**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-K**

 

** (Mark One)**

ý** ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934**

 

**For thefiscal year ended December 31, 2005**

 

**or**

 

**o**** TRANSITION REPORT PURSUANTTO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For thetransition period from                   to                  .**

 

**Commission file number 001-16757**

 

**DJ ORTHOPEDICS, INC.**

(Exact name of Registrant asspecified 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 pursuantto 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 pursuantto Section 12(g) of the Act:

**None**

 

**Indicate by check mark if the Registrant is awell-known seasoned issuer, as defined in Rule 405 of the Securities Act.**

**Yes**o  No ý

 

**Indicate by check mark if the Registrant is not required to filereports pursuant to Section 13 or Section 15(d) of the Act.**

**Yes**o  No ý

 

**Indicate by check mark whether the Registrant (1) hasfiled 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 such shorterperiod that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days.**

**Yes****ý  No****o**

 

**Indicate by check mark if disclosure ofdelinquent filers pursuant to Item 405 of Regulation S-K is not containedherein, and will not be contained, to the best of registrant’s knowledge, indefinitive proxy or information statements incorporated by reference in Part IIIof this Form 10-K or any amendment to this Form 10-K. ****o**

 

**Indicate by check mark whether the Registrant is a large acceleratedfiler, an accelerated filer, or a non-accelerated filer.  See definition of “accelerated filer and largeaccelerated filer” in Rule 12b-2 of the Exchange Act. (Check One):**

 
| **Large  accelerated filer****o** | **Accelerated filer****ý** | **Non-accelerated filer****o** |
|-----------------------------------|---------------------------------|--------------------------------|

** **

**Indicate by check mark whether the Registrant is ashell company (as defined in Rule 12b-2 of the Exchange Act).**

**Yes****o  No****ý**

 

**The aggregate market value of all outstandingcommon equity held by non-affiliates of the Registrant based on the closingprice of common stock as reported on the New York Stock Exchange on July 1,2005 was $494,913,948.**

 

**The number of shares of the Registrant’s commonstock outstanding at February 10, 2006 was 22,190,085 shares.**

 

**Documents Incorporated by Reference**

 

**Portions of the Proxy Statement for the Registrant’s2006 Annual Meeting of Stockholders to be filed with the Commission on orbefore April 30, 2006 are incorporated by reference in Part III ofthis Annual Report on Form 10-K. With the exception of those portions that are specifically incorporatedby reference in this Annual Report on Form 10-K, such Proxy Statementshall not be deemed filed as part of this Report or incorporated by referenceherein.**

 

 

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**DJORTHOPEDICS, INC.**

**FORM 10-K**

**TABLE OFCONTENTS**

 
|       | PART I                                                                                                             |   |
|------------|-------------------------------------------------------------------------------------------------------------------------|--------|
| Item 1.    | Business                                                                                                                |   |
| Item 1A.   | Risk Factors                                                                                                            |   |
| Item 1B.   | Unresolved  Staff Comments                                                                                              |   |
| 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 |                                                                                                                    |

 

***Explanatory Notes***

 

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., andour other wholly-owned and indirect subsidiaries.  When we refer to “we,” “us” and “our” fordates prior to November 20, 2001, the date of our reorganization, theterms are meant to refer to our predecessor, DonJoy, L.L.C.  In November 2003, we acquired the bonegrowth stimulation device business of OrthoLogic Corp. We refer to thisbusiness as our “Regeneration” business, formerly known as our Regentekbusiness, the acquisition as the “Regeneration acquisition” and the products weacquired as our bone growth stimulation (BGS) products.

 

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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***Note on Forward-Looking Information***

 

This annual report on Form 10-K contains, inaddition to historical information, statements by us with respect to ourexpectations regarding future financial results and other aspects of ourbusiness that involve risks and uncertainties and may constituteforward-looking statements within the meaning of Section 27A of theSecurities Act and Section 21E of the Exchange Act.  These statements reflect our current viewsand are based on certain assumptions. Actual results could differ materiallyfrom those currently anticipated as a result of a number of factors, includingmaterial risks discussed under the heading “Risk Factors” in this annualreport.  If the expectations orassumptions underlying our forward-looking statements prove inaccurate or ifrisks or uncertainties arise, actual results could differ materially from thosepredicted 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 2004 to 2005, ourconsolidated revenues grew 11.8% to $286.2 million.

 

Marketed under the DonJoy and ProCare brands, ourbroad range of over 600 rehabilitation products, including rigid knee braces,soft goods and pain management products, are used to prevent injury, to treatchronic conditions and to aid in recovery after surgery or injury.  Our regeneration products consist of bonegrowth stimulation devices that are used to treat nonunion fractures and as anadjunct therapy after spinal fusion surgery.

 

We sell our products in the United States and in morethan 50 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 names, reputationfor quality, 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 arecapitalization pursuant to which J.P. Morgan DJ Partners, LLC obtained acontrolling interest in DonJoy from Smith & Nephew.  Concurrently with the completion of ourinitial public offering on November 20, 2001, DonJoy merged with usthrough a series of transactions.  Ourheadquarters are located at 2985 Scott Street, Vista, California 92081.  Our telephone number is (800) 336-5690.  Our website address is *www.djortho.com*.

 

We file annual reports, such as this Form 10-K,as well as quarterly reports on Form 10-Q and current reports on Form 8-K,with the United States (U.S.) Securities and Exchange Commission (SEC).  We make these reports available free ofcharge 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 2005.

 

4TITUDE®, Defiance®, dj Ortho®,DonJoy®, FourcePointTM, IceMan®, OfficeCare®,ProCare®, SpinaLogic®, UltraSling®, LegendTM,UltraSling ERTM, Knee GuaranteeTM, OL1000TM,OL1000 SCTM, DonJoy Pain Control DeviceTM, VelocityTMand ArcticFlowTM, are certain of our registered trademarks andtrademarks for which we have applications pending or common law rights.  All other brand names, trademarks and servicemarks appearing in this annual report are the property of their respectiveholders.

 

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**OurStrategy**

 

Our strategy is to increase revenue andprofitability and enhance cash flow by strengthening our market leadershipposition.  Our key initiatives toimplement this strategy include:

 

•                       *Increase our Lead in the Domestic RehabilitationMarket Segment.*We believewe are the market leader in the Domestic Rehabilitation markets in which wecompete. We believe we will be able to continue to grow our DomesticRehabilitation business segment and increase our market share further byfocusing on growth initiatives related to maintaining a continuous flow of newproduct introductions and continuing to enhance the productivity of our salesforce and optimize our distribution strategy. Our key Domestic Rehabilitationgrowth strategies include the following:

 

*- Continue to Introduce New Products and Product Enhancements.*  We have ahistory of developing and introducing innovative products into the marketplace,and are committed to continuing that tradition by introducing new productsacross our product platform.  In the yearended December 31, 2005, we launched 30 new products.  We believe that product innovation througheffective and focused research and development will provide a sustainablecompetitive advantage.  We believe we arecurrently a technology leader in several product categories and we intend tocontinue to develop next generation technologies.

 

*- Expand Product Offerings for the Spine and for Foot and Ankle*.  Accordingto Frost & 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 compression back brace to address the spinemarket and we intend to add more products to address this market segment.  In addition, according to Frost &Sullivan, the ankle braces and supports segment of the Domestic Rehabilitationmarket is approximately $226 million in 2005 and offers us an opportunity forfuture growth as our current level of sales in this market segment isrelatively low. In 2005, we launchedour Velocity Ankle, a new rigid ankle brace. This product has been one of ourmost successful new products in recent years. We intend to further expand ourfoot and ankle product offerings. For example, in early 2006, we launched a newfoot orthotic to treat subtle cavus foot.

 

*- Expand Our OfficeCare Channel.*  Our OfficeCare channel currentlyincludes over 850 physician offices encompassing over 3,400 physicians.  We believe that our OfficeCare channel servesa growing need among orthopedic practices to have a number of products readilyavailable for immediate distribution to patients. Expanding our OfficeCarechannel also permits us to increase our weighted-average selling prices, as theunits sold through this channel are billed to insurance companies and otherthird-party payors at higher prices than most of our other sales channels.  Accordingly, our OfficeCare initiativesrepresent an opportunity for sales growth based on increases in both unitvolume and average selling prices.  Weintend to expand our OfficeCare channel into more “high-volume” orthopedicoffices, thereby increasing the number of potential customers to whom we sellour products.  In the year ended December 31,2005, we added approximately 200 new offices to our OfficeCare channel, net ofaccount terminations, including approximately 45 accounts added through ouracquisition of the stock and bill business of Superior Medical Equipment, LLC(SME acquisition).

 

*- Maximize Existing and Secure Additional National Accounts.*  We planto capitalize on the growing practice in healthcare in which hospitals andother large healthcare providers seek to consolidate their purchasingactivities to national buying groups. Contracts with these national accounts represent a significantopportunity for sales growth. We believe that our broad range of products iswell suited to the goals of these buying groups and intend to aggressivelypursue these contracts.  In the yearended December 31, 2005, we signed four new significant nationalcontracts, including a new three-year, multi-source contract with MedAssetsSupply Chain Systems for our soft goods products, and we renewed two othersignificant national contracts.  Inaddition, in connection with our August 2005 acquisition of the orthopedicsoft goods business from Encore Medical L.P. (OSG acquisition), we added onenew significant national contract and increased our penetration into severalother national account opportunities already within our portfolio.

 

•                       *Grow Our Regeneration Business.* We haveintegrated the sales force for our OL1000 bone growth stimulator product intoour domestic rehabilitation sales organization. We have also increased the number of regeneration sales specialistsdedicated to selling our OL1000 product. We believe these specialists will be able to use the established

 

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relationshipsof our DonJoy sales representatives to enhance sales of the OL1000product.  Our distribution arrangementwith DePuy Spine has also become non-exclusive for 2006, which permits us tosell the SpinaLogic product directly or through other independent salesrepresentatives in all territories where we choose to do so.  We intend to add additional selling resourcesin those geographical parts of the country where sales are not meeting ourexpectations.  We believe that our newselling strategies for our Regeneration segment will drive faster growth forthis business.

 

•                       *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. We believe that sales to foreign markets continue torepresent a significant growth opportunity and we intend to continue todevelop direct distribution capabilities in selected additional foreignmarkets.  We also believe we can increaseour international revenues by expanding the number of our products we sell ininternational markets.  Historically wehave only sold a limited range of our products in our internationalmarkets.  In 2005, we successfullylaunched an expanded range of soft goods, our cold therapy products and ourbone growth stimulation products in our International segment.

 

•                       *Pursue Selective Acquisitions.* We believe that acquisitions represent anattractive and efficient means to broaden our product lines, expand ourgeographic reach and increase our revenue. We intend to pursue acquisitionopportunities that enhance sales growth, are accretive to earnings, increasecustomer penetration and/or provide geographic diversity. In the year ended December 31,2005, we completed the SME and OSGacquisitions that meet these criteria as discussed in Note 3 to theconsolidated financial statements included in Item 8 herein. In January 2006,we also completed the acquisition of Newmed SAS (Newmed), as discussed in Note13 to the consolidated financial statements included in Item 8, herein, whichis intended to increase our international revenue in France and other parts ofEurope.

 

**RehabilitationProducts**

 

*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 basic frameswhich are then custom-manufactured to fit a patient’s particular measurements,or are standard braces which are available “off-the-shelf” in various sizes andcan be easily adjusted to fit the patient in the orthopedic professional’soffice.  Sales of rigid knee bracesrepresented approximately 31% of our revenues for 2005.

 

*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-shelfbraces generally designed for use in less rigorous activity.  We offer a Knee Guarantee program inconnection with our Defiance ligament brace. The Knee Guarantee program will,in specified instances, cover a patient’s insurance deductible up to $1,000, orgive uninsured patients $1,000 towards surgery, should an ACL re-injury occurwhile wearing the Defiance ligament brace. We believe that we are the onlyorthopedic company in the United States that provides such a guarantee.  Since we introduced this guarantee, claimsunder the program have been minimal.

 

*Post-operative Braces.*Post-operativebraces are designed to limit a patient’s range of motion after knee surgery andprotect the repaired ligaments and/or joints from stress and strain that wouldslow or prevent a healthy healing process. The products within this lineprovide both immobilization and a protected range of motion, depending on therehabilitation protocol prescribed by the orthopedic surgeon. Ourpost-operative bracing product line includes a range of premium to lower pricedoff-the-shelf braces and accessory products.

 

*Osteoarthritic Braces.*Osteoarthriticbraces are used to treat patients suffering from osteoarthritis of the knee.Our line of customized and off-the-shelf osteoarthritic braces is designed toredistribute weight through the knee, providing additional stability andreducing pain, and in some cases may serve as a cost-efficient alternative tototal knee replacement.  Frost &Sullivan estimates that sales of osteoarthritic braces are expected to growfaster than other categories of rigid knee bracing.

 

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*Soft Goods*

 

Our soft goods product line originally consisted ofsimple neoprene braces for the knee, thigh, elbow and ankle.  We now have over 500 soft goods products thatoffer immobilization and support from head to toe.  In addition, in connection with our August 2005OSG acquisition, we acquired a line of patient safety products and pressurecare products. Our soft goods products represented approximately 42% of our revenuesfor 2005.

 

*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.  We recently introduced theVelocity ankle brace.  The Velocityrepresents an evolution in DonJoy ankle brace technology, utilizing severalnew, proprietary design features.  TheVelocity is a low profile, lightweight ankle brace that prevents abnormal ankleinversion, eversion, and rotation while allowing natural, unrestricted range ofmotion.  The combination of soft goodswith a rigid, hinged foot plate and calf cuff provides enhanced levels ofcontrol, fit, and support.  The Velocityhas been one of our most successful new product introductions in recent years.

 

*Lower Extremity Fracture Boots.*Theseproducts are boots that fit on a patient’s foot and provide comfort andstability for ankle and foot injuries ranging from ankle sprains, soft tissueinjuries and stress fractures in the lower leg to stable fractures of theankle.  Fracture boots are used as analternative to traditional casts. We also sell a line of fracture bootsdesigned for patients suffering from pre-ulcerative and ulcerative footconditions, primarily related to complications from diabetes.

 

*Shoulder and Elbow Braces.*Weoffer a line of shoulder and elbow braces and slings, which are designed forimmobilization after surgery and allow for controlled motion. For example, theUltraSling is a durable oversized sling, which offers immobilization andsupport for mild shoulder sprains and strains. We recently introduced theUltraSling ER that externally rotates the injured shoulder for improved healingof certain conditions.

 

*Patient Safety*.  We offer a variety of patient safety devicesto hospitals and healthcare facilities to accommodate ambulatory andnon-ambulatory patients, including limb positioning devices and wheelchair andbed safety products*.*

 

*Pressure Care Products.*  These products are designed to eliminate thedevelopment of ulcers, which form when blood supply to skin tissue is reducedor cut off by pressure.  Our pressurecare products are constructed with lightweight premium grade material to offerresilience, durability and patient comfort. The products offered within this line are used primarily during or aftersurgical treatment.

 

*Pain Management Products*

 

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 2005.

 

*Cold Therapy Products.**Cold therapy products*aredesigned to *help reduce swelling,minimize the need for post-operative pain medications and generally acceleratethe rehabilitation process. *Wemanufacture, market and sell the IceMan and the ArcticFlow devices, as well asother cold therapy products such as ice packs and wraps. The IceMan product isa portable device used after surgery or injury. The product consists of a durable quiet pump and control system used tocirculate cold water from a reservoir to a pad designed to fit the injuredarea, such as the ankle, knee or shoulder. The IceMan product uses a patentedcirculation system to provide constant fluid flow rates, thereby minimizingtemperature fluctuations. The ArcticFlow product is a manual cold therapyproduct that involves a simple, gravity-based means of applying cold therapy.

 

*Ambulatory Infusion Pumps.**Ambulatory infusion pumps*aredesigned to provide a continuous infusion of local anesthetic dispensed by aphysician directly into a surgical site following surgical procedures.  We are the exclusive North American distributorof a pain management system manufactured by McKinley Medical, LLLP called theDonJoy Pain Control Device.  Thisportable device consists of a range of introducer needles, catheters for easyinsertion and connection during surgery and pumps for continuous infusion forup to 72 hours. The pain control systems are intended to provide direct painrelief, reduce hospital stays and allow earlier and greater ambulation. Ourexclusive distribution rights for this product continue until 2007 and may beextended thereafter.

 

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**Regeneration Products**

 

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.  Approximately 3-5%of fractures become nonunion.  TheSpinaLogic product is used as an adjunct therapy after primary lumbar spinalfusion surgery for at-risk patients. Patients are considered at-risk when the natural healing process of thebone may be compromised by other health conditions of the patient, such asdiabetes, smoking habits, weight, age and the severity and location of thefracture.  Our BGS products accounted forapproximately 19% of our revenues for 2005.

 

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 treatment protocol.  The length of therapy with our productsvaries, but usually is between 25 and 40 weeks.

 

We offer the Technology You Can Trust program inconnection with our BGS products. If a patient has a nonunion fracture thatfails to heal while using a BGS product, the Technology You Can Trust program will,if the patient meets the specified requirements of the program, refund thecosts for treatment using the BGS product. Since the Technology You Can Trust program was introduced, refunds underthis program have been minimal.

 

*OL1000.*  The OL1000 product is a FDA approved devicethat comprises two magnetic field treatment transducers, or coils, and amicroprocessor-controlled signal generator that delivers a highly specific,low-energy signal to the injured area.  Thissignal is designed to stimulate bone growth and healing.  This unique system has a micro-controllerthat tracks the patient’s daily treatment compliance.  The OL1000 is used for the non-invasivetreatment of an established nonunion fracture in all major long bones, such asthe 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.  In2005, we launched our newest design for our SpinaLogic product. The new, moreergonomic design is smaller, lighter and has a gently curved oval shape that conformsto the spine’s anatomy, making it more comfortable than spine bone growthstimulators previously offered by the Company. The new design incorporates the same patented Combined Magnetic Field(CMF) waveform technology that has established SpinaLogic as aconvenient-to-use spinal bone growth stimulator, with a daily treatment time of30 minutes.

 

**Sales, Marketingand Distribution**

 

We distribute our products through four saleschannels: DonJoy, ProCare, OfficeCare and International.  Our DonJoy, ProCare and OfficeCare channelsare managed by regional general managers who are responsible for managing thesale of all of our products across these channels, a general manager who isresponsible for managing the sale of our Regeneration products in the U.S. anda vice president who is responsible for managing the sale of our ProCareproducts in the U.S.  Our internationalchannel consists of sales by our wholly-owned foreign subsidiaries and foreignindependent distributors.  For the yearended December 31, 2005, no single customer represented more than 10% ofour revenues.

 

Our Domestic Rehabilitation segment, which includessales of our rehabilitation products through the DonJoy, ProCare and OfficeCaresales channels discussed below, accounted for approximately 69% of our revenuesfor 2005.  Our Regeneration segment,which includes sales of our regeneration products through the DonJoy saleschannel discussed below, accounted for approximately 19% of our revenues for2005.

 

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*DonJoy*

 

The DonJoy sales channel is responsible forsales of rigid knee braces, pain management products, Regeneration products(effective August 2004) and certain soft goods. The channel consists ofapproximately 300 independent commissioned sales representatives who areemployed by approximately 45 independent sales agents and a few of our directsales representatives and approximately 120 sales representatives dedicated toselling our OL1000 product, of which approximately 60 are employed by us. TheDonJoy channel is primarily dedicated to the sale of our products to orthopedicsurgeons, podiatrists, orthopedic and prosthetic centers, hospitals, surgerycenters, physical therapists, athletic trainers and other healthcareprofessionals.  Because the DonJoyproduct lines generally require customer education on the application and useof the product, our sales representatives are technical specialists who receiveextensive training both from us and the agent and use their expertise to helpfit the patient with the product and assist the orthopedic professional inchoosing the appropriate product to meet the patient’s needs.

 

The SpinaLogic product was, until the end of2004, sold by DePuy Spine in the U.S. under an exclusive sales agreement, whichcan be unilaterally terminated by DePuy Spine with four months notice andexpires by its terms in 2010.  Theagreement required DePuy Spine to meet annual sales minimums in order tomaintain exclusivity.  In January 2005,we amended the agreement with DePuy Spine to divide the U.S. into territoriesin which DePuy Spine had exclusive sales rights and non-exclusive territoriesin which we engaged in our own sales efforts or retained another salesagent.  Commencing early in 2006, theagreement with DePuy Spine became a non-exclusive arrangement for the entireU.S.  This permits us to sell theSpinaLogic product directly or through other independent sales representativesin all territories where we choose to do so.

 

After a sales representative receives aproduct order, we generally ship and bill the product directly to theorthopedic professional, paying a sales commission to the agent. For most BGSproducts and certain custom rigid braces, we sell directly to the patient andbill a third-party payor, if applicable, on behalf of the patient.  We enjoy long-standing relationships withmost of our agents and sales representatives. Under the arrangements with theagents, each agent is granted an exclusive geographic territory for sales ofour products and is not permitted to market products, or represent competitorswho sell or distribute products, that compete with our existing products. Theagents receive a commission, which varies based on the type of product beingsold. If an agent fails to achieve specified sales quotas, we may terminate theagent.

 

*ProCare*

 

The ProCare channel employs approximately 45direct and independent representatives that manage over 310 dealers focused onprimary and acute facilities.  Productsin this channel consist primarily of our soft goods, 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 the emergence of managed careand the formation of buying groups, national purchasing contracts and variousbidding procedures imposed by hospitals and buying groups, we have entered intonational contracts primarily for the sale of soft goods products, but oftenalso covering our other product categories, with large healthcare providers andbuying groups, such as Broadlane, Premier, HealthTrust Purchasing Group,AmeriNet Inc., Novation and US Government/Military hospitals. Under thesecontracts, we provide favorable pricing to the buying group and, as a result,are generally designated a preferred purchasing source for the members of thebuying group for specified products. Members, however, are not obligated to purchase our products. As part ofour strategy, we seek to secure additional national contracts with otherhealthcare providers and buying groups in the future.

 

*OfficeCare*

 

Through OfficeCare, we maintain an inventoryof product (mostly soft goods) on hand at orthopedic practices for immediatedistribution to the patient.  For theseproducts, we arrange billing to the patient or third-party payor after theproduct is provided to the patient. As of December 31, 2005, theOfficeCare program was located at over 850 physician offices throughout theUnited States.  We have contracts withover 700 third-party payors for our OfficeCare products.

 

We currently outsource most of the revenuecycle portion of this program, from billing to collecting, to an independentthird-party contractor. As a result of the growth of this program, our workingcapital needs have increased due to higher levels of accounts receivable andinventories necessary to operate the program. The collection period for thesereceivables as compared to other portions of our business is significantlylonger.

 

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*International*

 

We market our products in over 50 countriesoutside the United States, primarily countries in Europe as well as inAustralia, Canada and Japan. International sales are currently made through twodistinct channels: independent third-party distributors and throughwholly-owned foreign subsidiaries in Germany, the United Kingdom, Canada,France and Denmark. The International sales channel accounted for approximately12% of our revenues for 2005.  Inconnection with our January 2006 acquisition of Newmed, as discussed inNote 13 to the consolidated financial statements included in Item 8 herein, wehave increased the size and scale of our international business. The Newmedacquisition increased our sales and marketing presence in France and through theNewmed subsidiary in Spain, we now have a direct sales presence in Spain.Newmed also adds research and development capabilities in Europe, as well asmanufacturing capabilities in Tunisia.

 

We believe that future opportunities forsales growth within international markets are significant.  To this end, we established our directdistributorship subsidiaries in foreign countries.  These wholly-owned subsidiaries have enabledus to obtain higher gross margins on our products than we would have obtainedon sales through third-party distributors. In addition, we believe that more direct control of the distributionnetwork in these countries will allow us to accelerate the launch of newproducts and product enhancements.

 

**Manufacturing**

 

Nearly all of our rehabilitation products aremanufactured in Tijuana, Mexico.  In August 2004,we completed construction of a new 200,000 square foot leased facility inTijuana, Mexico, to replace three separate facilities we operated in the samearea and to further expand our Mexico manufacturing operations. We increasedthe size of our Mexico facility by another 25,000 square feet in 2005. Our onlyproducts that are still manufactured in Vista, California consist of our customrigid knee bracing products, which remain in the U.S. primarily to facilitatequick turn-around on custom orders, and the assembly and calibration of ourRegeneration product lines which was moved to our Vista facility from Tempe,Arizona in the first quarter of 2005 as the final step of integrating theacquired Regeneration operations.  Withinour Vista and Tijuana facilities, we operate a vertically integratedmanufacturing and cleanroom packaging operation and are capable of producing amajority of our subassemblies and components in-house. These include metalstamped parts, injection molding components and fabric-strapping materials. Wealso have extensive in-house tool and die fabrication capabilities, whichprovide savings in the development of typically expensive tools and molds aswell as flexibility to respond to and capitalize on market opportunities asthey are identified.  In connection withour January 2006 acquisition of Newmed, as discussed in Note 13 to theconsolidated financial statements included in Item 8 herein, we now havemanufacturing capabilities in Tunisia, which, although on a smaller scale, arevery similar to our manufacturing capabilities in Mexico.

 

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 andDevelopment**

 

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 and materials.The research and development team uses computational tools and computer aideddesign, or CAD, systems during the development process that allow a designto be directly produced on computer-based fabrication equipment, reducing bothproduction time and costs. Our current research and development activities arefocused on using new materials, innovative designs and state of the artmanufacturing processes to develop new products and to enhance our existingproducts.

 

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

 

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involved. Our medical advisory board, consisting of five orthopedicsurgeons, also assists in our product development by advising us ontechnological advances in orthopedics, along with competitive and reimbursementupdates within the orthopedic 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 competitive products. We hostnumerous orthopedic professionals at our biomechanical and surgical techniquelaboratories, which allows the professionals to practice procedures and measurethe effectiveness of those procedures.

 

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,diversified orthopedic companies and numerous smaller niche companies. Some ofour competitors 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, Ossur hf. and Townsend Industries Inc. In the softgoods products market, our competitors include Aircast Inc., Biomet, Inc.,DeRoyal Industries, Ossur hf. and Zimmer Holdings, Inc.  In the pain management products market, ourcompetitors include Aircast, I-Flow Corp., Orthofix and StrykerCorporation.  In the nonunion bone growthstimulation market, our competitors include Orthofix, Biomet and Smith &Nephew, and in the spinal fusion market we compete with Biomet and Orthofix.Several competitors have initiated stock and bill programs similar to ourOfficeCare 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 and painmanagement markets is less dependent on innovation and technology and isprimarily based on product range, quality, service and price. Competition inbone growth stimulation devices is more limited as higher regulatory thresholdsprovide a barrier to market entry.  Weestimate that Biomet has dominant shares of the U.S. markets for bone growthstimulation products used both to treat nonunion fractures and as adjuncttherapy after spinal fusion surgery. International competition is primarily from foreign manufacturers whosecosts may be lower due to their ability to manufacture products within theirrespective 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.

 

**IntellectualProperty**

 

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 289U.S. and foreign patents and approximately 108 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 productsusing our “Four Points of Leverage” system in the U.S. accounted forapproximately 14%, 15% and 22% of our historical net revenues for 2005, 2004,and 2003, respectively.  We have securedadditional patents in recent years that cover several component parts orfunctions of our line of knee braces, 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 andosteoarthritic braces.  In addition, weown patents covering a

 

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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 on an exclusive basis covering the combined magnetic fieldtechnology used in our BGS 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.

 

# ***Employees***

 

As of December 31,2005, we had approximately 1,700 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.

 

**GovernmentRegulation**

 

*Medical Device Regulation*

 

*United States. *Ourproducts and operations are subject to regulation by the FDA, state authoritiesand comparable authorities in foreign jurisdictions. Among other things,pursuant to the federal Food, Drug and Cosmetic Act and its implementingregulations, the FDA regulates the research, testing, manufacturing, safety,labeling, storage, recordkeeping, premarket clearance or approval, marketingand promotion, and sales and distribution of medical devices in the United Statesto ensure that medical products distributed domestically are safe and effectivefor their intended uses.  In addition,the FDA regulates the export of medical devices manufactured in the UnitedStates to international markets.

