debt instruments, pay dividends or make other distributions (exceptfor certain tax distributions), redeem or repurchase equity, make investments,loans or advances, make acquisitions, engage in mergers or consolidations,change the business conducted by us and our subsidiaries, make capitalexpenditures, grant liens, sell our assets and engage in certain otheractivities. Indebtedness under the credit agreement is secured by substantiallyall of our assets, including our real and personal property, inventory,accounts receivable, intellectual property and other intangibles. The creditagreement requires us to maintain: a ratio of total debt to consolidated EBITDAof no more than 3.5 to 1.00 at December 31, 2004 and gradually decreasingthrough the first quarter of 2007 to 2.50 to 1.00 for the first quarter of 2007and thereafter; a ratio of senior debt to consolidated EBITDA of no more than2.25 to 1.00 at December 31, 2004 gradually decreasing through the thirdquarter of 2006 to 1.75 to 1.00 for the third quarter of 2006 and thereafter; aratio of consolidated EBITDA to consolidated interest expense of at least 3.0to 1.00 at December 31, 2004 and increasing to 3.50 to 1.00 for the firstquarter 2005 and thereafter; and a ratio of consolidated EBITDA to fixedcharges of at least 1.5 to 1.00 at December 31, 2004 and thereafter. At December 31,2004, our ratio of total debt to consolidated EBITDA was approximately 1.78 to1.00, our ratio of senior debt to consolidated EBITDA was approximately 1.78 to1.00, our ratio of consolidated EBITDA to consolidated interest expense wasapproximately 4.57 to 1.00 and our ratio of consolidated EBITDA to fixedcharges was approximately 5.11 to 1.00.

 

As part of our strategy, we may pursueadditional acquisitions, investments and strategic alliances.  We may require new sources of financing toconsummate any such transactions, including additional debt or equityfinancing.  We cannot assure you thatsuch additional sources of financing will be available on acceptable terms, ifat all.  In addition, we may not be ableto consummate any such transactions due to the operating and financialrestrictions and covenants in our credit agreement.

 

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The following table lists our contractualobligations as of December 31, 2004 (in thousands):

 
| ** **                          | ** ** | **Payments Due by Period** | ** ** |
|-------------------------------------|------------|----------------------------|------------|
| ** **                          | ** ** | ** **                 | ** ** | **2005** | ** ** | **2006-2008** | ** ** | **2009-2010** | ** ** | **2011+** | ** ** |
| **Contractual  Obligations**        | ** ** | **Total**                  | ** ** | **Less than 1  Year** | ** ** | **1-3 Years** | ** ** | **4-5 Years** | ** ** | **After 5 years** | ** ** |
| ** **                          | ** ** | ** **                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Long-Term  Debt (1)                 |       | $                          | 95,000     |   | $ | 5,000 |   | $ | 15,000 |   | $ | 75,000 |   | $ | — |   |
| Operating  Leases                   |       | 24,284                     |       | 5,188 |   | 11,123 |   | 2,990 |   | 4,983 |   |
| Total  Contractual Cash Obligations |       | $                          | 119,284    |   | $ | 10,188 |   | $ | 26,123 |   | $ | 77,990 |   | $ | 4,983 |   |

 

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(1)          Represents scheduledprincipal payments for 2005 through 2009 under the term loan portion of ourcredit facility.

 

On October 20, 2004, we entered into a leaseagreement with Professional Real Estate Services, Inc. (PRES) under which PRESwill undertake to build a new 110,000 square foot corporate headquartersfacility for us on vacant land currently leased to us in Vista,California.  Once completed, we will occupy the facility under a 15-yearlease with two five-year options to extend the term and will move out of ourexisting facilities in Vista.  Rent for the new facility will be based onan agreed percentage of the total project cost for the construction of thefacility and is not expected to exceed the rent currently paid by us for ourexisting Vista facilities.  The contractual obligations table aboveincludes only the rent for our current Vista facilities as future rent paymentsto PRES for the new facility cannot be determined as of December 31, 2004.

 

The new lease with PRES was contingent onPRES closing a transaction to purchase the existing facilities in Vista, Californialeased by us, as well as the real property underlying the new lease.  Thepurchase transaction closed in February 2005. Effective on the closingdate, our lease for the vacant land was terminated, and when the newheadquarters facility is completed and occupied, our leases for our existingVista facilities will be terminated.  Those leases would otherwise havecontinued until February 2008.  Upon occupancy of the new facility,expected to occur in mid-2006, we will make a lump sum rent payment to PRES,which will be recorded as operating expense when incurred, equal to 40% of therent that would have been due under the existing facilities leases from thetermination date of the existing leases through the original expiration date.If PRES is able to lease our former Vista facilities during what would haveremained of the term of our existing leases, a portion of that sum may berefunded to us.

 

Our ability to pay principal and interest onour indebtedness, fund working capital requirements and make anticipatedcapital expenditures will depend on our future performance, which is subject togeneral economic, financial and other factors, some of which are beyond ourcontrol.  We believe that based oncurrent levels of operations and anticipated growth, cash flow from operations,together with other available sources of funds including the availability ofborrowings under the revolving credit facility, will be adequate for at leastthe next twelve months to make required payments of principal and interest onour indebtedness, to fund anticipated capital expenditures and for workingcapital requirements.  There can be noassurance, however, that our business will generate sufficient cash flow fromoperations or that future borrowings will be available under the revolvingcredit facility in an amount sufficient to enable us to service ourindebtedness or to fund our other liquidity needs.  In such event, we may need to raiseadditional funds through public or private equity or debt financings.  We cannot assure you that any such funds willbe available to us on favorable terms or at all.

 

We do not currently have and have never hadany relationships with unconsolidated entities or financial partnerships, suchas entities often referred to as structured finance or special purposeentities, which would have been established for the purpose of facilitatingoff-balance sheet arrangements or other contractually narrow or limitedpurposes.  In addition, we do not engagein trading activities involving non-exchange traded contracts.  As such, we are not materially exposed to anyfinancing, liquidity, market or credit risk that could arise if we had engagedin these relationships.

 

As of December 31, 2004, we hadavailable a total of approximately $11.2 million in cash and cash equivalentsand $26.2 million available under the revolving credit facility. For 2005, weexpect to spend total cash of approximately $20.0 million for the followingrequirements:

 

•                    approximately$10.0 million scheduled principal and interest payments on our credit facility;and

 

•                    approximately$10.0 million for capital expenditures.

 

In addition, we expect to make other generalcorporate payments in 2005.

 

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***Seasonality***

 

We generally record our highest net revenuesper day in the fourth quarter due to a greater number of orthopedic surgeriesand injuries resulting from increased sports activity, particularly footballand skiing. In addition, during the fourth quarter, a patient has a greater likelihoodof having satisfied his or her annual insurance deductible than in the firstthree quarters of the year, and thus there is an increase in the number ofelective orthopedic surgeries. We follow a manufacturing calendar that has avaried number of shipping days in each quarter. Although on a per day basis net revenues may be higher in a certainquarter, total net revenues may be higher or lower based upon the number ofshipping days in such quarter. Conversely, we generally have lower net revenuesper day during our second quarter as a result of decreased sports activity.

 

# * **Recent AccountingPronouncements***

# * *

For information on the recent accountingpronouncements impacting our business, see Note 1 of the notes to ourconsolidated financial statements included in Item 8.

 

**Item 7A****. Quantitative and Qualitative Disclosures About Market Risk**

 

We are exposed to certain market risks aspart of our ongoing business operations. Our primary exposures include changesin interest rates and foreign exchange rates.

 

We are exposed to interest rate risk inconnection with the term loan and borrowings under our revolving creditfacility, which bear interest at floating rates based on the London Inter-BankOffered Rate (LIBOR) or the prime rate plus an applicable borrowing margin. Forvariable rate debt, interest rate changes generally do not affect the fairmarket value of the underlying debt, but do impact future earnings and cashflows, assuming other factors are held constant.

 

As of December 31, 2004, we had$95.0 million of variable rate debt represented by borrowings under ourcredit facility (at a weighted-average interest rate of 4.32% at December 31,2004). Based on the balance outstanding under the credit facility as of December 31,2004, an immediate change of one percentage point in the applicable interestrate would have caused an increase or decrease in interest expense ofapproximately $1.0 million on an annual basis. At December 31, 2004,up to $26.2 million of variable rate borrowings were available under our$30.0 million revolving credit facility. As of December 31, 2004, wedid not have any amount outstanding under the revolving credit facility, but wewere contingently liable for letters of credit issued under the facilityaggregating $3.8 million.  We may usederivative financial instruments, where appropriate, to manage our interestrate risks. However, as a matter of policy, we do not enter into derivative orother financial investments for trading or speculative purposes. At December 31,2004, we had no such derivative financial instruments outstanding.

 

*Through our wholly-ownedinternational subsidiaries, we sell products in Euros, Pounds Sterling,Canadian Dollars and Danish Krones. The U.S. dollar equivalent of ourinternational sales denominated in foreign currencies in 2004, 2003 and 2002were favorably impacted by foreign currency exchange rate fluctuations with theweakening of the U.S. dollar against the foreign currencies of oursubsidiaries.  The U.S. dollar equivalentof the related costs denominated in these foreign currencies were unfavorablyimpacted during the same period.  Inaddition, the costs associated with our Mexico-based manufacturing operationsare incurred in Mexican pesos.  As wecontinue to distribute and manufacture our products in selected foreigncountries, we expect that future sales and costs associated with our activitiesin these markets will continue to be denominated in the applicable foreigncurrencies, which could cause currency fluctuations to materially impact our operatingresults. Occasionally we seek to reduce the potential impact of currencyfluctuations on our business through hedging transactions. At December 31,2004, we had no hedging transactions in place.*

 

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**Item 8****. Financial Statements and Supplementary Data**

 

The following documents are filed as part ofthis report:

 
| Report of Independent Registered Public  Accounting Firm                                                                          |   |
|-----------------------------------------------------------------------------------------------------------------------------------|--------|
| Consolidated Balance Sheets as of December 31, 2004 and 2003                                                                 |   |
| Consolidated Statements of Operations for  the years ended December 31, 2004, 2003 and 2002                                  |   |
| Consolidated Statements of Changes in  Stockholders’ Equity for the  Years  ended December 31, 2004, 2003 and 2002 |   |
| Consolidated Statements of Cash Flows for  the years ended  December 31,  2004, 2003 and 2002                           |   |
| Notes to Consolidated Financial Statements                                                                                        |   |

 

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**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

 

To the Board of Directors and Stockholders

dj Orthopedics, Inc.

 

We have audited the accompanying consolidated balancesheets of dj Orthopedics, Inc. as of December 31, 2004 and 2003, and therelated consolidated statements of operations, stockholders’ equity and cashflows for each of the three years in the period ended December 31,2004.  Our audits also included thefinancial statement schedule listed in the Index at Item 15(a).  These consolidated financial statements and schedule arethe responsibility of the Company’s management. Our responsibility is to express an opinion on these financialstatements and schedule based on our audits.

 

We conducted our audits in accordance with auditingstandards generally accepted in the United States.  Those standards require that we plan andperform the audit to obtain reasonable assurance about whether the financialstatements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting theamounts and disclosures in the financial statements.  An audit also includes assessing theaccounting principles used and significant estimates made by management, aswell as evaluating the overall financial statement presentation.  We believe that our audits provide areasonable basis for our opinion.

 

In our opinion, the financial statements referred toabove present fairly, in all material respects, the consolidated financialposition of dj Orthopedics, Inc. at December 31, 2004 and 2003, and theconsolidated results of its operations and its cash flows for each of the threeyears in the period ended December 31, 2004, in conformity with accountingprinciples generally accepted in the United States.  Also, in our opinion, the related financialstatement schedule, when considered in relation to the basic financialstatements taken as a whole, presents fairly in all material respects the informationset forth therein.

 

We also have audited, in accordance with the standardsof the Public Company Accounting Oversight Board (United States), theeffectiveness of dj Orthopedics, Inc.’s internal control over financialreporting as of December 31, 2004, based on criteria established inInternal Control – Integrated Framework issued by the Committee of SponsoringOrganizations of the Treadway Commission and our report dated February 22,2005 expressed an unqualified opinion thereon.

 
|                   | /s/ Ernst &  Young LLP |   |
|------------------------|----------------------------|--------|
|                   |                       |
|                   |                       |
| San Diego, California  |                       |
| February 22, 2005 |                       |

 

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# ***dj Orthopedics, Inc.***

# ***CONSOLIDATED BALANCE SHEETS***

(In thousands, except share andpar value data)

 
| ** **                                                                                                                                                                                      | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                      | ** ** | **2004**              | ** ** | **2003** | ** ** |
| **Assets**                                                                                                                                                                                      |       |                  |       |   |   |
| Current  assets:                                                                                                                                                                                |       |                  |       |   |   |
| Cash and  cash equivalents                                                                                                                                                                      |       | $                     | 11,182     |   | $ | 19,146 |   |
| Accounts  receivable, net of provisions for contractual allowances and doubtful  accounts of $26,628 and $20,717 at December 31, 2004 and 2003,  respectively                              |       | 46,981                |       | 43,876 |   |
| Inventories,  net                                                                                                                                                                               |       | 19,071                |       | 15,534 |   |
| Deferred tax  asset, current portion                                                                                                                                                            |       | 7,902                 |       | 11,283 |   |
| Other  current assets                                                                                                                                                                           |       | 5,359                 |       | 6,342 |   |
| Total  current assets                                                                                                                                                                           |       | 90,495                |       | 96,181 |   |
| Property,  plant and equipment, net                                                                                                                                                             |       | 15,463                |       | 15,556 |   |
| Goodwill                                                                                                                                                                                        |       | 96,639                |       | 96,552 |   |
| Intangible  assets, net                                                                                                                                                                         |       | 54,717                |       | 59,045 |   |
| Debt  issuance costs, net                                                                                                                                                                       |       | 2,374                 |       | 5,042 |   |
| Deferred tax  asset                                                                                                                                                                             |       | 46,100                |       | 47,509 |   |
| Other assets                                                                                                                                                                                    |       | 1,062                 |       | 619 |   |
| Total assets                                                                                                                                                                                    |       | $                     | 306,850    |   | $ | 320,504 |   |
|                                                                                                                                                                                            |       |                  |       |   |   |
| **Liabilities  and stockholders’ equity**                                                                                                                                                  |       |                  |       |   |   |
| Current  liabilities:                                                                                                                                                                           |       |                  |       |   |   |
| Accounts  payable                                                                                                                                                                               |       | $                     | 7,300      |   | $ | 8,325 |   |
| Accrued  compensation                                                                                                                                                                           |       | 5,484                 |       | 6,646 |   |
| Accrued  commissions                                                                                                                                                                            |       | 4,425                 |       | 4,629 |   |
| Long-term  debt, current portion                                                                                                                                                                |       | 5,000                 |       | 5,000 |   |
| Accrued  restructuring costs                                                                                                                                                                    |       | 2,288                 |       | 766 |   |
| Other  accrued liabilities                                                                                                                                                                      |       | 9,315                 |       | 8,649 |   |
| Total  current liabilities                                                                                                                                                                      |       | 33,812                |       | 34,015 |   |
|                                                                                                                                                                                            |       |                  |       |   |   |
| Long-term  debt, less current portion                                                                                                                                                           |       | 90,000                |       | 95,000 |   |
| 12 5/8%  senior subordinated notes, net of unamortized discount                                                                                                                                 |       | —                |       | 74,156 |   |
|                                                                                                                                                                                            |       |                  |       |   |   |
| Commitments  and contingencies                                                                                                                                                                  |       |                  |       |   |   |
|                                                                                                                                                                                            |       |                  |       |   |   |
| Stockholders’  equity:                                                                                                                                                                     |       |                  |       |   |   |
| Preferred  stock, $0.01 par value; 1,000,000 and 25,000,000 shares authorized at December 31,  2004 and 2003, respectively, none issued and outstanding                                    |       | —                |       | — |   |
| Common  stock, $0.01 par value; 39,000,000 and 100,000,000 shares authorized,  21,459,428 shares and 18,304,269 shares issued and outstanding at December 31,  2004 and 2003, respectively |       | 215                   |       | 183 |   |
| Additional  paid-in-capital                                                                                                                                                                     |       | 121,139               |       | 69,545 |   |
| Notes  receivable from stockholders and officers for stock purchases                                                                                                                            |       | (1,749                | )          | (1,988 | ) |
| Accumulated  other comprehensive income                                                                                                                                                         |       | 931                   |       | 1,106 |   |
| Retained  earnings                                                                                                                                                                              |       | 62,502                |       | 48,487 |   |
| Total  stockholders’ equity                                                                                                                                                                |       | 183,038               |       | 117,333 |   |
| Total  liabilities and stockholders’ equity                                                                                                                                                |       | $                     | 306,850    |   | $ | 320,504 |   |

 

See accompanying Notes.

 

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**djOrthopedics, Inc.**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

(In thousands, except per sharedata)

 
| ** **                                                                          | ** ** | **Years Ended  December 31,** | ** ** |
|-------------------------------------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                                                          | ** ** | **2004**                           | ** ** | **2003** | ** ** | **2002** | ** ** |
| Net revenues                                                                        |       | $                                  | 255,999    |   | $ | 197,939 |   | $ | 182,636 |   |
| Costs of goods  sold                                                                |       | 95,164                             |       | 85,927 |   | 95,878 |   |
| Gross profit                                                                        |       | 160,835                            |       | 112,012 |   | 86,758 |   |
| Operating  expenses:                                                                |       |                               |       |   |   |   |   |
| Sales and  marketing                                                                |       | 78,984                             |       | 54,067 |   | 56,216 |   |
| General and  administrative                                                         |       | 27,727                             |       | 21,767 |   | 26,414 |   |
| Research and  development                                                           |       | 5,627                              |       | 4,442 |   | 2,922 |   |
| Amortization  of acquired intangibles                                               |       | 4,731                              |       | 464 |   | — |   |
| Impairment  of long-lived assets                                                    |       | —                             |       | — |   | 3,666 |   |
| Performance  improvement, restructuring and other costs                             |       | 4,693                              |       | (497 | ) | 10,008 |   |
| Total  operating expenses                                                           |       | 121,762                            |       | 80,243 |   | 99,226 |   |
| Income  (loss) from operations                                                      |       | 39,073                             |       | 31,769 |   | (12,468 | ) |
| Other income  (expense):                                                            |       |                               |       |   |   |   |   |
| Interest  expense                                                                   |       | (9,431                             | )          | (12,582 | ) | (12,477 | ) |
| Interest  income                                                                    |       | 472                                |       | 398 |   | 590 |   |
| Prepayment  premium and other costs related to senior subordinated notes redemption |       | (7,760                             | )          | — |   | — |   |
| Other income  (expense)                                                             |       | 683                                |       | 466 |   | (201 | ) |
| Other income  (expense), net                                                        |       | (16,036                            | )          | (11,718 | ) | (12,088 | ) |
| Income  (loss) before income taxes                                                  |       | 23,037                             |       | 20,051 |   | (24,556 | ) |
| Benefit  (provision) for income taxes                                               |       | (9,022                             | )          | (7,980 | ) | 9,361 |   |
| Net income  (loss)                                                                  |       | $                                  | 14,015     |   | $ | 12,071 |   | $ | (15,195 | ) |
| Net income  (loss) per share:                                                       |       |                               |       |   |   |   |   |
| Basic                                                                               |       | $                                  | 0.66       |   | $ | 0.67 |   | $ | (0.85 | ) |
| Diluted                                                                             |       | $                                  | 0.63       |   | $ | 0.64 |   | $ | (0.85 | ) |
|                                                                                |       |                               |       |   |   |   |   |
| Weighted  average shares outstanding used to                                        |       |                               |       |   |   |   |   |
| calculate  per share information:                                                   |       |                               |       |   |   |   |   |
| Basic                                                                               |       | 21,221                             |       | 17,963 |   | 17,873 |   |
| Diluted                                                                             |       | 22,209                             |       | 18,791 |   | 17,873 |   |

 

See accompanying Notes.

