**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

**FORM 10-K**

**(Mark One)**

**x**                               ANNUAL REPORT PURSUANT TO SECTION 13OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

**Forthe fiscal year ended December 31, 2006**

**or**

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

**Forthe transition period from                         to                         .**

**Commissionfile number 001-16757**

**DJO INCORPORATED**

**(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) |
| **1430 Decision Street**                                         |   | **92081**                                |
| **Vista,  California**                                           |   | (Zip Code)                               |
| (Address of  principal executive offices)                        |   |                                     |

 

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

Securities registeredpursuant to Section 12(b) of the Act:

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

 

Securities registeredpursuant to Section 12(g) of the Act: **None**

Indicate by check mark ifthe Registrant is a well-known seasoned issuer, as defined in Rule 405 ofthe Securities Act.

Yes x No o

Indicateby check mark if the Registrant is not required to file reports pursuant to Section 13or Section 15(d) of the Act.

Yes o No x

Indicate by check markwhether the Registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding 12months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements forthe past 90 days. Yes x No o

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

Indicateby check mark whether the Registrant is a large accelerated filer, anaccelerated filer, or a non-accelerated filer. See definition of “acceleratedfiler and large accelerated filer” in Rule 12b-2 of the ExchangeAct. (Check One):

| Large accelerated filer x |   | Accelerated filer o |   | Non-accelerated  filer o |
|---------------------------|--------|---------------------|--------|--------------------------|

 

Indicate by check markwhether the Registrant is a shell company (as defined in Rule 12b-2of the Exchange Act).

Yes o No x

The aggregate market valueof all outstanding common equity held by non-affiliates of the Registrant basedon the closing price of common stock as reported on the New York Stock Exchangeon June 30, 2006 was $834,645,401.

The number of shares of theRegistrant’s common stock outstanding at February 23, 2007 was 23,440,486shares.

**Documents Incorporated byReference**

**Portionsof the Proxy Statement for the Registrant’s 2007 Annual Meeting of Stockholdersto be filed with the Commission on or before April 30, 2007 areincorporated by reference in Part III of this Annual Report on Form 10-K.With the exception of those portions that are specifically incorporated byreference 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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**DJO INCORPORATEDFORM 10-KTABLE OF CONTENTS**

|               | ** **                                                                                                              | ** ** | **Page  No.** |
|---------------|-------------------------------------------------------------------------------------------------------------------------|------------|---------------|
| PART I   |                                                                                                                    |       |
| Item 1.       | Business                                                                                                                |       |          | 3 |   |
| Item 1A.      | Risk Factors                                                                                                            |       |          | 20 |   |
| Item 1B.      | Unresolved Staff Comments                                                                                               |       |          | 38 |   |
| Item 2.       | Properties                                                                                                              |       |          | 39 |   |
| Item 3.       | Legal Proceedings                                                                                                       |       |          | 39 |   |
| Item 4.       | Submission of Matters to a  Vote of Security Holders                                                                    |       |          | 40 |   |
|          | Executive Officers of the Registrant                                                                                    |       |          | 40 |   |
| PART II  |                                                                                                                    |       |          |   |
| Item 5.       | Market for the Registrant’s  Common Equity, Related Stockholder Matters and Issuer Purchases of Equity  Securities |       |          | 42 |   |
| Item 6.       | Selected Financial Data                                                                                                 |       |          | 43 |   |
| Item 7.       | Management’s Discussion and  Analysis of Financial Condition and Results of Operations                             |       |          | 45 |   |
| Item 7A.      | Quantitative and Qualitative  Disclosures About Market Risk                                                             |       |          | 63 |   |
| Item 8.       | Financial Statements and  Supplementary Data                                                                            |       |          | 64 |   |
| Item 9.       | Changes in and Disagreements  with Accountants on Accounting and Financial Disclosure                                   |       |          | 97 |   |
| Item 9A.      | Controls and Procedures                                                                                                 |       |          | 97 |   |
| Item 9B.      | Other Information                                                                                                       |       |          | 101 |   |
| PART III |                                                                                                                    |       |          |   |
| Item 10.      | Directors, Executive  Officers and Corporate Governance                                                                 |       |          | 101 |   |
| Item 11.      | Executive Compensation                                                                                                  |       |          | 101 |   |
| Item 12.      | Security Ownership of  Certain Beneficial Owners and Management and Related Stockholder Matters                         |       |          | 101 |   |
| Item 13.      | Certain Relationships and  Related Transactions, and Director Independence                                              |       |          | 102 |   |
| Item 14.      | Principal Accounting Fees  and Services                                                                                 |       |          | 102 |   |
| PART IV  |                                                                                                                    |       |          |   |
| Item 15.      | Exhibits, Financial  Statement Schedules                                                                                |       |          | 102 |   |
| SIGNATURES    |                                                                                                                    |       | 106           |   |

 

***Explanatory Notes***

Unless the context requires otherwise, in this annualreport the terms “we,” “us” and “our” refer to DJO Incorporated, formerly djOrthopedics, Inc., DJO, LLC, formerly dj Orthopedics, LLC, a wholly ownedsubsidiary of DJO Incorporated, and our other wholly owned and indirectsubsidiaries.

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 economicassumptions relied upon therein. While we are not aware of any misstatementsregarding the industry and market data presented herein, such data involverisks and uncertainties and are subject to change based on various factors,including those discussed under the heading “Risk Factors” in this annualreport.

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***Note onForward-Looking Information***

This annual report on Form 10-Kcontains, in addition to historical information, statements by us with respectto our expectations 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 statementsreflect our current views and are based on certain assumptions. Actual resultscould differ materially from those currently anticipated as a result of anumber of factors, including material risks discussed under the heading “RiskFactors” in this annual report. If the expectations or assumptions underlyingour forward-looking statements prove inaccurate or if risks or uncertaintiesarise, actual results could differ materially from those predicted in anyforward-looking statement.