 

Under the Federal Food, Drug, and Cosmetic Act, orFFDCA, medical devices are classified into one of three classes—Class I, Class IIor Class III—depending on the degree of risk associated with each medicaldevice and the extent of control needed to ensure safety and effectiveness.  Our currently marketed rehabilitation productsare 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 regulatory guidelinescalled General Controls, including compliance with the applicable portions ofthe FDA’s Quality System Regulation, or QSR, which sets forth the current goodmanufacturing practices for medical devices, facility registration and productlisting, 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 in order to receive marketingclearance from the FDA.  Premarket reviewand clearance by the FDA for these devices may be accomplished through the510(k) premarket notification procedure. When a 510(k) is required, the manufacturer must submit to the FDA apremarket notification submission demonstrating that the device is “substantiallyequivalent” to either a device that was legally marketed prior to May 28,1976 (the date upon which the Medical Device Amendments of 1976 were enacted)or another commercially available, similar device that was subsequently clearedthrough the 510(k) process.  Byregulation, the FDA is required to respond to a 510(k) premarket notificationwithin 90 days of submission.  As apractical matter, clearances can take significantly longer. If the FDAdetermines that the device, or its intended use, is not “substantiallyequivalent” to a previously-cleared device or use, the FDA will place the device,or the particular use of the device, into Class III, and the devicesponsor must then fulfill more rigorous premarked review 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 IIIdevices cannot be assured solely by the General Controls and the otherrequirements described above.  Thesedevices almost always 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 todemonstrate that the device is safe and effective, must be supported byextensive data, including data from preclinical studies and human clinicaltrials and information on manufacturing and labeling.  The FDA, by statute and regulation, has 180days to review a PMA that is accepted for filing, but review of a PMAapplication often occurs over a significantly longer period of time and cantake up to several years.  In approving aPMA application 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.

 

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A clinical trial is generally required to support aPMA application and is sometimes required for a 510(k) premarketnotification.  These trials generallyrequire submission of an application for an investigational device exemption,or IDE, to the FDA.  The IDE applicationmust be supported by appropriate data, such as animal and laboratory testingresults, showing that it is safe to test the device in humans and that thetesting protocol is scientifically sound. The IDE application must be approved in advance by the FDA for a specifiednumber of patients, unless the product is deemed a non-significant risk deviceand eligible for more abbreviated IDE requirements.  Clinical trials for a significant risk devicemay begin once the IDE application is approved by the FDA and the appropriateinstitutional review boards at the clinical trial sites.

 

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.  The FDA requires eachmanufacturer to make this determination initially, but the FDA can review any suchdecision and can disagree with the manufacturers’ determination. We havemodified various aspects of our devices in the past and determined that newapprovals, clearances or supplements were not required.  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. Also, inthese circumstances, we may be subject to significant regulatory fines andpenalties.

 

Our manufacturing processes and those of our suppliersare required to comply with the applicable portions of the QSR, which coversthe methods and documentation of the design, testing, production, processes,controls, quality assurance, labeling, packaging and shipping of ourproducts.  Our domestic facility recordsand manufacturing processes are subject to periodic unscheduled inspections bythe FDA.  Our Mexican facilities, whichexport products to the United States, may also be inspected by the FDA.  Based on internal audits of our domestic andMexican facilities, we believe that our facilities are in substantialcompliance with the applicable QSR regulations. We also are required to report to the FDA if our products cause or contributeto a death or serious injury or malfunction in a way that would likely cause orcontribute to death or serious injury were the malfunction to recur.  Although medical device reports have beensubmitted in the past 5 years, none have resulted in a recall of our productsor other regulatory action by the FDA. The FDA and authorities in other countries can require the recall ofproducts in the event of material defects or deficiencies in design ormanufacturing.  The FDA can also withdrawor limit our product approvals or clearances in the event of serious,unanticipated health or safety concerns.

 

Even if regulatory approval or clearance of a medicaldevice is granted, the FDA may impose limitations or restrictions on the usesand indications for which the device may be labeled and promoted.  Medical devices may be marketed only for theuses and indications for which they are cleared or approved.  FDA regulations prohibit a manufacturer frompromoting a device for an unapproved, or “off-label” use.

 

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.  We believe that all of ourcurrent products which are exported to foreign countries currently comply withthese restrictions.

 

*International. **In many of the foreign countries in which wemarket our products, we are subject to regulations affecting, among otherthings, product standards, packaging requirements, labeling requirements,import restrictions, tariff regulations, duties and tax requirements.  Many of the regulations applicable to ourdevices and products in such countries are essentially similar to those of theFDA, 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 legislative bodies ofthe European Union have adopted directives in order to harmonize nationalprovisions regulating the design, manufacture, clinical trials, labeling andadverse event reporting for medical devices and the member states of theEuropean Economic Area have implemented the directives into their respectivenational law.  Medical*

* *

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*devices that comply with the essential requirementsof the national provisions and the directives will be entitled to bear a CEmarking.  Unless an exemption applies,only medical devices which bear a CE marking may be marketed within theEuropean Economic Area.  The EuropeanCommission has adopted numerous guidelines relating to the medical devicesdirectives to ensure their uniform application. The method of assessing conformity varies depending on the class andtype of the medical device and can involve a combination of self-assessment bythe manufacturer and a third-party assessment by a Notified Body, which is anindependent and neutral institution appointed by the member states to conductthe conformity assessment.  Thisthird-party assessment may consist of an audit of the manufacturer’s qualitysystem and specific testing of the manufacturer’s devices.  An assessment by a Notified Body in onecountry within the European Economic Area is generally required in order for amanufacturer to commercially distribute the product throughout the EuropeanEconomic Area.*

 

*TheEuropean Standardization Committees have adopted numerous harmonized standardsfor specific types of medical devices. Compliance with relevant standards establishes the presumption ofconformity with the essential requirements for a CE marking.  Our quality system relating to the development,production and distribution of rigid and soft orthopedic bracing, cold therapyand regeneration products is certified to international standards through September 28,2008 for our facilities in Vista, California and Tijuana, Mexico.  Our regeneration, sterile cold therapy padsand CCMI (leg contour measuring devices and angle reference bending tools) inour facilities in Vista, California have been certified and the existingcertificates have been or are in the process of being extended. The existingcertificate remains valid until the issue of a new certificate.*

 

*In manycountries, the national health or social security organizations require ourproducts to be qualified before they can be marketed with the benefit ofreimbursement eligibility.  To date, wehave not experienced difficulty in complying with these regulations.  Due to the movement towards harmonization ofstandards in the European Union, we expect a changing regulatory environment inEurope characterized by a shift from a country-by-country regulatory system toa European Union-wide single regulatory system.  The timing of this harmonization and itseffect on us cannot currently be predicted.*

 

*Federal Privacy and Transaction Law and Regulations*

 

Other federal legislationrequires major changes in the transmission and retention of health informationby us.  The Health Insurance Portabilityand Accountability Act of 1996, or HIPAA, mandates, among other things, theadoption of standards for the electronic exchange of health information thathas required significant and costly changes to prior 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 tocertain healthcare transactions and health information.  The first rule requires the use ofuniform standards for common healthcare transactions, including healthcareclaims information, plan eligibility, referral certification and authorization,claims status, plan enrollment and disenrollment, payment and remittanceadvice, plan premium payments, and coordination of benefits. The second rule releasedby HHS imposes new standards relating to the privacy of individuallyidentifiable health information. These standards not only require our compliancewith rules governing the use and disclosure of protected healthinformation, but they also require us to obtain satisfactory assurances thatany business associate of ours to whom such information is disclosed willsafeguard the information. The third rule released by HHS establishesminimum standards for the security of electronic health information. We wererequired to comply with the transaction standards by October 16, 2003 andthe privacy standards by April 14, 2003, and were required to comply withthe security standards by April 21, 2005.

 

*Third-Party Reimbursement*

 

*Ourproducts generally are prescribed by physicians and are eligible forthird-party reimbursement. An important consideration for our business iswhether third-party payment amounts will be adequate, since this is a factor inour customers’ selection of our products. We believe that third-party payors will continue to focus on measures tocontain or reduce their costs through managed care and other efforts.  Medicare policies are important to ourbusiness because third-party payors often model their policies after theMedicare program’s coverage and reimbursement policies.*

 

Healthcare reform legislation in the Medicare area hasfocused on containing healthcare spending. For example, the MedicarePrescription Drug, Improvement and Modernization Act of 2003, or theModernization Act, provides for revisions to payment methodologies and otherstandards for items of durable medical equipment and orthotic devices under theMedicare program.  First, beginning in2004 through 2008, the payment amounts for orthotic devices (2004 through 2006)and durable medical equipment (2004 through 2008) will no longer be increasedon an annual basis.  The freeze does notaffect Class III devices such as bone growth stimulators, however.  Second, a competitive bidding program isscheduled to be phased in to replace the existing fee schedule paymentmethodology beginning in 2007.  Under theModernization Act, off-the-shelf orthotic devices and other non-Class IIIdevices are subject to the program.  Thecompetitive bidding program is scheduled to begin in ten high populationmetropolitan statistical areas and in 2009 is to be expanded to 80 metropolitanstatistical 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 byindependent

 

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accreditation organizations.  InSeptember 2005, the Centers for Medicare and Medicaid Services, or CMS, whichis the agency that administers the Medicare program, published draft supplierquality standards.  The draft standardsconsist of business-related standards, such as financial and human resourcesmanagement standards, which would be applicable to all durable medicalequipment, orthotics and prosthetics suppliers, and product-specific standards,such as those for customized orthotics products, which focus on productspecialization and service standards for such items. CMS has stated that itexpects to release the final supplier quality standards in Spring 2006.  Fourth, clinical conditions for payment willbe established for certain products. Fifth, the Modernization Act mandated that the Government AccountabilityOffice (GAO) make a recommendation to Medicare in 2006 regarding the 2007 fee schedule updatefor bone growth stimulators.  In 2005,the GAO gathered information from bone growth stimulator manufacturers todevelop 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.

 

On February 11, 2003, the Centers for Medicare and MedicaidServices, or CMS, made effective an interim final regulation implementing ‘‘inherentreasonableness’’ authority, which allows the agency and contractors to adjustpayment amounts by up to 15% per year for certain items and services when theexisting payment amount is determined to be grossly excessive or grosslydeficient.  CMS may make a largeradjustment each year if it undertakes prescribed procedures.  The Modernization Act, clarified that the useof inherent reasonableness authority is precluded for devices provided undercompetitive bidding.  CMS finalized theinherent reasonableness regulation in December 2005, with an effectivedate of February 10, 2006, essentially keeping in place the policies inthe interim final regulation. We do not know what impact inherentreasonableness and competitive bidding will 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 32%, 31% and 19% of ourhistorical net revenues for the years ended December 31, 2005, 2004 and2003, respectively.  Medicarereimbursement consisted of approximately 14% of our historical net revenuesfrom third-party reimbursement or approximately 4% of our total historical netrevenues for the year ended December 31, 2005.

 

*Fraud and 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 and Fraud Laws. *Our operations aresubject 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 adopted prohibitionssimilar to the Medicare Fraud and Abuse Statute, some of which apply to thereferral of patients for healthcare services reimbursed by any source, not onlyby 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.  Inconjunction with the OfficeCare program, we may pay participating physicians afee for rental space and support services provided by such physicians tous.  In a Special Fraud Alert issued byHHS’ Office of Inspector General, or OIG, in February 2000, the OIGindicated that it may scrutinize stock and bill programs involving excessive

 

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rental payments or rental space for possible violation of the MedicareFraud and Abuse Statute, but noted that legitimate arrangements, including fairmarket value rental arrangements, will not be considered violations of thestatute.  We believe we have structuredthe OfficeCare program 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.  Thisstatute applies to any health benefit plan, not just Medicare andMedicaid.  Additionally, HIPAA grantedexpanded enforcement 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.

 

*Physician Self-Referral Laws. *We are also subjectto 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 to anunlawful referral, and any person collecting any amounts in connection with anunlawful 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.  The penaltiesfor violating the Stark Law also include civil monetary penalties of up to$15,000 per referral and possible exclusion from federal healthcare programssuch as Medicare and Medicaid.  Variousstates have corollary laws to the Stark Law, including laws that requirephysicians to disclose any financial interest they may have with a healthcareprovider to their patients when referring patients to that provider.  Both the scope and exceptions for such lawsvary from state to state.

 

*False Claims Laws. *Under separate statutes, submission of claimsfor payment that are “not provided as claimed” may lead to civil moneypenalties, criminal fines and imprisonment, and/or exclusion from participationin Medicare, Medicaid and other federally funded state health programs.  These false claims statutes include thefederal False Claims Act, which prohibits the knowing filing of a false claimor the knowing use of false statements to obtain payment from the federalgovernment.  When an entity is determinedto have violated the False Claims Act, it must pay three times the actualdamages sustained by the government, plus mandatory civil penalties of between$5,500 and $11,000 for each separate false claim.  Suits filed under the False Claims Act, knownas “qui tam” actions, can be brought by any individual on behalf of thegovernment and such individuals (known as “relators” or, more commonly, as “whistleblowers”)may share in any amounts paid by the entity to the government in fines orsettlement.  In addition, certain stateshave enacted laws modeled after the federal False Claims Act.  Qui tam actions have increased significantlyin recent years, causing greater numbers of healthcare companies to have todefend a false claim action, pay fines or be excluded from the Medicare,Medicaid or other federal or state healthcare programs as a result of aninvestigation arising out of such action.

 

*Governmental Audits*

 

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.

 

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**Item 1A. Risk Factors**

 

*Our ability to achieve our operating andfinancial goals is subject to a number of risks, including risks relating toour business operations, our debt level and government regulations.  If any of the following risks actually occur,our business, operating results, prospects or financial condition could bematerially and adversely affected.  Therisks described below are not the only ones that we face. Additional risks notpresently known to us or that we currently deem immaterial may also affect ourbusiness operations.*

 

***Risks Related to Our Business***

 

**Prior to the Regenerationacquisition, we did not have experience operating in the regeneration segmentof the non-operative orthopedic 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 and the third-party payor coverage andreimbursement issues are more complex than in our traditional rehabilitationmarkets.  In addition, the products weacquired from OrthoLogic are subject to Class III Food and DrugAdministration, or FDA, review.  Thislevel of review is more stringent than that required for our rehabilitationproducts.

 

In addition, we have made significant changes andadditions to the sales force for the BGS products as compared to the salesforce in place at the time of the Regeneration acquisition.  With respect to the OL1000, we have hired andtrained a significant number of new sales specialist and introduced the productto our DonJoy direct distribution sales force. At the time of the Regeneration acquisition, DePuy Spine was acting asthe exclusive distributor of the SpinaLogic device in significant portions ofthe U.S.  The agreement with DePuy Spinewas amended in 2005 to make certain territories non-exclusive and commencingearly in 2006, will become a non-exclusive arrangement for the U.S.  We have begun developing alternative sellingresources for SpinaLogic and will continue that effort, but prior to theRegeneration acquisition, we did not have any relationships with spine surgeonsor with independent distributors who specialize in spine products.  The different nature of the Regenerationbusiness from our traditional rehabilitation business and the significantchanges we have made and will be required to make to the Regeneration salesforce could involve risks to our business such as the following:

 

•                       We may have difficulty trainingand retaining the number of product specialists we will need to grow the OL1000and SpinaLogic business. To date, we have experienced, and may continue toexperience, relatively high turnover among our Regeneration sales specialistsand sales managers, which can lead to disruption of customer relations andincreased training time and costs;

 

•                       In those areas of the countrywhere we will need to supplement the DePuy Spine distributors, we may not beable to develop a network of distributors who can effectively market and sellthe SpinaLogic product to spine surgeons;

 

•                       Our existing customers may nothave a need for bone growth stimulation products or may have existingrelationships with our competitors for similar products;

 

•                       Our prior experience in billingMedicare is limited, and we may encounter difficulties in processing the higher                   levelof Medicare claims in the Regeneration business as compared to our otherbusinesses; and

 

•                       Competitive products ortechnologies in fracture repair or spinal fusion surgery may undermine oursales and profitability goals.

 

As a result of these factors, wecannot assure you that we will be successful in operating in the regenerationsegment of the non-operative orthopedic and spine markets.

 

**Changes in the regulatory status of our BGSproducts could adversely affect the operations and financial results of ourRegeneration business.**

 

Earlier in 2005 a petition was filed with theUS Food and Drug Administration (“FDA”) seeking to reclassify non-invasive bonegrowth stimulator devices from Class III to Class II.  Although our BGS products that utilizecombined magnetic field technology were subsequently excluded from thepetition, if the petition were to succeed, new market entrants could seek clearanceof a BGS device through the 510(k) process (as opposed to the PMA process).This would likely increase competition

 

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from new products in the electrical bone growth stimulation devicebusiness which could result in downward price pressures on our products andbusiness.  In addition, the medicalcommittee responsible for providing advice on coverage matters to Medicare helda meeting during 2005 for the purpose of, among other things, considering theeffectiveness of products such as our BGS products on healing nonunionfractures among the Medicare patient population.  We have actively opposed the granting of thepetition to the FDA to reclassify BGS products, and we have providedinformation to the Medicare advisory committee on the clinical data oneffectiveness of our BGS products. Although it has not sought to do so, CMS, which is responsible forMedicare coverage determinations, may decide to re-evaluate current coveragepolicies in a way that restrict payment for our BGS products. We cannot becertain of the outcome of either regulatory matter, and an adverse outcome oneither such matter could impact our ability to grow sales and realize profitsin our Regeneration business. Furthermore, we cannot be sure that other regulatory changes will not beproposed or implemented that adversely impact our Regeneration business.  See additional risk factors under the heading“Risks Relating to Government Regulation” below.

 

**We intend to pursue, but may not be able toidentify, finance or successfully complete, strategic acquisitions.**

 

One element of our growthstrategy is to pursue acquisitions, both domestically and, in particular,internationally.  We may not be able toidentify acceptable opportunities or complete acceptable acquisitions oftargets identified in a timely manner. Acquisitions involve a number of risks, including the following:

 

•                       Our management’s attention will be divertedfrom our existing business while evaluating acquisitions and thereafter whileintegrating the operations and personnel of the new business into our business;

 

•                       We may experience adverse short-term effectson our operating results;

 

•                       We may be unable to successfully and rapidlyintegrate the new businesses, personnel and products with our existingbusiness, including financial reporting, management and information technologysystems;

 

**•****                      **We may experience higher than anticipatedcosts of integration and unforeseen operating difficulties and expenditures;

 

**•****                      **An acquisition may be in a market orgeographical area in which we have little experience;

 

•                       We may have difficulty in retaining keyemployees, including employees who may have been instrumental to the success orgrowth of the acquired business; and

 

•                       We may use a substantial amount of our cashand other financial resources to consummate an acquisition.

 

In addition, we may requireadditional debt or equity financing for future acquisitions, and such financingmay not be available or on favorable terms, if available at all.  We may not be able to successfully integrateor operate profitably any new business we acquire, and we cannot assure youthat any such acquisition will meet our expectations.  Finally, in the event we decideto discontinue pursuit of a potential acquisition, we will be required toimmediately expense all costs incurred in pursuit of the possible acquisitionthat could have an adverse effect on our results of operations in the period inwhich the expense is recognized.

 

**If we do not effectively manageour growth, our existing infrastructure may become strained, and we may beunable to increase sales of our products or generate revenue growth.**

 

The growth that we have experienced, and in the futuremay experience, may provide challenges to our organization, requiring us toexpand our personnel, manufacturing and distribution operations.  Future growth may strain our infrastructure,operations, product development and other managerial and operating resources.  If our business resources become strained, wemay be unable to increase sales of our products or generate revenue growth.

 

**We have outsourced certainadministrative functions relating to our OfficeCare sales channel to athird-party contractor and 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.  Weoutsource the revenue cycle of this program, from billing to collections, to anindependent third-party

 

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contractor. This provider may not remain successful in achieving ormaintaining our billing and collections goals and there can be no assurancethat we will not have to resume these administrative functions in the future.

 

**We rely onintellectual property to develop and manufacture our products and our businesscould be adversely affected if and when we lose our intellectual propertyrights.**

 

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 expired in January 2005. Revenues generated from the sale ofproducts in the U.S. using our “Four Points of Leverage” system representedapproximately 14%, 15% and 22% of our historical net revenues for 2005, 2004and 2003, 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 competitorsmay 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;

 

•                       osteoarthriticbracing 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 proprietaryinformation. However, these methods may not provide us with adequateprotection. Our proprietary information may become known to, or beindependently developed by, competitors, or our proprietary rights in intellectualproperty may be challenged, any of which could have an adverse effect on ourbusiness.

 

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**If we are not ableto develop, license or acquire and market new products or product enhancementswe may 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 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 onour relationships with orthopedic professionals who prescribe and dispense ourproducts and our failure to maintain these relationships could adversely affectour 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 support and recommendour products.  Failure of our products toretain the support of these surgeons and specialists, or the failure of ourproducts to secure and retain similar support from leading surgeons andspecialists, could have an adverse effect on our business.

 

**The majorityof our sales force consists of independent agents and distributors who maintainclose relationships with our hospital and physician customers.**

 

Our success also depends largely upon arrangementswith independent agents and distributors and their relationships with ourhospital and physician customers in the marketplace. These agents anddistributors are not our employees, and our ability to influence their actionsand performance is limited.  Ourinability to effectively manage these agents and distributors or our failuregenerally to maintain relationships with these independent agents anddistributors could have an adverse effect on our business.

 

**We operate in avery competitive 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 of corporate groups that have significantly greater financial, marketingand 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, Ossur hf. and Townsend Industries Inc.  Our competitors in the soft goods productsmarket include Aircast Inc., Biomet, Inc., DeRoyal Industries, Ossur hf.and Zimmer Holdings, Inc.  Ourprimary competitors in the pain management products market include Aircast, I-FlowCorp., 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 sellbone growth stimulation products for use by spinal fusion patients.  We estimate that Biomet has dominant sharesof the U.S. markets for bone growth stimulation products used both to treatnonunion fractures and as adjunct therapy after spinal fusion surgery.

 

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**Our quarterlyoperating results are subject to substantial fluctuations and you should notrely on them as 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 our productson 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 futureperiods or that we will be profitable in any future period.

 

**Our business planrelies on certain assumptions for the market for our products, which, ifincorrect, 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 led to increased injuries, especially among women; and

 

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

 

**These demographics and trends arebeyond our control.  The projected demandfor our products 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.**

 

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**Our business,operating results and financial condition could be adversely affected if webecome involved in litigation regarding our patents or other intellectualproperty rights.**

 

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 property suits,USPTO interference proceedings or the foreign equivalents thereto and relatedlegal and administrative proceedings are both costly and time consuming. Anadverse determination in litigation or interference proceedings to which we maybecome 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 limitedsuppliers for some of our components and products which makes us susceptible tosupply shortages 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 2005, we obtainedapproximately 10% 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 OL1000â and SpinaLogicdevices from a single manufacturer. Although there are feasible alternatemicroprocessors that might be used immediately, all are produced by a singlesupplier.  In addition, there are singlesuppliers for other components used in the OL1000 and SpinaLogic devices andonly two suppliers for the magnetic field sensor employed in them.  Establishment of additional or replacementsuppliers for these components cannot be accomplished quickly.

 

**Our internationalsales and 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 2005, 2004 and 2003 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 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

 

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shipping, currency fluctuations, difficulties in staffing and managinginternational operations, labor disputes, difficulties in collecting accountsreceivable and longer collection periods and potentially adverse taxconsequences.  For example, in Germany,our largest foreign market, orthopedic professionals began re-using our bracingdevices on multiple patients during 2004, which adversely impacted our sales ofthese devices in this market in 2004.  Aswe continue to expand our international business, our success will bedependent, in part, on our ability to anticipate and effectively manage theseand other risks.  If we are unable to doso, these and other factors may have an adverse effect on our internationaloperations.

 

**The directdistribution of our products in selected foreign countries involves financialand operational risks.**

 

**We have implemented a strategy toselectively replace our third-party international distributors withwholly-owned distributorships.  In 2002,we began to distribute our products in Germany/Austria, the United Kingdom andCanada through wholly-owned subsidiaries. We established a wholly-owned distributorship in France in September 2003and one in the Nordic countries in August 2004.  The creation of direct distributioncapabilities in foreign markets requires additional financial and operationalcontrols.  We cannot assure you that wewill be able to successfully maintain organizational controls in our foreignoperations or that our international strategy will result in increased revenuesor profitability.**

 

**Our concentrationon manufacturing operations in North America may cause our products to be lesscompetitive in international markets.**

 

Other than a relatively small manufacturing operationin Tunisia acquired in the recent Newmed acquisition, we have no manufacturingoperations in any foreign country other than Mexico. For our internationalsales to third-party distributors, the cost of transporting our products toforeign countries is currently borne by our third-party distributors who arealso often required to pay foreign import duties on our products. As a result,the cost of our products to our third-party distributors is often greater thanproducts manufactured 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 expand 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 liabilityclaims may harm our business if our insurance proves inadequate or the numberof claims 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.

 

**We maybe adversely affected if we lose the services of any member of our seniormanagement team.**

 

**We are dependent on the continuedservices of our senior management team, who have made significant contributionsto our growth and success.  Leslie H.Cross, our President and Chief Executive Officer, for example, has worked forus for 16 years and helped lead our 1999 recapitalization and transition fromownership by Smith & Nephew to a stand-alone company.  The loss of any one or more members of oursenior management team could have a material adverse effect on us.**

 

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**Any claimsrelating to our improper handling, storage or disposal of wastes could be timeconsuming and costly.**

 

**Our facilities and operations aresubject to federal, state and local environmental and occupational health andsafety requirements 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 orman-made disaster strikes our manufacturing facilities, we will be unable tomanufacture our products for a substantial amount of time and our sales willdecline.**

 

Nearly all of our rehabilitation products aremanufactured in our new facility in Tijuana, Mexico, with a number of productsfor the European market manufactured in our recently-acquired Tunisianfacility.  The products that are stillmanufactured in Vista, California consist of our custom rigid bracing products,which remain in the U.S. to facilitate quick turn-around on custom orders andthe Regeneration product line. These facilities and the manufacturing equipmentwe use to produce our products would be difficult to repair or replace.  Our facilities may be affected by natural orman-made disasters.  If one of ourfacilities were affected by a disaster, we would be forced to rely onthird-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 havevarious mechanisms in place to discourage takeover attempts, a change incontrol of our company that a stockholder may consider favorable could beprevented.**

 

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 owns or within the last three yearshas owned 15% of the corporation’s voting stock, for a period of three yearsafter the date of the transaction in which the person became an interestedstockholder, unless the business combination is approved in a prescribedmanner. Accordingly, Section 203 may discourage, delay or prevent a changein 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.

 

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***Risks Related to Government Regulation***

 

**Our failure tocomply with regulatory requirements or receive regulatory clearance or approvalfor our products or operations in the United States or abroad would adverselyaffect our revenues and potential for future growth.**

 

Our products are medical devices that aresubject to extensive regulation in the United States by the Food and DrugAdministration, or FDA, and by respective authorities in foreign countrieswhere we do business.  The FDA regulatesvirtually all aspects of a medical device’s design and testing, manufacture,safety, labeling, storage, recordkeeping, reporting, clearance and approval,promotion and distribution.  The FDA alsoregulates the export of medical devices to foreign countries.  Failure to comply with the regulatoryrequirements of the FDA and other applicable U.S. regulatory requirements maysubject a company to administrative or judicially imposed sanctions rangingfrom warning letters to criminal penalties or product withdrawal. Unless anexemption applies, a medical device must receive either clearance or premarketapproval from the FDA before it can be marketed in the United States.  The FDA’s 510(k) clearance process for Class IIdevices usually takes from three to twelve months, but may take significantlylonger.  The premarket approval processfor Class III devices generally takes from one to three years from thetime the application is filed with the FDA, but also can be significantlylonger.  Premarket approval typicallyrequires extensive clinical data and can be significantly longer, moreexpensive and more 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.

 

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.  We havemodified various aspects of our devices in the past and we determined that newapprovals, supplements or clearances either were not required.  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.

 

Our failure to obtain FDA clearance or approvals ofnew products, new indications or product modifications that we develop in thefuture, 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.

 

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.  Due to the movement towardsharmonization of standards in the European Union and the expansion of theEuropean Union, we expect a changing regulatory environment in Europecharacterized by a shift from a country-by-country regulatory system to aEuropean Union-wide single regulatory system. Failure to receive, or delays inthe receipt of, relevant foreign qualifications, such as the CE marking, couldhave a material adverse effect on our international operations.

 

**Our products aresubject to recalls even after receiving FDA clearance or approval, or afterreceiving CE-markings, which would harm our reputation and business.**

 

We are subject to medical device reporting regulationsthat require us to report to the FDA or governmental authorities in othercountries if our products cause or contribute to a death or serious injury ormalfunction in a way that would be reasonably likely to contribute to death orserious 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 in design or manufacturing, andwe have been subject to product recalls in the past.  A government mandated, or voluntary, recallby us could occur as a result of component failures, manufacturing errors ordesign defects, including defects in labeling. Any recall would

 

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divert managerial and financial resources and could harm our reputationwith customers.  There can be noassurance that there will not be product recalls in the future or that suchrecalls would not have a material adverse effect on our business.