 

52

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**dj Orthopedics, Inc.**

**CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY**

(In thousands, except share data)

 
| ** **                                                                     | ** ** | ** ** | ** ** | ** ** | ** ** | **Additional  Paid-in  Capital** | ** ** | **Notes  Receivable  from  Stockholders  and Officers for  Stock Purchases** | ** ** | **Accumulated  Other  Comprehensive  Income  (Loss)** | ** ** | **Retained  Earnings** | ** ** | **Total  Stockholders’  Equity** | ** ** |
|--------------------------------------------------------------------------------|------------|------------|------------|------------|------------|----------------------------------|------------|------------------------------------------------------------------------------|------------|-------------------------------------------------------|------------|------------------------|------------|---------------------------------------|------------|
| ** **                                                                     |
| **Common Stock**                                                               |
| **Shares**                                                                     | ** ** | **Amount** |
| **Balance at December 31, 2001**                                          |       | 17,855,566 |       | $          | 179        |                             | $          | 65,642                                                                       |       | $                                                     | (2,082     | )                      | $          | (110                                  | )          | $ | 51,611 |   | $ | 115,240 |   |
| Transfer of interest receivable to notes receivable  from management           |       | —     |       | —     |       | —                           |       | (115                                                                         | )          | —                                                |       | —                 |       | (115                                  | )          |
| Stock options granted for services                                             |       | —     |       | —     |       | 32                               |       | —                                                                       |       | —                                                |       | —                 |       | 32                                    |       |
| Additional costs related to initial public offering                            |       | —     |       | —     |       | (317                             | )          | —                                                                       |       | —                                                |       | —                 |       | (317                                  | )          |
| Net proceeds from issuance of common stock under  Employee Stock Purchase Plan |       | 17,390     |       | —     |       | 121                              |       | —                                                                       |       | —                                                |       | —                 |       | 121                                   |       |
| Comprehensive income (loss):                                                   |       |       |       |       |       |                             |       |                                                                         |       |                                                  |       |                   |       |                                  |       |
| Unearned compensation expense                                                  |       | —     |       | —     |       | —                           |       | —                                                                       |       | 14                                                    |       | —                 |       | 14                                    |       |
| Foreign currency translation adjustment                                        |       | —     |       | —     |       | —                           |       | —                                                                       |       | 1,133                                                 |       | —                 |       | 1,133                                 |       |
| Net loss                                                                       |       | —     |       | —     |       | —                           |       | —                                                                       |       | —                                                |       | (15,195                | )          | (15,195                               | )          |
| Total comprehensive loss                                                       |       |       |       |       |       |                             |       |                                                                         |       |                                                  |       |                   |       | (14,048                               | )          |
| **Balance at December 31, 2002**                                          |       | 17,872,956 |       | 179        |       | 65,478                           |       | (2,197                                                                       | )          | 1,037                                                 |       | 36,416                 |       | 100,913                               |       |
| Transfer of interest receivable to notes receivable  from management           |       | —     |       | —     |       | —                           |       | (123                                                                         | )          | —                                                |       | —                 |       | (123                                  | )          |
| Proceeds from payment of notes receivable                                      |       | —     |       | —     |       | —                           |       | 332                                                                          |       | —                                                |       | —                 |       | 332                                   |       |
| Stock options granted for services                                             |       | —     |       | —     |       | 178                              |       | —                                                                       |       | —                                                |       | —                 |       | 178                                   |       |
| Net proceeds from issuance of common stock under  Employee Stock Purchase Plan |       | 73,172     |       | 1          |       | 227                              |       | —                                                                       |       | —                                                |       | —                 |       | 228                                   |       |
| Net proceeds from exercise of stock options                                    |       | 358,141    |       | 3          |       | 3,662                            |       | —                                                                       |       | —                                                |       | —                 |       | 3,665                                 |       |
| Comprehensive income (loss):                                                   |       |       |       |       |       |                             |       |                                                                         |       |                                                  |       |                   |       |                                  |       |
| Foreign currency translation adjustment                                        |       | —     |       | —     |       | —                           |       | —                                                                       |       | 69                                                    |       | —                 |       | 69                                    |       |
| Net income                                                                     |       | —     |       | —     |       | —                           |       | —                                                                       |       | —                                                |       | 12,071                 |       | 12,071                                |       |
| Total comprehensive income                                                     |       |       |       |       |       |                             |       |                                                                         |       |                                                  |       |                   |       | 12,140                                |       |
| **Balance at December 31, 2003**                                          |       | 18,304,269 |       | 183        |       | 69,545                           |       | (1,988                                                                       | )          | 1,106                                                 |       | 48,487                 |       | 117,333                               |       |
| Transfer of interest receivable to notes receivable  from management           |       | —     |       | —     |       | —                           |       | (92                                                                          | )          | —                                                |       | —                 |       | (92                                   | )          |
| Proceeds from payment of notes receivable                                      |       | —     |       | —     |       | —                           |       | 331                                                                          |       | —                                                |       | —                 |       | 331                                   |       |
| Stock options granted for services                                             |       | —     |       | —     |       | 63                               |       | —                                                                       |       | —                                                |       | —                 |       | 63                                    |       |
| Net proceeds from issuance of common stock under  Employee Stock Purchase Plan |       | 346,919    |       | 3          |       | 1,614                            |       | —                                                                       |       | —                                                |       | —                 |       | 1,617                                 |       |
| Net proceeds from exercise of stock options                                    |       | 483,040    |       | 5          |       | 4,128                            |       | —                                                                       |       | —                                                |       | —                 |       | 4,133                                 |       |
| Tax benefit of stock option exercises                                          |       | —     |       | —     |       | 4,315                            |       | —                                                                       |       | —                                                |       | —                 |       | 4,315                                 |       |
| Proceeds from sale of common stock, net of expenses  of $1,077                 |       | 3,162,500  |       | 32         |       | 56,499                           |       | —                                                                       |       | —                                                |       | —                 |       | 56,531                                |       |
| Expenses of sale of common stock by stockholders                               |       | —     |       | —     |       | (245                             | )          | —                                                                       |       | —                                                |       | —                 |       | (245                                  | )          |
| Repurchases of common stock                                                    |       | (837,300   | )          | (8         | )          | (14,780                          | )          | —                                                                       |       | —                                                |       | —                 |       | (14,788                               | )          |
| Comprehensive income (loss):                                                   |       |       |       |       |       |                             |       |                                                                         |       |                                                  |       |                   |       |                                  |       |
| Foreign currency translation adjustment                                        |       | —     |       | —     |       | —                           |       | —                                                                       |       | (175                                                  | )          | —                 |       | (175                                  | )          |
| Net income                                                                     |       | —     |       | —     |       | —                           |       | —                                                                       |       | —                                                |       | 14,015                 |       | 14,015                                |       |
| Total comprehensive income                                                     |       |       |       |       |       |                             |       |                                                                         |       |                                                  |       |                   |       | 13,840                                |       |
| **Balance at December 31, 2004**                                          |       | 21,459,428 |       | $          | 215        |                             | $          | 121,139                                                                      |       | $                                                     | (1,749     | )                      | $          | 931                                   |       | $ | 62,502 |   | $ | 183,038 |   |

 

See accompanying Notes.

 

53

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**dj Orthopedics, Inc.**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

(In thousands)

 
| ** **                                                                                | ** ** | **Years Ended December 31,** | ** ** |
|-------------------------------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                                                | ** ** | **2004**                          | ** ** | **2003** | ** ** | **2002** | ** ** |
| **Operating activities**                                                                  |       |                              |       |   |   |   |   |
| Net income  (loss)                                                                        |       | $                                 | 14,015     |   | $ | 12,071 |   | $ | (15,195 | ) |
| Adjustments  to reconcile net income (loss) to net cash provided by operating activities: |       |                              |       |   |   |   |   |
| Provision  for contractual allowances and doubtful accounts                               |       | 30,556                            |       | 22,641 |   | 22,269 |   |
| Provision  for excess and obsolete inventories                                            |       | (113                              | )          | 2,087 |   | 6,124 |   |
| Impairment  of long-lived assets                                                          |       | —                            |       | — |   | 3,666 |   |
| Restructuring  costs                                                                      |       | 4,693                             |       | (497 | ) | 10,008 |   |
| Depreciation  and amortization                                                            |       | 13,070                            |       | 8,186 |   | 7,283 |   |
| Step-up to  fair value of inventory charged to costs of goods sold                        |       | 438                               |       | — |   | — |   |
| Amortization  of debt issuance costs and discount on senior subordinated notes            |       | 808                               |       | 1,499 |   | 935 |   |
| Write-off of  debt issuance costs and discount on senior subordinated notes               |       | 3,025                             |       | — |   | — |   |
| Liquidation  preference on redemption of senior subordinated notes                        |       | 4,735                             |       | — |   | — |   |
| Other                                                                                     |       | 63                                |       | 178 |   | 46 |   |
| Changes in  operating assets and liabilities:                                             |       |                              |       |   |   |   |   |
| Accounts  receivable                                                                      |       | (33,353                           | )          | (24,708 | ) | (10,409 | ) |
| Inventories                                                                               |       | (3,635                            | )          | 58 |   | 8,248 |   |
| Other  current assets                                                                     |       | 856                               |       | (1,991 | ) | (3,571 | ) |
| Accounts  payable                                                                         |       | (1,403                            | )          | (501 | ) | (1,659 | ) |
| Accrued  compensation                                                                     |       | (1,065                            | )          | 1,494 |   | 2,829 |   |
| Accrued  commissions                                                                      |       | (214                              | )          | 2,847 |   | 416 |   |
| Deferred  income taxes                                                                    |       | 9,044                             |       | 6,944 |   | (9,695 | ) |
| Accrued  restructuring costs                                                              |       | (3,171                            | )          | (4,631 | ) | (3,961 | ) |
| Other  accrued liabilities                                                                |       | 1,121                             |       | 850 |   | (2,495 | ) |
| Net cash  provided by operating activities                                                |       | 39,470                            |       | 26,527 |   | 14,839 |   |
|                                                                                      |       |                              |       |   |   |   |   |
| **Investing  activities**                                                                 |       |                              |       |   |   |   |   |
| Purchases of  property, plant and equipment                                               |       | (5,959                            | )          | (5,334 | ) | (4,131 | ) |
| Proceeds  from sale of property, plant and equipment                                      |       | —                            |       | — |   | 288 |   |
| Purchase of  intangible assets                                                            |       | (3,277                            | )          | (3,000 | ) | (2,590 | ) |
| Purchase of  Regeneration business                                                        |       | —                            |       | (93,939 | ) | — |   |
| Purchase of  DuraKold business                                                            |       | —                            |       | (2,899 | ) | — |   |
| Purchase of  dj Nordic business, net of cash acquired                                     |       | (578                              | )          | — |   | — |   |
| Change in  other assets, net                                                              |       | (360                              | )          | (280 | ) | (916 | ) |
| Net cash  used in investing activities                                                    |       | (10,174                           | )          | (105,452 | ) | (7,349 | ) |
|                                                                                      |       |                              |       |   |   |   |   |
| **Financing  activities**                                                                 |       |                              |       |   |   |   |   |
| Repayment of  senior subordinated notes                                                   |       | (75,000                           | )          | — |   | — |   |
| Prepayment  premium on redemption of senior subordinated notes                            |       | (4,735                            | )          | — |   | — |   |
| Proceeds  from long-term debt                                                             |       | —                            |       | 100,000 |   | — |   |
| Repayment of  long-term debt                                                              |       | (5,000                            | )          | (35,815 | ) | (1,272 | ) |
| Net proceeds  from exercise of stock options                                              |       | 4,133                             |       | 3,665 |   | — |   |
| Net proceeds  from issuance of common stock under Employee Stock Purchase Plan            |       | 1,617                             |       | 228 |   | 121 |   |
| Net proceeds  from (costs of) issuance of common stock                                    |       | 56,286                            |       | — |   | (317 | ) |
| Repurchases  of common stock                                                              |       | (14,788                           | )          | — |   | — |   |
| Debt  issuance costs                                                                      |       | (313                              | )          | (2,600 | ) | — |   |
| Proceeds  from payment of notes receivable                                                |       | 331                               |       | 332 |   | — |   |
| Net cash  (used in) provided by financing activities                                      |       | (37,469                           | )          | 65,810 |   | (1,468 | ) |
| Effect of  exchange rate changes on cash and cash equivalents                             |       | 209                               |       | 176 |   | 249 |   |
| Net  (decrease) increase in cash and cash equivalents                                     |       | (7,964                            | )          | (12,939 | ) | 6,271 |   |
| Cash and  cash equivalents at beginning of year                                           |       | 19,146                            |       | 32,085 |   | 25,814 |   |
| Cash and  cash equivalents at end of year                                                 |       | $                                 | 11,182     |   | $ | 19,146 |   | $ | 32,085 |   |
|                                                                                      |       |                              |       |   |   |   |   |
| **Supplemental  disclosure of cash flow information:**                                    |       |                              |       |   |   |   |   |
| Interest  paid                                                                            |       | $                                 | 3,844      |   | $ | 10,513 |   | $ | 11,308 |   |
| Income taxes  paid (refunded), net                                                        |       | $                                 | 618        |   | $ | (43 | ) | $ | 760 |   |
| **Supplemental  disclosure of non-cash transactions:**                                    |       |                              |       |   |   |   |   |
| Transfer of  interest receivable to notes receivable                                      |       | $                                 | 92         |   | $ | 123 |   | $ | 115 |   |

 

See accompanying Notes.

 

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**djOrthopedics, Inc.**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

(In thousands)

 

**1.****                                      Organizationand Summary of Significant Accounting Policies**

 

djOrthopedics, Inc. (dj Orthopedics), through its subsidiary dj Orthopedics, LLC(dj Ortho) and dj Ortho’s subsidiaries (collectively, the Company) is a globalmedical device company specializing in rehabilitation and regeneration productsfor the non-operative orthopedic and spine markets.

 

*Basis of Presentation and Principles ofConsolidation*

 

Theaccompanying consolidated financial statements present the historical financialposition and results of operations of dj Orthopedics and include the accountsof dj Ortho, dj Orthopedics Development Corporation (dj Development), DJOrthopedics Capital Corporation (dj Capital), dj Ortho’s wholly owned Mexicansubsidiary that manufactures a majority of dj Ortho’s products under Mexico’smaquiladora program, dj Ortho’s wholly-owned subsidiaries in Canada, Germany,France, the United Kingdom and Denmark, and, in 2002 only, dj Ortho’s majorityowned subsidiary in Australia (divested in December 2002). Allintercompany accounts and transactions have been eliminated in consolidation.

 

In August 2004, the Company commenceddirect distribution of its products in Denmark, Finland, Norway and Swedenthrough a new wholly-owned subsidiary, dj Nordic. In October 2003, theCompany commenced direct distribution of its products in France through a newwholly-owned subsidiary, dj Orthopedics France S.A.S. (dj France). EffectiveMay 2002, the Company commenced direct distribution of its products in Canadathrough a new wholly-owned subsidiary, dj Ortho, Canada Inc. (dj Canada).  Effective January 2002, the Companycommenced direct distribution of its products in Germany and the United Kingdomthrough two new wholly-owned subsidiaries, dj Orthopedics Deutschland GmbH (djGermany) and dj Orthopaedics UK Ltd (dj UK). In each of these countries the Company had previously sold its productsthrough third-party distributors.

 

*Use of Estimates in the Preparation ofFinancial Statements*

 

Thepreparation of these financial statements requires that the Company makeestimates and judgments that affect the reported amounts of assets,liabilities, revenues and expenses and related disclosure of contingent assetsand liabilities. On an ongoing basis, the Company evaluates its estimates,including those related to contractual allowances, doubtful accounts,inventories, rebates, product returns, warranty obligations, income taxes andintangibles.  The Company bases itsestimates on historical experience and on various other assumptions that arebelieved to be reasonable under the circumstances, the results of which formthe basis for making judgments about the carrying values of assets andliabilities that are not readily apparent from other sources.  Actual results may differ from theseestimates.

 

*Cash Equivalents*

 

Cash equivalentsare short-term, highly liquid investments and consist of investments in moneymarket funds and commercial paper with maturities of three months or less atthe time of purchase.

 

*Fair Value of Financial Instruments*

 

In accordance with Financial AccountingStandards Board (FASB) Statement of Financial Accounting Standards (SFAS)No. 107, *Disclosures about Fair Value of FinancialInstruments*, the following methods and assumptions were used inestimating fair value disclosures:

 

•                    *Cash and Cash Equivalents and Accounts Receivable.* The carrying amounts approximate fair valuesbecause of the short maturities of these instruments and the reserves forcontractual allowances and doubtful accounts which, in the opinion ofmanagement, are adequate to state accounts receivable at their fair value.

 

•                    *Long-Term Debt. *Basedon the borrowing rates currently available to the Company for loans withsimilar terms and average maturities, management of the Company believes thefair value of long-term debt approximates its carrying value at December 31,2004.

 

55

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*Discounts and Allowances*

 

Accountsreceivable in the accompanying consolidated balance sheets are presented net ofreserves for estimated payment discounts, contractual allowances related tothird-party payors, and allowances for doubtful accounts.