**Part I**

**Item1.**                        Business

**Overview**

We are a global providerof solutions for musculoskeletal and vascular health, specializing inrehabilitation and regeneration products for the non-operative orthopedic,spine and vascular markets. We believe that we have a leading market share inthe non-operative orthopedic, spine and vascular markets that we target. During2006 we significantly increased both our domestic and international revenueswith the acquisition in January 2006 of Newmed SAS, a French orthopedicscompany trading under the name “Axmed” (the “Axmed acquisition”), and theacquisition in April 2006 of Aircast Incorporated, a U.S. basedorthopedics company with extensive operations in Europe (the “Aircastacquisition”). With contribution from these acquisitions, our consolidatedrevenues grew 44.3% to $413.1 million from 2005 to 2006.

Marketed under the DonJoy,ProCare and Aircast brands, our broad range of over 700 rehabilitationproducts, including rigid knee braces, soft goods and pain management products,are used in the prevention of injury, in the treatment of chronic conditionsand for recovery after surgery or injury. Our regeneration products consist ofbone growth stimulation (BGS) devices that are used to treat nonunion fracturesand as an adjunct therapy after spinal fusion surgery. Our vascular systemsproducts help prevent deep vein thrombosis and pulmonary embolism that canoccur after orthopedic and other surgeries.

We sell our products inthe United States and in more than 70 other countries through networks ofagents, distributors and our direct sales employees that market our products toorthopedic and spine surgeons, podiatrists, orthopedic and prosthetic centers,third-party distributors, hospitals, surgery centers, pharmacies, physicaltherapists, athletic trainers and other healthcare professionals. We believethat we have one of the largest distribution networks in the markets weparticipate in for non-operative orthopedic spine and vascular products. Webelieve that this distribution network, along with our recognized brand names,reputation for quality, innovation and customer service, and our strongrelationships with orthopedic professionals have contributed to our leadingmarket position.

Our business is seasonal,with revenues generally stronger in the fourth quarter of each year due to thegreater number of orthopedic surgeries and injuries resulting from increasedsports activity, particularly football and skiing. In addition, during thefourth quarter, individuals are more likely to have satisfied their annualinsurance deductible than in the first three quarters of the year, and thisleads to an increase in the number of elective orthopedic surgeries.

We were incorporated inDelaware in August 2001. Our headquarters are located at 1430 DecisionStreet, Vista, California 92081. Our telephone number is (800) 336-5690. Ourwebsite address is *www.djortho.com*.

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We file annual reports,such as this Form 10-K, as well as quarterly reports on Form 10-Qand current reports on Form 8-K, with the United States (U.S.)Securities and Exchange Commission (SEC). We make these reports available freeof charge on our website under the investor relations page. These reports canbe accessed the same day they are filed with the SEC. All such reports weremade available in this fashion during 2006.

Aircast®, Air-Stirrup®, ArcticFlow®, ArterialFlow®, AutoChill®, CryoCuff®, Defiance®, dj Ortho®, DonJoy®, FourcePointTM, IceMan®, OfficeCare®, ProCare®, SpinaLogic®, UltraSling®, UltraSling ERTM, Knee GuaranteeTM, OL1000TM,OL1000 SCTM, DonJoy Pain Control DeviceTM, VelocityTM and VenaFlow® are certain of our registered trademarks andtrademarks for which we have applications pending or common law rights. Allother brand names, trademarks and service marks appearing in this annual reportare the property of their respective holders.

**Our Strategy**

Ourstrategy is to increase revenues and profitability and enhance cash flow bystrengthening our market leadership position. Our key initiatives to implementthis strategy include:

·       *Increase our Lead in the Domestic RehabilitationMarket Segment.  *We believe we are the market leader in theDomestic Rehabilitation markets in which we compete. We believe we will be ableto continue to grow our Domestic Rehabilitation business segment and increaseour market share further by focusing on 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:

–       *Introduce New Products and ProductEnhancements.**  *We have a history of developing and introducinginnovative products into the marketplace, and are committed to continuing thattradition by introducing new products across our product platform. In the yearended December 31, 2006, we launched 20 new products. We believe thatproduct innovation through effective and focused research and development willprovide a sustainable competitive advantage. We believe we are currently atechnology leader in several product categories and we intend to continue todevelop next generation technologies.

–       *Increase Sales Force Productivity.  *We have integratedthe Aircast sales force into our existing sales organization and focused itsvarious elements on specific targeted customers. Our sales representatives willgenerally have a targeted customer base and a broad product offering for those customers.For example, the DonJoy sales force focuses on orthopedic and podiatry offices,orthotists, and athletic trainers, while the Aircast and ProCare sales forceconcentrates primarily on hospitals and third party distributors. With ourfocused sales organization and a sales compensation plan in place toincentivize all the sales representatives to sell the full range of products weoffer, we believe that we can encourage cross-selling and increase theproductivity of the entire sales force.

–       *Expand Our OfficeCare andInsurance Channels.  *Through OfficeCare, we maintain aninventory of product (mostly soft goods) on hand at orthopedic practices forimmediate distribution to the patient. For these products, we bill the patientor third-party payor after the product is provided to the patient. Through ourInsurance channel, we also provide our custom knee braces and certain otherproducts directly to patients and bill the patient or the patient’s third partypayor. Our OfficeCare and Insurancechannels currently cover over 1,000 physician offices encompassing over 4,000physicians. We believe that our OfficeCare and Insurance channels serve agrowing need among orthopedic practices to improve inventory management andpatient service. Expanding our OfficeCare and Insurance channels also permitsus to increase our weighted-average selling prices, as the units sold throughthese channels are billed 

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to insurance companies and other third-party payors at higher prices thanunits sold through most of our other sales channels. Accordingly, ourOfficeCare and Insurance initiatives represent an opportunity for sales growthbased on increases in both unit volume and average selling prices. We intend toexpand our OfficeCare and Insurance channels into more large orthopedicoffices, thereby increasing the number of potential customers to whom we sellour products. In the year ended December 31, 2006, we added approximately214 new offices to our OfficeCare and Insurance channels, net of accountterminations.