 

**If we fail tocomply with the FDA’s Quality System Regulation, our manufacturing could bedelayed, and our product sales and profitability could suffer.**

 

Our manufacturing processes are required to comply with the FDA’sQuality System Regulation, which covers the procedures concerning (anddocumentation of) the design, testing, production processes, controls, qualityassurance, labeling, packaging, storage and shipping of our devices.  We also are subject to state requirements andlicenses 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 Regeneration products and the products soldthrough our OfficeCare program, we submit claims to third-party payors for reimbursement.Our ability to sell our products successfully will depend in part on thepurchasing and practice patterns of healthcare providers and physicians, whoare influenced by cost containment measures taken by third-party payors.  Limitations or reductions in third-partyreimbursement for our products can have a material adverse effect on our salesand profitability.

 

Congress and state legislatures consider reforms inthe healthcare industry that may modify reimbursement methodologies andpractices, including controls on healthcare spending of the Medicare andMedicaid programs.  It is not clear atthis time what proposals, if any, will be adopted or, if adopted, what effectthe proposals 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.  These changesinclude a freeze in reimbursement levels 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 stimulatordevices, for example, are not affected by the reimbursement level freeze andare not subject to competitive bidding. Off-the-shelf orthotic devices are subject to competitive bidding. Undercompetitive bidding, which is scheduled to be phased in beginning in 2007,Medicare will change its approach to reimbursing certain items and servicescovered by Medicare from the current fee schedule amount to an amountestablished through a bidding process between the government andsuppliers.  Competitive bidding mayreduce the number of suppliers providing certain items and services to Medicarebeneficiaries and the amounts paid for such items and services.  Also, Medicare payments in regions notsubject to competitive bidding may be reduced using payment information fromregions 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, CMS madeeffective an interim final regulation implementing “inherent reasonableness”authority, which allows adjustments to payment amounts for certain items andservices covered by Medicare when the existing payment amount is determined tobe grossly excessive or grossly deficient. The regulation lists factors that may be used to determine whether anexisting reimbursement rate is grossly excessive or grossly deficient and todetermine what is a realistic and equitable payment amount.  Also, under the regulation, a payment amountwill not be considered grossly excessive or

 

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grossly deficient if an overall payment adjustment of less than fifteenpercent would be necessary to produce a realistic and equitable paymentamount.  The Modernization Act clarifiedthat the use of inherent reasonableness authority is precluded for devicesprovided under competitive bidding.  CMSfinalized the inherent reasonableness regulation in December 2005, with aneffective date of February 10, 2006, essentially keeping in place thepolicies in the interim final regulation. When using the inherent reasonableness authority, CMS may reducereimbursement levels for certain items and services, which could have amaterial 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 ininternational regulations regarding reimbursement for our products couldadversely affect our business 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. Anydevelopments in our foreign markets that eliminate or reduce reimbursementrates for our products could have an adverse effect on our ability to sell ourproducts or cause our orthopedic professional customers to use less expensiveproducts in these markets.

 

**Medicare lawsmandating new supplier quality standards and conditions for coverage couldadversely impact our business.**

 

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, such as bonegrowth stimulators, and orthotics and that has a supplier number for submissionof such bills will be subject to new quality standards as a condition ofreceiving payment from the Medicare program. In September 2005, CMS published draft supplier quality standards.  The draft standards consist ofbusiness-related standards, such as financial and human resources managementstandards, which would be applicable to all durable medical equipment,orthotics and prosthetics suppliers, and product-specific standards, such asthose for customized orthotics products, which focus on product specializationand service standards for such items. CMS has stated that it expects to releasethe final supplier quality standards in Spring 2006.  The Modernization Act also authorizes CMS toestablish clinical conditions for payment for durable medical equipment.  These new supplier quality standards andclinical conditions for payment could affect our ability to bill Medicare,limit or reduce the number of individuals who can fit, sell or provide ourproducts and could restrict coverage for our products.

 

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

 

The development of managed care programs in which theproviders contract to provide comprehensive healthcare to a patient populationat a fixed cost per person (referred to as capitation) has put pressure on, andis expected to continue to cause, healthcare providers to lower costs.  One result has been, and is expected tocontinue to be, a shift toward lower priced products, and any such shift in ourproduct mix to lower margin, off-the-shelf products could have an adverseimpact on our operating results.  Forexample, in our rigid knee-bracing segment, we and many of our competitors areoffering lower priced, off-the-shelf products in response to managed carecustomers.

 

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

 

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not deliver high levels of compliance, we may not be able to offset thenegative impact of lower per unit prices or lower margins with any increases inunit sales or in market share.

 

In international markets, we have experienced downwardpressure on product pricing and other effects of healthcare reform similar tothat which we have experienced in the United States.  We expect healthcare reform and managed careto continue to develop in our primary international markets, which we expectwill result in further downward pressure in product pricing.  The timing and effects on us of healthcarereform and the development of managed care in international markets cannotcurrently be predicted.

 

**Proposed laws thatwould limit 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 or sell our orthotic device products or who can seek reimbursement forthem.  Several states have adoptedlegislation which imposes certification or licensing requirements on themeasuring, fitting and adjusting of certain orthotic devices.  Some of these laws have exemptions formanufacturers’ representatives.  Otherlaws apply to the activities of such representatives.  Other states may be considering similarlegislation.  Such laws could limit ourpotential customers in those jurisdictions in which such legislation orregulations are enacted by limiting the measuring and fitting of these devicesto certain licensed individuals.  We maynot be successful in opposing their adoption and, therefore, such laws couldhave a material adverse effect on our business. In addition, efforts have beenmade to establish such requirements at the federal level for the Medicareprogram.  For example, in 2000 Congresspassed the Medicare, Medicaid, and SCHIP Benefits Improvement and ProtectionAct of 2000 (BIPA).  BIPA contained aprovision requiring as a condition for payment by the Medicare program thatcertain certification or licensing requirements be met for individuals andsuppliers furnishing certain, but not all, custom-fabricated orthoticdevices.  CMS has not implemented thisrequirement.  We cannot predict theeffect of implementation of BIPA or implementation of other such laws will haveon our business.

 

**We may need tochange our business practices to comply with healthcare fraud and abuse lawsand regulations.**

 

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, imprisonment and exclusion from participation in federal andstate healthcare programs, including Medicare, Medicaid, VeteransAdministration health programs and TRICARE. Because of the far-reaching nature of these laws, we may be required toalter one or more of our practices. Healthcare fraud and abuse regulations are complex and even minor,inadvertent irregularities in submissions can potentially give rise to claimsthat a fraud and abuse law or regulation has been violated.  Any violations of these laws or regulationscould result in a material adverse effect on our business, financial conditionand results of operations.  If there is achange in law, regulation or administrative or judicial interpretations, we mayhave to change our business practices or our existing business practices couldbe challenged as unlawful.

 

**Audits or denialsof our claims by government agencies could reduce our revenue or profits.**

 

As part of our business structure, we submitclaims directly 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 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.

 

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***Risks Related to our Debt***

 

**Our debtagreements contain operating and financial restrictions, which restrict ourbusiness and financing 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:

 

•                       we are not in default under thecredit agreement;

 

•                       after giving pro forma effect tothe transaction, we remain in compliance with the financial covenants containedin the credit agreement;

 

•                       if the acquisition price isgreater than $10 million, the company we are acquiring has positive EBITDA;

 

•                       the acquisition price is lessthan $50 million individually and less than $75 million in the aggregate withall other permitted acquisitions consummated during the term of the creditagreement; and

 

•                       if the acquisition involvesassets outside the United States, the acquisition price is less than $25million in the aggregate with all other permitted acquisitions consummatedoutside the United States 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.

 

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 creditagreement, the lenders could elect to declare all amounts outstanding under thecredit agreement, together with accrued interest, to be immediately due andpayable. If we were unable to repay those amounts, the lenders could proceedagainst the collateral granted to them to secure such indebtedness. If thelenders under the credit agreement accelerate the payment of the indebtedness,there can be no assurance that our assets would be sufficient to repay in fullsuch indebtedness and our other indebtedness.

 

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**We may not be able to generatesufficient cash to service our indebtedness, which could require us to reduceour expenditures, sell assets, restructure our indebtedness or seek additionalequity 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.

 

**Item 1B. Unresolved Staff Comments**

 

We havereceived no written comments from the Commission staff regarding our periodicor current reports under the Exchange Act of 1934 less than 180 days before theend of our fiscal year ended December 31, 2005 that remain unresolved.

 

**Item 2. Properties**

 

We areheadquartered in Vista, California and operate manufacturing locations inVista, California and Tijuana, Mexico. We are party to a 15-year lease for a 110,000square foot built-to-suit facility which is under construction in Vista,California, and we intend to consolidate our Vista operations in that facilitywhen completed, which is estimated to be in July 2006. Our manufacturingfacilities located in Tijuana, Mexico are less than 100 miles from Vista andconsist of a 225,000 square foot built-to-suit factory which we occupied inlate 2004.  We lease a distributionfacility in Indianapolis, Indiana to distribute our products to customers inthe Eastern United States.  The followingtable summarizes the largest properties we lease as of December 31, 2005.

 
| **Location**            | ** ** | **Use (1)**                                                                                    | ** ** | **Owned/Leased** | ** ** | **Lease Termination  Date**                                                                | ** ** | **Size (Square Feet)** | ** ** |
|-------------------------|------------|------------------------------------------------------------------------------------------------|------------|------------------|------------|--------------------------------------------------------------------------------------------|------------|------------------------|------------|
| Vista, California       |       | Corporate  Headquarters Research & Development Manufacturing &  Distribution |       | Leased           |       | Upon  completion of construction of new corporate headquarters (estimated  July 2006) |       | 266,041                |       |
| Vista, California       |       | New  Corporate Headquarters Under Construction                                                 |       | Leased           |       | 15 years  from completion of construction (estimated July 2006)                       |       | 110,000                |       |
| Tijuana, Mexico         |       | Manufacturing  Facility                                                                        |       | Leased           |       | September 2014                                                                        |       | 225,000                |       |
| Indianapolis, Indiana   |       | Distribution                                                                                   |       | Leased           |       | April 2010                                                                            |       | 41,600                 |       |
| Neudrossenfeld, Germany |       | Office &  Distribution                                                                |       | Leased           |       | December 2007                                                                         |       | 14,300                 |       |

 

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(1) Our leases in Vista, Californiaserve all of our business segments and our Tijuana, Mexico lease serves ourDomestic Rehabilitiation and International segments.  The Indianapolis, Indiana distribution centeris used only for our Domestic Rehabilitation segment and our German facility isused for our International segment only.

 

We also lease a total of approximately 20,000 squarefeet of aggregate warehouse and office space in Tempe, Arizona; Ontario,Canada; Tournes, France; Surrey, United Kingdom; and Horsholm, Denmark.  All of our facilities are leased; none areowned.

 

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In connection with our January 2006acquisition of Newmed (see Note 13 of the notes to our consolidated financialstatements), we also lease additional office, warehouse and manufacturingfacilities aggregating 54,000 square feet in France, Spain and Tunisia and weterminated our lease in Tournes, France.

 

**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 to a Vote ofSecurity Holders**

 

No matters were submitted to a vote ofsecurity holders during the quarter ended December 31, 2005.

 

**Executive Officers**

 

The following table sets forth informationwith respect to our executive officers:

 
| **Name**          | ** ** | **Age** | ** ** | **Position with dj Orthopedics**                                       |
|-------------------|------------|---------|------------|------------------------------------------------------------------------|
|              |       |    |       |                                                                   |
| Leslie H. Cross   |       | 55      |       | President, Chief Executive Officer and  Director                       |
| Vickie L. Capps   |       | 44      |       | Senior Vice President, Finance, Chief  Financial Officer and Treasurer |
| Luke T. Faulstick |       | 42      |       | Senior Vice President, Operations                                      |
| Louis T. Ruggiero |       | 46      |       | Senior Vice President, Sales and Marketing                             |
| Donald M. Roberts |       | 57      |       | Senior Vice President, General Counsel and  Secretary                  |

 

*Leslie H. Cross* hasbeen our Chief Executive Officer and President and a member of our board ofdirectors since our incorporation in August 2001. He served as the ChiefExecutive Officer and a Manager of DonJoy, L.L.C., our predecessor, from June 1999until November 2001, and has served as President of dj Orthopedics, LLC,our wholly owned operating subsidiary, or its predecessor, the Bracing &Support Systems division of Smith & Nephew, Inc. since June 1995.  From 1990 to 1994, Mr. Cross held theposition of Senior Vice President of Marketing and Business Development of theBracing & Support Systems division of Smith & Nephew. He wasa Managing Director of two different divisions of Smith & Nephew from1982 to 1990. Prior to that time, he worked at American Hospital SupplyCorporation. Mr. Cross earned a diploma in medical technology from SydneyTechnical College in Sydney, Australia and studied business at the Universityof Cape Town in Cape Town, South Africa.

 

*Vickie L. Capps*joined us in July 2002 and serves as our Senior Vice President, Finance,Chief Financial Officer and Treasurer. From September 2001 until July 2002, Ms. Capps wasemployed 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 VicePresident of Finance 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 auditand accounting professional for Ernst & Young LLP from 1982 to 1992. Ms. Cappsis a California Certified Public Accountant and received a B.S. degree inbusiness administration/accounting from San Diego State University.

 

*Luke T. Faulstick*currently serves as our Senior Vice President, Operations. He joined us as VicePresident of Manufacturing in June of 2001.  From 1998 to June 2001, Mr. Faulstickserved as General Manager for Tyco Healthcare. From 1996 to 1998, Mr. Faulstickserved as Plant Manager for Mitsubishi Consumer Electronics. In 1994, hestarted a contract manufacturing business that supplied products to themedical, electronic and photographic industries. Mr. Faulstick began hiscareer in 1985 working for Eastman Kodak Company in Rochester New York where heheld various positions in Engineering, Marketing, and Product Research andDevelopment.  He currently serves on the boardof directors of Power Partners, Inc., a privately held power transmissionmanufacturer. Mr. Faulstick received a B.S. in engineering from MichiganState University and an M.S. in engineering from Rochester Institute ofTechnology.

 

*Louis T. Ruggiero*joined us as Senior Vice President, Sales and Marketing in August 2003.  Mr. Ruggiero brings more than 20 yearsof sales experience in medical devices, with more than half of his tenure inmanagement roles. From 2000 to 2003, Mr. Ruggiero served as President andChief Executive Officer of Titan Scan Technologies, a subsidiary of TitanCorporation, a

 

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leader in electron beamtechnology for medical device sterilization, mail sanitization and industrialprocesses. From 1990 to 2000, Mr. Ruggiero was employed by GE MedicalSystems, a global leader in medical diagnostic imaging, healthcare IT,productivity solutions, services and financing. He most recently served asdirector of corporate alliances. Prior to 1990, Mr. Ruggiero was employedby Davol, Inc., a division of C.R. Bard, Inc., where he served assales manager in the northeast district. He has also held field sales positionswith American V. Mueller, a division of American Hospital Supply, and Proctor &Gamble. Mr. Ruggiero received his undergraduate degree in interpersonalcommunication/political science from St. John’s University and his M.B.A. fromthe J.L. Kellogg School of Management, Northwestern University.

 

*Donald M. Roberts*joined us in December 2002 and currently serves as Senior Vice President,General Counsel and Secretary.  From 1994to December 2002, Mr. Roberts served as Vice President, Secretary andGeneral Counsel for Maxwell Technologies, Inc., a publicly held technologycompany. Previous to that, he was with the Los Angeles-based law firm ofParker, Milliken, Clark, O’Hara & Samuelian for 21 years.  Mr. Roberts was a shareholder in thefirm, having served as partner in a predecessor partnership. Mr. Robertsreceived his undergraduate degree in political science from Yale University andearned his J.D. at the University of California, Berkeley, Boalt Hall School ofLaw.

 

**PART II**

 

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

 

Our common stock is listed on the New YorkStock Exchange under the symbol DJO. The following table sets forth, for thecalendar quarters indicated, the high and low sales prices per share of ourcommon stock as reported on the New York Stock Exchange:

 
| ** **                             | ** ** | **High** | ** ** | **Low** | ** ** |
|----------------------------------------|------------|----------|------------|---------|------------|
| **Year ended December 31, 2005:** |       |     |       |    |       |
| First Quarter                          |       | $        | 26.50      |    | $          | 19.84 |   |
| Second Quarter                         |       | 29.00    |       | 24.14   |       |
| Third Quarter                          |       | 30.43    |       | 23.70   |       |
| Fourth Quarter                         |       | 32.84    |       | 25.79   |       |
|                                   |       |     |       |    |       |
| **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   |       |

 

As of February 10, 2006, there wereapproximately 13 stockholders of record of our common stock.

 

We have not declared or paid any cashdividends since our inception. We currently intend to retain our futureearnings, if any, to finance the further expansion and continued growth of ourbusiness. In addition, our ability to pay cash dividends on our common stock iscurrently restricted under the terms of our credit agreement. Future dividends,if any, will be determined by our board of directors.

 

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**Item 6. Selected Financial Data**

 

The selected financial data set forth belowwith respect to our consolidated financial statements has been derived from ouraudited financial statements.  The dataset forth below should be read in conjunction with “Management’s Discussion andAnalysis of Financial Condition and Results of Operations” and our auditedfinancial statements and Notes thereto appearing elsewhere herein.

 
| ** **                                                                              | ** ** | **Years Ended December 31,**         | ** ** |
|-----------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                              | ** ** | **2005**                                  | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                                                                              | ** ** | **(In thousands, except per share data)** | ** ** |
| **Statement of Operations Data:**                                                       |       |                                      |       |   |   |   |   |   |   |   |   |
| Net revenues                                                                            |       | $                                         | 286,167    |   | $ | 255,999 |   | $ | 197,939 |   | $ | 182,636 |   | $ | 169,170 |   |
| Costs of goods sold (a)                                                                 |       | 105,289                                   |       | 95,164 |   | 85,927 |   | 95,878 |   | 83,079 |   |
| Gross profit                                                                            |       | 180,878                                   |       | 160,835 |   | 112,012 |   | 86,758 |   | 86,091 |   |
| Operating expenses:                                                                     |       |                                      |       |   |   |   |   |   |   |   |   |
| Sales and marketing (b)                                                                 |       | 86,241                                    |       | 78,984 |   | 54,067 |   | 56,216 |   | 36,175 |   |
| General and administrative                                                              |       | 29,432                                    |       | 27,727 |   | 21,767 |   | 26,414 |   | 25,042 |   |
| Research and development                                                                |       | 6,350                                     |       | 5,627 |   | 4,442 |   | 2,922 |   | 2,285 |   |
| Amortization of acquired intangibles                                                    |       | 4,996                                     |       | 4,731 |   | 464 |   | — |   | — |   |
| Impairment of long-lived assets (c)                                                     |       | —                                    |       | — |   | — |   | 3,666 |   | — |   |
| Performance improvement, restructuring and  other costs (d)                             |       | —                                    |       | 4,693 |   | (497 | ) | 10,008 |   | — |   |
| Total operating expenses                                                                |       | 127,019                                   |       | 121,762 |   | 80,243 |   | 99,226 |   | 63,502 |   |
| Income (loss) from operations                                                           |       | 53,859                                    |       | 39,073 |   | 31,769 |   | (12,468 | ) | 22,589 |   |
| Prepayment premium and other costs related  to senior subordinated notes redemption (e) |       | —                                    |       | (7,760 | ) | — |   | — |   | (4,669 | ) |
| Interest expense and other, net                                                         |       | (5,398                                    | )          | (8,276 | ) | (11,718 | ) | (12,088 | ) | (17,388 | ) |
| Income (loss) before income taxes                                                       |       | 48,461                                    |       | 23,037 |   | 20,051 |   | (24,556 | ) | 532 |   |
| Benefit (provision) for income taxes (f)                                                |       | (19,263                                   | )          | (9,022 | ) | (7,980 | ) | 9,361 |   | 55,958 |   |
| Net income (loss)                                                                       |       | 29,198                                    |       | 14,015 |   | 12,071 |   | (15,195 | ) | 56,490 |   |
| Less: Preferred unit dividends and  accretion of preferred unit fees                    |       | —                                    |       | — |   | — |   | — |   | (5,667 | ) |
| Net income (loss) available to common  stockholders                                     |       | $                                         | 29,198     |   | $ | 14,015 |   | $ | 12,071 |   | $ | (15,195 | ) | $ | 50,823 |   |
|                                                                                    |       |                                      |       |   |   |   |   |   |   |   |   |
| Net income (loss) per share available to  common stockholders:                          |       |                                      |       |   |   |   |   |   |   |   |   |
| Basic                                                                                   |       | $                                         | 1.34       |   | $ | 0.66 |   | $ | 0.67 |   | $ | (0.85 | ) | $ | 4.80 |   |
| Diluted                                                                                 |       | $                                         | 1.29       |   | $ | 0.63 |   | $ | 0.64 |   | $ | (0.85 | ) | $ | 4.68 |   |
| Weighted average shares outstanding:                                                    |       |                                      |       |   |   |   |   |   |   |   |   |
| Basic                                                                                   |       | 21,786                                    |       | 21,221 |   | 17,963 |   | 17,873 |   | 10,593 |   |
| Diluted                                                                                 |       | 22,699                                    |       | 22,209 |   | 18,791 |   | 17,873 |   | 10,858 |   |
| **Balance Sheet Data (at end of period):**                                              |       |                                      |       |   |   |   |   |   |   |   |   |
| Cash                                                                                    |       | $                                         | 1,107      |   | $ | 11,182 |   | $ | 19,146 |   | $ | 32,085 |   | $ | 25,814 |   |
| Total assets                                                                            |       | 304,664                                   |       | 306,850 |   | 320,504 |   | 237,724 |   | 247,922 |   |
| Long-term obligations                                                                   |       | 47,500                                    |       | 95,000 |   | 174,156 |   | 109,816 |   | 110,934 |   |
| Total stockholders’ equity                                                         |       | 226,069                                   |       | 183,038 |   | 117,333 |   | 100,913 |   | 115,240 |   |

 

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(a)          The year ended December 31,2002 included aggregate charges of $5.1 million to provide reserves for excessinventories, substantially related to product lines that we discontinued inconnection with our 2002 performance improvement program.

 

(b)         The year ended December 31,2002 included an aggregate increase of $6.7 million in our estimated reservesfor contractual allowances and bad debts related to our accounts receivablefrom third-party payor customers.

 

(c)          The year ended December 31,2002 included $3.7 million in charges related to impairment of certain of ourlong-lived assets.

 

(d)         The year ended December 31,2004 includes $4.7 million in restructuring charges related to the integrationof our Regeneration business and the relocation of certain manufacturingoperations to Mexico (see Note 4 of the notes to our consolidated financialstatements). The year ended December 31, 2002 includes $10.0 million incharges related to our 2002

 

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performance improvementprogram, including an accrual for estimated future net rent for vacatedfacilities. In 2003, we decided to retain the vacant space for future expansionand reversed the remaining accrual of $0.5 million.

 

(e)          The year ended December 31,2004 includes charges aggregating $7.8 million related to the redemption of allof our outstanding senior subordinated notes in June 2004.  The $7.8 million charge includes a prepaymentpremium and unamortized debt issuance costs and original issue discounts. Theyear ended December 31, 2001 included a charge of approximately $4.7million for the write-off of unamortized deferred debt issuance costs, debtdiscount and a prepayment premium incurred as a result of an early redemptionof a portion of our senior subordinated notes.

 

(f)            We recorded a taxbenefit (provision) at an effective tax rate of 39.8%, 39.2%, 39.8% and (38.1%)on our income (loss) before income taxes for the years ended December 31,2005, 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, thedate of our reorganization, to December 31, 2001. Because DonJoy, L.L.C.operated as a limited liability company from the date of its recapitalizationin June 1999 through November 20, 2001, the date on which thereorganization was consummated, in accordance with federal, state and localincome tax regulations that provide that no income taxes are levied on U.S.limited liability companies as each member of the LLC is individuallyresponsible for reporting the member’s share of net income or loss, we did notprovide for income taxes in our historical consolidated financial statementsprior to the reorganization. In connection with the reorganization, we recordeda deferred tax benefit of $54.2 million related to the difference between thebook and the tax bases of certain assets and liabilities of DonJoy at November 20,2001.

 

**Item 7. Management’s Discussion and Analysisof Financial Condition and Results of Operations**

 

***Overview***

 

We are a global medical device companyspecializing in rehabilitation and regeneration products for the non-operativeorthopedic and spine markets.  Marketedunder the DonJoy and ProCare brands, our broad range of over 600 rehabilitationproducts, including rigid knee braces, soft goods, and pain managementproducts, are used to prevent injury, to treat chronic conditions and to aid inrecovery after surgery or injury. Our regeneration products consist of bonegrowth stimulation devices that are used to treat nonunion fractures and as anadjunct therapy after spinal fusion surgery. We sell our products in the UnitedStates and in more than 50 other countries through networks of agents,distributors and our direct sales force that market our products to orthopedicand spine surgeons, podiatrists, orthopedic and prosthetic centers, third-partydistributors, hospitals, surgery centers, physical therapists, athletictrainers and other healthcare professionals.

 

# ***Acquisitionsand Other Recent Transactions***

 

On August 8, 2005, we completed thepurchase of substantially all of the assets of the orthopedics soft goods (OSG)business of Encore Medical, L.P. (OSG acquisition) for approximately $9.5million, paid in cash upon closing, plus the assumption of certain liabilitiesaggregating approximately $0.6 million. The OSG business is comprised of the manufacture and sale of orthopedicsoft goods, patient safety products and pressure care products. The OSGacquisition was accounted for using the purchase method of accounting wherebythe total purchase price was allocated to tangible and intangible assetsacquired based on estimated fair market values with the remainder classified asgoodwill. We acquired the OSG business to expand our portfolio of nationalcontracts and increase our related revenues and also to gain access to thepatient safety products and pressure care products, which were not previouslyincluded in our product portfolio.

 

On March 10, 2005, we completed thepurchase of substantially all of the assets of Superior Medical Equipment, LLC(SME), a Connecticut based distributor of orthopedic products and supplies, foran aggregate purchase price of up to $4.2 million, of which approximately $3.1million was paid upon closing, $0.1 million was paid as a final purchase priceadjustment in April 2005 and $0.5 million will be paid in March 2006.The remaining amount of up to $0.5 million will be paid in March 2006subject to achievement of certain operating targets. The assets acquired fromSME included tangible and intangible assets related to the distribution oforthopedic products and supplies. The SME acquisition was accounted for usingthe purchase method of accounting whereby the total purchase price was allocatedto tangible and intangible assets acquired based on estimated fair marketvalues with the remainder classified as goodwill.

 

In August 2004, we completedconstruction of a new 200,000 square foot leased facility in Tijuana, Mexico,to replace three separate facilities we operated in the same area and toprovide further opportunities to expand our Mexico manufacturingoperations.  In late 2004, we moved allof our existing Mexico operations to this new facility and we completed therelocation 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.

 

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On November 26, 2003, we acquired thebone growth stimulation device business from OrthoLogic, which we now call ourRegeneration business. Following the Regeneration acquisition in November 2003,we operated the Regeneration business as a stand alone division in Tempe,Arizona with a sales force separate from our domestic rehabilitation productsales force.  In August 2004, webegan the integration of the former Regeneration sales force into our domesticrehabilitation sales organization, and we took the first steps towardsintegrating most of the other Regeneration operations into our corporatefacility in Vista, California. By the end of 2004, we completed the integrationof most of the Regeneration operations except for the assembly and calibrationoperations which we expect to move to Vista in the first quarter of 2005following site approval of the U.S. Food and Drug Administration. One of theprincipal objectives of the integration was to enhance the sales anddistribution activities of the Regeneration business to capture more of thegrowth opportunities in the regeneration market.  In addition, we believed the integration wouldenable 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 had been incurred.  Theaccompanying consolidated statement of income for the year ended December 31,2004 includes restructuring charges related to the integration totalingapproximately $3.8 million ($2.4 million net of tax). The costs of theintegration were primarily severance, recruiting and training.

 

On January 2, 2006, we completed theacquisition, under an agreement originally signed on December 15, 2005, ofthe shares of Newmed SAS (Newmed) for cash payments aggregating 13 millionEuros (approximately $15.4 million), which included payment of certain debts ofNewmed.  Certain sellers may also receive up to an additional 1 millionEuros (approximately $1.2 million) based on achievement of certain revenuetargets for 2006. We also incurred certain transaction costs and other expensesin connection with the acquisition that are estimated to be approximately $0.4million.  Newmed, through wholly-ownedsubsidiaries in France and Spain, operating under the trade name Axmed, isengaged in the design, manufacture and sale of orthopedic rehabilitationdevices including rigid knee braces and soft goods. Newmed also owns 70% of amanufacturing subsidiary in Tunisia, which provides low cost manufacturingcapabilities to the Axmed group. The Newmed acquisition will be accounted forin the first quarter of 2006 using the purchase method of accounting wherebythe total purchase price, including transaction expenses, will be allocated totangible and intangible assets acquired based on estimated fair market values,with the remainder classified as goodwill. We acquired Newmed to increase ourrevenue and improve our market share in France and Spain. We funded the cashpaid on January 2, 2006 and our transaction expenses, with the proceeds ofa $16.0 million draw on our revolving line of credit.