 

*Long-Lived Assets*

 

Property, plant and equipment and intangibleassets are recorded at cost. The Company provides for depreciation of property,plant and equipment (3 to 7 years) and amortization of intangible assets (4 monthsto 20 years) using the straight-line method over the estimated useful lives ofthe assets. Leasehold improvements are amortized over the lesser of theirestimated useful lives or the terms of the related leases.

 

*Computer Software Costs*

 

The Company applies the American Institute ofCertified Public Accountants Statement of Position 98-1, *Accountingfor Costs of Computer Software Developed or Obtained for Internal Use*.This standard requires companies to capitalize qualifying computer softwarecosts, incurred during the application development stage and then amortizes thecosts over the estimated useful life of the software.  During 2001, the Company capitalized $1.2million related to the acquisition and implementation of its enterpriseresource planning system.  The Company isamortizing these costs over seven years.

 

*Debt Issuance Costs*

 

Debt issuance costs are capitalized and theCompany amortizes these costs over the life of the related debt instruments,ranging from six to ten years and classifies the amortization expense withinterest expense in the accompanying consolidated statements of operations.

 

*Inventories*

 

Inventories are stated at the lower of costor market, with cost determined on a first-in, first-out (FIFO) basis.

 

*Revenue Recognition*

 

The Company distributes its products in theUnited States and international markets primarily through networks of agents,distributors and the Company’s direct sales force that market its products toorthopedic and spine surgeons, podiatrists, orthopedic and prosthetic centers,third-party distributors, hospitals, surgery centers, physical therapists,athletic trainers and other healthcare professionals.

 

The Company recognizes revenue pursuant toStaff Accounting Bulletin (SAB) No. 104, *RevenueRecognition*. Accordingly, revenue is recognized when all four of thefollowing criteria are met: (i) persuasive evidence that an arrangementexists; (ii) shipment of goods and passage of title; (iii) theselling price is fixed or determinable; and (iv) collectibility isreasonably assured. Revenues from third-party insurance payors are recorded netof estimated contractual allowances, which are accrued as a percent of revenuesbased on actual historical experience. Revenues are also reduced by allowancesfor estimated returns and rebates related to sales transacted throughdistribution agreements that provide the distributors with a right to returnexcess and obsolete inventory. Estimated returns, based on historical actualreturns, are accrued in accordance with the provisions of SFAS No. 48, *Revenue Recognition When Right of Return Exists*, in the period sales are recognized.In addition, rebates are accrued at the time of sale based upon historicalexperience and estimated revenue levels in accordance with agreed upon termswith customers.  Furthermore, the Companyincludes amounts billed to customers for freight in revenue.

 

*Shipping and Handling Costs*

 

Shipping and handling costs are included incosts of goods sold and were $13.9 million, $10.7 million and $9.2 million forthe years ended December 31, 2004, 2003 and 2002, respectively.

 

56

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*Warranty Costs*

 

Some products have a limited warranty andestimated warranty costs are accrued based on historical experience in theperiod sales are recognized.  Warrantycosts are included in costs of goods sold and were $1.3 million, $0.5 millionand $0.5 million for the years ended December 31, 2004, 2003 and 2002,respectively.

 

*Advertising Expense*

 

Advertising costs are expensed asincurred.  The Company incurred $0.5million, $0.2 million and $0.1 million in advertising expenses for the yearsended December 31, 2004, 2003 and 2002, respectively.

 

*Foreign Currency Translation*

 

Thefinancial statements of the Company’s international operations where the localcurrency is the functional currency are translated into U.S. dollars usingperiod-end exchange rates for assets and liabilities and average exchange ratesduring the period for revenues and expenses. Cumulative translation gains andlosses are excluded from results of operations and recorded as a separatecomponent of consolidated stockholders’ equity. Gains and losses resulting from foreign currency transactions(transactions denominated in a currency other than the entity’s local currency)are included in the consolidated statements of operations as either a componentof costs of goods sold or other income or expense, depending on the nature ofthe transaction.  The aggregate exchangerate gain or (loss) included in determining net income for the years endedDecember 31, 2004 and 2003 was $0.6 million and $0.4 million,respectively.  There was no exchange rategain or (loss) included in determining net loss for the year ended December 31,2002.

 

*Concentration of Credit Risk*

 

The Company sells the majority of itsproducts in the United States to orthopedic professionals, distributors,specialty dealers and buying groups. International sales comprised 11%, 13% and 12% of the Company’s netrevenues for the years ended December 31, 2004, 2003 and 2002,respectively, and are sold through wholly-owned subsidiaries and independentdistributors. Credit is extended based on an evaluation of the customer’sfinancial condition and generally collateral is not required. The Company alsoprovides a reserve for estimated bad debts. In addition, approximately 48% and 41% of the Company’s net receivablesat December 31, 2004 and 2003, respectively, are from third-partypayors.  Management reviews and revisesits estimates for credit losses from time to time and such credit losses havebeen within management’s estimates.

 

During the three years ended December 31,2004, the Company had no individual customer or distributor, which accountedfor 10% or more of total annual revenues.

 

*Per Share Information*

 

Earnings per share are computed in accordancewith SFAS No. 128, *Earnings Per Share*.  Basic earnings per share are computed usingthe weighted average number of common shares outstanding during eachperiod.  Diluted earnings per shareinclude the dilutive effect of weighted average common share equivalentspotentially issuable upon the exercise of stock options. For purposes ofcomputing diluted earnings per share, weighted average common share equivalents(computed using the treasury stock method) do not include stock options with anexercise price that exceeds the average fair market value of the Company’scommon stock during the periods presented. For the years ended December 31, the weighted average sharesoutstanding used to calculate basic and diluted share information consist ofthe following (in thousands):

 
| ** **                                                                                   | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|----------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Shares used  in basic net income (loss) per share – weighted average shares outstanding |       | 21,221   |       | 17,963   |       | 17,873   |       |
| Net effect  of dilutive common share equivalents based on treasury stock method              |       | 988      |       | 828      |       | —   |       |
| Shares used  in computations of diluted net income (loss) per share                          |       | 22,209   |       | 18,791   |       | 17,873   |       |

 

*Stock-Based Compensation*

 

The Company accounts for its employee stockoption plans and employee stock purchase plan under recognition and measurementprinciples of Accounting Principles Board (APB) Opinion No. 25, *Accounting for Stock Issued to Employees*and its relatedinterpretations, and has adopted the disclosure only provisions of SFAS No.123, *Accounting for Stock-Based Compensation*andits related interpretations. Accordingly, no compensation cost has beenrecognized for the fixed stock

 

57

----

 

option plans or stock purchase plan. In accordance with EITF 96-18, *Accountingfor Equity Instruments That Are Issued to Other Than Employees for Acquiring,or in Conjunction with Selling, Goods or Services*, stock options andwarrants issued to consultants and other non-employees as compensation forservices provided to the Company are accounted for based upon the fair value ofthe services provided or the estimated fair market value of the option orwarrant, whichever can be more clearly determined. The Company recognizes thisexpense over the period the services are provided; however, the amount ofexpense related to these types of arrangements has never been significant.

 

Pro forma information regarding net income isrequired by SFAS No. 123 and has been determined as if the Company hadaccounted for its employee stock options and employee stock purchase planpurchases under the fair value method of SFAS No. 123.  The fair value of the options was estimatedat the date of grant using the Black-Scholes valuation model for option pricingwith the following assumptions for 2004, 2003 and 2002: a risk-free interestrate of 3.18%, 2.68% and 2.92%, respectively; a dividend yield of zero;expected volatility of the market price of the Company’s common stock of 71.5%,74.2% and 90.9%, respectively, and a weighted average life of an option of fouryears.  The fair value of the employeestock purchase plan purchases was estimated using the Black-Scholes valuationmodel with the following assumptions for 2004, 2003 and 2002: a risk-free interestrate of 1.51%, 1.30% and 1.86%, respectively; a dividend yield of zero;expected volatility of the market price of the Company’s common stock of 61.7%,59.0% and 90.9%, respectively, and a weighted average life of 1.3 years, 0.8years and 0.6 years, respectively.

 

For the years ended December 31, thefollowing table illustrates the effect on net income (loss) and net income(loss) per share had the Company applied the fair value recognition provisionsof SFAS No. 123 to stock-based employee compensation (in thousands, except pershare amounts):

 
| ** **                                                                                                                                                    | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------|----------|------------|----------|------------|----------|------------|
| Net income  (loss) as reported                                                                                                                                |     | $          | 14,015   |       | $        | 12,071     |   | $ | (15,195 | ) |
| Total  stock-based employee compensation expense determined under fair value method  for all option plans and stock purchase plan, net of related tax effects |     | (6,356     | )        | (2,026     | )        | (654       | ) |
| Pro forma  net income (loss)                                                                                                                                  |     | $          | 7,659    |       | $        | 10,045     |   | $ | (15,849 | ) |
| Basic net  income (loss) per share:                                                                                                                           |     |       |     |       |     |       |   |
| As reported                                                                                                                                                   |     | $          | 0.66     |       | $        | 0.67       |   | $ | (0.85 | ) |
| Pro forma                                                                                                                                                     |     | $          | 0.36     |       | $        | 0.56       |   | $ | (0.89 | ) |
|                                                                                                                                                          |     |       |     |       |     |       |   |
| Diluted net  income (loss) per share:                                                                                                                         |     |       |     |       |     |       |   |
| As reported                                                                                                                                                   |     | $          | 0.63     |       | $        | 0.64       |   | $ | (0.85 | ) |
| Pro forma                                                                                                                                                     |     | $          | 0.34     |       | $        | 0.53       |   | $ | (0.89 | ) |

 

The pro forma effect on net income (loss) asshown above is not necessarily indicative of potential pro forma effects onresults for future years.  The weightedaverage fair value of options granted during 2004, 2003 and 2002 was $12.09,$11.30 and $3.20 per share, respectively.

 

# *Income Taxes*

# * *

The Company utilizes the liability method ofaccounting for income taxes as set forth in SFAS No. 109, *Accounting for Income Taxes*. Under theliability method, deferred taxes are determined based on the temporarydifferences between the financial statement and tax bases of assets andliabilities using enacted tax rates. A valuation allowance is recorded when itis more likely than not that some of the deferred tax assets will not berealized.

 

*Comprehensive Income (Loss)*

 

The Company has adopted SFAS No. 130, *Reporting Comprehensive Income*, which requires that allcomponents of comprehensive income (loss), including net income (loss), bereported in the financial statements in the period in which they arerecognized. Comprehensive income (loss) is defined as the change in equityduring a period from transactions and other events and circumstances fromnon-owner sources. Net income (loss) and other comprehensive income (loss),including foreign currency translation adjustments, and unrealized gains andlosses on investments, are reported, net of related tax, to arrive atcomprehensive income (loss).

 

58

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*Recently Issued Accounting Standards*

 

In November 2004,the FASB issued SFAS No. 151, *Inventory Costs*, an amendment of ARB No. 43, which is theresult of its efforts to converge U.S. accounting standards for inventorieswith International Accounting Standards. SFAS No. 151 requires idle facility expenses, freight, handling costs,and wasted material (spoilage) costs to be recognized as current-periodcharges.  It also requires that theallocation of fixed production overheads to the costs of conversion be based onthe normal capacity of the production facilities.  SFAS No. 151 will be effective for inventorycosts incurred during fiscal years beginning after June 15, 2005.  The Company does not expect the adoption ofSFAS No. 151 to have a material impact on its consolidated financialstatements.

 

On December 16,2004, the FASB issued SFAS No. 123 (revised 2004), or SFAS No. 123(R), *Share-Based Payment*,which is a revision of SFAS No. 123. SFAS No. 123(R) supersedes APB Opinion No. 25, and amends SFASNo. 95, *Statement of Cash Flows*.Generally, the approach in SFAS No. 123(R)is similar to the approach described in SFAS No. 123.  However, SFAS No. 123(R) requires all share-based payments to employees, includinggrants of employee stock options, to be recognized in the income statementbased on their fair values.  Pro formadisclosure is no longer an alternative. SFAS No. 123(R) must beadopted in the first interim period beginning after June 15, 2005. TheCompany expects to adopt SFAS No. 123(R)effective in its third fiscal quarter beginning July 3, 2005.  The Company has not yet quantified the impactthat adoption of SFAS No. 123(R) will have on its financial statements, butexpects such impact to be material.  TheCompany is currently determining how or if the adoption of SFAS No. 123(R) willimpact the magnitude or form of its share-based compensation to employees.

 

# *Purchase of Rights toDistributor Territories*

# * *

# *During the year ended December 31, 2004, theCompany purchased rights to certain distributor territories in the U.S., foramounts aggregating $1.9 million, in connection with a reorganization of thedistribution activities within such territories.  These reorganizations are intended to achieveseveral objectives, including improvement of sales results within the affectedterritories and reduction of the Company’s distribution costs within suchterritories for a defined period of time. Purchase price aggregating $1.2 million was capitalized as an intangibleasset and will be amortized over the period of cost reduction.  Purchase price aggregating $0.7 million wasrecorded as notes receivable and is included in other current or long-termassets, depending on maturity, and will be repaid over periods ranging fromthree years to five years.*

# * *

# *Goodwill and OtherIntangible Assets*

# * *

The Company accounts for goodwill and otherintangible assets in accordance with SFAS No. 141, *Business Combinations*, and SFAS No. 142, *Goodwill and Other Intangible Assets*. SFASNo. 141 replaced prior accounting standards and eliminated pooling-of-interestsaccounting prospectively. It also provides guidance on purchase accountingrelated to the recognition of intangible assets and accounting for negativegoodwill. SFAS No. 142 changed the accounting for goodwill from an amortizationmethod to an impairment write-off approach. Under SFAS No. 142, goodwill istested annually and whenever events or circumstances occur indicating thatgoodwill might be impaired. On an ongoing basis, absent any indicators ofimpairment, the Company performs an annual impairment evaluation during thefourth quarter, as of October 1st each year.  With the exception of goodwill related to ourRegeneration acquisition of $39 million, the Company believes that the goodwillacquired through December 31, 2004 benefits the entire enterprise andsince its reporting units share the majority of the Company’s assets, theCompany compares the total carrying value of the Company’s consolidated netassets (including goodwill) to the fair value of the Company.  With respect to goodwill related to theRegeneration acquisition, the Company compares the carrying value of thegoodwill related to the Regeneration segment to the fair value of theRegeneration segment.

 

During the yearended December 31, 2004, the Company acquired a license to a patent for$0.8 million. This amount was recorded as an intangible asset and will beamortized over the remaining life of the patent, through June 2010.

 

59

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Components of intangible assets acquired in businesscombinations and acquired as individual assets are as follows (in thousands):

 
| ** **                                      | ** ** | **December 31, 2004** | ** ** | **December 31, 2003**  | ** ** |
|-------------------------------------------------|------------|----------------------------|------------|-----------------------------|------------|
| ** **                                      | ** ** | **Useful  Life**           | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net  Carrying  Amount** | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated Amortization** | ** ** | **Net  Carrying  Amount** | ** ** |
| ** **                                      | ** ** | **(years)**                | ** ** | ** **                  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Intangible  assets subject to amortization:     |       |                       |       |                        |       |   |   |   |   |   |   |   |   |   |   |
| Patented and  existing technology               |       | 5-20                       |       | $                           | 51,886     |   | $ | (16,250 | ) | $ | 35,636 |   | $ | 51,886 |   | $ | (11,897 | ) | $ | 39,989 |   |
| Customer  base                                  |       | 15-20                      |       | 18,026                      |       | (6,187 | ) | 11,839 |   | 17,519 |   | (5,020 | ) | 12,499 |   |
| Licensing  agreements                           |       | 5                          |       | 4,200                       |       | (654 | ) | 3,546 |   | 6,000 |   | (2,233 | ) | 3,767 |   |
| Other                                           |       | 0.3-20                     |       | 5,487                       |       | (1,791 | ) | 3,696 |   | 5,254 |   | (2,464 | ) | 2,790 |   |
|                                            |       |                       |       | $                           | 79,599     |   | $ | (24,882 | ) | $ | 54,717 |   | $ | 80,659 |   | $ | (21,614 | ) | $ | 59,045 |   |
| Intangible  assets not subject to amortization: |       |                       |       |                        |       |   |   |   |   |   |   |   |   |   |   |
| Goodwill                                        |       | N/A                        |       | $                           | 110,587    |   | N/A |   | $ | 96,639 |   | $ | 110,499 |   | N/A |   | $ | 96,552 |   |

 

Amortization expense related to intangible assets was$7.0 million, $3.4 million and $2.8 million for the years ended December 31,2004, 2003 and 2002, respectively.

 

Futureamortization expense of intangible assets is estimated to be $54.7 million, asfollows: 2005 - $7.3 million, 2006 - $6.9 million, 2007 - $6.5 million, 2008 -$5.8 million, 2009 - $5.7 million and thereafter - $22.5 million.

 

Except for the goodwill attributed to theRegeneration segment (see Note 3), the Company does not allocate goodwill toindividual reporting segments.

 

*Reclassifications*

 

Certain amountsin prior periods have been reclassified to conform with current periodpresentation.

 

**2.****                                      FinancialStatement Information**

 

## *Inventories*

## * *

Inventories consist of the following at December 31(in thousands):

 
| ** **                                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
|---------------------------------------------------------------|------------|----------|------------|----------|------------|
| Raw  materials                                                |       | $        | 7,116      |     | $          | 7,074 |   |
| Work-in-progress                                              |       | 1,027    |       | 1,565    |       |
| Finished  goods                                               |       | 14,109   |       | 13,264   |       |
|                                                          |       | 22,252   |       | 21,903   |       |
| Less  reserves, primarily for excess and obsolete Inventories |       | (3,181   | )          | (6,369   | )          |
|                                                          |       | $        | 19,071     |     | $          | 15,534 |   |

 

## *During the year ended December 31, 2004, theCompany disposed of gross inventories aggregating $2.4 million which had beenfully reserved for in a previous year.*

 

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## * *

## *Property, Plant andEquipment*

## * *

Property, plant and equipment consists of thefollowing at December 31 (in thousands):

 
| ** **                                      | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------------------------------|------------|----------|------------|----------|------------|
| Leasehold  improvements                         |       | $        | 4,430      |     | $          | 4,477 |   |
| Furniture,  fixtures and equipment              |       | 39,362   |       | 38,849   |       |
|                                            |       | 43,792   |       | 43,326   |       |
| Less  accumulated depreciation and amortization |       | (28,329  | )          | (27,770  | )          |
|                                            |       | $        | 15,463     |     | $          | 15,556 |   |
|                                                 |            |          |            |          |            |  |  |  |

# * *

Depreciation expense was approximately $5.3million, $4.3 million and $3.9 million for the years ended December 31,2004, 2003 and 2002, respectively, and amortization expense related toproperty, plant and equipment was approximately $0.7 million, $0.5 million and$0.4 million for the years ended December 31, 2004, 2003 and 2002,respectively.