–       *Maximize Existing and Secure Additional National Accounts.  *We plan to capitalize on the growing practice inhealthcare in which hospitals and other large healthcare providers seek toconsolidate their purchasing activities to national buying groups. Contractswith these national accounts represent a significant opportunity for salesgrowth. We believe that our broad range of products is well suited to the goalsof these buying groups and intend to aggressively pursue these contracts. Inthe year ended December 31, 2006, we signed or renewed five significantnational contracts; including a new three-year sole source contract withConsorta, Inc. for all of our bracing and soft goods products, a newprivate label contract with Amerinet, Inc. for our pain management andcold therapy products, a renewal of our sole source contract with Broadlane, Inc.for all of our soft goods, bracing and cold therapy products, a renewal of ourmulti-source agreement with Premier Purchasing Partners, L.P. for all of ourbracing, soft goods, cold therapy and BGS products, and a renewal of our solesource bracing agreement with Healthtrust Purchasing Group, L.P. In addition,we successfully added Aircast products to each of these national contracts.

·       *Grow Our Regeneration Business.*   Wehave increased the number of regeneration sales specialists dedicated toselling our OL1000 BGS product, and we have aligned these specialists with ourDonJoy sales force. We believe these specialists will be able to use theestablished relationships of our DonJoy sales representatives to enhance salesof the OL1000 product. Our distribution arrangement with DePuy Spine becamenon-exclusive beginning in March 2006, permitting us to sell ourSpinaLogic BGS product through our own sales representatives or otherindependent sales representatives in all territories where we choose to do so. Wehave added additional selling resources in those geographical parts of thecountry where sales were not meeting our expectations. We believe our patentedCombined Magnetic field technology has features that make our BGS productssignificantly easier for patients to use than our competitors’ products. Webelieve that our new selling strategies for our Regeneration segment and ourtechnology advantages will permit us to maintain or improve our growth in thisbusiness.

·       *Expand International Sales*.   Since 2002, we have successfully established direct distributioncapabilities in several major international markets. We believe that sales toforeign markets continue to represent a significant growth opportunity, and weintend to continue to develop direct distribution capabilities in selectedadditional foreign markets. We also believe we can increase our internationalrevenues by expanding the number of our products we sell in internationalmarkets. Historically, we have sold only a limited range of our products in ourinternational markets. Beginning in 2005, we began to focus on selling anexpanded range of soft goods, our cold therapy products and our BGS products`in our International segment. In January 2006,we completed the Axmed acquisition, as discussed in Note 3 to the consolidatedfinancial statements included in Part II, Item 8, herein, which increasedour international revenues in France. The Aircast acquisition in April 2006(discussed below and in Note 3 to the consolidated financial statementsincluded in Part II, Item 8, herein) also substantially increased ourinternational revenues, especially in Germany, France, the United Kingdom andCanada. For the year ended December 31, 2006, international salesincreased to 19.7% of our revenues, compared to 11.7% for the year ended December 31,2005.

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·       *PursueSelective Acquisitions*.   Webelieve that acquisitions represent an attractive and efficient means tobroaden our product lines, expand our geographic reach and increase our revenuesand profitability. We intend to pursue acquisition opportunities that enhancesales growth, are accretive to earnings, increase customer penetration and/orprovide geographic diversity. Since the beginning of 2005, we have completedfour acquisitions, all of which meet or are expected to meet these criteria:our acquisition of substantially all of the assets of Superior MedicalEquipment, LLC (SME acquisition) and our acquisition of substantially allof the assets of the orthopedics soft goods business of Encore Medical, L.P.(OSG acquisition), both of which were completed in 2005, as well as the Axmedacquisition in January 2006 and the Aircast acquisition in April 2006.

**Rehabilitation Products**

*Rigid Knee Bracing*

We design, manufacture andmarket a broad range of rigid knee braces, including ligament braces, which aredesigned to provide support for knee ligament instabilities, post-operativebraces, which are designed to provide both knee immobilization and a protectedrange of motion, and osteoarthritic braces, which are designed to providerelief of knee pain due to osteoarthritis. These products are generallyprescribed to a patient by an orthopedic physician or provided by athletictrainers for use in preventing injury. Our rigid knee braces are either customizedbraces, utilizing basic frames which are then custom-manufactured to fita patient’s particular measurements, or are standard braces which are availablein various sizes and can be easily adjusted to fit the patient in theorthopedic professional’s office. Sales of rigid knee braces representedapproximately 23% of our revenues for 2006.

*Ligament Braces.  **Ligament braces are designed to providedurable support for moderate to severe knee ligament instabilities to helppatients regain range of motion capability so they can successfully completerehabilitation and resume daily activities after knee surgery or injury.Ligament braces are generally prescribed six to eight weeks after knee surgery,often after use of a more restrictive post-operative brace. Our ligamentbraces can also be used to support the normal functioning of the knee toprevent injury. Our ligament bracing product line includes customized bracesgenerally designed for strenuous athletic activity and standard-sized bracesgenerally designed for use in less rigorous activity. We offer a Knee Guaranteeprogram in connection with our Defiance ligament brace. The Knee Guaranteeprogram will, in specified instances, cover a patient’s insurance deductible upto $1,000, or give uninsured patients $1,000 towards surgery, should an ACLre-injury occur while wearing the Defiance ligament brace. We believe that weare the only orthopedic company in the United States that provides such aguarantee. Since we introduced this guarantee, claims under the program havebeen 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 pricedstandard sized braces and accessory products.