 

***Segments***

 

Prior to 2005, we disclosed the followingreportable segments, which, except for Regeneration, were based on our saleschannels:  DonJoy, ProCare, OfficeCare,Regeneration and International. Effective 2005, we have aggregated the DonJoy, ProCare and OfficeCaresegments into one new segment, Domestic Rehabilitation.  In accordance with the aggregation criteriain SFAS No. 131, *Disclosure aboutSegments of an Enterprise and Related Information*,**the historical segments have beenaggregated due to changes in our management and compensation structure thatfocus on the results of Domestic Rehabilitation, taken as a whole, rather thanon its separate components. The segment data for all prior periods have beenrestated (aggregated) to conform to the new segmentation.  The following are our current reportablesegments.

 

•                       *Domestic Rehabilitation* consists of the sale of our rehabilitation products (rigid kneebraces, soft goods and pain management products) in the United States throughthree sales channels, DonJoy, ProCare and OfficeCare.

 

Through the DonJoy sales channel, we sell ourrehabilitation products utilizing a few of our direct sales representatives anda network of approximately 300 independent commissioned sales representativeswho are employed by approximately 45 independent sales agents. These salesrepresentatives are primarily dedicated to the sale of our products toorthopedic surgeons, podiatrists, orthopedic and prosthetic centers, hospitals,surgery centers, physical therapists, athletic trainers and other healthcareprofessionals.  Because certain of theDonJoy product lines require customer education on the application and use ofthe product, our sales representatives are technical specialists who receiveextensive training both from us and the agent and use their expertise to helpfit the patient with the product and assist the orthopedic professional inchoosing the appropriate product to meet the patient’s needs. After a productorder is received by a sales representative, we generally ship the productdirectly to the orthopedic professional and pay a sales commission to theagent. These commissions are reflected in sales and marketing expense in ourconsolidated statements of income.

 

Through the ProCare sales channel, which is comprised of approximately45 direct and independent representatives that manage over 310 dealers focusedon primary and acute facilities, we sell our rehabilitation products tonational third-party distributors, other regional medical supply dealers andmedical product buying groups, generally at a discount from list prices. Themajority of these products are soft goods which require little or no patienteducation. The distributors and dealers generally resell these products tolarge hospital chains, hospital buying groups, primary care networks andorthopedic physicians for use by the patients.

 

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Through theOfficeCare sales channel, we maintain an inventory of rehabilitation products(mostly soft goods) on hand at orthopedic practices for immediate distributionto the patient. For these products, we arrange billing to the patient orthird-party payor after the product is provided to the patient. As of December 31,2005, the OfficeCare program was located at over 850 physician officesthroughout the United States. We have contracts with over 700 third-partypayors.

 

•                       *Regeneration*consists of the sale of our bone growth stimulation products in the UnitedStates.** Our OL1000 product is sold through acombination of the DonJoy channel direct sales representatives andapproximately 120 additional sales representatives dedicated to selling ourOL1000 product, of which approximately 60 are employed by us. The SpinaLogicproduct is also included in this segment and was, until the end of 2004, soldby DePuy Spine in the U.S. under an exclusive sales agreement. In January 2005,we amended the agreement with DePuy to divide the U.S. into territories inwhich DePuy Spine has exclusive sales rights and non-exclusive territories inwhich we are permitted to engage in our own sales efforts or retain anothersales agent.   In early 2006, theagreement was further modified to be non-exclusive in all territories.  These products are sold either directly tothe patient or to independent distributors. We arrange billing to the third-party payors or patients, for productssold directly to the patient.

 

•                       *International* consists of the sale of our products inforeign countries through wholly-owned subsidiaries or independentdistributors.  We sell our products inover 50 foreign countries, primarily in Europe, Canada, Australia and Japan.

 

Set forth below is net revenues, gross profitand operating income information for our reporting segments for the years endedDecember 31 (in thousands). This information excludes the impact of otherexpenses not allocated to segments, which are comprised of (i) generalcorporate expenses for all periods presented and (ii) the restructuringcosts associated with the manufacturing moves in 2004. Information for theRegeneration segment includes operations for the period subsequent to theRegeneration acquisition on November 26, 2003 and includes the impact ofpurchase accounting and related amortization of acquired intangibleassets.  For the years ended December 31,2005, 2004 and 2003, Regeneration income from operations was reduced byamortization of acquired intangible assets amounting to $4.6 million, $4.7million and $0.5 million, respectively.  For the year ended December 31, 2005, Domestic Rehabilitationincome from operations was reduced by amortization of acquired intangibleassets amounting to $0.3 million for 2005 acquisitions.  For the year ended December 31, 2004,Regeneration income from operations was also reduced by restructuring chargesof $3.8 million related to the integration of the business operations of thesegment.

 
| ** **                                     | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| **Domestic Rehabilitation:**                   |       |     |       |     |       |     |       |
| Net revenues                                   |       | $        | 197,279    |     | $          | 177,481  |       | $ | 168,842 |   |
| Gross profit                                   |       | 109,752  |       | 100,200  |       | 93,791   |       |
| Gross profit margin                            |       | 55.6     | %          | 56.5     | %          | 55.5     | %          |
| Operating income                               |       | 41,878   |       | 36,341   |       | 35,462   |       |
| Operating income as a percent of net  revenues |       | 21.2     | %          | 20.5     | %          | 21.0     | %          |
| **Regeneration:**                              |       |     |       |     |       |     |       |
| Net revenues                                   |       | $        | 55,474     |     | $          | 49,658   |       | $ | 3,989 |   |
| Gross profit                                   |       | 49,710   |       | 43,032   |       | 3,145    |       |
| Gross profit margin                            |       | 89.6     | %          | 86.7     | %          | 78.8     | %          |
| Operating income                               |       | 14,623   |       | 7,836    |       | 537      |       |
| Operating income as a percent of net  revenues |       | 26.4     | %          | 15.8     | %          | 13.5     | %          |
| **International:**                             |       |     |       |     |       |     |       |
| Net revenues                                   |       | $        | 33,414     |     | $          | 28,860   |       | $ | 25,108 |   |
| Gross profit                                   |       | 21,416   |       | 17,603   |       | 15,076   |       |
| Gross profit margin                            |       | 64.1     | %          | 61.0     | %          | 60.0     | %          |
| Operating income                               |       | 8,430    |       | 5,398    |       | 6,255    |       |
| Operating income as a percent of net  revenues |       | 25.2     | %          | 18.7     | %          | 24.9     | %          |

 

# ***DomesticSales***

 

Domestic sales, including all sales of ourDomestic Rehabilitation and Regeneration segments, accounted for approximately88%, 89% and 87% of our net revenues in 2005, 2004 and 2003, respectively.

 

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# ***International***

 

International sales accounted forapproximately 12%, 11% and 13% of our net revenues in 2005, 2004 and 2003,respectively. The following table sets forth our international net revenues asa percentage of our total net revenues, by country for the years ended December 31:

 
| ** **                | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|---------------------------|------------|----------|------------|----------|------------|----------|------------|
|                      |       |     |       |     |       |     |       |
| Germany                   |       | 3.9      | %          | 4.3      | %          | 5.2      | %          |
| Canada                    |       | 2.0      |       | 1.9      |       | 2.1      |       |
| United Kingdom            |       | 1.2      |       | 1.0      |       | 0.9      |       |
| Japan                     |       | 0.7      |       | 0.7      |       | 1.1      |       |
| Other countries           |       | 3.9      |       | 3.4      |       | 3.4      |       |
| Total international sales |       | 11.7     | %          | 11.3     | %          | 12.7     | %          |

 

The “Other countries” category consistsprimarily of sales in France, Denmark, Belgium, Italy, Australia and the CzechRepublic.

 

Internationalsales are made primarily through two distinct channels: independent third-partydistributors and through our wholly-ownedforeign subsidiaries. Through our wholly-owned internationalsubsidiaries, we sell products in Euros, Pounds Sterling, Canadian Dollars andDanish Krones. The U.S. dollar equivalent of our international salesdenominated in foreign currencies in 2005, 2004 and 2003 were favorablyimpacted by foreign currency exchange rate fluctuations with the weakening ofthe U.S. dollar against the foreign currencies of our subsidiaries.  The U.S. dollar equivalent of the relatedcosts denominated in these foreign currencies were unfavorably impacted duringthe same periods.  In addition, the costsassociated with our Mexico-based manufacturing operations are incurred inMexican pesos.  As we continue todistribute and manufacture our products in selected foreign countries, weexpect that future sales and costs associated with our activities in thesemarkets will continue to be denominated in the applicable foreign currencies,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 31,2005, we had no hedging transactions in place.

 

**OurStrategy**

 

Our strategy is to increase revenue andprofitability and enhance cash flow by strengthening our market leadershipposition.  Our key initiatives toimplement this strategy include:

 

•                       *Increase our Lead in the Domestic RehabilitationMarket Segment.*We believewe are the market leader in the Domestic Rehabilitation markets in which wecompete. We believe we will be able to continue to grow our DomesticRehabilitation business segment and increase our market share further byfocusing on growth initiatives related to maintaining a continuous flow of newproduct introductions and continuing to enhance the productivity of our salesforce and optimize our distribution strategy. Our key Domestic Rehabilitationgrowth strategies include the following:

 

*- Continue to Introduce New Products and Product Enhancements.*  We have ahistory of developing and introducing innovative products into the marketplace,and are committed to continuing that tradition by introducing new productsacross our product platform.  In the yearended December 31, 2005, we launched 30 new products.  We believe that product innovation througheffective and focused research and development will provide a sustainablecompetitive advantage.  We believe we arecurrently a technology leader in several product categories and we intend tocontinue to develop next generation technologies.

 

*- Expand Product Offerings for the Spine and for Foot and Ankle*.  Accordingto Frost & 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 compression back brace to address the spinemarket and we intend to add more products to address this market segment.  In addition, according to Frost &Sullivan, the ankle braces and supports segment of the Domestic Rehabilitationmarket is approximately $226 million in 2005 and offers us an opportunity forfuture growth as our current level of sales in this market segment isrelatively low. In 2005, we launchedour Velocity Ankle, a new rigid ankle brace. This product has been one of ourmost successful new products in recent years. We intend to further expand ourfoot and ankle product offerings. For example, in early 2006, we launched a newfoot orthotic to treat subtle cavus foot.

 

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*- Expand Our OfficeCare Channel.*  Our OfficeCare channel currentlyincludes over 850 physician offices encompassing over 3,400 physicians.  We believe that our OfficeCare channel servesa growing need among orthopedic practices to have a number of products readilyavailable for immediate distribution to patients. Expanding our OfficeCarechannel also permits us to increase our weighted-average selling prices, as theunits sold through this channel are billed to insurance companies and otherthird-party payors at higher prices than most of our other sales channels.  Accordingly, our OfficeCare initiativesrepresent an opportunity for sales growth based on increases in both unitvolume and average selling prices.  Weintend to expand our OfficeCare channel into more “high-volume” orthopedicoffices, thereby increasing the number of potential customers to whom we sellour products.  In the year ended December 31,2005, we added approximately 200 new offices to our OfficeCare channel, net ofaccount terminations, including approximately 45 accounts added through the SMEacquisition.

 

*- Maximize Existing and Secure Additional National Accounts.*  We planto capitalize on the growing practice in healthcare in which hospitals andother large healthcare providers seek to consolidate their purchasingactivities to national buying groups. Contracts with these national accounts represent a significantopportunity for sales growth. We believe that our broad range of products iswell suited to the goals of these buying groups and intend to aggressivelypursue these contracts.  In the yearended December 31, 2005, we signed four new significant nationalcontracts, including a new three-year, multi-source contract with MedAssetsSupply Chain Systems for our soft goods products, and we renewed two othersignificant national contracts.  Inaddition, in connection with the OSG acquisition, we added one new significantnational contract and increased our penetration into several other nationalaccount opportunities already within our portfolio.

 

•                       *Grow Our Regeneration Business.* We haveintegrated the sales force for our OL1000 bone growth stimulator product intoour domestic rehabilitation sales organization. We have also increased the number of regeneration sales specialistsdedicated to selling our OL1000 product. We believe these specialists will be able to use the establishedrelationships of our DonJoy sales representatives to enhance sales of theOL1000 product.  Our distributionarrangement with DePuy Spine has also become non-exclusive for 2006, whichpermits us to sell the SpinaLogic product directly or through other independentsales representatives in all territories where we choose to do so.  We intend to add additional selling resourcesin those geographical parts of the country where sales are not meeting ourexpectations.  We believe that our newselling strategies for our Regeneration segment will drive faster growth forthis business.

 

•                       *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. We believe that sales to foreign markets continue torepresent a significant growth opportunity and we intend to continue todevelop direct distribution capabilities in selected additional foreignmarkets.  We also believe we can increaseour international revenues by expanding the number of our products we sell ininternational markets.  Historically wehave only sold a limited range of our products in our internationalmarkets.  In 2005, we successfullylaunched an expanded range of soft goods, our cold therapy products and ourbone growth stimulation products in our International segment.

 

•                       *Pursue Selective Acquisitions*. We believe that acquisitions represent an attractive and efficient meansto broaden our product lines, expand our geographic reach and increase ourrevenue. We intend to pursue acquisition opportunities that enhance salesgrowth, are accretive to earnings, increase customer penetration and/or providegeographic diversity. In the year ended December 31, 2005, we completedthe SME and OSG acquisitions thatmeet these criteria as discussed in Note 3 to the consolidated financialstatements included in Item 8 herein. In January 2006, we also completedthe acquisition of Newmed SAS (Newmed), as discussed in Note 13 to theconsolidated financial statements included in Item 8, herein, which is intendedto increase our international revenue in France and other parts of Europe.

 

## ***CriticalAccounting Policies and Estimates***

 

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

 

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obligations, incometaxes, intangibles and investments.  Webase our estimates on historical experience and on various other assumptionsthat we believe to be reasonable under the circumstances, the results of whichform the basis for making judgments about the carrying values of assets andliabilities that are not readily apparent from other sources.  Actual 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:

 

*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 2005 and 2004, we reservedfor and reduced gross revenues from third-party payors by between 29% and 39%for allowances related to these contractual reductions.  For our Regeneration business, we recordrevenue net of actual contractual allowances and discounts from our grossprices, which are determined on a specific identification basis and amount toapproximately 29% to 34% of our gross prices for bone growth stimulationproducts.

 

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 51% of our net accounts receivable at December 31, 2005, andwe have historically experienced write-offs of less than 2% of these accountsreceivable. Our third-party reimbursement customers including insurancecompanies, managed care companies and certain governmental payors such asMedicare include all of our OfficeCare customers and certain other customers ofour Domestic Rehabilitation business segment and the majority of ourRegeneration customers. Our third-party payor customers representedapproximately 32% of our net revenue for the year ended December 31, 2005 and49% of our net accounts receivable at December 31, 2005, and we estimatebad debt expense to be approximately 4% to 8% of gross revenues from thesethird-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 ofcertain of our third-party payor customers, including the data utilized todetermine reserves for contractual allowances and doubtful accounts. In March 2003,we completed the transition to a new third-party insurance billing serviceprovider.  Based on information currentlyavailable to us, we believe we have provided adequate reserves for ourthird-party payor accounts receivable. If claims are denied, or amounts areotherwise not paid, in excess of our estimates, the recoverability of our netaccounts receivable could be reduced by a material amount. In addition, if ourthird-party insurance billing service provider does not perform to ourexpectations we may be required to increase our reserve estimates.

 

# *Reserve for Excessand Obsolete 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 onhistorical shrinkage rates of approximately 16%.  If actual shrinkage rates differ from ourestimated shrinkage rates, revisions to the reserve may be required.  We also provide reserves for newer productinventories, as appropriate, based on any minimum purchase commitments and ourlevel of sales of the new products.

 

*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.

 

*Returns and Warranties.*  We provide for the estimated cost of returnsand product warranties at the time revenue is recognized based on historicaltrends.  While we engage in extensiveproduct quality programs and processes, including actively monitoring andevaluating the quality of our suppliers, our actual returns and warranty costscould differ from our estimates.  Ifactual product returns, failure rates, material usage or service costs differfrom our estimates, revisions to the estimated return and/or warrantyliabilities may be required.

 

*Valuation Allowance for Deferred Tax Asset.*As of December 31, 2005, we have approximately $39.5 million of netdeferred tax assets on our balance sheet related primarily to tax deductiblegoodwill arising at the date of our reorganization in 2001 and not recognizedfor book purposes and net operating loss carryforwards.  Realization of our deferred tax assets is

 

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dependent on our ability togenerate 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 accordance with Statement of Financial Accounting Standards No. 142, orSFAS No. 142, *Goodwill and OtherIntangible Assets*, we do not amortize 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, 2005, 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, 2005 benefits the entire enterpriseand since 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 ofthe Regeneration segment.

 

At December 31, 2005, other intangibles wereevaluated for impairment as required by SFAS No. 144, *Accounting for Impairment or Disposal of Long-LivedAssets*.  The determination ofthe fair value of certain acquired assets and liabilities is subjective innature and often involves the use of significant estimates andassumptions.  Determining the fair valuesand useful lives of 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 animpairment charge for certain long-lived assets in 2002 as a result of certainnew products not achieving anticipated revenues and estimated recovery valuesof assets 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.

 

***Results of Operations***

 

We operate our business on a manufacturingcalendar, with our fiscal year always ending on December 31.  Each quarter is 13 weeks, consisting of onefive-week and two four-week periods.  Thefirst and fourth quarters may have more or less working days from year to yearbased on the days of the week on which holidays and December 31 fall.

 

***Year Ended December 31, 2005 Compared ToYear Ended December 31, 2004***

 

**NetRevenues*.***Setforth below are net revenues for our reporting segments (in thousands):

 
| ** **                | ** ** | **Years Ended**             | ** ** | ** **            | ** ** | ** **                 | ** ** |
|---------------------------|------------|-----------------------------|------------|-----------------------|------------|----------------------------|------------|
| ** **                | ** ** | **December 31,  2005** | ** ** | **% of Net Revenues** | ** ** | **December 31, 2004** | ** ** | **% of Net  Revenues** | ** ** | **Increase** | ** ** | **%  Increase** | ** ** |
| Domestic Rehabilitation   |       | $                           | 197,279    |                  | 68.9       |                       | $          | 177,481 |   | 69.3 |   | $ | 19,798 |   | 11.2 |   |
| Regeneration              |       | 55,474                      |       | 19.4                  |       | 49,658                     |       | 19.4 |   | 5,816 |   | 11.7 |   |
| International             |       | 33,414                      |       | 11.7                  |       | 28,860                     |       | 11.3 |   | 4,554 |   | 15.8 |   |
| Consolidated net revenues |       | $                           | 286,167    |                  | 100.0      |                       | $          | 255,999 |   | 100.0 |   | $ | 30,168 |   | 11.8 |   |

 

Net revenues in our Domestic Rehabilitation segment increased due tonormal market growth in existing product lines, sales of new products, salesattributed to the OSG acquisition, an increase in the number of units billed tothird-party payors, which are sold at higher average selling prices, and growthin sales related to national contracts in our ProCare sales channel.  We have also gained incremental revenue fromthe addition of approximately 200 new OfficeCare locations in 2005, net ofaccount terminations, including approximately 45 accounts added in connectionwith our March 2005 SME acquisition. Net revenues in our Regeneration segment increased, in part, from oursales force integration and an increased number of sales specialists sellingour OL1000 product.  Sales of ourSpinaLogic product also increased due to selling resources added in territoriesthat became non-exclusive in 2005. International net revenues increased partly due to favorable changes inexchange rates compared to the rates in

 

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effect in 2004, an increase in the number ofproducts we sell in international markets, incremental revenues from the OSGacquisition, and the addition of our new direct sales subsidiary in the Nordiccountries, effective September 1, 2004. Excluding the impact of exchange rates, local currency international revenuesincreased 14.6% in the year ended December 31, 2005 compared to the yearended December 31, 2004.

 

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

 
| ** **                | ** ** | **Years Ended**             | ** ** | ** **             | ** ** | ** **                  | ** ** |
|---------------------------|------------|-----------------------------|------------|------------------------|------------|-----------------------------|------------|
| ** **                | ** ** | **December 31,  2005** | ** ** | **% of Net  Revenues** | ** ** | **December 31,  2004** | ** ** | **% of Net  Revenues** | ** ** | **Increase** | ** ** | **%  Increase** | ** ** |
| Domestic Rehabilitation   |       | $                           | 109,752    |                   | 55.6       |                        | $          | 100,200 |   | 56.5 |   | $ | 9,552 |   | 9.5 |   |
| Regeneration              |       | 49,710                      |       | 89.6                   |       | 43,032                      |       | 86.7 |   | 6,678 |   | 15.5 |   |
| International             |       | 21,416                      |       | 64.1                   |       | 17,603                      |       | 61.0 |   | 3,813 |   | 21.7 |   |
| Consolidated gross profit |       | $                           | 180,878    |                   | 63.2       |                        | $          | 160,835 |   | 62.8 |   | $ | 20,043 |   | 12.5 |   |

 

The improvement inconsolidated gross profit and gross profit margin is related partly toincreased revenues from the higher gross margin products sold in ourRegeneration segment and partly due to certain manufacturing cost reductions,offset by increased freight costs and increased expenses related to employeebonuses.   Gross profit decreased as apercentage of net revenues in our Domestic Rehabilitation segment primarily dueto increased freight costs and a change in product mix including incrementalsales from the OSG acquisition, which are primarily sold to third-partydistributors at a reduced gross margin. The Regeneration segment gross profit increased as a percentage ofrevenues due to increased sales volume, an increase in the proportion of unitsales sold to third-party payors, which are sold at higher average sellingprices, and certain cost benefits realized upon the consolidation of theRegeneration product manufacturing into our facility in Vista, California.  The increase in the International segmentgross profit is primarily related to the favorable impact of changes inexchange rates and the addition of the incremental in-market gross margin fromour direct sales in the Nordic countries since September 1, 2004.

 

**Operating Expenses.* ***Set forth belowis operating expense information (in thousands):

 
| ** **                           | ** ** | **Years Ended**             | ** ** | ** **             | ** ** | **%**                       | ** ** |
|--------------------------------------|------------|-----------------------------|------------|------------------------|------------|-----------------------------|------------|
| ** **                           | ** ** | **December 31,  2005** | ** ** | **% of Net  Revenues** | ** ** | **December 31,  2004** | ** ** | **% of Net  Revenues** | ** ** | **Increase  (Decrease)** | ** ** | **Increase  (Decrease)** | ** ** |
| Sales and marketing                  |       | $                           | 86,241     |                   | 30.1       |                        | $          | 78,984 |   | 30.9 |   | $ | 7,257 |   | 9.2 |   |
| General and administrative           |       | 29,432                      |       | 10.3                   |       | 27,727                      |       | 10.8 |   | 1,705 |   | 6.1 |   |
| Research and development             |       | 6,350                       |       | 2.2                    |       | 5,627                       |       | 2.2 |   | 723 |   | 12.8 |   |
| Amortization of acquired intangibles |       | 4,996                       |       | 1.7                    |       | 4,731                       |       | 1.9 |   | 265 |   | 5.6 |   |
| Restructuring costs                  |       | —                      |       | —                 |       | 4,693                       |       | 1.8 |   | (4,693 | ) | (100.0 | ) |
| Consolidated operating expenses      |       | $                           | 127,019    |                   | 44.3       |                        | $          | 121,762 |   | 47.6 |   | $ | 5,257 |   | 4.3 |   |

 

***Sales and Marketing Expenses. ***The increase insales and marketing expenses is due to costs associated with additional salespersonnel in our Regeneration segment and increases in commissions on increasedsales, advertising and marketing programs, employee bonus expenses and costsrelated to the businesses we acquired in 2005.

 

***General and Administrative Expenses.***Theincrease in general and administrative expenses is primarily due to increasesin legal costs, employee bonus expenses and costs associated with the businesseswe acquired in 2005, partially offset by savings related to the integration ofthe Regeneration business.

 

***Research and Development Expenses.***Theincrease in research and development expenses is primarily due to an increasein costs associated with prototyping new products, increased employee bonusexpenses and certain severance costs incurred in 2005.

 

***Amortization of Acquired Intangibles. ***The increase inamortization of acquired intangibles relates to intangible assets acquired in2005 in connection with the SME acquisition, which are being amortized overlives ranging from five to ten years, and intangible assets acquired in 2005 inconnection with the OSG acquisition, which are being amortized over livesranging from three to eight years.  For2004, all amortization of acquired intangibles related to intangible assetsacquired in connection with the Regeneration acquisition, which are beingamortized over lives ranging from four months to ten years.

 

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###### ***Restructuring costs.***  In 2004, we incurred restructuring charges related to our Regenerationintegration and certain manufacturing moves, including charges for severance,recruiting, training and other related exit costs.

 

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

 
| ** **                                     | ** ** | **Years Ended**             | ** ** | ** **             | ** ** | ** **                  | ** ** |
|------------------------------------------------|------------|-----------------------------|------------|------------------------|------------|-----------------------------|------------|
| ** **                                     | ** ** | **December 31,  2005** | ** ** | **% of Net  Revenues** | ** ** | **December 31,  2004** | ** ** | **% of Net  Revenues** | ** ** | **Increase** | ** ** | **%  Increase** | ** ** |
| Domestic Rehabilitation                        |       | $                           | 41,878     |                   | 21.2       |                        | $          | 36,341 |   | 20.5 |   | $ | 5,537 |   | 15.2 |   |
| Regeneration                                   |       | 14,623                      |       | 26.4                   |       | 7,836                       |       | 15.8 |   | 6,787 |   | 86.6 |   |
| International                                  |       | 8,430                       |       | 25.2                   |       | 5,398                       |       | 18.7 |   | 3,032 |   | 56.2 |   |
| Income from operations of reportable  segments |       | 64,931                      |       | 22.7                   |       | 49,575                      |       | 19.4 |   | 15,356 |   | 31.0 |   |
| Expenses not allocated to segments             |       | (11,072                     | )          | (3.9                   | )          | (10,502                     | )          | (4.1 | ) | 570 |   | 5.4 |   |
| Consolidated income from operations            |       | $                           | 53,859     |                   | 18.8       |                        | $          | 39,073 |   | 15.3 |   | $ | 14,786 |   | 37.8 |   |

 

The increase in income from operations for each of oursegments is due to increased net revenues and gross profit, which exceedincreased operating expenses for each respective segment.

 

**InterestExpense, Net of Interest Income and Prepayment premium and other costs relatedto Senior Subordinated Notes redemption.****Interestexpense, net of interest income, was $4.4 million in the year ended December 31,2005 compared to $9.0 million in the year ended December 31, 2004.  The decrease is due to reduced debt levelsfollowing the June 2004 redemption of our senior subordinated notes and otherdebt repayments made after the third quarter of 2004. We incurred pre-taxcharges aggregating $7.8 million in the second quarter of 2004 related to theredemption of our senior subordinated notes.

 

**OtherIncome (Expense).****Otherincome (expense) for the year ended December 31, 2005 reflects a write-offof costs related to potential acquisitions that were abandoned in 2005 and netforeign exchange transaction losses. Other income (expense) for the year ended December 31, 2004includes a net foreign exchange transaction gain and a gain on the sale of aninvestment, partially offset by a write-off of costs related to a potentialacquisition.

 

**Provisionfor Income Taxes.****Ourestimated worldwide effective tax rate was 39.8% for the year ended December 31,2005 and 39.2% for the year ended December 31, 2004.  Our tax rate for 2005 increased compared to2004 primarily due to a higher average effective state tax rate in 2004.

 

**Net Income*.***Net income was $29.2 million for the yearended December 31, 2005 compared to net income of $14.0 million for theyear ended December 31, 2004 as a result of the changes discussed above.

 

***Year Ended December 31, 2004 Compared ToYear Ended December 31, 2003***

 

Regeneration segment amounts in the tables below include operations forthe period subsequent to the Regeneration acquisition on November 26, 2003and include the impact of the Regeneration purchase accounting and relatedamortization of acquired intangible assets. For the years ended December 31, 2004 and 2003, Regeneration incomefrom operations was reduced by amortization of acquired intangible assetsamounting 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 chargesof $3.8 million related to the integration of the business operations of thesegment.  The proforma amounts in thetables below show the impact of the Regeneration acquisition as if it hadoccurred on January 1, 2003.