 

# *AccruedCompensation*

# * *

Accrued compensationconsists of the following at December 31 (in thousands):

 
| ** **                          | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------------------|------------|----------|------------|----------|------------|
| Accrued  vacation                   |       | $        | 1,670      |     | $          | 1,296 |   |
| Accrued  workers’ compensation |       | 2,049    |       | 2,566    |       |
| Other  accrued compensation         |       | 1,765    |       | 2,784    |       |
|                                |       | $        | 5,484      |     | $          | 6,646 |   |
|                                     |            |          |            |          |            |  |  |  |

 

**3.****              Acquisitions**

 

*KD Innovation Acquisition*

 

On August 30, 2004, the Company acquired theoutstanding stock of KD Innovation A/S (KDI), its independent distributor inDenmark. The acquired company, renamed dj Orthopedics Nordic ApS (dj Nordic),has direct responsibility for sales, marketing and distribution of djOrthopedics’ products in Denmark, Finland, Norway and Sweden.  The stock purchase agreement provided for thepurchase of all of the outstanding capital stock for KDI for an initial cashpurchase price of $0.7 million, paid in October 2004, plus amountsaggregating up to an additional $0.5 million through 2006 if certain netoperating income targets are met.  Theacquisition was accounted for using the purchase method of accounting whereby atotal purchase price of approximately $1.0 million, including the portion ofthe contingent future payments that are deemed by management to be probable, wasallocated to tangible and intangible assets acquired and liabilities assumedbased on their estimated fair market values as of the acquisition date. Theassets acquired included cash of approximately $0.1 million.

 

*Regeneration Acquisition*

 

On November 26, 2003, the Companyacquired the Regeneration business from OrthoLogic for approximately $93.0million in cash plus certain assumed liabilities aggregating approximately $0.9million and transaction costs amounting to approximately $0.9 million. The Companyfinanced the purchase with cash on hand of $12.1 million and a portion of theproceeds of a $100.0 million term loan received in connection with a new creditagreement.

 

The total purchase price was comprised of thefollowing (in thousands):

 
| Cash paid  for Regeneration business |   | $   | 93,000 |   |
|--------------------------------------|--------|-----|--------|--------|
| Transaction  costs                   |   | 939 |   |
| Total  purchase price                |   | $   | 93,939 |   |

 

The Regeneration acquisition was accountedfor using the purchase method of accounting whereby the total purchase pricewas allocated to tangible and intangible assets acquired and liabilitiesassumed based on their estimated fair market values as of the acquisition date,adjusted in 2004 to equal the final purchase price. The final purchase pricewas allocated as follows (in thousands):

 

61

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| Fair value  of net tangible assets acquired and liabilities assumed: |   |   |   |   |   |
|----------------------------------------------------------------------|--------|--------|--------|--------|--------|
| Accounts  receivable, net                                            |   | $      | 7,927  |   |   |   |
| Inventories,  net                                                    |   | 2,611  |   |   |   |
| Other  current assets                                                |   | 42     |   |   |   |
| Fixed  assets, net                                                   |   | 922    |   |   |   |
| Other assets                                                         |   | 14     |   |   |   |
| Accounts  payable                                                    |   | (401   | )      |   |   |
| Accrued  compensation and commissions                                |   | (277   | )      |   |   |
| Other  accrued liabilities                                           |   | (200   | )      |   |   |
|                                                                 |   |   |   | 10,638 |   |
| Fair value  of identifiable intangible assets acquired:              |   |   |   |   |   |
| Existing  technology                                                 |   | 27,800 |   |   |   |
| Patented  technology                                                 |   | 10,100 |   |   |   |
| Customer  relationships                                              |   | 5,200  |   |   |   |
| Customer  contract                                                   |   | 800    |   |   |   |
| Distribution  agreement                                              |   | 700    |   |   |   |
| Order  backlog                                                       |   | 200    |   |   |   |
|                                                                 |   |   |   | 44,800 |   |
| Goodwill                                                             |   |   |   | 38,501 |   |
| Total  purchase price allocation                                     |   |   |   | $      | 93,939 |   |
|                                                                      |        |        |        |        |        |  |  |

 

The intangible assets are being amortizedover their estimated useful lives, which range from 4 months to 10 years.

 

The accompanying consolidated statements ofoperations reflect the operating results of the Regeneration business since theacquisition date of November 26, 2003. Assuming the purchase of the Regenerationbusiness had occurred on January 1 of the respective years ended December 31,the pro forma unaudited results of operations would have been as follows (inthousands, except per share data):

 
| ** **                                                                    | ** ** | **2003** | ** ** | **2002** | ** ** |
|-------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| Net revenues                                                                  |       | $        | 240,378    |     | $          | 221,600 |   |
| Costs of  goods sold                                                          |       | 92,562   |       | 102,727  |       |
| Gross profit                                                                  |       | 147,816  |       | 118,873  |       |
| Operating  expenses:                                                          |       |     |       |     |       |
| Sales,  marketing, general and administrative                                 |       | 98,794   |       | 104,221  |       |
| Research and  development                                                     |       | 5,211    |       | 3,779    |       |
| Amortization  of acquired intangibles                                         |       | 4,808    |       | 4,808    |       |
| Impairment  of long-lived assets                                              |       | —   |       | 3,666    |       |
| Performance  improvement, restructuring and other                             |       | (497     | )          | 10,008   |       |
| Total  operating expenses                                                     |       | 108,316  |       | 126,482  |       |
| Income  (loss) from operations                                                |       | 39,500   |       | (7,609   | )          |
| Interest  expense, net of interest income                                     |       | (14,434  | )          | (14,365  | )          |
| Other income  (expense)                                                       |       | 466      |       | (200     | )          |
| Income  (loss) before income taxes                                            |       | 25,532   |       | (22,174  | )          |
| Benefit  (provision) for income taxes                                         |       | (10,162  | )          | 8,453    |       |
| Net income  (loss)                                                            |       | $        | 15,370     |     | $          | (13,721 | ) |
|                                                                          |       |     |       |     |       |
| Net income  (loss) per share:                                                 |       |     |       |     |       |
| Basic                                                                         |       | $        | 0.86       |     | $          | (0.77 | ) |
| Diluted                                                                       |       | $        | 0.82       |     | $          | (0.77 | ) |
|                                                                          |       |     |       |     |       |
| Weighted  average shares outstanding used to calculate per share information: |       |     |       |     |       |
| Basic                                                                         |       | 17,963   |       | 17,873   |       |
| Diluted                                                                       |       | 18,791   |       | 17,873   |       |

 

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*DuraKold acquisition*

 

In June 2003, the Company completed the purchase of specifiedassets and assumed certain liabilities of Dura*Kold Corporation (DuraKold) foran aggregate purchase price of $3.0 million. The assets acquired from DuraKoldincluded tangible and intangible assets related to a line of proprietary coldwrap products for orthopedic and medical applications. The Company beganselling the products manufactured by DuraKold in July 2001 under adistribution agreement. The DuraKold acquisition was accounted for using thepurchase method of accounting whereby the total purchase price was allocated totangible and intangible assets acquired and liabilities assumed based on theirestimated fair values as of the acquisition date, as follows:

 
| Goodwill                 |   | $   | 2,446  |   |
|--------------------------|--------|-----|--------|--------|
| Other  intangible assets |   | 368 |   |
| Tangible  assets         |   | 186 |   |
| Net assets  acquired     |   | $   | 3,000  |   |

 

The other intangible assets include acovenant not to compete and the acquired customer base, which are beingamortized over their estimated useful lives.

 

**4.****              PerformanceImprovement, Restructuring and Other Charges**

 

*RestructuringCosts*

* *

In August 2004, the Company began the integrationof its Regeneration sales organization into its DonJoy sales organization andmost of its remaining Regeneration operations in Tempe, Arizona into itscorporate facility in Vista, California. The objectives of the Regeneration integration are to strengthen thedistribution activities of the Regeneration business and to reduce both costsof goods sold and operating expenses as a percentage of net revenues in futureperiods, after the related costs of the integration have been incurred.  There can be no assurance the integrationwill be successful or achieve the desired goals.  In addition, in August 2004, the Companycompleted construction of a new leased 200,000 square foot manufacturingfacility in Tijuana, Mexico to replace three separate facilities it operated inthe same area. All of the Company’s existing Mexico facilities were moved tothis new facility in 2004.  In the fourthquarter of 2004, the Company initiated the relocation of the manufacturing ofits cold therapy products and machine shop activities from Vista, California tothe new Mexico plant. The relocation to Mexico of these California-basedactivities is expected to result in reduced manufacturing costs beginning in2005.  The Regeneration integration andthe move of the U.S. manufacturing operations resulted in the elimination ofapproximately 130 positions, including temporary employees, by December 31,2004.  Approximately 110 new positionswere added in Vista and Mexico in the aggregate to accommodate the operationsmoved to each of those locations. The Regeneration integration andmanufacturing move were both substantially completed by December 31, 2004.

 

*The Company accounts forrestructuring costs in accordance with SFAS No. 146,*Accounting for Costs Associated with Exit orDisposal Activities, which addressesfinancial accounting and reporting for costs associated with exit or disposalactivities.  SFAS 146 requires that costsassociated with an exit or disposal activity be recorded as an expense and aliability when incurred.  The results forthe year ended December 31, 2004 include charges totaling $4.7 million($2.9 million net of tax) including $3.8 million related to the Company’sRegeneration integration and $0.9 million related to the manufacturing move.

* *

Restructuring costs in the accompanying consolidated statement ofincome for the year ended December 31, 2004, are as follows (in thousands):

 
| ** **                              | ** ** | **Total Costs  Incurred** | ** ** | **Completed  Activity  (Cash)** | ** ** | **Completed  Activity  (Non-Cash)** | ** ** | **Accrued Liability  at December 31,  2004** | ** ** |
|-----------------------------------------|------------|---------------------------|------------|---------------------------------|------------|-------------------------------------|------------|---------------------------------------------------|------------|
|                                    |       |                      |       |                            |       |                                |       |                                              |       |
| Employee  severance and retention costs |       | $                         | 2,435      |                            | $          | (943                                | )          | $                                                 | —     |   | $ | 1,492 |   |
| Other                                   |       | 2,258                     |       | (1,735                          | )          | (167                                | )          | 356                                               |       |
| Total                                   |       | $                         | 4,693      |                            | $          | (2,678                              | )          | $                                                 | (167       | ) | $ | 1,848 |   |

 

63

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*Performance Improvement Program*

 

*In 2002, the Company completed a company-wideperformance improvement program with the objective of increasing revenues andreducing both costs of goods sold and operating expenses as a percentage of netrevenues beginning in 2003.  The Companyretained the services of AlixPartners, LLC, a consulting firm specializing incorporate performance enhancement, to assist with its performance improvementprogram.*  The Company’s performance improvement programincluded the elimination of several employee positions.  The Company also moved the manufacturing ofall its remaining soft goods and certain non-custom rigid braces manufacturedin the United States to its manufacturing facilities in Mexico. In connectionwith the manufacturing move, a portion of the Company’s United Statesmanufacturing facilities was vacated and in 2002 the Company accrued theestimated future net rent that would be paid for the vacated facilities, inexcess of estimated sublease income. In 2003, the Company decided to retain thevacant space for future expansion and discontinued its efforts to sublease thevacant space.  Accordingly, the remainingaccrual for rent for the vacant space of $0.5 million was reversed in 2003 andcredited to operating expenses.

* *

The results for 2002 include charges totaling$10.0 million ($6.4 million net of tax) related to the Company’s performanceimprovement program, including charges for severance pay, consultants, movingcosts and accrued rent related to manufacturing facilities vacated by theCompany in the United States.

 

Total restructuring costsaccrued in 2002 and reflected in the accompanying consolidated balance sheet atDecember 31, 2004 are as follows (in thousands):

 
| ** **                              | ** ** | **Total Costs  Incurred** | ** ** | **Completed  Activity  (Cash)** | ** ** | **Completed  Activity  (Non-Cash)** | ** ** | **Reversals Affecting  Operating Results** | ** ** | **Accrued Liability  at December 31,   2004** | ** ** |
|-----------------------------------------|------------|---------------------------|------------|---------------------------------|------------|-------------------------------------|------------|--------------------------------------------|------------|----------------------------------------------------|------------|
|                                    |       |                      |       |                            |       |                                |       |                                       |       |                                               |       |
| Employee  severance costs               |       | $                         | 3,936      |                            | $          | (3,936                              | )          | $                                          | —     |                                               | $          | — |   | $ | — |   |
| Lease  termination and other exit costs |       | 1,926                     |       | (989                            | )          | —                              |       | (497                                       | )          | 440                                                |       |
| Total                                   |       | $                         | 5,862      |                            | $          | (4,925                              | )          | $                                          | —     |                                               | $          | (497 | ) | $ | 440 |   |

 

Historically, the Company relied heavily onthird-party billing service providers to provide information about the accountsreceivable of its third-party payor customers, including the data utilized todetermine reserves for contractual allowances and doubtful accounts.  During 2002, the Company enhanced the abilityof its systems to obtain and analyze the information processed by these billingservice providers.  The Company’sincreased ability to obtain and better analyze information beginning in 2002revealed that, as a result of historical third-party billing problems, theCompany had experienced an increase in allowances and bad debts for accountsreceivable from the Company’s third-party payor customers and the Companyincreased its provisions for contractual allowances and doubtful accounts by anaggregate of $6.7 million ($4.3 million net of tax) for the year ended December 31,2002, which is included in sales and marketing expenses in the accompanyingconsolidated statements of operations for 2002.

 

In connection with its performanceimprovement program, the Company also refocused its resources on its corebusiness within the rehabilitation segment of the orthopedic market.  As a result, the Company ceased activecommercialization of its surgical product lines and discontinued marketing itsknee replacement product.  In 2002, theCompany recorded provisions for inventories related to discontinued productlines in the aggregate amount of $2.8 million ($1.8 million net of tax).  Additionally, the Company providedincremental provisions for estimated excess inventories in the amount of $2.3million ($1.5 million net of tax) in 2002. The increase in the Company’s accounting estimate for these reserves wasprimarily related to inventories on hand for certain new product areas whichhad not achieved anticipated market share.

 

As a result of certain new products notachieving anticipated revenues or estimated recovery values of assets beingdisposed of being less than anticipated, the Company’s cash flows from such newproducts or assets were lower through December 31, 2002 than originallyestimated. In accordance with SFAS No. 144, the Company recognized charges of$3.7 million related to impairment of certain long-lived assets during 2002.

 

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**5.****                                      Long-TermDebt**

 

The Company’s long-term debt consists of thefollowing at December 31 (in thousands):

 
| ** **                                                                                                                 | ** ** | **2004** | ** ** | **2003** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| Term loan due in installments through May 15, 2009 bearing Interest  at LIBOR plus 2.25% (4.32% at December 31, 2004) |       | $        | 95,000     |     | $          | 100,000 |   |
| Less current  portion                                                                                                      |       | (5,000   | )          | (5,000   | )          |
| Long-term  portion of term loan                                                                                            |       | $        | 90,000     |     | $          | 95,000 |   |
|                                                                                                                       |       |     |       |     |       |
| 12 5/8%  senior subordinated notes, net of unamortized discount of $844 at December 31,  2003, repaid in 2004         |       | $        | —     |     | $          | 74,156 |   |

 

*Redemption of Senior Subordinated Notes*

 

In June 2004, the Company redeemed allof its outstanding senior subordinated notes for $79.7 million, including aredemption premium of $4.7 million.  Theredemption was funded by net proceeds of $56.5 million from the Company’s February 2004sale of common stock and from existing cash. As a result of the redemption, the Company recorded a charge of $7.8million, including a redemption premium of $4.7 million, unamortized debtissuance costs of $2.3 million and original issue discounts of $0.8 million.  Prior to the redemption, the Company hadreceived the consents necessary under its credit agreement to use the proceedsfrom the sale of shares by the Company and cash on hand to redeem the notes.

 

# *Credit Agreement*

# * *

In connection with the Regeneration acquisition, the Company enteredinto a new credit agreement, which was comprised of a $100.0 million term loanand also provides the Company with available borrowings under a $30.0 millionrevolving credit facility. Proceeds from the term loan were also used to repaythe Company’s existing bank debt, amounting to approximately $15.5 million. Therevolving credit facility permits the Company to enter into revolving loans ofup to $30.0 million, enter into swing line loans and obtain letters of credit.The Company currently has no borrowed amounts drawn under the revolving creditfacility, but is contingently liable for outstanding letters of creditaggregating $3.8 million. Borrowings under the revolving credit facility, ifany, will bear interest at variable rates plus an applicable margin. Thematurity date of the revolving credit facility is November 26, 2008. In July 2004,the Company completed an amendment of its credit agreement providing for areduction in the interest rate applicable to its outstanding term loan fromLIBOR plus 2.75% to LIBOR plus 2.25% (4.32% at December 31, 2004). On September 28,2004, the Company completed a second amendment to its credit agreementpermitting the Company to repurchase up to $20 million of its common stock,subject to certain liquidity requirements.

 

*Repayment*.  Principal repayment of the term loan isscheduled in quarterly installments of $1.25 million through December 31,2008, with the remaining principal due in two equal installments on March 31,2009 and May 15, 2009. The credit agreement also requires the Company to makemandatory prepayments under certain circumstances.

 

*Security; Guarantees*.  The obligations of dj Ortho under the creditagreement are irrevocably guaranteed, jointly and severally, by dj Orthopedics,Inc., dj Development, DJ Capital and future U.S. subsidiaries.  In addition, the credit agreement and theguarantees thereunder are secured by substantially all the assets of theCompany.

 

*Covenants*.  The credit facility contains a number ofcovenants that, among other things, restrict the ability of the Company to (i)incur additional indebtedness; (ii) incur or guarantee obligations; (iii)prepay subordinated indebtedness or amend other debt instruments; (iv) paydividends or make other distributions (except for certain tax distributions);(v) redeem or repurchase equity, make investments, loans or advances, makeacquisitions; (vi) engage in mergers or consolidations; (vii) change thebusiness conducted by the Company; (viii) grant liens, sell its assets; (ix) orengage in certain other activities.  Inaddition, the credit agreement requires the Company to maintain specifiedfinancial ratios, including maximum total and senior leverage ratios, a minimumconsolidated interest coverage ratio and a minimum consolidated fixed chargecoverage ratio.  The Company was incompliance with all covenants as of December 31, 2004.