*Osteoarthritic Braces.**  *Osteoarthriticbraces are used to treat patients suffering from osteoarthritis of the knee.Our line of customized and standard sized osteoarthritic braces is designed toredistribute weight through the knee, providing additional stability andreducing pain, and in some cases may serve as a cost-efficientalternative to total knee replacement. Frost & Sullivan estimates thatsales of osteoarthritic braces are expected to grow faster than othercategories of rigid knee bracing.

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*Soft Goods*

Our soft goods productline consists of over 500 soft goods products that offer immobilization andsupport 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 51% of ourrevenues for 2006.

*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 or upperextremities, including the shoulder, elbow, neck and wrist. We offer productsranging from simple neoprene knee sleeves to more advanced products thatincorporate materials and features such as air-inflated cushions and metal alloyhinge components.

*Ankle Bracing.*   Asa result of the Aircast acquisition, we now offer a line of premium anklebracing products, led by the Air Stirrup, an ankle brace featuring anatomicallydesigned shells cushioned with an air cell system. The air cell system providessupport and compression to promote edema reduction and acceleraterehabilitation. We believe the Aircast line of ankle products has been a marketleader for years. Under the DonJoy brand, we introduced our Velocity anklebrace in 2005, a low profile, lightweight ankle brace that prevents abnormalankle inversion, eversion, and rotation while allowing natural, unrestrictedrange of motion. The Velocity has been one of our most successful new productintroductions in recent years.

*Lower Extremity FractureBoots.**  *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 the ankle.Fracture boots are used as an alternative to traditional casts. We also sell aline of fracture boots designed for patients suffering from pre-ulcerative andulcerative foot conditions, 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.

*Back Bracing.**  *We offer a line of products designed for back supportranging from rigid braces to elastic supports that provide compression andwarmth. Our premier rigid bracing line, the DonJoy BOA back brace, providessupport for a broad range of spinal indications from acute low back pain reliefto post-operative support and stabilization.

*Patient Safety.*   Weoffer a variety of patient safety devices to hospitals and healthcarefacilities to accommodate ambulatory and non-ambulatory patients, includinglimb positioning devices and wheelchair and bed safety products*.*

*Pressure Care Products.**  *These products are designed toeliminate the development of ulcers, which form when blood supply to skintissue is reduced or cut off by pressure. Our pressure care products are constructedwith lightweight premium grade material to offer resilience, durability andpatient comfort. The products offered within this line are used primarilyduring or after surgical treatment.

*Pain Management Products*

Our portfolio of painmanagement products primarily includes cold therapy products to assist in thereduction of pain and swelling. We also offer a system that employs ambulatoryinfusion pumps for the delivery of local anesthetic to a surgical site. Ourpain management products accounted for approximately 8% of our revenues for2006.

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*Cold Therapy Products.**  **Cold therapy products*aredesigned to help reduce swelling, minimize the need for post-operative painmedications and generally accelerate the rehabilitation process. Following theAircast acquisition, we now manufacture, market and sell the IceMan and theArcticFlow devices under the DonJoy brand and the Cryo/Cuff and AutoChilldevices under the Aircast brand, as well as other cold therapy products such asice packs and wraps. The IceMan and AutoChill products are portable devicesthat utilize pumps to circulate cold water from a reservoir to a pad designedto fit the injured area, such as the ankle, knee or shoulder. The Cryo/Cuff andArcticFlow products also involve circulating cold water to a pad but use asimple gravity-based system to circulate the water from the reservoir.

*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. Since2004, we have been the exclusive North American distributor of a painmanagement system manufactured by Curlin Medical, Inc. (successor toMcKinley Medical, LLLP) called the DonJoy Pain Control Device. This portabledevice consists of a range of introducer needles, catheters for easy insertionand connection during surgery and pumps for continuous infusion for up to 72hours. The pain control systems are intended to provide direct pain relief,reduce hospital stays and allow earlier and greater ambulation. Ourdistribution rights for this product expired at the end of 2006, and we are inthe process of renewing those rights in orthopedic applications for anotherone-year term.

*Vascular Systems Products*

We offer the VenaFlowsystem to hospitals and surgery centers for prevention of deep vein thrombosisin patients who are inactive following surgery. This system provides rapidinflation with graduated sequential compression delivered to a patient’s calf,foot or thigh through specialized cuffs and stimulates circulation to preventblood clots. We are developing the ArterialFlow system designed to provideintermittent compression of a patient’s extremities to increase arterial bloodflow to help prevent or reduce complications of poor circulation. Our vascularsystems products accounted for approximately 3% of our revenues for 2006.

**Regeneration Products**

BGS devices are designedto promote the healing of musculoskeletal bone and tissue throughelectromagnetic field technology. The BGS products we offer utilize proprietaryCombined Magnetic Field (CMF) technology to deliver a highly specific,low-energy signal. The OL1000 product is used for the non-invasive treatment ofan established 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 thenatural healing process of the bone may be compromised by other healthconditions of the patient, such as diabetes, smoking habits, weight, age andthe severity and location of the fracture. Our BGS products accounted forapproximately 16% of our revenues for 2006.

Patients using BGS devicesgenerally receive a prescription for the product from their physician. Afterinsurance approval, the patient receives the device and starts therapy,typically at home. The patient is usually instructed to wear our bone growthstimulators for only 30 minutes each day, a significantly shorter period thanmost competing products, which may require up to 24 hours of daily therapy. Webelieve the reduced treatment time leads to increased patient compliance withtreatment protocol. The length of therapy with our products varies, but usuallyis between 25 and 40 weeks.