 

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**NetRevenues*.***Setforth below are net 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** | ** ** |
| Domestic Rehabilitation   |       | $                           | 177,481    |                   | 69.3       |                        | $          | 168,842                   |       | 85.3 |   | $ | 8,639 |   | 5.1 |   | $ | 168,842 |   | 70.3 |   |
| Regeneration              |       | 49,658                      |       | 19.4                   |       | 3,989                       |       | 2.0                       |       | 45,669 |   | 1,144.9 |   | 46,428 |   | 19.3 |   |
| 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 Domestic Rehabilitation 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 changes in 2004 in the California workers compensationsystem and reduced sales of certain of our pain management products.  Net revenues in our Domestic Rehabilitationsegment also increased due to growth in sales related to national contracts,the addition of approximately 100 net new OfficeCare locations and priceincreases implemented in mid-2003, offset by price reductions in our fractureboot products due to a change in the Medicare reimbursement code.  On a pro forma basis, net revenue in ourRegeneration segment increased due to increased sales volumes, offset by anegative impact in the third quarter of 2004 caused by disruption from thecommencement of the integration of our Regeneration sales organization into ourDonJoy sales organization.  Revenues inour Regeneration segment were also impacted during the third quarter of 2004 bya decline in sales of our SpinaLogic product, which we believe was due partlyto slow market conditions and partly to weak sales performance in certainterritories.  International revenuesincreased due partly to favorable changes in exchange rates compared to therates in effect in 2003.  Excluding theimpact of exchange rates, local currency international revenue increased 8.6%in the year ended December 31, 2004 compared to the year ended December 31,2003, due to an increase in the number of our products we sell in ourinternational markets and the addition of our new direct sales subsidiary inthe 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** | ** ** | **%  Increase** | ** ** | **December 31,  2003** | ** ** | **% of Net  Revenues** | ** ** |
| Domestic Rehabilitation   |       | $                           | 100,200    |                   | 56.5       |                        | $          | 93,791                    |       | 55.5 |   | $ | 6,409 |   | 6.8 |   | $ | 93,791 |   | 55.5 |   |
| Regeneration              |       | 43,032                      |       | 86.7                   |       | 3,145                       |       | 78.8                      |       | 39,887 |   | 1,268.3 |   | 38,949 |   | 83.9 |   |
| 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 inconsolidated gross profit and gross profit margin is primarily related to thefavorable impact of higher gross margins associated with the products sold inour Regeneration segment, continued manufacturing cost reduction initiativesand a reduction in expenses associated with employee bonuses, partially offsetby increased freight costs. Gross profit increased in the DomesticRehabilitation segment primarily due to a favorable product mix, includingincreased sales to our third-party payor customers which carry a higher grossmargin than other Domestic Rehabilitation sales, and certain price increasesimplemented in mid-2003, partially offset by price reductions due to a changein the Medicare reimbursement code for certain fracture boot products and byincreased sales through our national contracts, which carry lower grossmargins. On a pro forma basis and excluding the impact of one-time purchaseaccounting adjustments, Regeneration gross profit increased as a percentage ofrevenues due to reduced cost of goods sold for these products and a higher mixof insurance sales, which have higher average selling prices and thereforegenerate higher gross margins than sales to wholesale customers. The increasein the International gross profit is primarily related to the favorable impactof changes in exchange rates and the addition of the incremental in-marketgross margin on our direct sales in the Nordic countries since September 1,2004.

 

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**Operating Expenses.* ***Set forth belowis operating expense information (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 Marketing Expenses. ***The increase insales and marketing expenses is primarily attributed to $21.4 million ofexpenses related to the Regeneration segment. In addition, selling and marketing expenses increased due to costsassociated with increased commissions on increased sales, additional salespersonnel, increased advertising and marketing programs and the impact ofunfavorable foreign exchange rate changes. These increases were offset by a reduction in expenses associated withemployee bonuses.  Our internationalsegment also incurred increased expenses in 2004 related to our newsubsidiaries in France and Denmark, added in September 2003 and September 2004,respectively, and a bi-annual trade exhibition in Europe.

 

***General and Administrative Expenses.***Theincrease in general and administrative expenses is primarily attributed to $4.3million of expenses related to the Regeneration segment, increased professionalfees related to compliance with section 404 of the Sarbanes-Oxley Act, andlegal costs, including the settlement of a contract dispute, offset by areduction in expenses associated with employee bonuses.  General and administrative expenses alsoincreased in 2004 related to increased efforts to maximize cash collectionsfrom our third-party payor customers.

 

***Research and Development Expenses.***Theincrease in research and development expense is attributed to $0.9 million ofexpenses related to the Regeneration segment and an increase in professionalfees related to various patents and technology offset by a reduction inexpenses associated with employee bonuses.

 

***Amortization of Acquired Intangibles. ***Amortization ofacquired intangibles relates to intangible assets acquired in connection withthe Regeneration acquisition, which are being amortized over lives ranging fromfour months to ten years.   On a proforma basis the amortization expense in the year ended December 31, 2004is consistent with the year ended December 31, 2003.

 

###### ***Restructuring costs.***  In 2004, we recorded charges of$4.7 million related toour Regeneration integration and manufacturing moves, including charges forseverance, recruiting, training and other related exit costs.  In the year ended December 31, 2003, werecorded a credit to restructuring costs of approximately $0.5 million as areversal of an accrual recorded in 2002 related to future rent to be paid forvacated facilities, as we decided to retain the vacant space for future expansion.

 

###### **Incomefrom Operations.*** *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** | ** ** |
| Domestic Rehabilitation                       |       | $                      | 36,341     |                   | 20.5       |                        | $          | 35,462                    |       | 21.0 |   | $ | 879 |   | 2.5 |   | $ | 35,462 |   | 21.0 |   |
| Regeneration                                  |       | 7,836                  |       | 15.8                   |       | 537                         |       | 13.5                      |       | 7,299 |   | 1,359.2 |   | 8,268 |   | 17.8 |   |
| 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 |   |

 

The decrease in income from operations as a percentageof net revenue for the Domestic Rehabilitation segment is primarily due to anincreased investment in sales and marketing expense for personnel and programsand lower gross profit margins associated with increased revenue from nationalcontracts, partially offset by increased margins from higher OfficeCare

 

43

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sales.  Thedecrease in income from operations, on a pro forma basis, for the Regenerationsegment is primarily the result of restructuring charges of $3.8 million in2004, partially offset by increased revenues and higher gross margins.  Income from operations in the Internationalsegment was reduced from the prior year due primarily to the investment we madein the start up activities of our new direct sales subsidiaries in France andDenmark, as well as the expenses associated with a bi-annual Europeanexhibition which occurred in the second quarter of 2004.

 

**InterestExpense, Net of Interest Income and Prepayment premium and other costs relatedto Senior Subordinated Notes redemption.****Interestexpense, net of interest income, was $9.0 million in the year ended December 31,2004 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 seniorsubordinated notes, offset by interest related to the incremental outstandingdebt we incurred in connection with the Regeneration acquisition. We incurredcosts of $7.8 million in connection with the redemption of the notes, comprisedof a $4.7 million redemption premium and write-offs of $2.3 million and $0.8million for debt issuance costs and unamortized discounts, respectively.

 

**OtherIncome (Expense).****Otherincome (expense) for the year ended December 31, 2004 includes a netforeign exchange transaction gain and a gain on the sale of an investment,partially offset by a write-off of costs related to a potential acquisition.For the year ended December 31, 2003, other income (expense) includes anet foreign exchange transaction gain.

 

**Provisionfor Income Taxes.****Ourestimated worldwide effective tax rate was 39.2% for the year ended December 31,2004 and 39.8% for the year ended December 31, 2003.  The tax rate in 2004 was reduced compared to2003 primarily due to a lower average effective state tax rate in 2004.

 

**Net Income*.***Net income was $14.0 million for the yearended December 31, 2004 compared to net income of $12.1 million for theyear ended December 31, 2003 as a result of the changes discussed above.

 

***Liquidity and Capital Resources***

 

Our principal liquidity requirements are to serviceour debt and meet our working capital and capital expenditure needs.  Total indebtedness was $47.5 million at December 31,2005. Total cash and cash equivalents were $1.1 million at December 31,2005.

 

Net cash provided by operating activities was$47.1 million and $39.5 million for the years ended December 31, 2005and 2004, respectively. The net cash provided by operations in both 2005 and2004 reflected positive operating results, partially offset by an increase innet working capital. In connection with the move of the billing and collectionsactivities of our Regeneration segment from Tempe, Arizona to Vista, Californiain 2004, we were required to amend certain registrations and contracts withcertain of our third-party payor customers of this business.  As a result of this transition, certainpayments owed to us by these payors were delayed, contributing to an increasein accounts receivable in this segment. We continue to work with these third-party payors to expedite thedelayed payments.  The percentage of ourrevenues that is derived from third-party payor customers also increased in2005, contributing to higher levels of accounts receivable as these customerstypically pay slower than our other customers. In addition, in 2005 approximately $1.9 million was used to pay forrestructuring costs accrued in 2004.

 

Cash flows used in investing activities were$19.3 million and $10.2 million for the years ended December 31,2005 and 2004, respectively. Cash used in investing activities in 2005 included$3.1 million used for the SME acquisition, $9.5 million used for the OSGacquisition, $0.1 million additional consideration to KD Innovation A/S (KDI)for meeting operating income targets, $5.1 million used for capitalexpenditures and $1.5 million used for purchasing rights to distributorterritories, net of amounts repaid to us by the new distributors.  We may be required to pay up to an additional$0.4 million to KDI through 2009, if certain net operating income targets aremet.

 

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 KDI, our independent distributor in Denmark.

 

Cash flows used in financing activities were$37.7 million and $37.5 million for the years ended December 31, 2005 and2004, respectively. Cash used in financing activities in 2005 included $55.5million of repayments on long-term debt and $0.7 million of debt issuancecosts, offset by proceeds of $8.7 million received from the issuance of commonstock through our Employee Stock

 

44

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Purchase Plan and the exerciseof stock options, $1.8 million received from collection of stockholder notesreceivable and $8.0 million received from borrowing.

 

Cash used in financing activities in 2004included $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 ofdirectors authorized a program to repurchase up to $20 million of our commonstock. 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. There were no repurchases of our commonstock during the year ended December 31, 2005.  The stock repurchase program expired in September 2005.

 

*Contractual Obligations and CommercialCommitments*

 

On May 5, 2005, we completed anamendment to our credit agreement. Previously, the credit agreement consistedof a $100.0 million term loan, of which approximately $93.8 million was owed asof the date of the amendment, and a $30.0 million revolving line of credit onwhich no amounts had been drawn. The amended credit agreement provides fortotal borrowings of $125.0 million, consisting of a term loan of $50.0 million,which was fully drawn at closing and $75.0 million available under a revolvingline of credit, of which approximately $43.8 million was drawn at closing.Prior to December 31, 2005, we repaid all of the amounts outstanding underthe revolving line of credit. We were contingently liable for outstandingletters of credit aggregating approximately $4.0 million at December 31,2005. Under the amended agreement, up to $25.0 million of outstandingborrowings may be denominated in British Pounds or Euros. As of December 31,2005, all borrowings under the credit agreement were denominated in U.S.dollars. Borrowings under the term loan and on the revolving credit facilitybear interest at variable rates (either a LIBOR rate or the lenders’ base rate,as elected by us) plus an applicable margin, which varies based on our leverageratio. The amended agreement reduced our interest rate to LIBOR plus anapplicable margin of 1.25% to 2.00%, or the lenders’ base rate plus anapplicable margin of 0.25% to 1.00%. At our current leverage ratio, theapplicable interest rate is either LIBOR plus 1.25% or base rate plus 0.25%.The weighted average interest rate applicable to our borrowings as of December 31,2005 was 5.35%.

 

*Repayment.*We are required to make quarterly principal payments on the term loan of$1.25 million, beginning in September 2005 and increasing to $1.875million in September 2007, $3.125 million in September 2008 and $5million in September 2009. The balance of the term loan, if any, and anyborrowings under the revolving credit facility are due in full on May 5,2010. Prior to December 31, 2005, we repaid $2.5 million of the amountsoutstanding under the term loan and $47.5 million remained outstanding as of December 31,2005.  In addition to scheduled principalpayments, we are required to make annual mandatory payments of the term loan inan amount equal to 50% of our excess cash flow if our ratio of total debt toconsolidated EBITDA (earnings before interest, taxes, depreciation andamortization) exceeds 2.25 to 1.00. Excess cash flow represents our net incomeadjusted for extraordinary gains or losses, depreciation, amortization andother non-cash charges, changes in working capital, changes in deferredrevenues, payments for capital expenditures, repayment of certain indebtednessand payments for certain common stock repurchases.  In addition, the term loan is subject tomandatory prepayments in an amount equal to (a) 50% of the net cashproceeds of certain equity issuances by us if our ratio of total debt toconsolidated EBITDA exceeds 2.25 to 1.00, (b) 100% of certain debtissuances by us and (c) 100% of the net cash proceeds of certain assetsales or other dispositions of property by us, in each case subject to certainexceptions.

 

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

 

***Covenants.*** The credit facility contains a number of covenantsthat, among other things, restrict our ability to (i) incur additionalindebtedness; (ii) incur or guarantee obligations; (iii) paydividends or make other distributions (except for certain tax distributions); (iv) redeemor repurchase equity, make investments, loans or advances, make acquisitions; (v) engagein mergers or consolidations; (vi) change the business we conduct; (vii) grantliens on or sell our assets; (viii) or engage in certain other activities.The amended agreement provides less restriction than our previous agreement inmost of these areas. The credit agreement also requires us to maintain a ratioof total debt to consolidated EBITDA of no more than 2.75 to 1.00 and a ratioof consolidated EBITDA to fixed charges of at least 1.50 to 1.00. At December 31,2005, our ratio of total debt to consolidated EBITDA was approximately 0.72 to1.00 and our ratio of consolidated EBITDA to fixed charges was approximately4.18 to 1.00. We were in compliance with all covenants as ofDecember 31, 2005.

 

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***Debt issuancecosts.***In connectionwith the amendment, we incurred costs of approximately $0.7 million, which werecapitalized. These costs, along with the unamortized balance of the costsincurred in connection with the original agreement and a previous amendment,are being amortized over the term of the amended credit agreement.

 

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.

 

The following table lists our contractualobligations as of December 31, 2005 (in thousands):

 
| ** **                         | ** ** | **Payments Due by Period** | ** ** |
|------------------------------------|------------|----------------------------|------------|
| ** **                         | ** ** | ** **                 | ** ** | **2006** | ** ** | **2007-2009** | ** ** | **2010-2011** | ** ** | **2012+** | ** ** |
| **Contractual Obligations**        | ** ** | **Total**                  | ** ** | **Less than 1  Year** | ** ** | **1-3 Years** | ** ** | **4-5 Years** | ** ** | **After 5 years** | ** ** |
| Long-Term Debt (1)                 |       | $                          | 47,500     |   | $ | 5,000 |   | $ | 32,500 |   | $ | 10,000 |   | $ | — |   |
| Operating Leases                   |       | 52,728                     |       | 6,950 |   | 11,856 |   | 7,231 |   | 26,691 |   |
| Total Contractual Cash Obligations |       | $                          | 100,228    |   | $ | 11,950 |   | $ | 44,356 |   | $ | 17,231 |   | $ | 26,691 |   |

 

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(1)          Represents scheduledprincipal payments for 2006 through 2010 under the term loan portion of ourcredit facility.

 

In October 2004, we entered into a leaseagreement with Professional Real Estate Services, Inc. (PRES) under whichPRES has undertaken to build a new 110,000 square foot corporate headquartersfacility for us on vacant land currently leased to us in Vista,California.  Construction of the new facility is underway and oncecompleted, we will occupy the facility under a 15-year lease with two five-yearoptions to extend the term and will move out of our existing facilities inVista.  Rent for the new facility will be based on an agreed percentage ofthe total project cost for the construction of the facility and is not expectedto exceed the rent currently paid by us for our existing Vista facilities.

 

The new lease with PRES was contingent onPRES closing a transaction to purchase the existing facilities in Vista,California leased by us, as well as the real property underlying the newlease.  The purchase transaction closed in February 2005. Effectiveon the closing date, our lease for the vacant land was terminated, and when thenew headquarters facility is completed and occupied, our leases for ourexisting Vista facilities will be terminated.  Those leases wouldotherwise have continued until February 2008.  Upon occupancy of thenew facility, expected to occur in mid-2006, we will make a lump sum rentpayment to PRES equal to 40% of the rent that would have been due under theexisting facilities leases from the termination date of the existing leasesthrough the original expiration date, estimated at $1.6 million. If PRES isable to lease our former facilities during what would have remained of the termof our existing leases, a portion of that sum may be refunded to us.  Thislump sum rent payment, net of the remaining $0.4 million accrual related tolease termination costs and other exit costs originally accrued in 2002 (seeNote 4 to the consolidated financialstatements included in Item 8 herein), will be accounted for asadditional rent expense over the term of the new lease. The contractualobligations table above assumes a July 2006 occupancy date for our newcorporate headquarters and includes both estimated rent for our new facilitybeginning in July 2006 and the estimated lump sum rent payment ofapproximately $1.6 million for termination of our existing facilities in July 2006.

 

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 our 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.

 

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On January 2, 2006, as discussed in Note13 to the consolidated financial statements included in Item 8 herein, wecompleted the acquisition, under an agreement originally signed on December 15,2005, of the shares of Newmed for cash payments aggregating 13 million Euros(approximately $15.4 million), which included payment of certain debts ofNewmed.  Certain sellers may also receive up to an additional 1 millionEuros (approximately $1.2 million) based on achievement of certain revenuetargets for 2006. We also incurred certain transaction costs and other expensesin connection with the acquisition that are estimated to be approximately $0.4million. We funded the cash paid on January 2, 2006 and our transactionexpenses, with the proceeds of a $16.0 million draw on our revolving line ofcredit.  We repaid $3.0 million of thisborrowing on January 31, 2006.

 

As of December 31, 2005, we hadavailable liquidity of approximately $1.1 million in cash and cash equivalentsand $71.0 million available under our revolving credit facility, net of $4.0million of outstanding letters of credit. For 2006, we have already spent orexpect to spend total cash of approximately $39.0 million for the followingrequirements:

 

•                       approximately$15.8 million for the Newmed acquisition in January 2006, includingtransaction expenses;

 

•                       approximately$5.0 million scheduled principal and interest payments on our credit facility;

 

•        approximately$7.0 million scheduled payments for noncancellable operating leases;

 

•                       upto approximately $1.2 million for additional purchase price that could be paidto certain of the Newmed sellers if certain revenue targets are attained; and

 

•                       upto approximately $10.0 million for capital expenditures.

 

In addition, weexpect to make other general corporate payments in 2006, including the $3.0million repayment we made on our revolving line of credit in January 2006.

 

***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 greaterlikelihood of having satisfied his or her annual insurance deductible than inthe first three quarters of the year, and thus there is an increase in thenumber of elective orthopedic surgeries. We follow a manufacturing calendarthat has a varied number of shipping days in each quarter.  Although on a per day basis net revenues maybe higher in a certain quarter, total net revenues may be higher or lower basedupon the number of shipping days in such quarter. Conversely, we generally havelower net revenues per day during our second quarter as a result of decreasedsports activity.

 

# ***RecentAccounting Pronouncements***

 

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

 

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**Item 7A. Quantitative and QualitativeDisclosures 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, 2005, we had$47.5 million of variable rate debt represented by borrowings under ourcredit facility (at a weighted-average interest rate of 5.35% at December 31,2005). Based on the balance outstanding under the credit facility as of December 31,2005, an immediate change of one percentage point in the applicable interestrate would have caused an increase or decrease in interest expense ofapproximately $0.5 million on an annual basis. At December 31, 2005,up to $71.0 million of variable rate borrowings were available under our$75.0 million revolving credit facility. We may use derivative financial instruments, where appropriate, tomanage our interest rate risks. However, as a matter of policy, we do not enterinto derivative or other financial investments for trading or speculative purposes.At December 31, 2005, we had no such derivative financial instrumentsoutstanding.

 

*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 2005, 2004 and 2003were 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 ouroperating results. Occasionally we seek to reduce the potential impact ofcurrency fluctuations on our business through hedging transactions. At December 31,2005, we had no hedging transactions in place.*

 

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**Item 8. Financial Statements andSupplementary Data**

 

The following documents are filed as part ofthis report:

 
| Report of Independent Registered Public  Accounting Firm                                                                    |   |
|-----------------------------------------------------------------------------------------------------------------------------|--------|
|                                                                                                                        |   |
| Consolidated Balance Sheets as of  December 31, 2005 and 2004                                                          |   |
|                                                                                                                        |   |
| Consolidated Statements of Income for the  years ended December 31, 2005, 2004 and 2003                                |   |
|                                                                                                                        |   |
| Consolidated Statements of Changes in  Stockholders’ Equity for the Years ended December 31, 2005, 2004 and  2003 |   |
|                                                                                                                        |   |
| Consolidated Statements of Cash Flows for  the years ended December 31, 2005, 2004 and 2003                            |   |
|                                                                                                                        |   |
| Notes to Consolidated Financial Statements                                                                                  |   |

 

49

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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 balance sheets of djOrthopedics, Inc. as of December 31, 2005 and 2004, and the relatedconsolidated statements of income, changes in stockholders’ equity and cashflows for each of the three years in the period ended December 31,2005.  Our audits also included thefinancial statement schedule listed in the Index at Item 15(a).  These 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 the standards of the PublicCompany Accounting Oversight Board (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, as wellas evaluating the overall financial statement presentation.  We believe that our audits provide areasonable basis for our opinion.

 

In our opinion, the financial statements referred to above presentfairly, in all material respects, the consolidated financial position of djOrthopedics, Inc. at December 31, 2005 and 2004, and the consolidatedresults of its operations and its cash flows for each of the three years in theperiod ended December 31, 2005, in conformity with U.S. generally acceptedaccounting principles.  Also, in ouropinion, the related financial statement schedule, when considered in relationto the basic financial statements taken as a whole, presents fairly in allmaterial respects the information set forth therein.

 

We also have audited, in accordance with the standards of the PublicCompany Accounting Oversight Board (United States), the effectiveness of djOrthopedics, Inc.’s internal control over financial reporting as of December 31,2005, based on criteria established in Internal Control – Integrated Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commissionand our report dated February 3, 2006 expressed an unqualified opinionthereon.

 

 
|                  | /s/ ERNST &  YOUNG LLP |   |
|-----------------------|---------------------------------|--------|
|                  |
|                  |
| San Diego, California |
| February 3, 2006 |

 

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

# ***CONSOLIDATED BALANCE SHEETS***

(In thousands, except share andpar value data)

 
| ** **                                                                                                                                                                     | ** ** | **December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                     | ** ** | **2005**              | ** ** | **2004** | ** ** |
| **Assets**                                                                                                                                                                     |       |                  |       |   |   |
| Current assets:                                                                                                                                                                |       |                  |       |   |   |
| Cash and cash equivalents                                                                                                                                                      |       | $                     | 1,107      |   | $ | 11,182 |   |
| Accounts receivable, net of provisions for  contractual allowances and doubtful accounts of $26,792 and $26,628 at  December 31, 2005 and 2004, respectively              |       | 62,068                |       | 46,981 |   |
| Inventories, net                                                                                                                                                               |       | 24,228                |       | 19,071 |   |
| Deferred tax asset, current portion                                                                                                                                            |       | 7,066                 |       | 7,902 |   |
| Prepaid expenses and other current assets                                                                                                                                      |       | 4,387                 |       | 5,359 |   |
| Total current assets                                                                                                                                                           |       | 98,856                |       | 90,495 |   |
| Property, plant and equipment, net                                                                                                                                             |       | 15,396                |       | 15,463 |   |
| Goodwill                                                                                                                                                                       |       | 101,235               |       | 96,639 |   |
| Intangible assets, net                                                                                                                                                         |       | 51,242                |       | 54,717 |   |
| Debt issuance costs, net                                                                                                                                                       |       | 2,479                 |       | 2,374 |   |
| Deferred tax asset                                                                                                                                                             |       | 32,437                |       | 46,100 |   |
| Other assets                                                                                                                                                                   |       | 3,019                 |       | 1,062 |   |
| Total assets                                                                                                                                                                   |       | $                     | 304,664    |   | $ | 306,850 |   |
|                                                                                                                                                                           |       |                  |       |   |   |
| **Liabilities and stockholders’ equity**                                                                                                                                  |       |                  |       |   |   |
| Current liabilities:                                                                                                                                                           |       |                  |       |   |   |
| Accounts payable                                                                                                                                                               |       | $                     | 10,270     |   | $ | 7,300 |   |
| Accrued compensation                                                                                                                                                           |       | 6,310                 |       | 5,484 |   |
| Accrued commissions                                                                                                                                                            |       | 3,483                 |       | 4,425 |   |
| Long-term debt, current portion                                                                                                                                                |       | 5,000                 |       | 5,000 |   |
| Accrued restructuring costs                                                                                                                                                    |       | 417                   |       | 2,288 |   |
| Other accrued liabilities                                                                                                                                                      |       | 10,615                |       | 9,315 |   |
| Total current liabilities                                                                                                                                                      |       | 36,095                |       | 33,812 |   |
|                                                                                                                                                                           |       |                  |       |   |   |
| Long-term debt, less current portion                                                                                                                                           |       | 42,500                |       | 90,000 |   |
|                                                                                                                                                                           |       |                  |       |   |   |
| Commitments and contingencies                                                                                                                                                  |       |                  |       |   |   |
|                                                                                                                                                                           |       |                  |       |   |   |
| Stockholders’ equity:                                                                                                                                                     |       |                  |       |   |   |
| Preferred stock, $0.01 par value; 1,000,000  shares authorized, none issued and outstanding at December 31, 2005 and  2004                                                |       | —                |       | — |   |
| Common stock, $0.01 par value; 39,000,000  shares authorized, 22,137,860 shares and 21,459,428 shares issued and  outstanding at December 31, 2005 and 2004, respectively |       | 221                   |       | 215 |   |
| Additional paid-in-capital                                                                                                                                                     |       | 133,656               |       | 121,139 |   |
| Notes receivable from stockholders and  officers for stock purchases                                                                                                           |       | —                |       | (1,749 | ) |
| Accumulated other comprehensive income                                                                                                                                         |       | 492                   |       | 931 |   |
| Retained earnings                                                                                                                                                              |       | 91,700                |       | 62,502 |   |
| Total stockholders’ equity                                                                                                                                                |       | 226,069               |       | 183,038 |   |
| Total liabilities and stockholders’ equity                                                                                                                                |       | $                     | 304,664    |   | $ | 306,850 |   |

 

See accompanying Notes.

 

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**djOrthopedics, Inc.**

**CONSOLIDATEDSTATEMENTS OF INCOME**

(In thousands, except per sharedata)

 
| ** **                                                                          | ** ** | **Years Ended December 31,** | ** ** |
|-------------------------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                                          | ** ** | **2005**                          | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net revenues                                                                        |       | $                                 | 286,167    |   | $ | 255,999 |   | $ | 197,939 |   |
| Costs of goods sold                                                                 |       | 105,289                           |       | 95,164 |   | 85,927 |   |
| Gross profit                                                                        |       | 180,878                           |       | 160,835 |   | 112,012 |   |
| Operating expenses:                                                                 |       |                              |       |   |   |   |   |
| Sales and marketing                                                                 |       | 86,241                            |       | 78,984 |   | 54,067 |   |
| General and administrative                                                          |       | 29,432                            |       | 27,727 |   | 21,767 |   |
| Research and development                                                            |       | 6,350                             |       | 5,627 |   | 4,442 |   |
| Amortization of acquired intangibles                                                |       | 4,996                             |       | 4,731 |   | 464 |   |
| Restructuring costs (credit)                                                        |       | —                            |       | 4,693 |   | (497 | ) |
| Total operating expenses                                                            |       | 127,019                           |       | 121,762 |   | 80,243 |   |
| Income from operations                                                              |       | 53,859                            |       | 39,073 |   | 31,769 |   |
| Other income (expense):                                                             |       |                              |       |   |   |   |   |
| Interest expense                                                                    |       | (4,667                            | )          | (9,431 | ) | (12,582 | ) |
| Interest income                                                                     |       | 249                               |       | 472 |   | 398 |   |
| Prepayment premium and other costs related  to senior subordinated notes redemption |       | —                            |       | (7,760 | ) | — |   |
| Other income (expense)                                                              |       | (980                              | )          | 683 |   | 466 |   |
| Other expense, net                                                                  |       | (5,398                            | )          | (16,036 | ) | (11,718 | ) |
| Income before income taxes                                                          |       | 48,461                            |       | 23,037 |   | 20,051 |   |
| Provision for income taxes                                                          |       | (19,263                           | )          | (9,022 | ) | (7,980 | ) |
| Net income                                                                          |       | $                                 | 29,198     |   | $ | 14,015 |   | $ | 12,071 |   |
| Net income per share:                                                               |       |                              |       |   |   |   |   |
| Basic                                                                               |       | $                                 | 1.34       |   | $ | 0.66 |   | $ | 0.67 |   |
| Diluted                                                                             |       | $                                 | 1.29       |   | $ | 0.63 |   | $ | 0.64 |   |
|                                                                                |       |                              |       |   |   |   |   |
| Weighted average shares outstanding used to  calculate per share information:       |       |                              |       |   |   |   |   |
| Basic                                                                               |       | 21,786                            |       | 21,221 |   | 17,963 |   |
| Diluted                                                                             |       | 22,699                            |       | 22,209 |   | 18,791 |   |

 

See accompanying Notes.