 

65

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*DebtIssuance Costs*

 

In 2003, the Companycapitalized debt issuance costs of $2.6 million in association with its newcredit agreement. An additional $0.3 million in costs were capitalized in 2004in connection with the July 2004 amendment of the credit agreement. The totalcosts related to the credit agreement are being amortized as interest expenseover the term of the credit agreement and are reflected in the accompanyingconsolidated balance sheets, net of accumulated amortization of $0.5 millionand $0.04 million at December 31, 2004 and 2003, respectively. In addition, theCompany capitalized debt issuance costs of $5.9 million in connection with itssenior subordinated notes. These debt issuance costs are reflected in theaccompanying consolidated balance sheet, net of accumulated amortization of $3.4 millionas of December 31, 2003. At the time of the redemption of the seniorsubordinated notes in June 2004, the net balance of the related debt issuancecosts was $2.3 million, which was expensed at the time of the redemption.

 

**6.****                                      RelatedParty Transactions**

 

The Company paidaffiliates of J.P. Morgan DJ Partners, LLC (JPMDJ Partners), a majorshareholder of the Company, $250,000 in 2002 for providing financial advisoryservices in connection with financings and acquisitions, including providingthe services of Charles T. Orsatti, the Company’s former Chairman. Thisarrangement terminated in 2002.

 

On June 30, 1999,DonJoy consummated a recapitalization pursuant to which JPMDJ Partners obtaineda controlling interest in DonJoy.  OnJune 28, 2000, JPMDJ Partners and certain members of management repurchased theremaining common units held by DonJoy’s former parent, Smith & Nephew.  In connection with an equity investment inJune 2001, JPMDJ Partners and certain members of management purchasedadditional common units in DonJoy.  Inconnection with these equity transactions, three members of managementpurchased a portion of the Company’s equity and financed the purchases withfull recourse promissory notes, aggregating $1.9 million at inception. In 2000,dj Orthopedics agreed to amend and restate these promissory notes. Theprincipal amount of each amended and restated note was equal to the sum ofoutstanding principal on the original notes and any accrued and unpaid intereston the notes. In addition, the amended and restated notes permit the members ofmanagement to increase the principal amount due under the note by the amount ofa scheduled annual interest payment (the “PIK Option”).  If a member of management elects the PIKOption, the principal amount of his note is increased by the amount of thescheduled interest payment and interest then accrues on the principal amount ofthe note as so increased.  The amendedand restated notes mature in 2007.

 

The promissory notes duefrom current management stockholders amounted to $1.7 million and $2.0 millionat December 31, 2004 and 2003, respectively. Two management stockholders have repaid the entire balances of theirpromissory notes owed to the Company, including $0.3 million paid in each of2004 and 2003. The remaining management stockholder repaid notes aggregating$0.5 million to the Company in February 2005 (see Note 13).  The notes are secured by common stock of dj Orthopedicsowned by each noteholder.

 

**7.****                                      Commonand Preferred Stock**

 

At December 31, 2004, theCompany had a total of 21,459,428 shares of common stock outstanding.

 

In June 2004, the Company completed apublic offering of 3,072,379 shares of its common stock.  All of these shares were sold by certain ofthe Company’s stockholders and the Company did not receive any of the netproceeds.  The Company incurred costs of$0.2 million related to this offering, which were recorded as a reduction inthe Company’s additional paid-in capital.

 

In February 2004, the Companycompleted a public offering of 8,625,000 shares of its common stock.  The offering consisted of 3,162,500 shares ofcommon stock sold by the Company at $19.00 per share for net proceeds, afterunderwriters’ commissions and other costs, of $56.5 million and 5,462,500shares sold by certain of the Company’s stockholders.

 

In May 2003, the Company’sshareholders approved a reduction in the total authorized number of shares ofcapital stock from 125 million to 40 million; a reduction in the authorizednumber of shares of common stock from 100 million to 39 million; and areduction in the authorized number of shares of preferred stock from 25 millionto 1 million.

 

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#### *Stock Options*

 

### ***2001 Omnibus Plan***

 

The 2001 Omnibus planprovides for awards of stock options, stock appreciation rights, performanceawards, restricted stock, restricted stock units, stock bonuses, stock unitawards and cash bonuses to key personnel, including consultants and advisors.  Except as hereafter described and subject toequitable adjustments to reflect certain corporate events, the maximum numberof shares of the Company’s common stock with respect to which awards may begranted under the Omnibus Plan is 5,865,110 at December 31, 2004.  On each January 1, commencing with January 1,2003, the number of shares of common stock available for issuance under theOmnibus Plan is automatically increased by a number of shares equal to 3% ofthe number of shares of common stock outstanding on the previous December31.  In addition, shares of common stockreserved for but not subject to options granted under the 1999 Option Plan orsubject to awards that are forfeited, terminated, canceled or settled withoutthe delivery of common stock under the Omnibus Plan and the 1999 Option Planwill increase the number of shares available for awards under the OmnibusPlan.  Also, shares tendered to djOrthopedics, Inc. in satisfaction or partial satisfaction of the exercise priceof any award under the Omnibus Plan or the 1999 Option Plan will increase thenumber of shares available for awards under the Omnibus Plan to the extentpermitted by Rule 16b-3 under the Securities Exchange Act of 1934, asamended.  The Omnibus Plan isadministered by the Compensation Committee of the Company’s Board of Directors,which has the sole and complete authority to grant awards under the OmnibusPlan to eligible employees and officers of, and consultants and advisors to, djOrthopedics, Inc. and its subsidiaries. At December 31, 2004 and 2003, optionsto purchase 3,173,472 and 2,559,550 shares had been granted and 610,343 and270,971 shares were exercisable, respectively. On December 31, 2004, 2,413,335 shares were available for future grantunder the Omnibus Plan. On January 1, 2005, the shares available for futuregrant were increased by 643,783 shares to 3,057,118 shares.

## * *

## *1999 Option Plan*

 

Under the Company’s Fifth Amended and Restated 1999Option Plan (the 1999 Option Plan), 1,933,174 common shares have been reservedfor issuance upon exercise of options granted under the plan. The 1999 OptionPlan is administered by the Compensation Committee. The plan will expire onAugust 19, 2015 unless the Company terminates it before that date. The 1999Option Plan provides for the grant of nonqualified options to officers,directors and employees of, and consultants and advisors to, dj Orthopedics,Inc.

* *

The Company has grantedoptions to purchase an aggregate of 637,681 shares of common stock under the1999 Option Plan of which approximately 71% are time-vesting options andapproximately 29% are event-vesting options of which 415,503 areoutstanding as of December 31, 2004.  Asof December 31, 2004, all event-vesting options were vested or had beencancelled. As of December 31, 2004, options to purchase 373,140 shares issuedunder the 1999 Option Plan were exercisable. No future options will be grantedunder the 1999 Option Plan, and all shares of common stock, which wouldotherwise have been available for issuance under the 1999 Option Plan will beavailable for issuance under the 2001 Omnibus Plan.

 

### ***2001 Non-Employee Director’sStock Option Plan***

 

The Company has adopted the dj Orthopedics, Inc.2001 Non-Employee Directors’ Stock Option Plan. In May 2003, the Company’s shareholdersapproved the following amendments to this plan: (1) individuals elected to theBoard more than 12 months after the company’s 2001 initial public offering ofcommon stock would receive an automatic grant of 30,000 options instead of15,000 options at an exercise price equal to 100% of the fair market value ofthe common stock as of such date; (2) options granted after the effective dateof the amendment would vest entirely on the first anniversary of the grantdate; and (3) individuals elected to the Board who represent J.P. Morgan DJPartners, LLC, would not be eligible for grants under the plan.  A total of 1,500,000 shares of the Company’scommon stock have been reserved for issuance under the plan.  A total of 255,000 and 135,000 options had beengranted under the Plan at December 31, 2004 and 2003, respectively.  No options were granted under this plan priorto 2002.  As of December 31, 2004,options to purchase 90,000 shares issued under the Director Plan wereexercisable.

 

67

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The following tablesummarizes option activity under all plans through December 31, 2004:

 
| ** **                        | ** ** | **Number of  Shares** | ** ** | **Price per Share** | ** ** | **Weighted Average Exercise  Price per Share** | ** ** |
|-----------------------------------|------------|-----------------------|------------|---------------------|------------|------------------------------------------------|------------|
| Outstanding at  December 31, 2001 |       | 2,009,889             |       | $9.25 - $17.00      |       | $                                              | 12.36      |   |
| Granted                           |       | 1,111,350             |       | $2.97 - $12.80      |       | 4.85                                           |       |
| Cancelled                         |       | (913,839              | )          | $3.52 - $17.00      |       | 10.54                                          |       |
| Outstanding at  December 31, 2002 |       | 2,207,400             |       | $2.97 - $17.00      |       | 8.03                                           |       |
| Granted                           |       | 1,715,500             |       | $3.91 - $25.92      |       | 19.82                                          |       |
| Exercised                         |       | (358,141              | )          | $2.97 - $17.00      |       | 10.22                                          |       |
| Cancelled                         |       | (232,528              | )          | $3.52 - $17.00      |       | 9.16                                           |       |
| Outstanding at  December 31, 2003 |       | 3,332,231             |       | $2.97 - $25.92      |       | 13.78                                          |       |
| Granted                           |       | 1,234,200             |       | $17.99-$26.65       |       | 21.75                                          |       |
| Exercised                         |       | (483,040              | )          | $2.97 - $17.00      |       | 8.51                                           |       |
| Cancelled                         |       | (264,416              | )          | $3.52 - $25.92      |       | 19.10                                          |       |
| Outstanding at  December 31, 2004 |       | 3,818,975             |       | $2.97 - $26.65      |       | $                                              | 16.74      |   |

 

The following tablesummarizes information concerning currently outstanding and exercisableoptions:

 
| **Options Outstanding**       | ** **               | **Options Exercisable**                           | ** ** |
|-------------------------------|--------------------------|---------------------------------------------------|------------|
| **Range of  Exercise Prices** | ** **               | **Options  Outstanding as of  December 31, 2004** | ** ** | **Weighted Average  Remaining Life in  Years** | ** ** | **Weighted  Average Exercise  Price** | ** ** | **Options  Exercisable as of  December 31, 2004** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
| $  2.97             |  -$  4.10 |                                              | 736,222    |   | 7.9 |   | $ | 3.82 |   | 293,422 |   | $ | 3.79 |   |
| $  7.24             |  -$10.80            |                                              | 656,869    |   | 6.6 |   | 8.72 |   | 409,244 |   | 8.96 |   |
| $12.25                        |  -$18.00            |                                              | 203,934    |   | 7.3 |   | 15.36 |   | 110,571 |   | 14.99 |   |
| $19.35                        |  -$26.65            |                                              | 2,221,950  |   | 9.3 |   | 23.52 |   | 260,246 |   | 25.48 |   |
| $  2.97             |  -$26.65            |                                              | 3,818,975  |   | 8.5 |   | 16.74 |   | 1,073,483 |   | 12.17 |   |
|                               |                          |                                                   |            |  |  |  |  |  |  |  |  |  |  |  |

 

*Employee Stock Purchase Plan*

 

The Employee StockPurchase Plan provides for the issuance of up to 1,361,771 shares of theCompany’s common stock.  During eachpurchase period, eligible employees may designate between 1% and 15% of theircash compensation, subject to certain limitations, to be deducted from theircash compensation for the purchase of common stock under the plan.  The purchase price of the shares under theplan is equal to 85% of the lesser of the fair market value per share on thefirst day of each twenty-four month offering period or the last day of eachsix-month purchase period during the offering period.  On January 1 of each year, commencing withJanuary 1, 2003, the aggregate number of shares reserved for issuance underthis plan will increase automatically by a number of shares equal to 1.0% ofthe Company’s outstanding shares on December 31 of the preceding year.  The Company’s Board of Directors or theCompensation Committee may reduce the amount of the increase in any particularyear.  The aggregate number of sharesreserved for issuance under the Employee Stock Purchase Plan may not exceed5,000,000 shares.  Through December 31,2004, 323,657 shares had been issued under the Employee Stock Purchase Plan. OnJanuary 1, 2005, 2004 and 2003, the number of shares reserved for issuanceunder the Employee Stock Purchase Plan was increased by 214,594, 183,042 and178,729 shares, respectively. On January 1, 2005 total shares reserved forissuance were 1,252,708.

 

*Repurchasesof Common Stock*

 

On September 27,2004, the Company’s board of directors authorized a program to repurchase up to$20 million of the Company’s common stock. The shares may be repurchased attimes and prices as determined by management and may be completed through openmarket or privately negotiated transactions. The repurchase program providesthat repurchases will be made in accordance with applicable state and federallaw and in accordance with the terms and subject to the restrictions of Rule10b-18 under the Securities Exchange Act of 1934, as amended. Shares will beretired and cancelled upon repurchase. Through December 31, 2004, the Companyhas repurchased 837,300 shares of its common stock at an average price of$17.62 per share, for an aggregate total cost of approximately $14.8 million.

 

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**8.****                                      IncomeTaxes**

 

The benefit (provision)for income taxes, including the deferred taxes, on income (loss) before incometaxes is as follows for the years ended December 31 (in thousands):

 
| ** **                            | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|---------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Current                               |       |     |       |     |       |     |       |
| Federal                               |       | $        | (30        | )        | $          | (15      | )          | $ | — |   |
| State                                 |       | 184      |       | (380     | )          | (150     | )          |
| Foreign                               |       | (268     | )          | (647     | )          | (183     | )          |
|                                  |       | (114     | )          | (1,042   | )          | (333     | )          |
| Deferred                              |       |     |       |     |       |     |       |
| Federal                               |       | (7,097   | )          | (5,064   | )          | 9,279    |       |
| State                                 |       | (1,403   | )          | (1,874   | )          | 415      |       |
| Foreign                               |       | (408     | )          | —   |       | —   |       |
|                                  |       | (8,908   | )          | (6,938   | )          | 9,694    |       |
|                                  |       |     |       |     |       |     |       |
| Benefit  (provision) for income taxes |       | $        | (9,022     | )        | $          | (7,980   | )          | $ | 9,361 |   |

 

Deferred taxassets and liabilities are determined based on differences between financialreporting and tax bases of assets and liabilities, and are measured using theenacted tax rates and laws that will be in effect when the differences areexpected to reverse.  Significantcomponents of the Company’s deferred tax assets and liabilities as of December31 are as follows (in thousands):

 
| ** **                                     | ** ** | **2004** | ** ** | **2003** | ** ** |
|------------------------------------------------|------------|----------|------------|----------|------------|
| Deferred tax  assets/(liabilities):            |       |     |       |     |       |
| Goodwill for                                   |       | $        | 33,091     |     | $          | 39,657 |   |
| Accrued expenses                               |       | 2,810    |       | 2,234    |       |
| Allowance for  bad debts                       |       | 2,650    |       | 5,987    |       |
| Provision for  excess and obsolete inventories |       | 2,442    |       | 3,062    |       |
| Net operating  loss carryforwards              |       | 14,481   |       | 10,623   |       |
| Fixed assets  depreciation                     |       | (1,156   | )          | (1,061   | )          |
| Other, net                                     |       | (316     | )          | 159      |       |
| Total deferred  taxes                          |       | 54,002   |       | 60,661   |       |
| Valuation  allowance                           |       | —   |       | (1,869   | )          |
| Net deferred tax  assets                       |       | $        | 54,002     |     | $          | 58,792 |   |

 

Realization of the Company’s deferred tax assets isdependent on the Company’s ability to generate future taxable income prior tothe expiration of net operating loss carryforwards.  As of December 31, 2003, the Company recordeda valuation allowance of $1.9 million related to net operating losscarryforwards from stock option deductions. Based upon expected usage of these loss carryforwards, the valuationallowance was released in 2004 and the benefit was recorded directly tostockholders’ equity.  Based on theCompany’s historical and expected future taxable earnings, management believesit is more likely than not that the Company will realize the benefit of theexisting net deferred tax assets at December 31, 2004.

 

As of December 31, 2004,the Company has U.S. federal net operating loss carryforwards of $37.2 million,which begin to expire in 2021. As a result of the Company's 2004 stockofferings (see Note 7), certain changes in the Company's ownership may limitfuture annual utilization of the Company's federal net operating losscarryforwards. The Company also has $29.3 million of various state netoperating loss carryforwards, which begin to expire in 2006 and $0.3 million ofvarious foreign net operating loss carryforwards, which begin to expire in2008.

 

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The reconciliation of income tax attributable toincome before provision/benefit for income taxes at the U.S. federal statutoryrate to income tax provision/benefit in the accompanying statements ofoperations for the years ended December 31 is as follows:

 
| ** **                                | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|-------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Federal tax at  statutory rate            |       | 35.0     | %          | 35.0     | %          | 34.0     | %          |
| State income  tax, net of federal benefit |       | 3.4      | %          | 7.3      | %          | 1.0      | %          |
| Other                                     |       | 0.8      | %          | (2.5     | )%         | 3.1      | %          |
|                                      |       | 39.2     | %          | 39.8     | %          | 38.1     | %          |

 

The Company made incometax payments, net of (refunds), totaling $0.6 million, ($0.1) million and $0.8million in the years ended December 31, 2004, 2003 and 2002, respectively.

 

Income (loss) beforeincome taxes includes the following components for the years ended December 31(in thousands):

 
| ** **    | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|---------------|------------|----------|------------|----------|------------|----------|------------|
| United States |       | $        | 21,270     |     | $          | 18,757   |       | $ | (23,823 | ) |
| Foreign       |       | 1,767    |       | 1,294    |       | (733     | )          |
|          |       | $        | 23,037     |     | $          | 20,051   |       | $ | (24,556 | ) |

 

Undistributed earnings ofthe Company’s foreign subsidiaries amounted to approximately $2.1 million atDecember 31, 2004.  Those earnings areconsidered to be indefinitely reinvested, and accordingly, no provision forU.S. federal and state income taxes has been provided thereon.  Upon distribution of those earnings in theform of dividends or otherwise, the Company would be subject to both U.S.income taxes and withholding taxes payable to the foreign countries, but wouldalso be able to generate foreign tax credits. Determination of the amount of unrecognized deferred U.S. income taxliability is not practicable because of the complexities associated with itshypothetical calculation; however, the Company does not believe the amountwould be material.