We offer the TechnologyYou Can Trust program in connection with our BGS products. If a patient has anonunion fracture that fails to heal while using a BGS product, the TechnologyYou Can Trust program will, if the patient meets the specified requirements ofthe program, refund the costs for treatment using the BGS product. Since theTechnology You Can Trust program was introduced, refunds under this program havebeen minimal.

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*OL1000.**  *The OL1000 product is a FDA approved device thatcomprises two magnetic field treatment transducers, or coils, and amicroprocessor-controlled signal generator that delivers a highly specific,low-energy signal to the injured area. This signal is designed to stimulatebone growth and healing. This unique system has a micro-controller that tracksthe patient’s daily treatment compliance. The OL1000 is used for thenon-invasive treatment of an established nonunion fracture in all major longbones, such as the tibia, femur and humerus.

The OL1000 device isdesigned to be attached to the patient’s arm, leg or other area where there isa nonunion fracture. The OL1000 is designed to evenly distribute a magneticfield over the patient’s injured area. Because of the even distribution of thefields, specific placement of the device over the nonunion fracture is not ascritical for product efficacy as it is for some competing products.

The OL1000 SC product is aFDA approved single coil device, which utilizes the same combined magneticfield as the OL1000. This product is available in three sizes and is designedto be more comfortable for patients with certain types of fractures, such asclavicle and hip fractures, where only a single coil can be applied.

*SpinaLogic.*   TheSpinaLogic product is a FDA approved, portable, non-invasive, electromagneticbone growth stimulator that is designed to enhance the healing process as anadjunct therapy after spinal fusion surgery. With the SpinaLogic product, thepatient attaches the device to the lumbar injury location where it is designedto provide localized magnetic field treatment 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. In 2005, we launched our newest design for ourSpinaLogic product. The new, more ergonomic design is smaller, lighter and hasa gently curved oval shape that conforms to the spine’s anatomy, making it morecomfortable than spine bone growth stimulators previously offered by theCompany. The new design incorporates the same patented CMF waveform technologythat has established SpinaLogic as a convenient-to-use spinal bone growthstimulator, with a daily treatment time of 30 minutes.

**Sales, Marketing and Distribution**

We distribute our productsthrough five sales channels: DonJoy, ProCare/Aircast, OfficeCare, Regenerationand International. Our DonJoy and OfficeCare channels are managed by regionalgeneral managers who are responsible for managing the sale of products acrossthese channels. We have a vice president who is responsible for managing thesale of our Regeneration products in the U.S., a vice president who isresponsible for managing the sale of our ProCare/Aircast products in the U.S.and a vice president who is responsible for managing the sale of our vascularsystems products in the U.S. Sales in our international channel are managed bya vice president with an office in the United Kingdom and local country generalmanagers in key markets. This channel consists of sales by our wholly ownedforeign subsidiaries and foreign independent distributors. For the year ended December 31,2006, no single customer represented more than 10% of our revenues.

Our DomesticRehabilitation segment, which includes sales of our rehabilitation productsthrough the DonJoy, ProCare/Aircast and OfficeCare sales channels discussedbelow, accounted for approximately 64.7% of our revenues for 2006. OurRegeneration segment, which includes sales of our regeneration products throughdedicated sales specialists, certain independent distributors and the DonJoysales channel, as discussed below, accounted for approximately 15.6% of ourrevenues for 2006.

We have two principaldistribution centers located in Tijuana, Mexico and Indianapolis, Indiana fromwhich products are shipped to customers in the U.S. Products destined forcustomers in foreign countries where we have direct subsidiaries are shippedfrom the Mexico distribution center, or, in the case of Canada, theIndianapolis distribution center, to smaller distribution hubs located inseveral of those 

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countriesfor further shipment to customers. Products ordered by our independentdistributors in countries in which we do not have a subsidiary are generallyshipped from our Mexico facility to the distributors.

***DonJoy***

The DonJoy sales channelis responsible for selling rigid knee braces, pain management products,regeneration products and certain soft goods. The channel consists ofapproximately 340 independent commissioned sales representatives who areemployed by approximately 40 independent sales agents and a few of our directsales representatives. The DonJoy channel is primarily dedicated to the sale ofour products to orthopedic surgeons, podiatrists, orthopedic and prostheticcenters, hospitals, surgery centers, physical therapists, athletic trainers andother healthcare professionals. Because the DonJoy product lines generallyrequire customer education on the application and use of the product, our salesrepresentatives are technical specialists who receive extensive training bothfrom us and the agent and use their expertise to help fit the patient with theproduct and assist the orthopedic professional in choosing the appropriateproduct to meet the patient’s needs.

After a salesrepresentative receives a product order, we generally ship and bill the productdirectly to the orthopedic professional, paying a sales commission to theagent. For certain custom rigid braces and other products, we sell directly tothe patient and bill a third-party payor, if applicable, on behalf of thepatient. We refer to this portion of our DonJoy channel as our Insurancechannel. We enjoy long-standing relationships with most of our agents and salesrepresentatives. Under the arrangements with the agents, each agent is grantedan exclusive geographic territory for sales of our products and is notpermitted to market products, or represent competitors who sell or distributeproducts, that compete with our existing products. The agents receive acommission, which varies based on the type of product being sold. If an agentfails to achieve specified sales quotas, we may terminate the agent.