 

52

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**dj Orthopedics, Inc.**

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

(In thousands, except share data)

 
| ** **                                                                     | ** ** | ** **        | ** ** | ** **  | ** ** | ** **            | ** ** | **Notes**            | ** ** | ** **      | ** ** | ** **             | ** ** | ** ** | ** ** |
|--------------------------------------------------------------------------------|------------|-------------------|------------|-------------|------------|-----------------------|------------|----------------------|------------|-----------------|------------|------------------------|------------|------------|------------|
| ** **                                                                     | ** ** | ** **        | ** ** | ** **  | ** ** | ** **            | ** ** | **Receivable**       | ** ** | ** **      | ** ** | ** **             | ** ** | ** ** | ** ** |
| ** **                                                                     | ** ** | ** **        | ** ** | ** **  | ** ** | ** **            | ** ** | **from**             | ** ** | **Accumulated** | ** ** | ** **             | ** ** | ** ** | ** ** |
| ** **                                                                     | ** ** | ** **        | ** ** | ** **  | ** ** | **Additional**        | ** ** | **Stockholders**     | ** ** | **Other**       | ** ** | ** **             | ** ** | **Total**  | ** ** |
| ** **                                                                     | ** ** | **Common  Stock** | ** ** | **Paid-in** | ** ** | **and  Officers for** | ** ** | **Comprehensive**    | ** ** | **Retained**    | ** ** | **Stockholders’** | ** ** |
| ** **                                                                     | ** ** | **Shares**        | ** ** | **Amount**  | ** ** | **Capital**           | ** ** | **Stock  Purchases** | ** ** | **Income**      | ** ** | **Earnings**           | ** ** | **Equity** | ** ** |
| **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:                                                         |       |              |       |        |       |                  |       |                 |       |            |       |                   |       |       |       |
| 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:                                                         |       |              |       |        |       |                  |       |                 |       |            |       |                   |       |       |       |
| 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    |       |
| Proceeds from payment  of notes receivable                                     |       | —            |       | —      |       | —                |       | 1,749                |       | —          |       | —                 |       | 1,749      |       |
| Stock options  granted for services                                            |       | —            |       | —      |       | 219                   |       | —               |       | —          |       | —                 |       | 219        |       |
| Net proceeds from  issuance of common stock under Employee Stock Purchase Plan |       | 59,767            |       | —      |       | 1,028                 |       | —               |       | —          |       | —                 |       | 1,028      |       |
| Net proceeds from  exercise of stock options                                   |       | 618,665           |       | 6           |       | 7,715                 |       | —               |       | —          |       | —                 |       | 7,721      |       |
| Tax benefit of  stock option exercises                                         |       | —            |       | —      |       | 3,455                 |       | —               |       | —          |       | —                 |       | 3,455      |       |
| Reversal of  expenses from 2004 sale of common stock                           |       | —            |       | —      |       | 100                   |       | —               |       | —          |       | —                 |       | 100        |       |
| Comprehensive  income:                                                         |       |              |       |        |       |                  |       |                 |       |            |       |                   |       |       |       |
| Foreign currency  translation adjustment                                       |       | —            |       | —      |       | —                |       | —               |       | (439            | )          | —                 |       | (439       | )          |
| Net income                                                                     |       | —            |       | —      |       | —                |       | —               |       | —          |       | 29,198                 |       | 29,198     |       |
| Total  comprehensive income                                                    |       |              |       |        |       |                  |       |                 |       |            |       |                   |       | 28,759     |       |
| **Balance  at December 31, 2005**                                         |       | 22,137,860        |       | $           | 221        |                  | $          | 133,656              |       | $               | —     |                   | $          | 492        |       | $ | 91,700 |   | $ | 226,069 |   |

 

See accompanying Notes.

 

53

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**dj Orthopedics, Inc.**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

(In thousands)

 
| ** **                                                                          | ** ** | **Years Ended December 31,** | ** ** |
|-------------------------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                                          | ** ** | **2005**                          | ** ** | **2004** | ** ** | **2003** | ** ** |
| **Operating activities**                                                            |       |                              |       |   |   |   |   |
| Net income                                                                          |       | $                                 | 29,198     |   | $ | 14,015 |   | $ | 12,071 |   |
| Adjustments to reconcile net income to net  cash provided by operating activities:  |       |                              |       |   |   |   |   |
| Provision for contractual allowances and  doubtful accounts                         |       | 34,594                            |       | 30,556 |   | 22,641 |   |
| Provision for excess and obsolete  inventories                                      |       | 983                               |       | (113 | ) | 2,087 |   |
| Restructuring costs                                                                 |       | —                            |       | 4,693 |   | (497 | ) |
| Depreciation and amortization                                                       |       | 13,320                            |       | 13,070 |   | 8,186 |   |
| Step-up to fair value of inventory charged  to costs of goods sold                  |       | 404                               |       | 438 |   | — |   |
| Amortization of debt issuance costs and  discount on senior subordinated notes      |       | 560                               |       | 808 |   | 1,499 |   |
| 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                                                                               |       | 219                               |       | 63 |   | 178 |   |
| Changes in operating assets and  liabilities:                                       |       |                              |       |   |   |   |   |
| Accounts receivable                                                                 |       | (49,681                           | )          | (33,353 | ) | (24,708 | ) |
| Inventories                                                                         |       | (2,599                            | )          | (3,635 | ) | 58 |   |
| Other current assets                                                                |       | 912                               |       | 856 |   | (1,991 | ) |
| Accounts payable                                                                    |       | 2,970                             |       | (1,403 | ) | (501 | ) |
| Accrued compensation                                                                |       | 826                               |       | (1,065 | ) | 1,494 |   |
| Accrued commissions                                                                 |       | (942                              | )          | (214 | ) | 2,847 |   |
| Deferred income taxes                                                               |       | 17,580                            |       | 9,044 |   | 6,944 |   |
| Accrued restructuring costs                                                         |       | (1,871                            | )          | (3,171 | ) | (4,631 | ) |
| Other accrued liabilities                                                           |       | 591                               |       | 1,121 |   | 850 |   |
| Net cash provided by operating activities                                           |       | 47,064                            |       | 39,470 |   | 26,527 |   |
|                                                                                |       |                              |       |   |   |   |   |
| **Investing activities**                                                            |       |                              |       |   |   |   |   |
| Purchases of property, plant and equipment                                          |       | (5,144                            | )          | (5,959 | ) | (5,334 | ) |
| Purchases of intangible assets                                                      |       | (76                               | )          | (3,277 | ) | (3,000 | ) |
| Purchase of Superior Medical Equipment  business                                    |       | (3,045                            | )          | — |   | — |   |
| Purchase of Encore Medical OSG business                                             |       | (9,491                            | )          | — |   | — |   |
| Purchase of Regeneration business                                                   |       | —                            |       | — |   | (93,939 | ) |
| Purchase of DuraKold business                                                       |       | —                            |       | — |   | (2,899 | ) |
| Purchase of dj Nordic business and related  earn-out payments, net of cash acquired |       | (125                              | )          | (578 | ) | — |   |
| Change in other assets, net                                                         |       | (1,454                            | )          | (360 | ) | (280 | ) |
| Net cash used in investing activities                                               |       | (19,335                           | )          | (10,174 | ) | (105,452 | ) |
|                                                                                |       |                              |       |   |   |   |   |
| **Financing activities**                                                            |       |                              |       |   |   |   |   |
| Proceeds from long-term debt                                                        |       | 8,000                             |       | — |   | 100,000 |   |
| Repayment of long-term debt                                                         |       | (55,500                           | )          | (5,000 | ) | (35,815 | ) |
| Net proceeds from exercise of stock options                                         |       | 7,721                             |       | 4,133 |   | 3,665 |   |
| Net proceeds from issuance of common stock  under Employee Stock Purchase Plan      |       | 1,028                             |       | 1,617 |   | 228 |   |
| Debt issuance costs                                                                 |       | (665                              | )          | (313 | ) | (2,600 | ) |
| Proceeds from payment of notes receivable                                           |       | 1,749                             |       | 331 |   | 332 |   |
| Net proceeds from issuance of common stock                                          |       | —                            |       | 56,286 |   | — |   |
| Repurchases of common stock                                                         |       | —                            |       | (14,788 | ) | — |   |
| Repayment of senior subordinated notes                                              |       | —                            |       | (75,000 | ) | — |   |
| Prepayment premium on redemption of senior  subordinated notes                      |       | —                            |       | (4,735 | ) | — |   |
| Net cash (used in) provided by financing  activities                                |       | (37,667                           | )          | (37,469 | ) | 65,810 |   |
| Effect of exchange rate changes on cash and  cash equivalents                       |       | (137                              | )          | 209 |   | 176 |   |
| Net decrease in cash and cash equivalents                                           |       | (10,075                           | )          | (7,964 | ) | (12,939 | ) |
| Cash and cash equivalents at beginning of  year                                     |       | 11,182                            |       | 19,146 |   | 32,085 |   |
| Cash and cash equivalents at end of year                                            |       | $                                 | 1,107      |   | $ | 11,182 |   | $ | 19,146 |   |
|                                                                                |       |                              |       |   |   |   |   |
| **Supplemental disclosure of cash flow  information:**                              |       |                              |       |   |   |   |   |
| Interest paid                                                                       |       | $                                 | 4,436      |   | $ | 3,844 |   | $ | 10,513 |   |
| Income taxes paid (refunded), net                                                   |       | $                                 | 1,263      |   | $ | 618 |   | $ | (43 | ) |
| **Supplemental disclosure of non-cash  transactions:**                              |       |                              |       |   |   |   |   |
| Transfer of interest receivable to notes  receivable                                |       | $                                 | —     |   | $ | 92 |   | $ | 123 |   |

 

See accompanying Notes.

 

54

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**dj Orthopedics, Inc.**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**(Inthousands)**

 

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

 

djOrthopedics, Inc. (the Company), is a global medical device companyspecializing in rehabilitation and regeneration products for the non-operativeorthopedic and spine markets.

 

*Basis of Presentation and Principles ofConsolidation*

 

Theaccompanying consolidated financial statements present the historical financialposition and results of operations of the Company and include the accounts ofits operating subsidiary, dj Orthopedics, LLC (dj Ortho), dj OrthopedicsDevelopment Corporation (dj Development), DJ Orthopedics Capital Corporation (DJCapital), dj Ortho’s wholly owned Mexican subsidiary that manufactures amajority of dj Ortho’s products under Mexico’s maquiladora program, and djOrtho’s wholly-owned subsidiaries in Canada, Germany, France, the UnitedKingdom and Denmark. All intercompany accounts and transactions have beeneliminated 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). In each ofthese countries the Company had previously sold its products throughthird-party distributors. In connection with the Company’s January 2006acquisition of Newmed SAS (Newmed), as discussed in Note 13, the Company hasincreased the size and scale of its international business. The Newmedacquisition increases the Company’s sales and marketing presence in France andthe business activities of dj France will be combined with Newmed. Through theNewmed subsidiary in Spain, the Company also now has a direct sales presence inSpain (dj Spain). Newmed also owns 70% of a manufacturing subsidiary inTunisia.

 

*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 equivalents are short-term, highly liquidinvestments and consist of investments in money market funds and commercialpaper with maturities of three months or less at the 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 31,2005.

 

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 (three to seven years) and amortization of intangibleassets (four months to 20 years) using the straight-line method over theestimated useful lives of the assets. Leasehold improvements are amortized overthe lesser of their estimated 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.  The Company is amortizing computer softwarecosts over lives of three to seven years. The Company has unamortized capitalized computer software costsaggregating $2.2 million and $2.6 million at December 31, 2005 and 2004,respectively.  Capitalized computersoftware amortization expense was approximately $1.1 million, $1.3 million and$1.0 million for the years ended December 31, 2005, 2004 and 2003,respectively.

 

*Debt Issuance Costs*

 

Debt issuance costs are capitalized.  The Company amortizes these costs over thelives of the related debt instruments (currently, five years) and classifiesthe amortization expense with interest expense in the accompanying consolidatedstatements of income.

 

*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.  The Company includesamounts billed to customers for freight in revenue.

 

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 $0.9 million, $1.3 millionand $0.5 million for the years ended December 31, 2005, 2004 and 2003,respectively.

 

*Advertising Expense*

 

Advertisingcosts are expensed as incurred.  TheCompany incurred $0.7 million, $0.5 million and $0.2 million in advertisingexpenses for the years ended December 31, 2005, 2004 and 2003,respectively.

 

*Foreign Currency Translation*

 

Thefinancial statements of the Company’s international operations where the localcurrency is the functional currency are translated into United States (U.S.)dollars using period-end exchange rates for assets and liabilities and averageexchange rates during the period for revenues and expenses. Cumulativetranslation gains and losses are excluded from results of operations andrecorded as a separate component of consolidated stockholders’ equity. Gainsand losses resulting from foreign currency transactions (transactionsdenominated in a currency other than the entity’s local currency) are includedin the consolidated statements of operations as either a component of costs ofgoods sold or other income or expense, depending on the nature of thetransaction. The aggregate exchange rate gain or (loss) included in determiningnet income for the years ended December 31, 2005, 2004 and 2003 was ($0.6)million, $0.6 million and $0.4 million, respectively.

 

*Concentration of Credit Risk*

 

The Company sells the majority of itsproducts in the United States to orthopedic professionals, distributors,specialty dealers, buying groups, insurance companies, managed care companiesand certain governmental payors such as Medicare. International sales comprised12%, 11% and 13% of the Company’s net revenues for the years ended December 31,2005, 2004 and 2003, respectively, and are sold through its wholly-ownedsubsidiaries and certain independent distributors. Credit is extended based onan evaluation of the customer’s financial condition and generally collateral isnot required. The Company also provides a reserve for estimated bad debts. Inaddition, approximately 49% and 48% of the Company’s net receivables at December 31,2005 and 2004, respectively, are from third-party payors.  Management reviews and revises its estimatesfor credit losses from time to time and such credit losses have been withinmanagement’s estimates.

 

During the three years ended December 31,2005, the Company had no individual customer or distributor that accounted for10% 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):

 
| ** **                                                                            | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|---------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Shares used in basic net income per share –  weighted average shares outstanding |       | 21,786   |       | 21,221   |       | 17,963   |       |
| Net effect of dilutive common share  equivalents based on treasury stock method       |       | 913      |       | 988      |       | 828      |       |
| Shares used in computations of diluted net  income per share                          |       | 22,699   |       | 22,209   |       | 18,791   |       |

 

*Stock-Based Compensation*

 

Through December 31, 2005, the Companyaccounted for its employee stock option plans and employee stock purchase planunder the recognition and measurement principles of Accounting Principles Board(APB) Opinion No. 25,

 

57

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*Accountingfor 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 Company’s fixed stock option plans or stock purchaseplan.  In accordance with EITF 96-18, *Accounting for Equity Instruments That Are Issued toOther Than Employees for Acquiring, or in Conjunction with Selling, Goods orServices*, stock options and warrants issued to consultants and othernon-employees as compensation for services provided to the Company areaccounted for based upon the fair value of the services provided or the estimatedfair market value of the option or warrant, whichever can be more clearlydetermined. The Company recognizes this expense over the period the servicesare provided; however, the amount of expense related to these types ofarrangements 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 2005, 2004 and 2003: a risk-free interestrate of 3.81%, 3.18% and 2.68%, respectively; a dividend yield of zero;expected volatility of the market price of the Company’s common stock of 59.6%,71.5% and 74.2%, respectively, and a weighted average life of an option of 3.7,4.0 and 4.0 years, respectively.  Thefair value of the employee stock purchase plan purchases was estimated usingthe Black-Scholes valuation model with the following assumptions for 2005, 2004and 2003: a risk-free interest rate of 2.71%, 1.51% and 1.30%, respectively; adividend yield of zero; expected volatility of the market price of the Company’scommon stock of 61.7%, 61.7% and 59.0%, respectively, and a weighted averagelife of 0.7 years, 1.3 years and 0.8 years, respectively.

 

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

 
| ** **                                                                                                                                                    | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Net income as reported                                                                                                                                        |       | $        | 29,198     |     | $          | 14,015   |       | $ | 12,071 |   |
| Total stock-based employee compensation  expense determined under fair value method for all option plans and stock  purchase plan, net of related tax effects |       | (6,993   | )          | (6,356   | )          | (2,026   | )          |
| Pro forma net income                                                                                                                                          |       | $        | 22,205     |     | $          | 7,659    |       | $ | 10,045 |   |
| Basic net income per share:                                                                                                                                   |       |     |       |     |       |     |       |
| As reported                                                                                                                                                   |       | $        | 1.34       |     | $          | 0.66     |       | $ | 0.67 |   |
| Pro forma                                                                                                                                                     |       | $        | 1.02       |     | $          | 0.36     |       | $ | 0.56 |   |
|                                                                                                                                                          |       |     |       |     |       |     |       |
| Diluted net income per share:                                                                                                                                 |       |     |       |     |       |     |       |
| As reported                                                                                                                                                   |       | $        | 1.29       |     | $          | 0.63     |       | $ | 0.64 |   |
| Pro forma                                                                                                                                                     |       | $        | 0.98       |     | $          | 0.34     |       | $ | 0.53 |   |

 

The pro forma effect on net income as shownabove is not necessarily indicative of potential effects on results for futureyears.  The weighted average fair valueof options granted during 2005, 2004 and 2003 was $12.54, $12.09 and $11.30 pershare, respectively.

 

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 APBOpinion No. 25, and amends SFAS No. 95, *Statement of Cash Flows*. Generally, the approach in SFAS No. 123(R) is similar to the approachdescribed in SFAS No. 123.  However,SFAS No. 123(R) requires allshare-based payments to employees, including grants of employee stock options,to be recognized in the income statement based on their fair values and proforma disclosure will no longer be an alternative.  SFAS No. 123(R) is required to beimplemented no later than the first interim period beginning after December 15,2005.  The Company plans to adopt SFAS No. 123(R)effective in its fiscal quarter beginning January 1, 2006.  The Company estimates that the adoption ofSFAS No. 123(R) will reduce its operating income for 2006 by an amountthat will not exceed the pro forma amount shown in the table above for 2005.  This estimate assumes that the number ofemployee stock options granted in 2006 will be similar to the number granted in2005 and is subject to change based on the actual number of stock optionsgranted in 2006, the dates on which the grants are made and the share price onthe date of grant.  In an effort toreduce stock based compensation expense for 2006, the Company postponed itsyear-end option grants from December 2005 to an estimated future grantdate of April 2006 and also has added a three-year vesting schedule tofuture annual director grants.

 

58

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# *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), includingforeign currency translation adjustments, and unrealized gains and losses oninvestments, are reported, net of related tax, to arrive at comprehensiveincome (loss).

 

*Recently Issued Accounting Standards*

 

In May 2005,the FASB issued SFAS No. 154, *AccountingChanges and Error Corrections*, which is a replacement of APB OpinionNo. 20, *Accounting Changes*,and SFAS No. 3, *Reporting AccountingChanges in Interim Financial Statements*.  Among other changes, SFAS No. 154requires that a voluntary change in accounting principle be appliedretrospectively such that all prior period financial statements are presentedin accordance with the new accounting principle, unless impracticable to do so.SFAS No. 154 also provides that (1) a change in method of depreciatingor amortizing a long-lived nonfinancial asset be accounted for as a change inestimate (prospectively) that was effected by a change in accounting principle,and (2) correction of errors in previously issued financial statementsshould be termed a “restatement”.  SFAS No. 154is effective for accounting changes and correction of errors made in fiscalyears beginning after December 15, 2005.

 

In November 2004, the FASB issued SFAS No. 151,*Inventory Costs*, an amendment of ARB No. 43, which isthe result of its efforts to converge U.S. accounting standards for inventorieswith International Accounting Standards. SFAS No. 151 requires idle facility expenses, freight, handlingcosts, 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 forinventory costs incurred during fiscal years beginning after June 15,2005.  The Company does not expect theadoption of SFAS No. 151 to have a material impact on its consolidatedfinancial statements.

 

# *Purchase of Rights toDistributor Territories*

 

From time to time the Company purchasesrights to certain distributor territories in the U.S. and then sells thedistribution rights to another party for similar amounts.  These distribution reorganizations areintended to achieve several objectives, including improvement of sales resultswithin the affected territories.  TheCompany generally receives promissory notes for the resale amounts, which arerecorded as notes receivable and included in other current and long-term assetsin the accompanying consolidated balance sheets.  For the years ended December 31, 2005 andDecember 31, 2004, the Company purchased and resold territory rights foramounts aggregating $2.1 million and $1.9 million, respectively, and did notrecord any gains or losses from the transfer of these distribution rights.  For the years ended December 31, 2005and 2004, purchase price aggregating $2.0 million and $0.7 million,respectively, was recorded as notes receivable and is included in other currentor long-term assets, depending on maturity, and will be repaid over periodsranging from three years to five years. For the years ended December 31,2005 and 2004, purchase price aggregating $0.1 million and $1.2 million,respectively, based on an estimate of future savings in selling expense, wascapitalized as an intangible asset and will be amortized over the period ofcost reduction.

 

# *Goodwill and OtherIntangible Assets*

 

The Company accounts for goodwill and otherintangible assets in accordance with SFAS No. 142, *Goodwill and Other Intangible Assets*. SFASNo. 142 changed the accounting for goodwill from an amortization method toan impairment write-off approach. Under SFAS No. 142, goodwill is testedannually and

 

59

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whenever events orcircumstances occur indicating that goodwill might be impaired. On an ongoingbasis, absent any indicators of impairment, the Company performs an annualimpairment evaluation during the fourth quarter, as of October 1 eachyear.  With the exception of goodwillrelated to the Regeneration acquisition of $39 million, the Company believesthat the goodwill acquired through December 31, 2005 benefits the entireenterprise and since its reporting units share the majority of the Company’sassets, the Company compares the total carrying value of the Company’sconsolidated net assets (excluding Regeneration net assets) to the fair valueof the Company.  With respect to goodwillrelated to the Regeneration acquisition, the Company compares the carryingvalue of the goodwill related to the Regeneration segment to the fair value ofthe Regeneration segment.

 

The Company hasacquired licenses to certain patents aggregating $4.2 million, including patentlicenses acquired in 2004 for $0.8 million. These amounts are recorded asintangible assets and are amortized over the remaining life of the patents,through June 2010.

 

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

 
| ** **                                      | ** ** | **December 31, 2005** | ** ** | **December 31, 2004**  | ** ** |
|-------------------------------------------------|------------|----------------------------|------------|-----------------------------|------------|
| ** **                                      | ** ** | **Useful  Life  (years)**  | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net  Carrying  Amount** | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net  Carrying  Amount** | ** ** |
| ** **                                      | ** ** | ** **                 | ** ** | ** **                  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Intangible assets subject to amortization:      |       |                       |       |                        |       |   |   |   |   |   |   |   |   |   |   |
| Patented and existing technology                |       | 5-20                       |       | $                           | 53,887     |   | $ | (20,722 | ) | $ | 33,165 |   | $ | 51,886 |   | $ | (16,250 | ) | $ | 35,636 |   |
| Customer base                                   |       | 15-20                      |       | 18,873                      |       | (7,556 | ) | 11,317 |   | 18,026 |   | (6,187 | ) | 11,839 |   |
| Licensing agreements                            |       | 5                          |       | 4,200                       |       | (1,076 | ) | 3,124 |   | 4,200 |   | (654 | ) | 3,546 |   |
| Other                                           |       | 0.3-20                     |       | 6,765                       |       | (3,129 | ) | 3,636 |   | 5,487 |   | (1,791 | ) | 3,696 |   |
|                                            |       |                       |       | $                           | 83,725     |   | $ | (32,483 | ) | $ | 51,242 |   | $ | 79,599 |   | $ | (24,882 | ) | $ | 54,717 |   |
| Intangible assets not subject to  amortization: |       |                       |       |                        |       |   |   |   |   |   |   |   |   |   |   |
| Goodwill                                        |       | N/A                        |       | $                           | 115,183    |   | $ | (13,948 | ) | $ | 101,235 |   | $ | 110,587 |   | $ | (13,948 | ) | $ | 96,639 |   |
|                                                 |            |                            |            |                             |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Amortization expense related to intangible assets was$7.6 million, $7.0 million and $3.4 million for the years ended December 31,2005, 2004 and 2003, respectively.

 

Futureamortization expense of intangible assets is estimated to be $51.2 million, asfollows: 2006 - $7.5 million, 2007 - $7.2 million, 2008 - $6.4 million, 2009 -$6.2 million, 2010 - $6.0 million and thereafter - $17.9 million.

 

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

 

## *Inventories*

 

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

 
| ** **                                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
|---------------------------------------------------------------|------------|----------|------------|----------|------------|
| Raw materials                                                 |       | $        | 7,335      |     | $          | 7,116 |   |
| Work-in-progress                                              |       | 1,010    |       | 1,027    |       |
| Finished goods                                                |       | 18,203   |       | 14,109   |       |
|                                                          |       | 26,548   |       | 22,252   |       |
| Less reserves, primarily for excess and  obsolete inventories |       | (2,320   | )          | (3,181   | )          |
|                                                          |       | $        | 24,228     |     | $          | 19,071 |   |

 

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## *Property, Plantand Equipment*

 

Property,plant and equipment consists of the following at December 31 (inthousands):

 
| ** **                                      | ** ** | **2005** | ** ** | **2004** | ** ** |
|-------------------------------------------------|------------|----------|------------|----------|------------|
| Leasehold improvements                          |       | $        | 5,514      |     | $          | 4,430 |   |
| Furniture, fixtures and equipment               |       | 43,537   |       | 39,362   |       |
|                                            |       | 49,051   |       | 43,792   |       |
| Less accumulated depreciation and  amortization |       | (33,655  | )          | (28,329  | )          |
|                                            |       | $        | 15,396     |     | $          | 15,463 |   |

 

Depreciation expense was approximately $5.1million, $5.3 million and $4.3 million for the years ended December 31,2005, 2004 and 2003, respectively, and amortization expense related toproperty, plant and equipment was approximately $0.6 million, $0.7 million and$0.5 million for the years ended December 31, 2005, 2004 and 2003,respectively.

 

# *AccruedCompensation*

 

Accrued compensation consists of the following at December 31 (inthousands):

 
| ** **                         | ** ** | **2005** | ** ** | **2004** | ** ** |
|------------------------------------|------------|----------|------------|----------|------------|
| Accrued vacation                   |       | $        | 1,884      |     | $          | 1,670 |   |
| Accrued bonus                      |       | 1,874    |       | 683      |       |
| Accrued workers’ compensation |       | 1,558    |       | 2,049    |       |
| Other accrued compensation         |       | 994      |       | 1,082    |       |
|                               |       | $        | 6,310      |     | $          | 5,484 |   |

 

**3.****                                      Acquisitions**

 

The Companyaccounts for acquisitions in accordance with SFAS No. 141, *Business Combinations*.SFAS No. 141 replaced prior accounting standards and eliminatedpooling-of-interests accounting prospectively. It also provides guidance onpurchase accounting related to the recognition of intangible assets andaccounting for negative goodwill.

 

# *OSG Acquisition*

 

On August 8, 2005, the Company completedthe purchase of substantially all of the assets of the orthopedics soft goods(OSG) business of Encore Medical, L.P. (OSG acquisition) for approximately $9.5million, paid in cash upon closing, plus the assumption of certain liabilitiesaggregating approximately $0.6 million. The OSG business is comprised of the manufacture and sale of orthopedicsoft goods, patient safety products and pressure care products.

 

The fair values of the assets acquired andthe liabilities assumed in connection with the OSG acquisition were estimatedin accordance with SFAS No. 141. The Company used an independent valuationfirm to assist management in estimating these fair values. The purchase pricewas allocated as follows to the fair values of the net tangible and intangibleassets acquired (in thousands):

 
| Inventories, net               |   | $     | 3,870  |   |
|--------------------------------|--------|-------|--------|--------|
| Fixed assets, net              |   | 409   |   |
| Accrued liabilities            |   | (589  | )      |
| Tangible assets, net           |   | 3,690 |   |
| Identifiable intangible assets |   | 3,500 |   |
| Goodwill                       |   | 2,301 |   |
| Net assets acquired            |   | $     | 9,491  |   |

 

The identifiable intangible assets are beingamortized over their estimated useful lives, which range from three to eightyears.