 

TheCompany is subject to ongoing audits from various taxing authorities in thejurisdictions in which it does business. It does not have a history of significant adjustments to its taxaccruals as a result of these audits. The Company believes that its accruals for tax liabilities are adequatefor the open years.

 

**9.****                                      Segmentand Related Information**

 

The Company’s reportable segments, except forRegeneration, reflect its primary distribution channels. Regeneration isconsidered a reportable segment because of management’s separate focus on itsgrowth and profitability. The Company’s reportable segments are as follows:

 

•                  *DonJoy*, is the Company’s largest sales channel, comprised ofthe sale of rigid knee braces, pain management products, Regeneration products(effective August 2004) and certain soft goods. The channel consists of approximately 300 independent commissioned salesrepresentatives who are employed by approximately 40 independent sales agentsand a few of the Company’s direct sales representatives. The Company’s salesrepresentatives are primarily dedicated to the sale of the Company’s productsto orthopedic surgeons, podiatrists, orthopedic and prosthetic centers,hospitals, surgery centers, physical therapists, athletic trainers and otherhealthcare professionals.  Because theDonJoy product lines generally require customer education on the applicationand use of the product, these sales representatives are technical specialistswho receive extensive training both from the Company and the agent and usetheir expertise to help fit the patient with the product and assist theorthopedic professional in choosing the appropriate product to meet the patient’sneeds. After a product order is received by a sales representative, the Companygenerally ships the product directly to the orthopedic professional and pays asales commission to the agent based on sales of such products. Thesecommissions are reflected in sales and marketing expense in the Company’sconsolidated financial statements;

 

•                  *ProCare*, in which products are sold by approximately 36direct and independent representatives that manage over 310 dealers focusedprimary and acute facilities. Products are sold primarily to nationalthird-party distributors, other regional medical supply dealers and medicalproduct buying groups, generally at a discount

 

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from list prices.The majority of these products are soft goods and specialty products requiringlittle or no patient education. These distributors resell these products tolarge hospital chains, hospital buying groups, primary care networks andorthopedic physicians for use by the patients;

 

•                  *Regeneration,*in which the Company’s OL1000 product is soldthrough a combination of direct sales representatives and approximately 100sales representatives dedicated to selling the OL1000 product, of whichapproximately 43 are employed by the Company. The SpinaLogic product is alsoincluded in this segment and was, until the end of 2004, sold by DePuy Spine inthe U.S. under an exclusive sales agreement. In January 2005, the Companyamended the agreement with DePuy to divide the U.S, into territories in whichDePuy Spine has exclusive sales rights and non-exclusive territories in whichthe Company is permitted to engage in its own sales efforts or retain anothersales agent. These products are sold either directly to the patient or toindependent distributors.  The Companyarranges billing to the third-party payors or patients, for products solddirectly to the patient;

 

•                  *OfficeCare*, in which the Company maintains an inventory ofproduct (mostly soft goods) on hand at orthopedic practices for immediatedistribution to the patient. For these products, the Company arranges billingto the patient or third-party payor after the product is provided to thepatient. The Company outsources most of the revenue cycle of this program, frombilling to collections, to an independent third-party contractor.  The OfficeCare program is also intended tofacilitate the introduction of the Company’s products to orthopedic surgeonswho had not previously been the Company’s customers.  As of December 31, 2004, the OfficeCareprogram was located at over 650 physician offices throughout the UnitedStates.  The Company has contracts withover 500 third-party payors for our OfficeCare products; and

 

•                  *International*, in which the Company’s products are sold inforeign countries through wholly-owned subsidiaries or independentdistributors.  The Company sells itsproducts in over 40 foreign countries, primarily in Europe, Australia, Canadaand Japan.

 

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Setforth below is net revenue, gross profit and operating income (loss)information for the Company’s reporting segments for the years endedDecember 31 (in thousands). This information excludes the impact of other expensesnot allocated to segments, which are comprised of (i) general corporateexpenses for all periods presented, (ii) the impairment of long-lived assetsand performance improvement, restructuring, and other costs for 2002 and (iii)the restructuring costs associated with the manufacturing move in 2004.  Information for the Regeneration segmentincludes operations for the period subsequent to the Regeneration acquisitionon November 26, 2003 and includes the impact of purchase accounting and relatedamortization of acquired intangible assets. For the years ended December 31,2004 and 2003, Regeneration income from operations was reduced by amortizationof acquired intangible assets amounting to $4.7 million and $0.5 million,respectively.   For the year endedDecember 31, 2004, Regeneration income from operations was also reduced byrestructuring charges of $3.8 million related to the integration of thebusiness operations of the segment.

 
| ** **                                     | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| **Net  Revenues:**                             |       |     |       |     |       |     |       |
| DonJoy                                         |       | $        | 99,771     |     | $          | 95,353   |       | $ | 90,796 |   |
| ProCare                                        |       | 50,159   |       | 47,858   |       | 46,444   |       |
| Regeneration                                   |       | 49,658   |       | 3,989    |       | —   |       |
| OfficeCare                                     |       | 27,551   |       | 25,631   |       | 22,966   |       |
| International                                  |       | 28,860   |       | 25,108   |       | 22,430   |       |
| Consolidated net  revenues                     |       | $        | 255,999    |     | $          | 197,939  |       | $ | 182,636 |   |
|                                           |       |     |       |     |       |     |       |
| **Gross  Profit:**                             |       |     |       |     |       |     |       |
| DonJoy                                         |       | 58,498   |       | 53,824   |       | 53,377   |       |
| ProCare                                        |       | 19,294   |       | 19,805   |       | 11,323   |       |
| Regeneration                                   |       | 43,032   |       | 3,145    |       | —   |       |
| OfficeCare                                     |       | 22,408   |       | 20,162   |       | 16,829   |       |
| International                                  |       | 17,603   |       | 15,076   |       | 10,325   |       |
| Gross profit of  reportable segments           |       | 160,835  |       | 112,012  |       | 91,854   |       |
| Expenses not  allocated to segments            |       | —   |       | —   |       | (5,096   | )          |
| Consolidated  gross profit                     |       | $        | 160,835    |     | $          | 112,012  |       | $ | 86,758 |   |
|                                           |       |     |       |     |       |     |       |
| **Income  (loss) from operations:**            |       |     |       |     |       |     |       |
| DonJoy                                         |       | 22,415   |       | 22,437   |       | 23,040   |       |
| ProCare                                        |       | 9,950    |       | 10,224   |       | 2,382    |       |
| Regeneration                                   |       | 7,836    |       | 537      |       | —   |       |
| OfficeCare                                     |       | 3,976    |       | 2,801    |       | (4,591   | )          |
| International                                  |       | 5,398    |       | 6,255    |       | 824      |       |
| Income from  operations of reportable segments |       | 49,575   |       | 42,254   |       | 21,655   |       |
| Expenses not  allocated to segments            |       | (10,502  | )          | (10,485  | )          | (34,123  | )          |
| Consolidated  income (loss) from operations    |       | $        | 39,073     |     | $          | 31,769   |       | $ | (12,468 | ) |

 

For the years endedDecember 31, 2004, 2003 and 2002, the Company had no individual customer ordistributor that accounted for 10% or more of total annual revenues.

 

The accounting policies of the reportable segments arethe same as the accounting policies of the Company. The Company allocatesresources and evaluates the performance of segments based on income fromoperations and therefore has not disclosed certain other items, such asinterest, depreciation and amortization by segment as permitted by SFAS No.131. The Company does not allocate assets to reportable segments because asignificant portion of assets are shared by the segments.

 

Net revenues, attributed to geographic location basedon the location of the customer, for the years ended December 31, were asfollows (in thousands):

 
| ** **                       | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|----------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                             |       |     |       |     |       |     |       |
| United States                    |       | $        | 227,139    |     | $          | 172,831  |       | $ | 160,206 |   |
| Europe                           |       | 20,369   |       | 16,265   |       | 13,073   |       |
| Other countries                  |       | 8,491    |       | 8,843    |       | 9,357    |       |
| Total  consolidated net revenues |       | $        | 255,999    |     | $          | 197,939  |       | $ | 182,636 |   |

 

72

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Total assets by region at December 31 were as follows(in thousands): 

 
| ** **                 | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|----------------------------|------------|------------|------------|------------|------------|
| ** **                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| United States              |       | $          | 296,923    |       | $          | 313,857 |   |
| International              |       | 9,927      |       | 6,647      |       |
| Total  consolidated assets |       | $          | 306,850    |       | $          | 320,504 |   |

 

**10.****                               Commitmentsand Contingencies**

 

The Company isobligated under various noncancellable operating leases for land, buildings,equipment and vehicles through August 2014. Certain of the leases provide that the Company pay all or a portion oftaxes, maintenance, insurance and other operating expenses, and certain of therents are subject to adjustment for changes as determined by certain consumerprice indices and exchange rates.  TheCompany is headquartered in Vista, California and operates manufacturinglocations in Vista, California and Tijuana, Mexico. The Company also leaseswarehouse and office space in Indiana, Germany, Canada, France, the UnitedKingdom and Denmark.  All of the Company’sfacilities are leased; none are owned.

 

Minimum annuallease commitments for noncancellable operating leases as of December 31, 2004are as follows (in thousands):

 
| 2005                 |   | $     | 5,188  |   |
|----------------------|--------|-------|--------|--------|
| 2006                 |   | 4,925 |   |
| 2007                 |   | 4,305 |   |
| 2008                 |   | 1,893 |   |
| 2009                 |   | 1,563 |   |
| 2010 and  thereafter |   | 6,410 |   |
|                 |   | $     | 24,284 |   |

 

On October 20, 2004, the Company entered into a LeaseAgreement with Professional Real Estate Services, Inc. (PRES) under which PRESwill undertake to build a new 110,000 square foot corporate headquartersfacility for the Company on vacant land currently leased to the Company inVista, California.  Once completed, the Company will occupy the facilityunder a 15-year lease with two five-year options to extend the term and willmove out of its existing facilities in Vista.  Rent for the new facilitywill be based on an agreed percentage of the total project cost for theconstruction of the facility and is not expected to exceed the rent currentlypaid by the Company for its existing Vista facilities.  The commitmentstable above includes only the rent for the Company’s current Vista facilitiesas future rent payments to PRES for the new facility cannot be determined as ofDecember 31, 2004.

 

The new lease with PRESwas contingent on PRES closing a transaction to purchase the existingfacilities in Vista, California leased by the Company, as well as the realproperty underlying the new lease.  The purchase transaction closed inFebruary 2005. Effective on the closing date, the Company’s lease for thevacant land was terminated, and when the new headquarters facility is completedand occupied, the Company’s leases for its existing Vista facilities will beterminated.  Those leases would otherwise have continued until February2008.  Upon occupancy of the new facility, expected to occur in mid-2006,the Company will make a lump sum rent payment to PRES, which will be recordedas operating expense when incurred, equal to 40% of the rent that would havebeen due under the existing facilities leases from the termination date of theexisting leases through the original expiration date. If PRES is able to leasethe Company’s former Vista facilities during what would have remained of theterm of the Company’s existing leases, a portion of that sum may be refunded tothe Company.

 

Aggregate rent expense was approximately $5.4 million,$3.4 million and $3.9 million for the years ended December 31, 2004, 2003 and2002, respectively.

 

*Contingencies*

 

From time to time, the Company has been involved inlawsuits arising in the ordinary course of business. This includes patent andother intellectual property disputes between its various competitors and theCompany.  With respect to these matters,management believes that it has adequate insurance coverage or has madeadequate accruals for related costs, and it may also have effective legaldefenses. The Company is not aware of any pending lawsuits that could have amaterial adverse effect on its business, financial condition and results ofoperations.

 

73

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**11.****                               EmployeeBenefit Plan**

 

The Company has aqualified 401(k) profit-sharing plan covering substantially all of its U.S.employees. The Company matches 100% of the first $500 contributed annually by eachemployee and 30 percent of additional employee contributions up to six percentof total compensation.  The Company’smatching contributions related to this plan were $0.5 million, $0.3 million and$0.4 million for the years ended December 31, 2004, 2003 and 2002,respectively. The plan also provides for discretionary Company contributions asapproved by the Board of Directors. There have been no such discretionarycontributions through December 31, 2004.

 

**12.****                               QuarterlyResults (unaudited)**

 

The following tablesummarizes certain of the Company’s operating results by quarter for 2004 and2003:

 
| ** **                    | ** ** | **Year Ended December 31, 2004**          | ** ** |
|-------------------------------|------------|-------------------------------------------|------------|
| ** **                    | ** ** | **First  Quarter**                        | ** ** | **Second  Quarter** | ** ** | **Third  Quarter** | ** ** | **Fourth  Quarter** | ** ** | **Total  Year** | ** ** |
| ** **                    | ** ** | **(In thousands, except per share data)** | ** ** |
| Net revenues                  |       | $                                         | 62,241     |   | $ | 63,186 |   | $ | 62,471 |   | $ | 68,101 |   | $ | 255,999 |   |
| Gross profit                  |       | 38,882                                    |       | 40,233 |   | 39,438 |   | 42,282 |   | 160,835 |   |
| Income from  operations       |       | 10,294                                    |       | 11,104 |   | 8,688 |   | 8,987 |   | 39,073 |   |
| Net income                    |       | $                                         | 3,980      |   | $ | 67 |   | $ | 4,668 |   | $ | 5,300 |   | $ | 14,015 |   |
| Basic net income  per share   |       | $                                         | 0.20       |   | $ | — |   | $ | 0.21 |   | $ | 0.25 |   | $ | 0.66 |   |
| Diluted net  income per share |       | $                                         | 0.19       |   | $ | — |   | $ | 0.20 |   | $ | 0.24 |   | $ | 0.63 |   |
| Number of  operating days     |       | 61                                        |       | 64 |   | 63 |   | 65 |   | 253 |   |

 
| ** **                    | ** ** | **Year Ended December 31, 2003**          | ** ** |
|-------------------------------|------------|-------------------------------------------|------------|
| ** **                    | ** ** | **First  Quarter**                        | ** ** | **Second  Quarter** | ** ** | **Third  Quarter** | ** ** | **Fourth  Quarter** | ** ** | **Total  Year** | ** ** |
| ** **                    | ** ** | **(In thousands, except per share data)** | ** ** |
| Net revenues                  |       | $                                         | 47,054     |   | $ | 47,420 |   | $ | 48,850 |   | $ | 54,615 |   | $ | 197,939 |   |
| Gross profit                  |       | 25,793                                    |       | 26,166 |   | 28,202 |   | 31,851 |   | 112,012 |   |
| Income from  operations       |       | 5,774                                     |       | 7,087 |   | 9,285 |   | 9,623 |   | 31,769 |   |
| Net income                    |       | $                                         | 1,659      |   | $ | 2,689 |   | $ | 3,642 |   | $ | 4,081 |   | $ | 12,071 |   |
| Basic net income  per share   |       | $                                         | 0.09       |   | $ | 0.15 |   | $ | 0.20 |   | $ | 0.23 |   | $ | 0.67 |   |
| Diluted net  income per share |       | $                                         | 0.09       |   | $ | 0.15 |   | $ | 0.19 |   | $ | 0.21 |   | $ | 0.64 |   |
| Number of operating  days     |       | 62                                        |       | 64 |   | 63 |   | 64 |   | 253 |   |

 

**13.****                               Subsequent Event**

 

In February 2005, amanagement stockholder owing $1.7 million of promissory notes to the Company asof December 31, 2004, repaid $0.5 million of those notes.

 

74

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**Item 9. Changes in andDisagreements with Accountants on Accounting and Financial Disclosure**

 

Not applicable.

 

**Item 9A. Controls and Procedures**

 

# *Disclosure Controls and Procedures*

 

Under the supervision andwith the participation of our management, including our Chief Executive Officerand our Chief Financial Officer, we carried out an evaluation of theeffectiveness of the Company’s disclosure controls and procedures (as such termis defined in SEC Rules 13a – 15(e) and 15d – 15(e)) as of December 31,2004.  Based on such evaluation, suchofficers have concluded that, as of such date, the Company’s disclosurecontrols and procedures are effective in alerting them on a timely basis tomaterial information relating to the Company (including its consolidatedsubsidiaries) required to be included in the Company’s periodic filings underthe Securities Exchange Act of 1934.

 

# *Management’s Report on Internal Control over FinancialReporting*

 

Internal control over financial reporting refers tothe process designed by, or under the supervision of, our Chief ExecutiveOfficer and Chief Financial Officer, and effected by our board of directors,management and other personnel, to provide reasonable assurance regarding thereliability of financial reporting and the preparation of financial statementsfor external purposes in accordance with generally accepted accountingprinciples, and includes those policies and procedures that:

 

(1) Pertain to themaintenance of records that, in reasonable detail, accurately and fairlyreflect the transactions and dispositions of the assets of the Company;

 

(2) Provide reasonableassurance that transactions are recorded as necessary to permit preparation offinancial statements in accordance with generally accepted accountingprinciples, and that receipts and expenditures of the Company are being madeonly in accordance with authorizations of management and directors of theCompany; and

 

(3) Provide reasonable assurance regarding preventionor timely detection of unauthorized acquisition, use or disposition of the

Company’s assets that could have a material effect onthe financial statements.

 

Internal control over financial reporting cannotprovide absolute assurance of achieving financial reporting objectives becauseof its inherent limitations. Internal control over financial reporting is aprocess that involves human diligence and compliance and is subject to lapsesin judgment and breakdowns resulting from human failures. Internal control overfinancial reporting also can be circumvented by collusion or impropermanagement override. Because of such limitations, there is a risk that materialmisstatements may not be prevented or detected on a timely basis by internalcontrol over financial reporting. However, these inherent limitations are knownfeatures of the financial reporting process. Therefore, it is possible todesign into the process safeguards to reduce, though not eliminate, this risk.Management is responsible for establishing and maintaining adequate internal controlover financial reporting for the Company.

 

Management has used the framework set forth in thereport entitled *Internal Control—IntegratedFramework* published by the Committee of Sponsoring Organizations(COSO) of the Treadway Commission to evaluate the effectiveness of the Company’sinternal control over financial reporting. Management has concluded that theCompany’s internal control over financial reporting was effective as ofDecember 31, 2004. Ernst & Young LLP, the Company’s independent registeredpublic accounting firm, has issued an attestation report on management’sassessment of the Company’s internal control over financial reporting which isincluded herein.

 

*Changesin Internal Control over Financial Reporting*

 

There has been no changeto our internal control over financial reporting during our most recent fiscalquarter that has materially affected, or is reasonably likely to materiallyaffect, our internal control over financial reporting.