*ProCare/Aircast*

The ProCare/Aircastchannel employs approximately 100 direct and independent representatives thatmanage over 380 dealers focused on primary and acute facilities. Approximatelysix vascular systems specialists are also included in this channel. Products inthis channel consist primarily of our soft goods, vascular systems and otherproducts, which are generally sold in non-exclusive territories to third-partydistributors. These distributors include large, national third-partydistributors such as Owens & Minor Inc., McKesson/HBOC, AllegianceHealthcare and Physican Sales and Service Inc., regional medical surgicaldealers, and medical products buying groups that consist of a number of dealerswho make purchases through the buying group. 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 ProCare/Aircast products generally do not requiresignificant customer education for their use. The vascular systems products aresold to hospitals and outpatient surgery centers through a combination ofdirect sales and third-party distributors. The pump and related equipment istypically consigned to the hospitals, and the hospitals then purchase the cuffsthat are applied to each patient.

In response to theemergence of managed care and the formation of buying groups, nationalpurchasing contracts and various bidding procedures imposed by hospitals andbuying groups, we have entered into national contracts primarily for the saleof soft goods products, but often also covering our other product categories,with large healthcare providers and buying groups, such as Broadlane, Premier,HealthTrust Purchasing Group, AmeriNet Inc., Novation and U.S.Government/Military hospitals. Under these contracts, we provide favorablepricing to the buying group and, as a result, are generally designated apreferred purchasing source for the members of the buying group for specifiedproducts. Members, however, are not obligated to purchase our products. As partof our strategy, we seek to secure additional national contracts with otherhealthcare providers and buying groups in the future.

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*OfficeCare*

Through OfficeCare, wemaintain an inventory of product (mostly soft goods) on hand at orthopedicpractices for immediate distribution to the patient. For these products, webill the patient or third-party payor after the product is provided to thepatient. As of December 31, 2006, the OfficeCare program was located atover 1,000 physician offices throughout the United States. We have contractswith over 700 third-party payors for our OfficeCare products.

We currently outsourcemost of the revenue cycle portion of this program, from billing to collecting,to an independent third-party contractor. As a result of the growth of thisprogram, our working capital needs have increased due to higher levels ofaccounts receivable and inventories necessary to operate the program. Thecollection period for these receivables as compared to other portions of ourbusiness is significantly longer.

*Regeneration*

Our OL1000 product is soldprimarily by approximately 124 sales representatives specially trained to sellthe product, of which approximately 57 are employed by us and approximately 67are employed by our independent DonJoy sales agents. The SpinaLogic productwas, until the end of 2004, sold by DePuy Spine in the U.S. under an exclusivesales agreement, which could be unilaterally terminated by DePuy Spine withfour months notice and expires by its terms in 2010. The agreement requiredDePuy Spine to meet annual sales minimums in order to maintain 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 sales agent. Commencingearly in 2006, the agreement with DePuy Spine became a non-exclusivearrangement for the entire U.S. This permits us to sell the SpinaLogic productdirectly or through other independent sales representatives in all territorieswhere we choose to do so. For most BGS products we sell directly to the patientand bill a third-party payor, if applicable, on behalf of the patient.

*International*

We market our products inover 70 countries outside the United States, primarily countries in Europe aswell as in Canada, Japan and Australia. International sales are currently madethrough two distinct channels: independent third-party distributors and throughwholly owned foreign subsidiaries. The International sales channel accountedfor approximately 19.7% of our revenues for 2006. In connection with our 2006acquisitions of Axmed and Aircast, we have increased the size and scale of ourinternational business. We believe that future opportunities for sales growthwithin international markets are significant. To this end, we have eitherestablished or acquired direct sales subsidiaries in Canada, the United Kingdom,France, Germany, Denmark, Italy and Spain. These wholly owned subsidiaries haveenabled us to obtain higher gross margins on our products than we would haveobtained on sales through third-party distributors. In addition, we believethat more direct control of the distribution network in these countries willallow us to accelerate the launch of new products and product enhancements.

**Manufacturing**

Nearly all of ourrehabilitation products, except those acquired with the Axmed acquisition, aremanufactured in Tijuana, Mexico. We operate a 225,000 square foot leasedmanufacturing facility in Tijuana, Mexico. In Vista, California we manufactureour custom rigid knee bracing products, which remain in the U.S. primarily tofacilitate quick turn-around on custom orders, our Regeneration product linesand, effective December 2006, the pump portion of our vascular systemsproducts. Within our Vista and Tijuana facilities, we operate a verticallyintegrated manufacturing and cleanroom packaging operation and are capable ofproducing a majority of our subassemblies and components in-house. Theseinclude metal stamped parts, injection molding components and fabric-strappingmaterials. We also have 

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extensivein-house tool and die fabrication capabilities, which provide savings in thedevelopment of typically expensive tools and molds as well as flexibility torespond to and capitalize on market opportunities as they are identified. Inconnection with our January 2006 acquisition of Axmed, we now havemanufacturing capabilities in Tunisia, which, although on a smaller scale, arevery similar to our manufacturing capabilities in Mexico. Most of the softgoods products we currently sell in France are manufactured in Tunisia.

Our Vista, Californiafacility has achieved ISO 9001 certification, EN46001 certification andcertification to the Canadian Medical Device Regulation (ISO 13485) andthe European Medical Device Directive. Our Tijuana, Mexico facility hasachieved ISO 9001 and ISO 13485 certification. These certifications areinternationally recognized quality standards for manufacturing and assist us inmarketing our products in certain foreign markets.

Most of the raw materialsthat we use in the manufacture of our products are available from more than onesource and are generally readily available on the open market. We source someof our finished products from manufacturers in China as well as otherthird-party manufacturers.