 

The purchase price allocation included valuesassigned to certain specific identifiable intangible assets aggregating $3.5million. A value of $2.0 million was assigned to existing technology,determined primarily by estimating the future discounted cash flows to bederived from the OSG products that existed at the date of the acquisition. Anaggregate value of $1.5 million was assigned to certain OSG customerrelationships existing on the acquisition date based upon an estimate of thefuture discounted cash flows that would be derived from those customers. Avalue of $2.3 million, representing the difference

 

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between the total purchaseprice and the aggregate fair values assigned to the net tangible assetsacquired and liabilities assumed and the identifiable intangible assetsacquired, was assigned to goodwill.

 

The Company acquired the OSG business toexpand its portfolio of national contracts and increase its related revenuesand also to gain access to the patient safety products and pressure careproducts, which were not previously included in the Company’s productportfolio. These are among the factors that contributed to a purchase price forthe OSG acquisition that resulted in the recognition of goodwill.

 

# *Superior Medical EquipmentAcquisition*

 

On March 10, 2005, the Company completedthe purchase of substantially all of the assets of Superior Medical Equipment,LLC (SME), a Connecticut based distributor of orthopedic products and supplies,for an aggregate purchase price of up to $4.2 million, of which approximately$3.1 million was paid upon closing, $0.1 million was paid as a final purchaseprice adjustment in April 2005 and $0.5 million will be paid in March 2006.The remaining amount of up to $0.5 million will be paid in March 2006subject to achievement of certain operating targets. The assets acquired fromSME included tangible and intangible assets related to the distribution oforthopedic products and supplies. The SME acquisition has been accounted forusing the purchase method of accounting whereby the total purchase price wasallocated to tangible and intangible assets acquired based on estimated fairmarket values with the remainder classified as goodwill.

 

*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, $0.1 million paid inSeptember 2005 for operating income target met, plus amounts aggregatingup to an additional $0.4 million through 2009 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 were 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. The assets acquiredincluded 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. TheCompany financed the purchase with cash on hand of $12.1 million and a portionof the proceeds of a $100.0 million term loan received in connection with a newcredit agreement.

 

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 |   |

 

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The fair values of the assets acquired andthe liabilities assumed in connection with the Regeneration acquisition wereestimated in accordance with SFAS No. 141. The Company used an independentvaluation firm to assist management in estimating these fair values. Thepurchase price was allocated as follows to the fair values of the net tangibleand intangible assets acquired (in thousands):

 
| 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 four months to ten years.

 

The purchase price allocation included valuesassigned to certain specific identifiable intangible assets aggregating $44.8million. A value of $27.8 million was assigned to existing technology,determined primarily by estimating the future discounted cash flows to bederived from the Regeneration technologies and products that existed at thedate of the acquisition. A value of $10.1 million was assigned to patentedtechnology, determined primarily by estimating the present value of futureroyalty or license costs that will be avoided due to the Company’s ownership ofthe proprietary technologies acquired.  Avalue of $5.2 million was assigned to customer relationships based on anestimate of the present value of future costs that would have been incurred toestablish similar relationships with Regeneration customers comparable in typeand number to those customers that existed at the date of acquisition. A valueof $0.8 million was assigned to one significant long-term customer contract ofthe Regeneration business based upon an estimate of the future discounted cashflows that would be derived from that contract. A value of $0.7 million wasassigned to a distribution agreement in place for the Regeneration business,pursuant to which certain independent sales representatives had been trained tosell certain of the acquired Regeneration products. The value assigned to thiscontract was determined based upon an estimate of the present value of coststhat the Company would have incurred to recruit and train a comparable salesforce had the distribution agreement not been in place. A value of $0.2 millionwas assigned to the order backlog of the Regeneration business as of the dateof the acquisition, based on an estimate of the present value of the cost thatwould be required to recreate a similar order backlog. A value of $38.5million, representing the difference between the total purchase price and theaggregate fair values assigned to the net tangible assets acquired andliabilities assumed and the identifiable intangible assets acquired, wasassigned to goodwill.

 

The Company acquired the Regenerationbusiness to enter the Regeneration segment of the non-operative orthopedic andspine markets, expanding the addressable markets served by the Company.  The Regeneration markets are estimated togrow faster than the rehabilitation markets in which the Company competes andthe Regeneration products generate gross margins and operating margins that arehigher than the Company’s rehabilitation products. These are among the factorsthat contributed to a purchase price for the Regeneration acquisition thatresulted in the recognition of goodwill.

 

The accompanying consolidated statement ofincome reflects the operating results of the Regeneration business since theacquisition date of November 26, 2003. Assuming the purchase of theRegeneration business had occurred on January 1 of the year ended December 31,2003 the pro forma unaudited results of operations for 2003 would have been asfollows (in thousands, except per share data):

 

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| Net revenues                                                                  |   | $       | 240,378 |   |
|-------------------------------------------------------------------------------|--------|---------|---------|--------|
| Costs of goods sold                                                           |   | 92,562  |    |
| Gross profit                                                                  |   | 147,816 |    |
| Operating expenses:                                                           |   |    |    |
| Sales, marketing, general and  administrative                                 |   | 98,794  |    |
| Research and development                                                      |   | 5,211   |    |
| Amortization of acquired intangibles                                          |   | 4,808   |    |
| Impairment of long-lived assets                                               |   | —  |    |
| Performance improvement, restructuring and  other                             |   | (497    | )       |
| Total operating expenses                                                      |   | 108,316 |    |
| Income from operations                                                        |   | 39,500  |    |
| Interest expense, net of interest income                                      |   | (14,434 | )       |
| Other income                                                                  |   | 466     |    |
| Income before income taxes                                                    |   | 25,532  |    |
| Provision for income taxes                                                    |   | (10,162 | )       |
| Net income                                                                    |   | $       | 15,370  |   |
|                                                                          |   |    |    |
| Net income per share:                                                         |   |    |    |
| Basic                                                                         |   | $       | 0.86    |   |
| Diluted                                                                       |   | $       | 0.82    |   |
|                                                                          |   |    |    |
| Weighted average shares outstanding used to  calculate per share information: |   |    |    |
| Basic                                                                         |   | 17,963  |    |
| Diluted                                                                       |   | 18,791  |    |

 

*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 a covenant not to compete and theacquired customer base, which are being amortized over their estimated usefullives.

 

**4.****                                      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 were 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 were incurred.  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.  The Companyalso relocated the manufacturing of its cold therapy products and machine shopactivities from Vista, California to the new Mexico plant in 2004. Therelocation to Mexico of these California-based activities resulted in reducedmanufacturing costs in 2005.  TheRegeneration integration and the move of the U.S. manufacturing operationsresulted in the elimination of approximately 130 positions, including temporaryemployees, by December 31, 2004. Approximately 110 new positions were added in Vista and

 

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Mexico in theaggregate to accommodate the operations moved to each of those locations. TheRegeneration integration and manufacturing moves were both substantiallycompleted 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 No.146 requires that costs associated with an exit ordisposal activity be recorded as an expense and a liability when incurred.  The results for the 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’s Regeneration integration and $0.9 millionrelated to the manufacturing moves.

 

Restructuring costs accrued in 2004 in connection with these activitiesare as follows (in thousands):

 
| ** **                             | ** ** | **Total Costs  Incurred** | ** ** | **Completed  Activity  (Cash)** | ** ** | **Completed  Activity  (Non-Cash)** | ** ** | **Accrued Liability  at December 31,  2005** | ** ** |
|----------------------------------------|------------|---------------------------|------------|---------------------------------|------------|-------------------------------------|------------|---------------------------------------------------|------------|
|                                   |       |                      |       |                            |       |                                |       |                                              |       |
| Employee severance and retention costs |       | $                         | 2,435      |                            | $          | (2,435                              | )          | $                                                 | —     |   | $ | — |   |
| Other                                  |       | 2,258                     |       | (2,091                          | )          | (167                                | )          | —                                            |       |
| Total                                  |       | $                         | 4,693      |                            | $          | (4,526                              | )          | $                                                 | (167       | ) | $ | — |   |

 

Accrued restructuring costs in theaccompanying consolidated balance sheet at December 31, 2005, includes$0.4 million of lease termination and other exit costs remaining from an amountaccrued in 2002.  This amount relates tovacant land previously leased by the Company (see Note 10).

 

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

 

The Company’slong-term debt consists of the following at December 31 (in thousands):

 
| ** **                                                                                                                      | ** ** | **2005** | ** ** | **2004** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| Term loan due in installments through  May 5, 2010 bearing interest at LIBOR plus 1.25% (5.35% at  December 31, 2005) |       | $        | 47,500     |     | $          | 95,000 |   |
| Less current portion                                                                                                            |       | (5,000   | )          | (5,000   | )          |
| Long-term portion of term loan                                                                                                  |       | $        | 42,500     |     | $          | 90,000 |   |

 

*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 in 2004 of$7.8 million, including a redemption premium of $4.7 million, unamortized debtissuance costs of $2.3 million and original issue discounts of $0.8 million.

 

# *Credit Agreement Amendment*

 

On May 5, 2005, the Company completed anamendment to its credit agreement. Previously, the credit agreement consistedof a $100.0 million term loan, of which approximately $93.8 million was owed asof the date of the amendment, and a $30.0 million revolving line of credit onwhich no amounts had been drawn. The amended credit agreement provides for totalborrowings of $125.0 million, consisting of a term loan of $50.0 million, whichwas fully drawn at closing and $75.0 million available under a revolving lineof credit, of which approximately $43.8 million was drawn at closing. Prior to December 31,2005, the Company repaid all of the amounts outstanding under the revolvingline of credit. The Company was contingently liable for outstanding letters ofcredit aggregating approximately $4.0 million at December 31, 2005. Underthe amended agreement, up to $25.0 million of outstanding borrowings may bedenominated in British Pounds or Euros. As of December 31, 2005, allborrowings under the credit agreement were denominated in U.S. dollars.Borrowings under the term loan and on the revolving credit facility bearinterest at variable rates (either a London Inter-Bank Offered Rate (LIBOR) orthe lenders’ base rate, as elected by the Company) plus an applicable margin,which varies based on the Company’s leverage ratio. The amended agreementreduced the Company’s interest rate to LIBOR plus an applicable margin of 1.25%to 2.00%, or the lenders’ base rate plus an applicable margin of 0.25% to1.00%. At the Company’s current leverage ratio, the applicable interest rate iseither

 

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LIBOR plus 1.25% or base rateplus 0.25%. The weighted average interest rate applicable to the Company’sborrowings as of December 31, 2005 was 5.35%.

 

*Repayment*.The Company is required to make quarterly principal payments on the term loanof $1.25 million, beginning in September 2005 and increasing to$1.875 million in September 2007, $3.125 million in September 2008and $5.0 million in September 2009. The balance of the term loan, if any,and any borrowings under the revolving credit facility are due in full on May 5,2010. The Company is also required to make mandatory prepayments under certaincircumstances.  Prior to December 31,2005, the Company repaid $2.5 million of the amounts outstanding under the termloan and $47.5 million remained outstanding under the term loan as of December 31,2005.

 

*Security; Guarantees*.  The obligations of dj Ortho under the creditagreement are irrevocably guaranteed, jointly and severally, by the Company, djDevelopment, 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 of covenants that, among other things,restrict the ability of the Company to (i) incur additional indebtedness; (ii) incuror guarantee obligations; (iii) pay dividends or make other distributions(except for certain tax distributions); (iv) redeem or repurchase equity,make investments, loans or advances, make acquisitions; (v) engage inmergers or consolidations; (vi) change the business conducted by theCompany; (vii) grant liens on or sell its assets; or (viii) engage incertain other activities. The amended agreement provides less restriction thanthe Company’s previous agreement in most of these areas. In addition, theamended credit agreement requires the Company to maintain specified financialratios, including a maximum leverage ratio and a minimum fixed charge coverageratio. The Company was in compliance with all covenants as of December 31,2005.

 

*Debt Issuance Costs*

 

The Company has capitalized debt issuancecosts aggregating $3.6 million in association with its current creditagreement, as amended. The total costs related to the credit agreement arebeing amortized as interest expense over the term of the credit agreement andare reflected in the accompanying consolidated balance sheets, net ofaccumulated amortization of $1.1 million and $0.5 million at December 31,2005 and 2004, respectively.

 

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

 

In 2005 and 2004, certain managementstockholders who previously purchased shares of the Company’s stock in exchangefor promissory notes, repaid the entire balances of such notes, includinginterest, owed to the Company.  Amountsrepaid included $1.8 million paid in 2005 and $0.3 million paid in each of 2004and 2003.

 

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

 

At December 31, 2005, the Company had atotal of 22,137,860 shares of common stock outstanding.

 

In June 2004,the Company completed a public offering of 3,072,379 shares of its commonstock.  All of these shares were sold bycertain of the Company’s stockholders and the Company did not receive any ofthe net proceeds.  The Company incurredcosts of $0.2 million related to this offering, which were recorded as areduction in the Company’s additional paid-in capital.

 

In February 2004,the Company completed a public offering of 8,625,000 shares of its commonstock.  The offering consisted of3,162,500 shares of common stock sold by the Company at $19.00 per share fornet proceeds, after underwriters’ commissions and other costs, of $56.5 millionand 5,462,500 shares sold by certain of the Company’s stockholders.

 

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*StockOptions*

 

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

 

The 2001 Omnibus plan provides for awards ofstock options, stock appreciation rights, performance awards, restricted stock,restricted stock units, stock bonuses, stock unit awards and cash bonuses tokey 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 6,517,732 at December 31, 2005.  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 December 31.  In addition, shares of common stock reservedfor but not subject to options granted under the 1999 Option Plan or subject toawards that are forfeited, terminated, canceled or settled without the deliveryof common stock under the Omnibus Plan and the 1999 Option Plan will increasethe number of shares available for awards under the Omnibus Plan.  Also, shares tendered to dj Orthopedics, Inc.in satisfaction or partial satisfaction of the exercise price of any awardunder the Omnibus Plan or the 1999 Option Plan will increase the number ofshares available for awards under the Omnibus Plan to the extent permitted by Rule 16b-3under the Securities Exchange Act of 1934, as amended.  The Omnibus Plan is administered by theCompensation Committee of the Company’s Board of Directors, which has the soleand complete authority to grant awards under the Omnibus Plan to eligibleemployees and officers of, and consultants and advisors to, dj Orthopedics, Inc.and its subsidiaries.  Most optionsgranted under the Omnibus Plan are subject to vesting in equal annualinstallments over four years.  Optionsgranted under the Omnibus Plan expire ten years from the date of grant.  At December 31, 2005 options to purchase3,303,387 shares had been granted. At December 31, 2005 and 2004, 828,520and 610,343 shares were exercisable, respectively.  On December 31, 2005, 3,214,345 shareswere available for future grant under the Omnibus Plan. On January 1,2006, the shares available for future grant were increased by 664,136 shares to3,878,481 shares.

 

## *1999 Option Plan*

 

Under the Company’s Fifth Amended and Restated 1999Option Plan (the 1999 Option Plan), 1,993,174 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 on August 19,2015 unless the Company terminates it before that date. The 1999 Option Planprovides for the grant of nonqualified options to officers, directors and employeesof, and consultants and advisors to, dj Orthopedics, Inc.

 

The Company granted options to purchase anaggregate of 944,542 shares of common stock under the 1999 Option Plan. As of December 31,2005, options to purchase 236,733 shares issued under the 1999 Option Plan wereoutstanding and all exercisable. No future options will be granted under the1999 Option Plan, and all shares of common stock, which would otherwise havebeen available for issuance under the 1999 Option Plan are available for issuanceunder 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 December 2005, theCompany’s Board amended this plan as follows: (1) upon initial election tothe Board, a director will receive an option grant covering 15,000 options atan exercise price equal to 100% of the fair market value of the common stock asof such date, such options will be fully vested upon date of grant; and (2) ongoingdirector options granted after the effective date of the amendment will vestover a three-year period, with one-third vesting on each of the first threeanniversary dates of the grant.  Optionsgranted under this plan expire ten years from the date of grant.  A total of 1,500,000 shares of the Company’scommon stock have been reserved for issuance under the plan.  A total of 355,000 and 255,000 options hadbeen granted under the Plan at December 31, 2005 and 2004,respectively.  No options were grantedunder this plan prior to 2002.  As of December 31,2005, options to purchase 320,000 shares issued under the Director Plan wereexercisable.

 

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The following table summarizes optionactivity under all plans from December 31, 2002 through December 31,2005:

 
| ** **                            | ** ** | **Number of  Shares** | ** ** | **Price per Share** | ** ** | **Weighted Average Exercise  Price per Share** | ** ** |
|---------------------------------------|------------|-----------------------|------------|---------------------|------------|------------------------------------------------|------------|
| 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 |   |
| Granted                               |       | 395,000               |       | 20.07               | -          | 31.81                                          |       | 26.47 |   |
| Exercised                             |       | (618,665              | )          | 2.97                | -          | 26.65                                          |       | 12.47 |   |
| Cancelled                             |       | (452,227              | )          | 3.52                | -          | 25.92                                          |       | 22.09 |   |
| Outstanding at December 31, 2005 |       | 3,143,083             |       | 2.97                | -          | 31.81                                          |       |   | 18.22 |   |

 

The following table summarizes informationconcerning currently outstanding and exercisable options:

 
| ** **                    | ** ** | **Options Outstanding**                                | ** ** | **Options Exercisable**                        | ** ** |
|-------------------------------|------------|--------------------------------------------------------|------------|------------------------------------------------|------------|
| **Range of  Exercise Prices** | ** ** | **Options  Outstanding as of  December 31, 2005** | ** ** | **Weighted Average  Remaining Life in  Years** | ** ** | **Weighted  Average Exercise  Price** | ** ** | **Options  Exercisable as of  December 31, 2005** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
| $                             | 2.97       | -                                                      | $          | 4.10                                           |       | 498,100 |   | 6.9 |   | $ | 3.75 |   | 305,946 |   | $ | 3.71 |   |
| 7.24                     | -          | 10.80                                                  |       | 451,082                                        |       | 5.7 |   | 8.69 |   | 299,332 |   | 8.82 |   |
| 12.25                    | -          | 18.00                                                  |       | 106,051                                        |       | 6.7 |   | 15.40 |   | 75,801 |   | 14.63 |   |
| 19.35                    | -          | 25.92                                                  |       | 1,817,850                                      |       | 8.5 |   | 23.24 |   | 601,674 |   | 23.60 |   |
| 26.35                    | -          | 31.81                                                  |       | 270,000                                        |       | 9.3 |   | 28.12 |   | 102,500 |   | 27.38 |   |
| 2.97                     | -          | 31.81                                                  |       | 3,143,083                                      |       | 7.8 |   | 18.22 |   | 1,385,253 |   | 15.80 |   |
|                               |            |                                                        |            |                                                |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

*Employee Stock Purchase Plan*

 

The Employee Stock Purchase Plan provides for theissuance of up to 1,576,365 shares of the Company’s common stock.  During each purchase period, eligibleemployees may designate between 1% and 15% of their cash compensation, subjectto certain limitations, to be deducted from their cash compensation for thepurchase of common stock under the plan. Through December 31, 2005, the purchase price of the shares underthe plan is equal to 85% of the lesser of the fair market value per share onthe first day of each twenty-four month offering period or the last day of eachsix-month purchase period during the offering period.  Effective January 1, 2006, the offeringperiod of the plan was reduced to six months. On January 1 of each year, the aggregate number of shares reservedfor issuance under this plan increases automatically by a number of sharesequal to 1.0% of the Company’s outstanding shares on December 31 of thepreceding year.  The Company’s Board ofDirectors or the Compensation Committee may reduce the amount of the increasein any particular year.  The aggregatenumber of shares reserved for issuance under the Employee Stock Purchase Planmay not exceed 5,000,000 shares.  ThroughDecember 31, 2005, 497,248 shares had been issued under the Employee StockPurchase Plan. On January 1, 2006, the number of shares reserved forissuance under the Employee Stock Purchase Plan was increased by 221,379,shares and total shares reserved for issuance were 1,300,496.

 

*Repurchases of Common Stock*

 

The Company’s board of directors authorized a stockrepurchase program in September 2004 that allowed the Company torepurchase up to $20 million of its common stock.  The shares could be repurchased at times andprices as determined by management and could be completed through open marketor privately negotiated transactions. The repurchase program provided thatrepurchases would be made in accordance with applicable state and federal lawand in accordance with the terms and subject to the restrictions of Rule 10b-18under the Securities Exchange Act of 1934, as amended. Shares would be retiredand cancelled upon repurchase. Through December 31, 2004, the Company hadrepurchased 837,300 shares of its common stock at an average price of $17.62per share, for an aggregate total cost of approximately $14.8 million.   No additional shares were repurchased in2005 and the stock repurchase program expired in September 2005.

 

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**8.****                                      IncomeTaxes**

 

The provision for income taxes, includingdeferred taxes, on income before income taxes is as follows for the years endedDecember 31 (in thousands):

 
| ** **                 | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|----------------------------|------------|----------|------------|----------|------------|----------|------------|
| Current                    |       |     |       |     |       |     |       |
| Federal                    |       | $        | (631       | )        | $          | (30      | )          | $ | (15 | ) |
| State                      |       | (422     | )          | 184      |       | (380     | )          |
| Foreign                    |       | (629     | )          | (268     | )          | (647     | )          |
|                       |       | (1,682   | )          | (114     | )          | (1,042   | )          |
| Deferred                   |       |     |       |     |       |     |       |
| Federal                    |       | (14,709  | )          | (7,097   | )          | (5,064   | )          |
| State                      |       | (2,914   | )          | (1,403   | )          | (1,874   | )          |
| Foreign                    |       | 42       |       | (408     | )          | —   |       |
|                       |       | (17,581  | )          | (8,908   | )          | (6,938   | )          |
|                       |       |     |       |     |       |     |       |
| Provision for income taxes |       | $        | (19,263    | )        | $          | (9,022   | )          | $ | (7,980 | ) |

 

Deferred tax assets and liabilities aredetermined based on differences between financial reporting and tax bases ofassets and liabilities, and are measured using the enacted tax rates and lawsthat will be in effect when the differences are expected to reverse.  Significant components of the Company’sdeferred tax assets and liabilities as of December 31 are as follows (inthousands):

 
| ** **                                     | ** ** | **2005** | ** ** | **2004** | ** ** |
|------------------------------------------------|------------|----------|------------|----------|------------|
| Deferred tax assets/(liabilities):             |       |     |       |     |       |
| Amortization of intangible assets              |       | $        | 26,766     |     | $          | 33,091 |   |
| Accrued expenses                               |       | 2,169    |       | 2,810    |       |
| Allowance for doubtful accounts                |       | 3,149    |       | 2,650    |       |
| Provision for excess and obsolete  inventories |       | 2,167    |       | 2,442    |       |
| Net operating loss carryforwards               |       | 5,627    |       | 14,481   |       |
| Depreciation of fixed assets                   |       | (752     | )          | (1,156   | )          |
| Other, net                                     |       | 377      |       | (316     | )          |
| Net deferred tax assets                        |       | $        | 39,503     |     | $          | 54,002 |   |

 

Realization of the Company’s deferred taxassets is dependent on the Company’s ability to generate future taxable incomeprior to the expiration of net operating loss carryforwards. 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, 2005.  No valuation allowance was provided for anyof the Company’s deferred tax assets at December 31, 2005 or 2004.

 

As of December 31, 2005, the Company hasU.S. federal net operating loss carryforwards of $14.5 million, which begin toexpire in 2022. As a result of the Company’s 2004 stock offerings (see Note 7),certain changes in the Company’s ownership may limit future annual utilizationof the Company’s federal net operating loss carryforwards. The Company also has$10.8 million of various state net operating loss carryforwards, which begin toexpire in 2007 and $0.3 million of various foreign net operating losscarryforwards, which begin to expire in 2008.

 

The reconciliation of income tax attributableto income before provision for income taxes at the U.S. federal statutory rateto income tax provision in the accompanying statements of income for the yearsended December 31 is as follows:

 
| ** **                               | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Federal tax at statutory rate            |       | 35.0     | %          | 35.0     | %          | 35.0     | %          |
| State income tax, net of federal benefit |       | 4.2      | %          | 3.4      | %          | 7.3      | %          |
| Other                                    |       | 0.6      | %          | 0.8      | %          | (2.5     | )%         |
|                                     |       | 39.8     | %          | 39.2     | %          | 39.8     | %          |

 

The Company made income tax payments, net of(refunds), totaling $1.3 million, $0.6 million and ($0.1) million in the yearsended December 31, 2005, 2004 and 2003, respectively.

 

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Income before income taxes includes thefollowing components for the years ended December 31 (in thousands):

 
| ** **    | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|---------------|------------|----------|------------|----------|------------|----------|------------|
| United States |       | $        | 46,862     |     | $          | 21,270   |       | $ | 18,757 |   |
| Foreign       |       | 1,599    |       | 1,767    |       | 1,294    |       |
|          |       | $        | 48,461     |     | $          | 23,037   |       | $ | 20,051 |   |

 

Undistributed earnings of the Company’sforeign subsidiaries amounted to approximately $3.3 million at December 31,2005.  Those earnings are considered tobe indefinitely reinvested, and accordingly, no provision for U.S. federal andstate income taxes has been provided thereon. Upon distribution of those earnings in the form of dividends orotherwise, the Company would be subject to both U.S. income taxes andwithholding taxes payable to the foreign countries, but would also be able togenerate 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.

 

The Companyis 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 all tax periods subject to audit.

 

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

 

Prior to 2005, the Company disclosed thefollowing reportable segments, which, except for Regeneration, were based onthe Company’s sales channels:  DonJoy,ProCare, OfficeCare, Regeneration and International.  Effective 2005, the Company has aggregatedthe DonJoy, ProCare and OfficeCare segments into one new segment, DomesticRehabilitation.  In accordance with theaggregation criteria in SFAS No. 131, *Disclosureabout Segments of an Enterprise and Related Information*,**the historical segments have beenaggregated due to changes in the Company’s management and compensationstructure that focus on the results of Domestic Rehabilitation, taken as awhole, rather than on its separate components. Segment data for all priorperiods have been restated (aggregated) to conform to the newsegmentation.  The following are theCompany’s current reportable segments.

 

•                       *Domestic Rehabilitation* consists of the sale of the Company’s rehabilitation products (rigidknee braces, soft goods and pain management products) in the United Statesthrough three sales channels, DonJoy, ProCare and OfficeCare.

 

Through the DonJoy sales channel, the Company sells itsrehabilitation products utilizing a few of the Company’s direct salesrepresentatives and a network of approximately 300 independent commissionedsales representatives who are employed by approximately 45 independent salesagents. These sales representatives are primarily dedicated to the sale of theCompany’s products to orthopedic surgeons, podiatrists, orthopedic andprosthetic centers, hospitals, surgery centers, physical therapists, athletictrainers and other healthcare professionals. Because certain of the DonJoy product lines require customer educationon the application and use of the product, these sales representatives aretechnical specialists who receive extensive training both from the Company andthe agent and use their expertise to help fit the patient with the product andassist the orthopedic professional in choosing the appropriate product to meetthe patient’s needs. After a product order is received by a salesrepresentative, the Company generally ships the product directly to theorthopedic professional and pays a sales commission to the agent. Thesecommissions are reflected in sales and marketing expense in the Company’sconsolidated financial statements.

 

Through the ProCare sales channel, which is comprised ofapproximately 45 direct and independent representatives that manage over 310dealers focused on primary and acute facilities, the Company sells itsrehabilitation products to national third-party distributors, other regionalmedical supply dealers and medical product buying groups, generally at adiscount from list prices. The majority of these products are soft goods whichrequire little or no patient education. The distributors and dealers generallyresell these products to large hospital chains, hospital buying groups, primarycare networks and orthopedic physicians for use by the patients.

 

Through the OfficeCare sales channel, the Companymaintains an inventory of rehabilitation products (mostly soft goods) on handat orthopedic practices for immediate distribution to the patient. For theseproducts, the Company arranges billing to the patient or third-party payorafter the product is provided to the patient. As of

 

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December 31, 2005, the OfficeCareprogram was located at over 850 physician offices throughout the UnitedStates.  The Company has contracts withover 700 third-party payors.

 

•                       *Regeneration*consists of the sale of the Company’s bone growth stimulation products in theUnited States.  The Company’sOL1000 product is sold through a combination of the DonJoy channel direct salesrepresentatives and approximately 120 additional sales representativesdedicated to selling the OL1000 product, of which approximately 60 are employedby the Company. The SpinaLogic product is also included in this segment andwas, until the end of 2004, sold by DePuy Spine in the U.S. under an exclusivesales agreement. In January 2005, the Company amended the agreement withDePuy to divide the U.S. into territories in which DePuy Spine has exclusivesales rights and non-exclusive territories in which the Company is permitted toengage in its own sales efforts or retain another sales agent. In early 2006,the agreement was further modified to be non-exclusive in all territories.  These products are sold either directly tothe patient or to independent distributors. The Company arranges billing to the third-party payors or patients, forproducts sold directly to the patient.