 

75

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**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTINGFIRM ON**

**INTERNAL CONTROL OVER FINANCIAL REPORTING**

** **

** **

**The Board of Directors and Stockholders**

**dj Orthopedics, Inc.**

** **

We have auditedmanagement’s assessment, included in the accompanying Management’s Report onInternal Control over Financial Reporting, that dj Orthopedics, Inc. maintainedeffective internal control over financial reporting as of December 31, 2004,based on criteria established inInternal Control—Integrated Framework issued by the Committee of SponsoringOrganizations of the Treadway Commission (the COSO criteria). djOrthopedics, Inc.’s management is responsible for maintaining effectiveinternal control over financial reporting and for its assessment of theeffectiveness of internal control over financial reporting. Our responsibilityis to express an opinion on management’s assessment and an opinion on theeffectiveness of the company’s internal control over financial reporting basedon our audit.

 

We conducted our auditin accordance with the standards of the Public Company Accounting OversightBoard (United States). Those standards require that we plan and perform theaudit to obtain reasonable assurance about whether effective internal controlover financial reporting was maintained in all material respects. Our auditincluded obtaining an understanding of internal control over financialreporting, evaluating management’s assessment, testing and evaluating thedesign and operating effectiveness of internal control, and performing such otherprocedures as we considered necessary in the circumstances. We believe that ouraudit provides a reasonable basis for our opinion.

 

A company’s internalcontrol over financial reporting is a process designed to provide reasonableassurance regarding the reliability of financial reporting and the preparationof financial statements for external purposes in accordance with generallyaccepted accounting principles. A company’s internal control over financialreporting includes those policies and procedures that (1) pertain to themaintenance of records that, in reasonable detail, accurately and fairlyreflect the transactions and dispositions of the assets of the company; (2)provide reasonable assurance that transactions are recorded as necessary topermit preparation of financial statements in accordance with generallyaccepted accounting principles, and that receipts and expenditures of thecompany are being made only in accordance with authorizations of management anddirectors of the company; and (3) provide reasonable assurance regardingprevention or timely detection of unauthorized acquisition, use, or dispositionof the company’s assets that could have a material effect on the financialstatements.

 

Because of its inherentlimitations, internal control over financial reporting may not prevent ordetect misstatements.  Also, projectionsof any evaluation of effectiveness to future periods are subject to the riskthat controls may become inadequate because of changes in conditions, or thatthe degree of compliance with the policies or procedures may deteriorate.

 

In our opinion,management’s assessment that dj Orthopedics, Inc. maintained effective internalcontrol over financial reporting as of December 31, 2004, is fairly stated, inall material respects, based on the COSO criteria.  Also, in our opinion, dj Orthopedics, Inc.maintained, in all material respects, effective internal control over financialreporting as of December 31, 2004, based on****the COSO criteria**.**

 

We also have audited, inaccordance with the standards of the Public Company Accounting Oversight Board(United States), the consolidated balance sheets of dj Orthopedics, Inc. as ofDecember 31, 2004 and 2003, and the related consolidated statements ofoperations, stockholders’ equity and cash flows for each of the three years inthe period ended December 31, 2004 of dj Orthopedics, Inc. and our reportdated February 22, 2005 expressed an unqualified opinion thereon.

 

 
|   | /s/ ERNST & YOUNG  LLP |   |
|--------|----------------------------|--------|

 

 

San Diego, California

February 22, 2005

 

76

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**Item 9B. Other Information**

None.

 

**PART III**

 

**Item 10. Directors and ExecutiveOfficers of the Registrant**

 

The Company hasadopted a Code of Business Conduct and Ethics and a set of Corporate GovernanceGuidelines.  These documents can beaccessed on the Company’s website under the investor relations page, and areavailable in print to stockholders who submit a written request to theSecretary of the Company at the address of the Company’s principal executiveoffices.  In addition, the Audit,Compensation and Nominating and Corporate Governance Committees are eachadopting a charter governing the activities of such committee.  In accordance with New York Stock Exchangerules, these documents will similarly be available either on the website or bywritten request no later than the date of the Company’s 2005 AnnualStockholders Meeting.

 

The otherinformation under Item 10 is hereby incorporated by reference from djOrthopedics, Inc.’s Definitive Proxy Statement to be filed with the Securitiesand Exchange Commission on or prior to April 30, 2005.  See also the identification of the ExecutiveOfficers following Item 4 of this Form 10-K.

 

**Item 11. Executive Compensation**

 

Item 11 is herebyincorporated by reference from dj Orthopedics, Inc.’s Definitive ProxyStatement to be filed with the Securities and Exchange Commission on or priorto April 30, 2005.

 

##### **Item12. Security Ownership of Certain Beneficial Owners and Management**

 

Item 12 is herebyincorporated by reference from dj Orthopedics, Inc.’s Definitive ProxyStatement to be filed with the Securities and Exchange Commission on or priorto April 30, 2005.

 

**Item 13. Certain Relationshipsand Related Transactions**

 

Item 13 is herebyincorporated by reference from dj Orthopedics, Inc.’s Definitive ProxyStatement to be filed with the Securities and Exchange Commission on or priorto April 30, 2005.

 

**Item 14. Principal AccountantFees and Services**

 

Item14 is hereby incorporated by reference from dj Orthopedics, Inc.’s DefinitiveProxy Statement to be filed with the Securities and Exchange Commission on orprior to April 30, 2005.

 

77

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**PART IV**

 

**Item 15. Exhibits, FinancialStatement Schedules**

 

(a)          Thefollowing documents are filed as part of this report:

 

1.               Thefollowing consolidated financial statements of dj Orthopedics, Inc., includingthe report thereon of Ernst & Young LLP, are filed as part of this reportunder Item 8- Financial Statements and Supplementary Data:

 
| Report  of Independent Registered Public Accounting Firm                                                               |
|------------------------------------------------------------------------------------------------------------------------|
| Consolidated Balance Sheets  as of December 31, 2004 and 2003                                                          |
| Consolidated  Statements of Operations for the years ended December 31, 2004, 2003 and 2002                            |
| Consolidated  Statements of Changes in Stockholders’ Equity for the years ended December  31, 2004, 2003 and 2002 |
| Consolidated  Statements of Cash Flows for the years ended December 31, 2004, 2003 and 2002                            |
| Notes to  Consolidated Financial Statements                                                                            |

 

2.               FinancialStatement Schedules:

 
| Schedule  II – Valuation and Qualifying Accounts |
|-------------------------------------------------------|

 

All other financial statementschedules are not required under the related instructions or are inapplicableand therefore have been omitted.

 

3.               Exhibits:

 
| **Exhibit  Number** | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                         |
|---------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1                 |       | Amended and Restated  Certificate of Incorporation of dj Orthopedics, Inc. (Incorporated by  reference to Exhibit 4.1 to the Registration Statement of dj Orthopedics,  Inc. on Form S-8 (Reg. No. 333-73966))                                                                                                                                          |
|                |       |                                                                                                                                                                                                                                                                                                                                                    |
| 3.2                 |       | Certificate of  Amendment of Amended and Restated Certificate of Incorporation of dj  Orthopedics, Inc. (Incorporated by reference to the Registration Statement of  dj Orthopedics, Inc. on Form S-3 (Reg. No. 333-111465))                                                                                                                            |
|                |       |                                                                                                                                                                                                                                                                                                                                                    |
| 3.3                 |       | Amended and Restated  By-laws of dj Orthopedics, Inc. (Incorporated by reference to Exhibit 4.2 to  the Registration Statement of dj Orthopedics, Inc. on Form S-8 (Reg. No.  333-73966))                                                                                                                                                               |
|                |       |                                                                                                                                                                                                                                                                                                                                                    |
| 10.1                |       | Subleases dated as of  June 30, 1999 between dj Orthopedics, LLC and Smith & Nephew  (Incorporated by reference to Exhibit 10.7 to the Registration Statement on  Form S-4 (Reg. No. 333-86835))                                                                                                                                                    |
|                |       |                                                                                                                                                                                                                                                                                                                                                    |
| 10.2                |       | Guaranties dated as of  June 30, 1999 of dj Orthopedics, Inc., as successor to DonJoy, L.L.C.  (Incorporated by reference to Exhibit 10.8 to the Registration Statement on  Form S-4 (Reg. No. 333-86835))                                                                                                                                              |
|                |       |                                                                                                                                                                                                                                                                                                                                                    |
| 10.3                |       | Fifth Amended and  Restated 1999 Option Plan of dj Orthopedics, Inc. dated October 25, 2001  (Incorporated by reference to Exhibit 4.3 to the Registration Statement on  Form S-8 of dj Orthopedics, Inc. (Reg. No. 333-73966))                                                                                                                         |
|                |       |                                                                                                                                                                                                                                                                                                                                                    |
| 10.4                |       | Secured Promissory Note  dated as of July 7, 2000 between Leslie H. Cross and dj Orthopedics, Inc., as  successor to DonJoy, L.L.C. (Incorporated by reference to Exhibit 4.3 to  DonJoy, L.L.C.’s report on Form 8-K dated July 21, 2000)                                                                                                         |
|                |       |                                                                                                                                                                                                                                                                                                                                                    |
| 10.5                |       | Third Amended and  Restated Pledge Agreement dated as of June 11, 2001, among Leslie H. Cross,  Leslie H. Cross & Deborah L. Cross Family Trust, and dj Orthopedics,  Inc., as successor to DonJoy, L.L.C. (Incorporated by reference to Exhibit  10.7 to DonJoy, L.L.C.’s quarterly report on Form 10-Q for the quarter ended  June 30, 2001) |
|                |       |                                                                                                                                                                                                                                                                                                                                                    |
| 10.6                |       | Amended and Restated  Secured Promissory Note dated as of June 28, 2000 among Leslie H. Cross &  Deborah L. Cross Family Trust, Leslie H. Cross and dj Orthopedics, Inc., as  successor to DonJoy, L.L.C. (Incorporated by reference to Exhibit 4.11 to  DonJoy, L.L.C.’s report on Form 8-K dated July 21, 2000)                              |
|                |       |                                                                                                                                                                                                                                                                                                                                                    |
| 10.7                |       | Secured Promissory Note  dated as of June 28, 2000 among Leslie H. Cross & Deborah L. Cross Family  Trust, Leslie H. Cross and dj Orthopedics, Inc., as successor to DonJoy,  L.L.C. (Incorporated by reference to Exhibit 4.13 to DonJoy’s report on Form  8-K dated July 21, 2000)                                                           |

 

78

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| **Exhibit  Number** | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
|---------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.8                |       | Secured Promissory Note  dated as of June 11, 2001 among Leslie H. Cross & Deborah L. Cross Family  Trust, Leslie H. Cross and dj Orthopedics, Inc., as successor to DonJoy,  L.L.C. (Incorporated by reference to Exhibit 10.4 to DonJoy, L.L.C.’s  quarterly report on Form 10-Q for the quarter ended June 30, 2001)                                                                                                                                                                                                                                                              |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 10.9                |       | dj Orthopedics, Inc.  2001 Omnibus Plan (Incorporated by reference to Exhibit 4.6 to the  Registration Statement on Form S-8 of dj Orthopedics, Inc. (Reg. No.  333-73966))                                                                                                                                                                                                                                                                                                                                                                                                                   |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 10.10               |       | dj Orthopedics, Inc.  2001 Non-Employee Director Plan (Incorporated by reference to Exhibit 4.5 to  the Registration Statement on Form S-8 of dj Orthopedics, Inc. (Reg. No.  333-73966))                                                                                                                                                                                                                                                                                                                                                                                                     |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 10.11               |       | dj Orthopedics, Inc.  2001 Employee Stock Purchase Plan (Incorporated by reference to Exhibit 4.4  to the Registration Statement on Form S-8 of dj Orthopedics, Inc. (Reg. No.  333-73966))                                                                                                                                                                                                                                                                                                                                                                                                   |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 10.12               |       | Registration Rights  Agreement dated November 20, 2001 by and among dj Orthopedics, Inc., J.P.  Morgan DJ Partners, L.L.C., Leslie H. Cross & Deborah L. Cross Family  Trust, Michael R. McBrayer, Cyril Talbot III, J.P. Morgan Partners (23A SBIC),  LLC, First Union Capital Partners, LLC, DJ Investment, LLC, DJC, Inc., TCW/  Crescent Mezzanine Trust II, TCW Leveraged Income Trust II, L.P., TCW  Investment Management Company and Crescent Mach I Partners, L.P.  (Incorporated by reference to Exhibit 10.53 to the Registration Statement on  Form S-1 (Reg. No. 333-74998)) |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 10.13               |       | Letter Agreement dated  November 20, 2001 between dj Orthopedics, Inc. and the Leslie H. Cross and  Deborah L. Cross Family Trust (Incorporated by reference to Exhibit 10.54 to  the Registration Statement on Form S-1 (Reg. No. 333-74998))                                                                                                                                                                                                                                                                                                                                                |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 10.14               |       | Outsourcing Agreement,  dated as of December 30, 2002 by and between Creditek MediFinancial, Inc. and  dj Orthopedics, LLC (Incorporated by reference to dj Orthopedics, Inc.’s  Report on Form 10-K for the year ended December 31, 2002)                                                                                                                                                                                                                                                                                                                                               |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 10.15               |       | The Asset Purchase  Agreement, dated June 18, 2003, by and between Dura*Kold Corporation and the  Company (Incorporated by reference to dj Orthopedics, Inc.’s Report on Form  10-Q for the quarter ended June 28, 2003)                                                                                                                                                                                                                                                                                                                                                                 |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 10.16               |       | Amendment Number One to  the DJ Orthopedics, Inc. 2001 Non-Employee Director Stock Option Plan, dated  May 29, 2003 (Incorporated by reference to dj Orthopedics, Inc.’s Report on  Form 10-Q for the quarter ended June 28, 2003)                                                                                                                                                                                                                                                                                                                                                       |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 10.17               |       | Non-exclusive License  and Settlement Agreement by and between Generation II Orthopedics Inc. and  Generation II USA Inc. and the Company entered into on May 29, 2003.  (Incorporated by reference to dj Orthopedics, Inc.’s Report on Form 10-Q for  the quarter ended June 28, 2003)                                                                                                                                                                                                                                                                                                  |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 10.18               |       | Asset Purchase  Agreement, dated October 8, 2003, by and between OrthoLogic Corp. and the  Company (Incorporated by reference to dj Orthopedics, Inc.’s Report on Form  10-Q for the quarter ended September 27, 2003)                                                                                                                                                                                                                                                                                                                                                                   |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 10.19               |       | Credit Agreement among  dj Orthopedics, LLC, as borrower, dj Orthopedics, Inc., the lenders named  thereto, Wachovia Bank, National Association, as Administrative Agent, Wells  Fargo Bank, National Association, as Syndication Agent, and Bank of America,  N.A., Bank of the West and Union Bank of California, N.A., as Documentation  Agents for $130,000,000 Senior Secured Credit Facilities, dated as of  November 26, 2003 (Incorporated by reference to dj Orthopedics, Inc.’s Report  on Form 8-K dated December 3, 2003)                                                    |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 10.20               |       | Amendment Number One to  Outsourcing Agreement, dated December 12, 2003 by and between Creditek  MediFinancial, Inc. and dj Orthopedics, LLC. (Incorporated by reference to dj  Orthopedics, Inc.’s Report on Form 10-K for the year ended December 31, 2003)                                                                                                                                                                                                                                                                                                                            |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 10.21+              |       | Sales Representative  Agreement, dated August 18, 2000, between dj Orthopedics LLC (successor to  OrthoLogic Corp. with respect to this agreement) and DePuy Spine, Inc.  (formally known as DePuy AcroMed, Inc.). (Incorporated by reference to dj  Orthopedics, Inc.’s Report on Form 10-K for the year ended December 31, 2003)                                                                                                                                                                                                                                                       |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 10.22+              |       | Amendment to Sales  Representative Agreement, dated March 1, 2002, between dj Orthopedics LLC  (successor to OrthoLogic Corp. with respect to this agreement) and DePuy  Spine, Inc. (formally known as DePuy AcroMed, Inc.). (Incorporated by  reference to dj Orthopedics, Inc.’s Report on Form 10-K for the year ended  December 31, 2003)                                                                                                                                                                                                                                           |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 10.23+              |       | Amendment No. 3 to  Sales Representative Agreement, dated September 15, 2003, between dj  Orthopedics LLC (successor to OrthoLogic Corp. with respect to this  agreement) and DePuy Spine, Inc. (formally known as DePuy AcroMed, Inc.).  (Incorporated by reference to dj Orthopedics, Inc.’s Report on Form 10-K for  the year ended December 31, 2003)                                                                                                                                                                                                                                |

 

79

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| **Exhibit  Number** | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
|---------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.24               |       | Underwriting Agreement,  dated June 2, 2004, by and among dj Orthopedics, Inc., the selling  stockholders named therein and Lehman Brothers Inc., related to the public  offering of 3,072,379 shares of dj Orthopedics, Inc.’s common stock, par  value $0.01 per share, pursuant to dj Orthopedics, Inc.’s Registration  Statement on Form S-3 (Reg. No. 333-115768). (Incorporated by reference to dj  Orthopedics, Inc.’s Report on Form 8-K dated June 4, 2004) |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
| 10.25               |       | First Amendment to  Credit Agreement, dated July 7, 2004, among dj Orthopedics, LLC, dj  Orthopedics, Inc., other Guarantors, Lendors and Wachovia Bank, National  Association, as administrative agent. (Incorporated by reference to dj  Orthopedics, Inc.’s Report on Form 10Q for the quarter ended June 26, 2004)                                                                                                                                                         |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
| 10.26               |       | Stock purchase  agreement between dj Orthopedics, LLC and KD Holdings dated as of August 30,  2004. (Incorporated by reference to dj Orthopedics, Inc.’s Report on Form 8-K  dated September 28, 2004)                                                                                                                                                                                                                                                                         |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
| 10.27               |       | Lease Agreement between  Professional Real Estate Services, Inc. and dj Orthopedics, LLC, dated  October 20, 2004. (Incorporated by reference to dj Orthopedics, Inc.’s Report  on Form 8-K dated October 26, 2004)                                                                                                                                                                                                                                                            |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
| 10.28               |       | Agreement Regarding  Termination of Leases among Professional Real Estate Services, Inc., dj  Orthopedics, LLC and Smith & Nephew, Inc., dated October 20, 2004.  (Incorporated by reference to dj Orthopedics, Inc.’s Report on Form 8-K dated  October 26, 2004)                                                                                                                                                                                                         |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
| 10.29               |       | Second Amendment to  Credit Agreement, dated September 28, 2004, among dj Orthopedics, LLC, dj  Orthopedics, Inc., other Guarantors, Lendors and Wachovia Bank, National  Association, as administrative agent. (Incorporated by reference to dj  Orthopedics, Inc.’s Report on Form 10Q for the quarter ended September 25,  2004)                                                                                                                                            |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
| 10.30*+             |       | Amended and Restated  Sales Representative Agreement, dated January 24, 2005 between dj Orthopedics  LLC (successor to OrthoLogic Corp. with respect to this agreement) and DePuy  Spine, Inc. (formally known as DePuy AcroMed, Inc.).                                                                                                                                                                                                                                             |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
| 21.1*               |       | Subsidiaries of the  Registrant                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
| 23.1*               |       | Consent of Independent  Registered Public Accounting Firm                                                                                                                                                                                                                                                                                                                                                                                                                           |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
| 31.1*               |       | Certification of Chief  Executive Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the  Securities Exchange Act, as amended.                                                                                                                                                                                                                                                                                                                                                |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
| 31.2*               |       | Certification of Chief  Financial Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the  Securities Exchange Act, as amended.                                                                                                                                                                                                                                                                                                                                                |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
| 32.0*               |       | Certification of Chief  Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. 1350, as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                                                                            |

 

----

* Filed herewith

+ Confidential treatmenthas been requested with respect to portions of this exhibit.