**Research and Development**

Our internal research anddevelopment program is aimed at developing and enhancing products, processesand technologies. The research and development activities for our rehabilitationproducts are conducted in our Vista, California facility by a group of productengineers and designers who have substantial experience in developing anddesigning products using advanced technologies, processes and materials. Theresearch 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 andmaintain close relationships with a number of widely recognized orthopedicsurgeons and professionals who assist in product research, development andmarketing. These professionals often become product proponents, speaking aboutour products at medical seminars, assisting in the training of otherprofessionals in the use and fitting of our products and providing us withfeedback on the industry’s acceptance of our new products. Some of thesesurgeons and specialists who participate in the design of products or provideconsulting services have contractual relationships with us under which theyreceive royalty payments or consultant fees in connection with the developmentof particular products with which they have been involved. Our medical advisoryboard, consisting of five orthopedic surgeons, also assists in our productdevelopment by advising us on technological advances in orthopedics, along withcompetitive and reimbursement updates within the orthopedic industry.

We maintain a clinicaleducation research laboratory in our Vista, California facility, which is usedby orthopedic surgeons to evaluate soft tissue repair products in a simulatedsurgical setting and practice surgical technique. These surgeons often provideus with feedback, which assists us in the development and enhancement of ourproducts. In addition, we utilize our biomechanical laboratory in our Vista,California facility 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 surgical procedures.Mechanical models are used to simulate behavior of normal, injured andosteoarthritic knees and observe the performance of new product designs as wellas competitive products. We host numerous orthopedic professionals at ourbiomechanical and surgical technique laboratories, which allows theprofessionals to practice procedures and measure the effectiveness of thoseprocedures.

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In addition to ourinternal research and development efforts, we have entered into a number oftechnology licensing arrangements with third-parties that provide us innovativetechnologies and processes for the manufacture and development of our products.Finally, we act as the distributor of a number of products that aremanufactured 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 Ossur hf., OrthofixInternational, N.V., Bledsoe Brace Systems and Townsend Industries Inc. In thesoft goods products market, our competitors include Biomet, Inc., DeRoyalIndustries, Ossur hf. and Zimmer Holdings, Inc. In the pain managementproducts market, our competitors include I-Flow Corp., Orthofix and StrykerCorporation. In the nonunion bone growth stimulation market, our competitorsinclude Orthofix, Biomet and Smith & Nephew, and in the spinal fusionmarket we compete with Biomet and Orthofix. Several competitors have initiatedstock and bill programs similar to our OfficeCare program.

Competition in the rigid knee brace market isprimarily based on product technology, quality and reputation, relationshipswith customers, service and price. Competition in the soft goods 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. International competition is primarily fromforeign manufacturers whose costs may be lower due to their ability tomanufacture products within their respective countries.

We believe that ourextensive product lines, advanced product design, strong distribution networks,reputation with leading orthopedic professionals and customer service provideus with an advantage over our competitors. In particular, we believe that ourbroad product lines provide us with a competitive advantage over the smallercompanies, while our established distribution networks and relationship-basedselling efforts provide us with a competitive advantage over largermanufacturers.

**IntellectualProperty**

Our most significant intellectual property rights areour patents and trademarks, including our brand names, and proprietary know-how.We own or have licensing rights to approximately 316 U.S. and foreign patentsand approximately 115 pending patent applications. We anticipate that we willapply for additional patents in the future as we develop new products andproduct enhancements.

Some of our 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, we own patents covering a series of hingesfor our rigid knee braces, as well as pneumatic pad design and productiontechnologies (which utilize air inflatable cushions that allow the patient tovary the location and degree of support) used in rigid knee braces such as theDefiance ligament brace. We also have patents relating to our osteoarthriticbraces and specific mechanisms in a number of our products, and we licensepatents on an exclusive basis covering the combined magnetic field technologyused in our BGS products.

In addition to thesepatents, we rely on non-patented know-how, trade secrets, processes and otherproprietary information, which we protect through a variety of methods,including confidentiality agreements and proprietary information agreementswith vendors, employees, consultants and others who have access to ourproprietary information. We believe that our patents, trademarks and otherproprietary 

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rightsare important to the development and conduct of our business and the marketingof our products. As a result, we intend to continue to aggressively protect ourintellectual property rights.

**Employees**

As of December 31,2006, we had approximately 3,000 employees. Approximately 28% of our employeeswork in the U.S., 63% of our employees work in Mexico and 9% are located invarious other countries, primarily in Europe. Our employees are not unionized. Wehave not experienced any strikes or work stoppages, and management considersits relationships with our employees to be good.

**GovernmentRegulation**

*Medical DeviceRegulation*

*UnitedStates.**  *Our products and operations are subjectto regulation by the FDA, state authorities and comparable authorities inforeign jurisdictions. Among other things, pursuant to the federal Food, Drugand Cosmetic Act and its implementing regulations, the FDA regulates theresearch, testing, manufacturing, safety, labeling, storage, recordkeeping,premarket clearance or approval, marketing and promotion, and sales anddistribution of medical devices in the United States to ensure that medicalproducts distributed domestically are safe and effective for their intendeduses. In addition, the FDA regulates the export of medical devices manufacturedin the United States to international markets.