 

•                       *International*consists of the sale of the Company’s productsin foreign countries through wholly-owned subsidiaries or independentdistributors.  The Company sells itsproducts in over 50 foreign countries, primarily in Europe, Australia, Canadaand Japan.

 

Set forth below is net revenues, gross profitand operating income information for the Company’s reporting segments for theyears ended December 31 (in thousands). This information excludes theimpact of expenses not allocated to segments, which are comprised of (i) generalcorporate expenses for all periods presented and (ii) the restructuringcosts associated with certain manufacturing moves 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 andrelated amortization of acquired intangible assets. For the years ended December 31,2005, 2004 and 2003, Regeneration income from operations was reduced byamortization of acquired intangible assets amounting to $4.6 million, $4.7million and $0.5 million, respectively. For the year ended December 31, 2005, Domestic Rehabilitationincome from operations was reduced by amortization of acquired intangibleassets amounting to $0.3 million for 2005 acquisitions. For the year ended December 31,2004, Regeneration income from operations was also reduced by restructuringcharges of $3.8 million related to the integration of the business operationsof the segment.

 
| ** **                                     | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| **Net Revenues:**                              |       |     |       |     |       |     |       |
| Domestic Rehabilitation                        |       | $        | 197,279    |     | $          | 177,481  |       | $ | 168,842 |   |
| Regeneration                                   |       | 55,474   |       | 49,658   |       | 3,989    |       |
| International                                  |       | 33,414   |       | 28,860   |       | 25,108   |       |
| Consolidated net revenues                      |       | $        | 286,167    |     | $          | 255,999  |       | $ | 197,939 |   |
|                                           |       |     |       |     |       |     |       |
| **Gross Profit:**                              |       |     |       |     |       |     |       |
| Domestic Rehabilitation                        |       | $        | 109,752    |     | $          | 100,200  |       | $ | 93,791 |   |
| Regeneration                                   |       | 49,710   |       | 43,032   |       | 3,145    |       |
| International                                  |       | 21,416   |       | 17,603   |       | 15,076   |       |
| Consolidated gross profit                      |       | $        | 180,878    |     | $          | 160,835  |       | $ | 112,012 |   |
|                                           |       |     |       |     |       |     |       |
| **Income from operations:**                    |       |     |       |     |       |     |       |
| Domestic Rehabilitation                        |       | $        | 41,878     |     | $          | 36,341   |       | $ | 35,462 |   |
| Regeneration                                   |       | 14,623   |       | 7,836    |       | 537      |       |
| International                                  |       | 8,430    |       | 5,398    |       | 6,255    |       |
| Income from operations of reportable  segments |       | 64,931   |       | 49,575   |       | 42,254   |       |
| Expenses not allocated to segments             |       | (11,072  | )          | (10,502  | )          | (10,485  | )          |
| Consolidated income from operations            |       | $        | 53,859     |     | $          | 39,073   |       | $ | 31,769 |   |

 

For the yearsended December 31, 2005, 2004 and 2003, the Company had no individualcustomer or distributor that accounted for 10% or more of total annualrevenues.

 

The accountingpolicies of the reportable segments are the same as the accounting policies ofthe Company. The Company allocates resources and evaluates the performance ofsegments based on income from operations and therefore has not disclosedcertain other items, such as interest, depreciation and amortization by segmentas permitted by SFAS No. 131.

 

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The Company does not allocate assets toreportable segments because a significant portion of assets are shared by thesegments.

 

Net revenues, attributed to geographic location based on the locationof the customer, for the years ended December 31, were as follows (inthousands):

 
| ** **                      | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|---------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                            |       |     |       |     |       |     |       |
| United States                   |       | $        | 252,753    |     | $          | 227,139  |       | $ | 172,831 |   |
| Europe                          |       | 23,424   |       | 20,369   |       | 16,265   |       |
| Other countries                 |       | 9,990    |       | 8,491    |       | 8,843    |       |
| Total consolidated net revenues |       | $        | 286,167    |     | $          | 255,999  |       | $ | 197,939 |   |

 

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

 
| ** **                | ** ** | **2005**   | ** ** | **2004**   | ** ** |
|---------------------------|------------|------------|------------|------------|------------|
| ** **                | ** ** | ** ** | ** ** | ** ** | ** ** |
| United States             |       | $          | 295,257    |       | $          | 296,923 |   |
| International             |       | 9,407      |       | 9,927      |       |
| Total consolidated assets |       | $          | 304,664    |       | $          | 306,850 |   |

 

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

 

The Company isobligated under various noncancellable operating leases for land, buildings,equipment and vehicles through approximately June 2021.  Certain of the leases provide that theCompany pay all or a portion of taxes, maintenance, insurance and otheroperating expenses, and certain of the rents are subject to adjustment forchanges as determined by certain consumer price indices and exchangerates.  The Company is headquartered inVista, California and operates manufacturing locations in Vista, California andTijuana, Mexico. The Company also leases warehouse and office space in Indiana,Arizona, Germany, Canada, France, the United Kingdom and Denmark.  All of the Company’s facilities are leased,none are owned.

 

Minimum annual lease payment commitments for noncancellable operatingleases as of December 31, 2005 are as follows (in thousands):

 
| 2006                 |   | $      | 6,950  |   |
|----------------------|--------|--------|--------|--------|
| 2007                 |   | 4,465  |   |
| 2008                 |   | 3,692  |   |
| 2009                 |   | 3,699  |   |
| 2010                 |   | 3,610  |   |
| 2011 and  thereafter |   | 30,312 |   |
|                 |   | $      | 52,728 |   |

 

In late 2004,the Company entered into a lease agreement with Professional Real EstateServices, Inc. (PRES) under which PRES has undertaken to build a new110,000 square foot corporate headquarters facility for the Company on vacantland near the Company’s current headquarters in Vista, California. Construction of the new facility is underway and once completed, the Companywill occupy the facility under a 15-year lease with two five-year options toextend the term and will move out of its existing facilities in Vista. Rent for the new facility will be based on an agreed percentage of the totalproject cost for the construction of the facility and is not expected to exceedthe rent currently paid by the Company for its existing Vista facilities.

 

The new lease with PRES was contingent onPRES closing a transaction to purchase the existing facilities in Vista,California leased by the Company, as well as the real property underlying thenew lease.  The purchase transaction closed in February 2005.Effective on the closing date, a lease for the vacant land on which the Companywas previously obligated was terminated, and when the new headquarters facilityis completed and occupied, the Company’s leases for its existing Vistafacilities will be terminated.  Those leases would otherwise havecontinued until February 2008.  Upon occupancy of the new facility,expected to occur in mid-2006, the Company will make a lump sum rent payment toPRES, equal to 40% of the rent that would have been due under the existingfacilities leases from the termination date of the existing leases through theoriginal expiration date, estimated at approximately $1.6 million. If PRES isable to lease the Company’s former facilities

 

72

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during what would have remainedof the term of the Company’s existing leases, a portion of that sum may berefunded to the Company. This lump sum rent payment, net of the remaining $0.4million accrual related to lease termination costs originally accrued in 2002(see Note 4), will be accounted for as additional rent expense over the term ofthe new lease. The minimum annual lease commitments table above assumes a July 2006occupancy date for the Company’s new corporate headquarters and includes bothestimated rent for the Company’s new facility beginning in July 2006 andthe estimated lump sum rent payment of approximately $1.6 million for terminationof the Company’s existing facilities in July 2006.

 

Aggregate rent expensewas approximately $6.4 million, $5.4 million and $3.4 million for the yearsended December 31, 2005, 2004 and 2003, respectively.

 

*Contingencies*

 

From time to time, the Company has been involved in lawsuits arising inthe ordinary course of business. This includes patent and other intellectualproperty disputes between its various competitors and the Company.  With respect to these matters, managementbelieves that it has adequate insurance coverage or has made adequate accrualsfor related costs, and it may also have effective legal defenses. The Companyis not aware of any pending lawsuits that could have a material adverse effecton its business, financial condition and results of operations.

 

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

 

The Company has aqualified 401(k) profit-sharing plan covering substantially all of its U.S.employees.  Through December 31,2005, the Company matched 100% of the first $500 contributed annually by each employeeand 30 percent of additional employee contributions up to six percent of totalcompensation.  The Company’s matchingcontributions related to this plan were $0.5 million, $0.5 million and $0.3million for the years ended December 31, 2005, 2004 and 2003,respectively. The plan also provides for discretionary Company contributions asapproved by the Board of Directors. There have been no such discretionarycontributions through December 31, 2005. Effective January 1, 2006, the Company will match 50 percent ofemployee contributions up to six percent of total compensation.

 

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

 

The Company operates its business on amanufacturing calendar, with its fiscal year always ending on December 31.Each quarter is 13 weeks, consisting of on five-week and two four-week periods.The first and fourth quarters may have more or less working days from year toyear based on the days of the week on which holidays and December 31 fall.

 

The following table summarizes certain of theCompany’s operating results by quarter for 2005 and 2004:

 
| ** **                   | ** ** | **Year Ended December 31, 2005**     | ** ** |
|------------------------------|------------|-------------------------------------------|------------|
| ** **                   | ** ** | **First  Quarter**                        | ** ** | **Second  Quarter** | ** ** | **Third  Quarter** | ** ** | **Fourth  Quarter** | ** ** | **Total  Year** | ** ** |
| ** **                   | ** ** | **(In thousands, except per share data)** | ** ** |
| Net revenues                 |       | $                                         | 70,250     |   | $ | 68,827 |   | $ | 72,133 |   | $ | 74,957 |   | $ | 286,167 |   |
| Gross profit                 |       | 44,029                                    |       | 44,254 |   | 45,632 |   | 46,963 |   | 180,878 |   |
| Income from operations       |       | 12,421                                    |       | 13,022 |   | 13,926 |   | 14,490 |   | 53,859 |   |
| Net income                   |       | $                                         | 6,597      |   | $ | 6,929 |   | $ | 7,536 |   | $ | 8,136 |   | $ | 29,198 |   |
| Basic net income per share   |       | $                                         | 0.31       |   | $ | 0.32 |   | $ | 0.34 |   | $ | 0.37 |   | $ | 1.34 |   |
| Diluted net income per share |       | $                                         | 0.29       |   | $ | 0.31 |   | $ | 0.33 |   | $ | 0.35 |   | $ | 1.29 |   |
| Number of operating days     |       | 65                                        |       | 64 |   | 63 |   | 61 |   | 253 |   |
|                              |            |                                           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 
| ** **                   | ** ** | **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 |   |
|                              |            |                                           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

73

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**13.****                               SubsequentEvents (unaudited)**

 

On January 2, 2006,the Company completed the acquisition, under an agreement originally signed on December 15,2005, of the shares of Newmed for cash payments aggregating 13 million Euros(approximately $15.4 million), which included payment of certain debts ofNewmed.  Certain sellers may also receive up to an additional 1 millionEuros (approximately $1.2 million) based on achievement of certain revenue targetsfor 2006. The Company also incurred certain transaction costs and otherexpenses in connection with the acquisition that are estimated to beapproximately $0.4 million.  Newmed,through wholly-owned subsidiaries in France and Spain, operating under the tradename Axmed, is engaged in the design, manufacture and sale of orthopedicrehabilitation devices including rigid knee braces and soft goods. Newmed alsoowns 70% of a manufacturing subsidiary in Tunisia, which provides low costmanufacturing capabilities to the Axmed group. The Newmed acquisition will beaccounted for in the first quarter of 2006 using the purchase method ofaccounting whereby the total purchase price, including transaction expenses,will be allocated to tangible and intangible assets acquired based on estimatedfair market values, with the remainder classified as goodwill. The Companyacquired Newmed to increase its revenue and improve its market share in Franceand Spain. The Company funded the cash paid on January 2, 2006 and thetransaction expenses with the proceeds of a $16.0 million draw on its revolvingline of credit.  The Company repaid $3.0million of this amount on January 31, 2006.

 

74

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**Item 9.Changes in and Disagreements with Accountants on Accounting and FinancialDisclosure**

 

Not applicable.

 

**Item 9A. Controls and Procedures**

 

# *Disclosure Controls andProcedures*

# * *

We maintain disclosure controls andprocedures that are designed to ensure that information required to bedisclosed in our Exchange Act reports is recorded, processed, summarized andreported within the timelines specified in the SEC’s rules and forms, andthat such information is accumulated and communicated to our management,including our Chief Executive Officer and Chief Financial Officer, asappropriate, to allow timely decisions regarding required disclosure. Indesigning and evaluating the disclosure controls and procedures, managementrecognized that any controls and procedures, no matter how well designed andoperated, can only provide reasonable assurance of achieving the desiredcontrol objectives, and in reaching a reasonable level of assurance, managementnecessarily was required to apply its judgment in evaluating the cost-benefitrelationship of possible controls and procedures.

 

Under the supervision and with theparticipation of our management, including our Chief Executive Officer and ourChief Financial Officer, we carried out an evaluation of the effectiveness ofthe Company’s disclosure controls and procedures (as such term is defined inSEC Rules 13a – 15(e) and 15d – 15(e)) as of December 31,2005.  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 onInternal Control over Financial Reporting*

 

Internal control over financial reporting refers to the processdesigned by, or under the supervision of, our Chief Executive Officer and ChiefFinancial Officer, and effected by our board of directors, management and otherpersonnel, to provide reasonable assurance regarding the reliability offinancial reporting and the preparation of financial statements for externalpurposes in accordance with generally accepted accounting principles, andincludes 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 reasonableassurance regarding prevention or 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 cannot provide absoluteassurance of achieving financial reporting objectives because of its inherentlimitations. Internal control over financial reporting is a process thatinvolves human diligence and compliance and is subject to lapses in judgmentand breakdowns resulting from human failures. Internal control over financialreporting also can be circumvented by collusion or improper managementoverride. 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. Managementis responsible for establishing and maintaining adequate internal control overfinancial reporting for the Company.

 

Management has used the framework set forth in the report entitled *Internal Control—Integrated Framework*published by the Committee of Sponsoring Organizations (COSO) of the TreadwayCommission to evaluate the effectiveness of the Company’s internal control overfinancial reporting. Management has concluded that the Company’s internalcontrol over financial reporting was effective as of December 31, 2005.Ernst & Young LLP, the Company’s independent registered publicaccounting firm, has issued an attestation report on management’s assessment ofthe Company’s internal control over financial reporting which is includedherein.

 

75

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*Changes in Internal Control over FinancialReporting*

 

There has been no change to our internalcontrol over financial reporting during our most recent fiscal quarter that hasmaterially affected, or is reasonably likely to materially affect, our internalcontrol over financial reporting.

 

76

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**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTINGFIRM**

**ON INTERNAL CONTROL OVER FINANCIAL REPORTING**

 

**The Board of Directors andStockholders**

**dj Orthopedics, Inc.**

 

We have auditedmanagement’s assessment, included in the accompanying Management’s Report onInternal Control over Financial Reporting, that dj Orthopedics, Inc.maintained effective internal control over financial reporting as of December 31,2005, 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 suchother procedures as we considered necessary in the circumstances. We believethat our audit 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) providereasonable assurance that transactions are recorded as necessary to permitpreparation of financial statements in accordance with generally acceptedaccounting principles, and that receipts and expenditures of the company arebeing made only in accordance with authorizations of management and directorsof the company; and (3) provide reasonable assurance regarding preventionor timely detection of unauthorized acquisition, use, or disposition of thecompany’s assets that could have a material effect on the financial statements.

 

Because of its inherent limitations, internal control over financialreporting may not prevent or detect misstatements.  Also, projections of any evaluation ofeffectiveness to future periods are subject to the risk that controls maybecome inadequate because of changes in conditions, or that the degree ofcompliance with the policies or procedures may deteriorate.

 

In our opinion, management’s assessment that dj Orthopedics, Inc. maintainedeffective internal control over financial reporting as of December 31,2005, is fairly stated, in all material respects, based on the COSOcriteria.  Also, in our opinion, djOrthopedics, Inc. maintained, in all material respects, effective internalcontrol over financial reporting as of December 31, 2005, based on****theCOSO criteria**.**

 

We also have audited, in accordance with the standards of the PublicCompany Accounting Oversight Board (United States), the consolidated balancesheets of dj Orthopedics, Inc. as of December 31, 2005 and 2004, andthe related consolidated statements of income, changes in stockholders’ equityand cash flows for each of the three years in the period ended December 31,2005 of dj Orthopedics, Inc. and our report dated February 3, 2006expressed an unqualified opinion thereon.

 

 
|                  | /s/ ERNST &  YOUNG LLP | ** ** |
|-----------------------|---------------------------------|------------|
|                  |
|                  |
| San Diego, California |
| February 3, 2006 |

 

77

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**Item 9B. Other Information**

 

None.

 

**PART III**

 

**Item 10. Directors and Executive Officers ofthe Registrant**

 

The Company’s Code of Business Conduct andEthics and Corporate Governance Guidelines can be accessed on the Company’swebsite under the investor relations page, and are available in print tostockholders who submit a written request to the Secretary of the Company atthe address of the Company’s principal executive offices. In addition, theAudit, Compensation and Nominating and Corporate Governance Committees haveeach adopted a charter governing the activities of such committee.  In accordance with New York Stock Exchangerules, these documents are also available either on the website or by writtenrequest no later than the date of the Company’s 2006 Annual StockholdersMeeting.

 

The other information under Item 10 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, 2006.  See also theidentification of the Executive Officers following Item 4 of this Form 10-K.

 

**Item 11. Executive Compensation**

 

Item 11 is hereby incorporated by referencefrom dj Orthopedics, Inc.’s Definitive Proxy Statement to be filed withthe Securities and Exchange Commission on or prior to April 30, 2006.

 

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

 

Item 12 is hereby incorporated by referencefrom dj Orthopedics, Inc.’s Definitive Proxy Statement to be filed withthe Securities and Exchange Commission on or prior to April 30, 2006.

 

**Item 13. Certain Relationships and RelatedTransactions**

 

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, 2006.

 

**Item 14. Principal Accountant Fees andServices**

 

Item 14 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, 2006.

 

78

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**PART IV**

 

**Item 15. Exhibits, Financial StatementSchedules**

 

(a)               The followingdocuments are filed as part of this report:

 

1.          The followingconsolidated financial statements of dj Orthopedics, Inc., including thereport 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, 2005 and 2004                                                          |   |
| Consolidated Statements of Income for the  years ended December 31, 2005, 2004 and 2003                                |   |
| Consolidated Statements of Changes in  Stockholders’ Equity for the years ended December 31, 2005, 2004 and  2003 |   |
| Consolidated Statements of Cash Flows for the years ended  December 31, 2005, 2004 and 2003                            |   |
| Notes to Consolidated Financial Statements                                                                                  |   |

 

2.          Financial StatementSchedules:

 

Schedule II – Valuation and QualifyingAccounts

 

All other financial statement schedules arenot required under the related instructions or are inapplicable and thereforehave 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                  |       | 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))            |
| 10.3                  |       | 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))                                                                      |
| 10.4                  |       | 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))                                                       |
| 10.5                  |       | 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))                                                     |
| 10.6                  |       | 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) |
| 10.7                  |       | 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)         |
| 10.8                  |       | 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)                          |
| 10.9                  |       | 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                                        |

 

79

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| **Exhibit****Number** | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
|-----------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                  |       | Form 10-K for the year ended  December 31, 2003)                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| 10.10                 |       | 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 2, 2004) |
| 10.11                 |       | 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 27, 2004)                                                                                                                                                                                                                                                                                                  |
| 10.12                 |       | 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 20, 2004)                                                                                                                                                                                                                                                                                |
| 10.13                 |       | 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 20, 2004)                                                                                                                                                                                                                   |
| 10.14+                |       | 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.). (Incorporated  by reference to dj Orthopedics, Inc.’s Report on Form 10-K for the  year ended December 31, 2004)                                                                                                                                      |
| 10.15                 |       | Asset Purchase Agreement, dated  March 10, 2005, between dj Orthopedics, LLC, and Superior Medical  Equipment, LLC. (Incorporated by reference to dj Orthopedics, Inc.’s  Report on Form 8-K dated March 10, 2005)                                                                                                                                                                                                                                                                                      |
| 10.16                 |       | Amendment Number Two to the dj Orthopedics, Inc.  2001 Non-Employee Director Stock Option Plan, dated May 3, 2005  (Incorporated by reference to dj Orthopedics, Inc.’s Report on  Form 8-K dated April 29, 2005)                                                                                                                                                                                                                                                                                  |
| 10.17                 |       | Amended and Restated Credit Agreement,  dated May 5, 2005, among dj Orthopedics, LLC, dj Orthopedics, Inc.,  certain foreign subsidiaries party thereto from time to time, Wachovia Bank,  National Association, as administrative agent and lenders party thereto.  (Incorporated by reference to dj Orthopedics, Inc.’s Report on Form 8-K  dated May 5, 2005)                                                                                                                                   |
| 10.18                 |       | dj Orthopedics Executive Deferred  Compensation Plan and related Adoption Agreement (Incorporated by reference  to dj Orthopedics, Inc.’s Report on Form 8-K dated July 27,  2005)                                                                                                                                                                                                                                                                                                                           |
| 10.19                 |       | Trust Agreement between dj Orthopedics, LLC  and Fidelity Management Trust Company (Incorporated by reference to dj  Orthopedics, Inc.’s Report on Form 8-K dated July 27, 2005)                                                                                                                                                                                                                                                                                                                             |
| 10.20                 |       | Asset Purchase Agreement, dated  August 8, 2005, between dj Orthopedics, LLC and Encore Medical, L.P.  (Incorporated by reference to dj Orthopedics, Inc.’s Report on  Form 8-K dated August 8, 2005)                                                                                                                                                                                                                                                                                                   |
| 10.21                 |       | Share Purchase Agreement, dated  December 15, 2005, by and among dj Orthopedics, LLC and the Stockholders  of Newmed SAS (Incorporated by reference to dj Orthopedics, Inc.’s Report  on Form 8-K dated December 15, 2005)                                                                                                                                                                                                                                                                              |
| 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 treatment has been requested with respect toportions of this exhibit.

 

80

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**DJ ORTHOPEDICS,INC.**

**SCHEDULE II— Valuation and Qualifying Accounts**

**For theThree Years Ended December 31, 2005**

 
| ** **                              | ** ** | **Allowance for  Doubtful  Accounts and  Sales Returns** | ** ** | **Reserve for  Excess and  Obsolete  Inventory** | ** ** |
|-----------------------------------------|------------|----------------------------------------------------------|------------|--------------------------------------------------|------------|
|                                    |       |                                                     |       |                                             |       |
| 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                                        |       |
| Provision                               |       | 34,594,000                                               |       | 983,000                                          |       |
| Write-offs and recoveries, net          |       | (34,430,000                                              | )          | (1,844,000                                       | )          |
| Balance at December 31, 2005       |       | $                                                        | 26,792,000 |                                             | $          | 2,320,000 |   |

 

81

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**SIGNATURES**

 

Pursuant to the requirements of Section 13or 15(d) of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned, thereuntoduly authorized.

 
| Date: February 16,  2006 | **DJ ORTHOPEDICS, INC.** |
|-------------------------------|--------------------------|
|                          |                     |
|                          | By:                      |   | /s/ Leslie H. Cross |   |
|                          |                     |   | Leslie H. Cross |
|                          |                     | *President and Chief Executive  Officer* |
|                               |                          |  |  |  |  |

 

Pursuant to the requirements of theSecurities Exchange Act of 1934, this Report has been signed below by thefollowing persons on behalf of the registrant and in the capacities and on thedates indicated.

 
| **Signature**            | ** ** | **Title**                                                | ** ** | **Date**               |
|--------------------------|------------|----------------------------------------------------------|------------|------------------------|
|                     |       |                                                     |       |                   |
| /s/ Leslie  H. Cross     |       | President, Chief Executive Officer and  Director         |       | February 16, 2006 |
| Leslie H.  Cross         |       | (Principal Executive Officer)                            |       |                   |
|                     |       |                                                     |       |                   |
| /s/ Vickie  L. Capps     |       | Senior Vice President, Finance, Chief  Financial Officer |       | February 16, 2006 |
| Vickie L.  Capps         |       | and Treasurer (Principal Financial and  Accounting       |       |                   |
|                     |       | Officer)                                                 |       |                   |
|                     |       |                                                     |       |                   |
| /s/ Jack R.  Blair       |       | Chairman of the Board of Directors                       |       | February 16, 2006 |
| Jack R.  Blair           |       |                                                     |       |                   |
|                     |       |                                                     |       |                   |
| /s/ Mitchell  J. Blutt   |       | Director                                                 |       | February 16, 2006 |
| Mitchell J.  Blutt, M.D. |       |                                                     |       |                   |
|                     |       |                                                     |       |                   |
| /s/ Thomas  Mitchell     |       | Director                                                 |       | February 16, 2006 |
| Thomas  Mitchell         |       |                                                     |       |                   |
|                     |       |                                                     |       |                   |
| /s/ Lewis  Parker        |       | Director                                                 |       | February 16, 2006 |
| Lewis Parker             |       |                                                     |       |                   |
|                     |       |                                                     |       |                   |
| /s/ Charles  T. Orsatti  |       | Director                                                 |       | February 16, 2006 |
| Charles T.  Orsatti      |       |                                                     |       |                   |
|                     |       |                                                     |       |                   |
| /s/ Lesley  H. Howe      |       | Director                                                 |       | February 16, 2006 |
| Lesley H.  Howe          |       |                                                     |       |                   |
|                     |       |                                                     |       |                   |
| /s/ Kirby L.  Cramer     |       | Director                                                 |       | February 16, 2006 |
| Kirby L.  Cramer         |       |                                                     |       |                   |

 

82

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**INDEX TO 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                  |       | 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))                                                                                                                                                                                                                                                                    |
| 10.3                  |       | 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))                                                                                                                                                                                                                                                                                                                              |
| 10.4                  |       | 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))                                                                                                                                                                                                                                                                                                                |
| 10.5                  |       | 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))                                                                                                                                                                                                                                                                                                             |
| 10.6                  |       | 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)                                                                                                                                                                                                                                                         |
| 10.7                  |       | 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)                                                                                                                                                                                                                                                                 |
| 10.8                  |       | 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)                                                                                                                                                                                                                                                                                  |
| 10.9                  |       | 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)                                                                                                                                                                                                                                     |
| 10.10                 |       | 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 2, 2004) |
| 10.11                 |       | 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 27, 2004)                                                                                                                                                                                                                                                                                                  |
| 10.12                 |       | 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 20, 2004)                                                                                                                                                                                                                                                                                |
| 10.13                 |       | 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 20, 2004)                                                                                                                                                                                                                   |
| 10.14+                |       | 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.). (Incorporated  by reference to dj Orthopedics, Inc.’s Report on Form 10-K for the  year ended December 31, 2004)                                                                                                                                      |
| 10.15                 |       | Asset Purchase Agreement, dated  March 10, 2005, between dj Orthopedics, LLC, and Superior Medical  Equipment, LLC. (Incorporated by reference to dj Orthopedics, Inc.’s  Report on Form 8-K dated March 10, 2005)                                                                                                                                                                                                                                                                                      |
| 10.16                 |       | Amendment Number Two to the dj  Orthopedics, Inc. 2001 Non-Employee Director Stock Option Plan, dated  May 3, 2005 (Incorporated by reference to dj Orthopedics, Inc.’s  Report on Form 8-K dated April 29, 2005)                                                                                                                                                                                                                                                                                  |
| 10.17                 |       | Amended and Restated Credit Agreement,  dated May 5, 2005, among dj Orthopedics, LLC, dj Orthopedics, Inc.,  certain foreign subsidiaries party thereto from time to time, Wachovia Bank,  National Association, as administrative agent and lenders party thereto.  (Incorporated by reference to dj Orthopedics, Inc.’s Report on  Form 8-K dated May 5, 2005)                                                                                                                                   |

 

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| **Exhibit****Number** | ** ** | **Description**                                                                                                                                                                                                                                     |
|-----------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.18                 |       | dj Orthopedics Executive Deferred  Compensation Plan and related Adoption Agreement (Incorporated by reference  to dj Orthopedics, Inc.’s Report on Form 8-K dated July 27,  2005)                                              |
| 10.19                 |       | Trust Agreement between dj Orthopedics, LLC  and Fidelity Management Trust Company (Incorporated by reference to dj  Orthopedics, Inc.’s Report on Form 8-K dated July 27, 2005)                                                |
| 10.20                 |       | Asset Purchase Agreement, dated  August 8, 2005, between dj Orthopedics, LLC and Encore Medical, L.P.  (Incorporated by reference to dj Orthopedics, Inc.’s Report on  Form 8-K dated August 8, 2005)                      |
| 10.21                 |       | Share Purchase Agreement, dated  December 15, 2005, by and among dj Orthopedics, LLC and the Stockholders  of Newmed SAS (Incorporated by reference to dj Orthopedics, Inc.’s  Report on Form 8-K dated December 15, 2005) |
| 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 treatment has been requested with respect toportions of this exhibit.

 

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