 

80

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**DJ ORTHOPEDICS, INC.**

**SCHEDULEII — Valuation and Qualifying Accounts**

**For theThree Years Ended December 31, 2004**

 
| ** **                               | ** ** | **Allowance for  Doubtful  Accounts and  Sales Returns** | ** ** | **Reserve for  Excess and  Obsolete  Inventory** | ** ** |
|------------------------------------------|------------|----------------------------------------------------------|------------|--------------------------------------------------|------------|
|                                     |       |                                                     |       |                                             |       |
| Balance at  December 31, 2001            |       | $                                                        | 8,741,000  |                                             | $          | 3,000,000 |   |
| Provision                                |       | 22,269,000                                               |       | 6,124,000                                        |       |
| Write-offs and  recoveries, net          |       | (20,965,000                                              | )          | (4,560,000                                       | )          |
| Balance at  December 31, 2002            |       | 10,045,000                                               |       | 4,564,000                                        |       |
| Provision                                |       | 22,641,000                                               |       | 2,087,000                                        |       |
| Write-offs and  recoveries, net          |       | (14,601,000                                              | )          | (1,449,000                                       | )          |
| Additions from  Regeneration acquisition |       | 2,632,000                                                |       | 1,167,000                                        |       |
| Balance at  December 31, 2003            |       | 20,717,000                                               |       | 6,369,000                                        |       |
| Provision                                |       | 30,556,000                                               |       | (113,000                                         | )          |
| Write-offs and recoveries,  net          |       | (24,645,000                                              | )          | (3,075,000                                       | )          |
| Balance at  December 31, 2004            |       | $                                                        | 26,628,000 |                                             | $          | 3,181,000 |   |

 

81

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**SIGNATURES**

 

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

 
| Date: March 4, 2005 | **DJ ORTHOPEDICS, INC.** |
|---------------------|--------------------------|
|                | By:                      | /s/ Leslie H.  Cross |   |
|                |                     | Leslie H. Cross |
| * *            | * *                 | *President and Chief Executive Officer* |

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, this Report has been signed below by the followingpersons on behalf of the registrant and in the capacities and on the datesindicated.

 
| **Signature**            | ** ** | **Title**                                                   | ** ** | **Date**      |
|--------------------------|------------|-------------------------------------------------------------|------------|---------------|
|                     |       |                                                        |       |          |
| /s/ Leslie H.  Cross     |       | President, Chief  Executive Officer and Director            |       | March 4, 2005 |
| Leslie H. Cross          |       | (Principal Executive  Officer)                              |       |          |
|                     |       |                                                        |       |          |
| /s/ Vickie L.  Capps     |       | Senior Vice President,  Finance, Chief Financial Officer    |       | March 4, 2005 |
| Vickie L. Capps          |       | and Treasurer  (Principal Financial and Accounting Officer) |       |          |
|                     |       |                                                        |       |          |
|                     |       | Chairman of the Board  of Directors                         |       |          |
| Jack R. Blair            |       |                                                        |       |          |
|                     |       |                                                        |       |          |
| /s/ Mitchell J.  Blutt   |       | Director                                                    |       | March 4, 2005 |
| Mitchell J.  Blutt, M.D. |       |                                                        |       |          |
|                     |       |                                                        |       |          |
| /s/ Thomas  Mitchell     |       | Director                                                    |       | March 4, 2005 |
| Thomas Mitchell          |       |                                                        |       |          |
|                     |       |                                                        |       |          |
| /s/ Lewis Parker         |       | Director                                                    |       | March 4, 2005 |
| Lewis Parker             |       |                                                        |       |          |
|                     |       |                                                        |       |          |
| /s/ Charles T.  Orsatti  |       | Director                                                    |       | March 4, 2005 |
| Charles T.  Orsatti      |       |                                                        |       |          |
|                     |       |                                                        |       |          |
| /s/ Lesley H.  Howe      |       | Director                                                    |       | March 4, 2005 |
| Lesley H. Howe           |       |                                                        |       |          |
|                     |       |                                                        |       |          |
| /s/ Kirby L.  Cramer     |       | Director                                                    |       | March 4, 2005 |
| Kirby L. Cramer          |       |                                                        |       |          |

 

82

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**INDEX TOEXHIBITS**
| **Exhibit  Number** | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
|---------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1                 |       | Amended and Restated  Certificate of Incorporation of dj Orthopedics, Inc. (Incorporated by  reference to Exhibit 4.1 to the Registration Statement of dj Orthopedics,  Inc. on Form S-8 (Reg. No. 333-73966))                                                                                                                                                                                                                                                                                                                                                                                |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 3.2                 |       | Certificate of  Amendment of Amended and Restated Certificate of Incorporation of dj  Orthopedics, Inc. (Incorporated by reference to the Registration Statement of  dj Orthopedics, Inc. on Form S-3 (Reg. No. 333-111465))                                                                                                                                                                                                                                                                                                                                                                  |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 3.3                 |       | Amended and Restated  By-laws of dj Orthopedics, Inc. (Incorporated by reference to Exhibit 4.2 to  the Registration Statement of dj Orthopedics, Inc. on Form S-8 (Reg. No.  333-73966))                                                                                                                                                                                                                                                                                                                                                                                                     |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 10.1                |       | Subleases dated as of  June 30, 1999 between dj Orthopedics, LLC and Smith & Nephew  (Incorporated by reference to Exhibit 10.7 to the Registration Statement on  Form S-4 (Reg. No. 333-86835))                                                                                                                                                                                                                                                                                                                                                                                          |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 10.2                |       | Guaranties dated as of  June 30, 1999 of dj Orthopedics, Inc., as successor to DonJoy, L.L.C.  (Incorporated by reference to Exhibit 10.8 to the Registration Statement on  Form S-4 (Reg. No. 333-86835))                                                                                                                                                                                                                                                                                                                                                                                    |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 10.3                |       | Fifth Amended and  Restated 1999 Option Plan of dj Orthopedics, Inc. dated October 25, 2001 (Incorporated  by reference to Exhibit 4.3 to the Registration Statement on Form S-8 of dj  Orthopedics, Inc. (Reg. No. 333-73966))                                                                                                                                                                                                                                                                                                                                                               |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 10.4                |       | Secured Promissory Note  dated as of July 7, 2000 between Leslie H. Cross and dj Orthopedics, Inc., as  successor to DonJoy, L.L.C. (Incorporated by reference to Exhibit 4.3 to  DonJoy, L.L.C.’s report on Form 8-K dated July 21, 2000)                                                                                                                                                                                                                                                                                                                                               |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 10.5                |       | Third Amended and  Restated Pledge Agreement dated as of June 11, 2001, among Leslie H. Cross,  Leslie H. Cross & Deborah L. Cross Family Trust, and dj Orthopedics,  Inc., as successor to DonJoy, L.L.C. (Incorporated by reference to Exhibit  10.7 to DonJoy, L.L.C.’s quarterly report on Form 10-Q for the quarter ended  June 30, 2001)                                                                                                                                                                                                                                       |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 10.6                |       | Amended and Restated  Secured Promissory Note dated as of June 28, 2000 among Leslie H. Cross &  Deborah L. Cross Family Trust, Leslie H. Cross and dj Orthopedics, Inc., as  successor to DonJoy, L.L.C. (Incorporated by reference to Exhibit 4.11 to  DonJoy, L.L.C.’s report on Form 8-K dated July 21, 2000)                                                                                                                                                                                                                                                                    |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 10.7                |       | Secured Promissory Note  dated as of June 28, 2000 among Leslie H. Cross & Deborah L. Cross Family  Trust, Leslie H. Cross and dj Orthopedics, Inc., as successor to DonJoy,  L.L.C. (Incorporated by reference to Exhibit 4.13 to DonJoy’s report on Form  8-K dated July 21, 2000)                                                                                                                                                                                                                                                                                                 |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 10.8                |       | Secured Promissory Note  dated as of June 11, 2001 among Leslie H. Cross & Deborah L. Cross Family  Trust, Leslie H. Cross and dj Orthopedics, Inc., as successor to DonJoy,  L.L.C. (Incorporated by reference to Exhibit 10.4 to DonJoy, L.L.C.’s  quarterly report on Form 10-Q for the quarter ended June 30, 2001)                                                                                                                                                                                                                                                              |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 10.9                |       | dj Orthopedics, Inc.  2001 Omnibus Plan (Incorporated by reference to Exhibit 4.6 to the  Registration Statement on Form S-8 of dj Orthopedics, Inc. (Reg. No.  333-73966))                                                                                                                                                                                                                                                                                                                                                                                                                   |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 10.10               |       | dj Orthopedics, Inc.  2001 Non-Employee Director Plan (Incorporated by reference to Exhibit 4.5 to  the Registration Statement on Form S-8 of dj Orthopedics, Inc. (Reg. No.  333-73966))                                                                                                                                                                                                                                                                                                                                                                                                     |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 10.11               |       | dj Orthopedics, Inc.  2001 Employee Stock Purchase Plan (Incorporated by reference to Exhibit 4.4  to the Registration Statement on Form S-8 of dj Orthopedics, Inc. (Reg. No.  333-73966))                                                                                                                                                                                                                                                                                                                                                                                                   |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 10.12               |       | Registration Rights  Agreement dated November 20, 2001 by and among dj Orthopedics, Inc., J.P.  Morgan DJ Partners, L.L.C., Leslie H. Cross & Deborah L. Cross Family  Trust, Michael R. McBrayer, Cyril Talbot III, J.P. Morgan Partners (23A  SBIC), LLC, First Union Capital Partners, LLC, DJ Investment, LLC, DJC, Inc.,  TCW/ Crescent Mezzanine Trust II, TCW Leveraged Income Trust II, L.P., TCW  Investment Management Company and Crescent Mach I Partners, L.P.  (Incorporated by reference to Exhibit 10.53 to the Registration Statement on  Form S-1 (Reg. No. 333-74998)) |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 10.13               |       | Letter Agreement dated  November 20, 2001 between dj Orthopedics, Inc. and the Leslie H. Cross and  Deborah L. Cross Family Trust (Incorporated by reference to Exhibit 10.54 to  the Registration Statement on Form S-1 (Reg. No. 333-74998))                                                                                                                                                                                                                                                                                                                                                |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 10.14               |       | Outsourcing Agreement,  dated as of December 30, 2002 by and between Creditek MediFinancial, Inc. and  dj Orthopedics, LLC (Incorporated by reference to dj Orthopedics, Inc.’s  Report on Form 10-K for the year ended December 31, 2002)                                                                                                                                                                                                                                                                                                                                               |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 10.15               |       | The Asset Purchase  Agreement, dated June 18, 2003, by and between Dura*Kold Corporation and the  Company (Incorporated by reference to dj Orthopedics, Inc.’s Report on Form  10-Q for the quarter ended June 28, 2003)                                                                                                                                                                                                                                                                                                                                                                 |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 10.16               |       | Amendment Number One to  the DJ Orthopedics, Inc. 2001 Non-Employee Director Stock Option Plan, dated  May 29, 2003 (Incorporated by reference to dj Orthopedics, Inc.’s Report on  Form 10-Q for the quarter ended June 28, 2003)                                                                                                                                                                                                                                                                                                                                                       |

 

83

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| **Exhibit  Number** | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
|---------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.17               |       | Non-exclusive License  and Settlement Agreement by and between Generation II Orthopedics Inc. and  Generation II USA Inc. and the Company entered into on May 29, 2003.  (Incorporated by reference to dj Orthopedics, Inc.’s Report on Form 10-Q for  the quarter ended June 28, 2003)                                                                                                                                                                                                                                               |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| 10.18               |       | Asset Purchase  Agreement, dated October 8, 2003, by and between OrthoLogic Corp. and the  Company (Incorporated by reference to dj Orthopedics, Inc.’s Report on Form  10-Q for the quarter ended September 27, 2003)                                                                                                                                                                                                                                                                                                                |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| 10.19               |       | Credit Agreement among  dj Orthopedics, LLC, as borrower, dj Orthopedics, Inc., the lenders named  thereto, Wachovia Bank, National Association, as Administrative Agent, Wells  Fargo Bank, National Association, as Syndication Agent, and Bank of  America, N.A., Bank of the West and Union Bank of California, N.A., as  Documentation Agents for $130,000,000 Senior Secured Credit Facilities, dated  as of November 26, 2003 (Incorporated by reference to dj Orthopedics, Inc.’s  Report on Form 8-K dated December 3, 2003) |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| 10.20               |       | Amendment Number One to  Outsourcing Agreement, dated December 12, 2003 by and between Creditek  MediFinancial, Inc. and dj Orthopedics, LLC. (Incorporated by reference to dj  Orthopedics, Inc.’s Report on Form 10-K for the year ended December 31, 2003)                                                                                                                                                                                                                                                                         |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| 10.21+              |       | Sales Representative  Agreement, dated August 18, 2000, between dj Orthopedics LLC (successor to  OrthoLogic Corp. with respect to this agreement) and DePuy Spine, Inc.  (formally known as DePuy AcroMed, Inc.). (Incorporated by reference to dj  Orthopedics, Inc.’s Report on Form 10-K for the year ended December 31, 2003)                                                                                                                                                                                                    |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| 10.22+              |       | Amendment to Sales  Representative Agreement, dated March 1, 2002, between dj Orthopedics LLC  (successor to OrthoLogic Corp. with respect to this agreement) and DePuy  Spine, Inc. (formally known as DePuy AcroMed, Inc.). (Incorporated by  reference to dj Orthopedics, Inc.’s Report on Form 10-K for the year ended  December 31, 2003)                                                                                                                                                                                        |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| 10.23+              |       | Amendment No. 3 to  Sales Representative Agreement, dated September 15, 2003, between dj Orthopedics  LLC (successor to OrthoLogic Corp. with respect to this agreement) and DePuy  Spine, Inc. (formally known as DePuy AcroMed, Inc.). (Incorporated by  reference to dj Orthopedics, Inc.’s Report on Form 10-K for the year ended  December 31, 2003)                                                                                                                                                                             |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| 10.24               |       | Underwriting Agreement,  dated June 2, 2004, by and among dj Orthopedics, Inc., the selling  stockholders named therein and Lehman Brothers Inc., related to the public  offering of 3,072,379 shares of dj Orthopedics, Inc.’s common stock, par  value $0.01 per share, pursuant to dj Orthopedics, Inc.’s Registration  Statement on Form S-3 (Reg. No. 333-115768). (Incorporated by reference to dj  Orthopedics, Inc.’s Report on Form 8-K dated June 4, 2004)                                                        |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| 10.25               |       | First Amendment to  Credit Agreement, dated July 7, 2004, among dj Orthopedics, LLC, dj  Orthopedics, Inc., other Guarantors, Lendors and Wachovia Bank, National  Association, as administrative agent. (Incorporated by reference to dj  Orthopedics, Inc.’s Report on Form 10Q for the quarter ended June 26, 2004)                                                                                                                                                                                                                |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| 10.26               |       | Stock purchase  agreement between dj Orthopedics, LLC and KD Holdings dated as of August 30,  2004. (Incorporated by reference to dj Orthopedics, Inc.’s Report on Form 8-K  dated September 28, 2004)                                                                                                                                                                                                                                                                                                                                |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| 10.27               |       | Lease Agreement between  Professional Real Estate Services, Inc. and dj Orthopedics, LLC, dated  October 20, 2004. (Incorporated by reference to dj Orthopedics, Inc.’s Report  on Form 8-K dated October 26, 2004)                                                                                                                                                                                                                                                                                                                   |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| 10.28               |       | Agreement Regarding  Termination of Leases among Professional Real Estate Services, Inc., dj  Orthopedics, LLC and Smith & Nephew, Inc., dated October 20, 2004.  (Incorporated by reference to dj Orthopedics, Inc.’s Report on Form 8-K dated  October 26, 2004)                                                                                                                                                                                                                                                                |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| 10.29               |       | Second Amendment to  Credit Agreement, dated September 28, 2004, among dj Orthopedics, LLC, dj  Orthopedics, Inc., other Guarantors, Lendors and Wachovia Bank, National  Association, as administrative agent. (Incorporated by reference to dj  Orthopedics, Inc.’s Report on Form 10Q for the quarter ended September 25, 2004)                                                                                                                                                                                                    |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| 10.30*+             |       | Amended and Restated  Sales Representative Agreement, dated January 24, 2005 between dj Orthopedics  LLC (successor to OrthoLogic Corp. with respect to this agreement) and DePuy  Spine, Inc. (formally known as DePuy AcroMed, Inc.).                                                                                                                                                                                                                                                                                                    |

 

84

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| **Exhibit  Number** | ** ** | **Description**                                                                                                                                                          |
|---------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 21.1*               |       | Subsidiaries of the  Registrant                                                                                                                                          |
|                |       |                                                                                                                                                                     |
| 23.1*               |       | Consent of Independent  Registered Public Accounting Firm                                                                                                                |
|                |       |                                                                                                                                                                     |
| 31.1*               |       | Certification of Chief  Executive Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the  Securities Exchange Act, as amended.                                     |
|                |       |                                                                                                                                                                     |
| 31.2*               |       | Certification of Chief  Financial Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the  Securities Exchange Act, as amended.                                     |
|                |       |                                                                                                                                                                     |
| 32.0*               |       | Certification of Chief  Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. 1350, as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |

 

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* Filed herewith

+ Confidential treatmenthas been requested with respect to portions of this exhibit.

 

85

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