Under the Federal Food, Drug, and Cosmetic Act, orFFDCA, medical devices are classified into one of three classes—Class I, Class IIor Class III—depending on the degree of risk associated with each medical deviceand the extent of control needed to ensure safety and effectiveness. Ourcurrently marketed rehabilitation products are all Class I or Class IImedical devices. Our currently marketed bone growth stimulation products are Class IIImedical 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 review and clearance by the FDA for thesedevices may be accomplished through the 510(k) premarket notificationprocedure. When a 510(k) is required, the manufacturer must submit to theFDA a premarket notification submission demonstrating that the device is “substantiallyequivalent” in technology, intended use, safety and effectiveness to either adevice that was legally marketed prior to May 28, 1976 (the date uponwhich the Medical Device Amendments of 1976 were enacted) or anothercommercially available, similar device that was subsequently cleared throughthe 510(k) process. By regulation, the FDA is required to respond to a 510(k) premarketnotification within 90 days of submission. As a practical matter,clearances can take significantly longer. If the FDA determines that the device,or its intended use, is not “substantially equivalent” to a previously-cleareddevice or use, the FDA will place the device, or the particular use of thedevice, into Class III, and the device sponsor must then fulfill morerigorous premarket 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 safetyand efficacy of Class III devices cannot be assured solely by the GeneralControls and the other requirements described above. These devices almostalways require formal clinical studies to demonstrate safety and effectiveness.Submission and FDA approval of a premarket approval application, or PMA, isrequired 

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before marketing of a Class IIIproduct can proceed. A PMA application, which is intended to demonstrate thatthe device is safe and effective, must be supported by extensive data,including data from preclinical studies and human clinical trials andinformation on manufacturing and labeling. The FDA, by statute and regulation,has 180 days 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 a PMA application or clearing a 510(k) application,the FDA may also require some form of post-market surveillance when necessaryto protect the public health or to provide additional safety and effectivenessdata for the device.

A clinical trial is generally required to support aPMA application and is sometimes required for a 510(k) premarketnotification. These trials generally require submission of an application foran 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 approvedin advance by the FDA for a specified number of patients, unless the product isdeemed a non-significant risk device and eligible for more abbreviated IDErequirements. Clinical trials for a significant risk device may begin once theIDE application is approved by the FDA and the appropriate institutional reviewboards at the clinical trial sites.

Medical devices can be marketed only for theindications for which they are cleared or approved. Modifications to apreviously cleared or approved device that could significantly affect itssafety or effectiveness or that would constitute a major change in its intendeduse, design or manufacture require a 510(k) clearance, premarket approvalsupplement or new premarket approval. The FDA requires each manufacturer tomake this determination initially, but the FDA can review any such decision andcan disagree with the manufacturers’ determination. We have modified variousaspects of our devices in the past and determined that new approvals,clearances or supplements were not required. Nonetheless, the FDA may disagreewith our conclusion that clearances or approvals were not required forparticular products and may require approval or clearances for such past or anyfuture modifications or to obtain new indications for our existing products. Suchsubmissions may require the submission of additional clinical or preclinicaldata and may be time consuming and costly, and may not ultimately be cleared orapproved by the FDA. Also, in these circumstances, we may be required to ceasedistribution of the modified product, the devices may be subject to seizure byFDA or to a voluntary or mandatory recall, and we also could be subject tosignificant regulatory fines and penalties.

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 our products. Ourdomestic facility records and manufacturing processes are subject to periodicunscheduled inspections by the FDA. Our Mexican facilities, which exportproducts to the United States, may also be inspected by the FDA. Based oninternal audits of our domestic and Mexican facilities, we believe that ourfacilities are in substantial compliance with the applicable QSR regulations. Wealso are required to report to the FDA if our products cause or contribute to adeath or serious injury or malfunction in a way that would likely cause orcontribute to death or serious injury were the malfunction to recur. Althoughmedical device reports have been submitted in the past 5 years, none haveresulted in a recall of our products or other regulatory action by the FDA. TheFDA and authorities in other countries can require the recall of products inthe event of material defects or deficiencies in design or manufacturing. TheFDA can also withdraw or limit our product approvals or clearances in the eventof 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. 

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Medical devices may bemarketed only for the uses and indications for which they are cleared orapproved. FDA regulations prohibit a manufacturer from promoting a device foran unapproved, or “off-label” use.

The FDA has broad regulatory and enforcement powers. Ifthe FDA determines that we have failed to comply with applicable regulatoryrequirements, it can impose a variety of enforcement actions from publicwarning letters, fines, injunctions, consent decrees and civil penalties tosuspension or delayed issuance of approvals, seizure or recall of our products,total or partial shutdown of production, withdrawal of approvals or clearancesalready granted, and criminal prosecution. The FDA can also require us torepair, replace or refund the cost of devices that we manufactured ordistributed. If any of these events were to occur, it could materiallyadversely 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 are restrictions under U.S. law on the export fromthe United States of medical devices that cannot be legally distributed in theUnited States. If a Class I or Class II device does not have 510(k) clearance,and the manufacturer reasonably believes that the device could obtain 510(k) clearancein the United States, then the device can be exported to a foreign country forcommercial marketing without the submission of any type of export request orprior FDA approval, if it satisfies certain limited criteria relating primarilyto specifications of the foreign purchaser and compliance with the laws of thecountry to which it is being exported. We believe that all of our currentproducts which are exported to foreign countries currently comply with theserestrictions.

*International.**  **In many of the foreign countries inwhich we market our products, we are subject to regulations affecting, amongother things, product standards, packaging requirements, labeling requirements,import restrictions, tariff regulations, duties and tax requirements. Many ofthe regulations applicable to our devices and products in such countries areessentially similar to those of the FDA, including those in Germany, ourlargest foreign market. The regulation of our products in Europe fallsprimarily within the European Economic Area, which consists of the fifteenmember states of the European Union as well as Iceland, Liechtenstein andNorway. The legislative bodies of the European Union have adopted directives inorder to harmonize national provisions regulating the design, manufacture,clinical trials, labeling and adverse event reporting for medical devices andthe member states of the European Economic Area have implemented the directivesinto their respective national law. Medical devices that comply with theessential requirements of the national provisions and the directives will beentitled to bear a CE marking. Unless an exemption applies, only medicaldevices which bear a CE marking may be marketed within the European EconomicArea. The European Commission has adopted numerous guidelines relating to themedical devices directives to ensure their uniform application. The method ofassessing conformity varies depending on the class and type of the medicaldevice and can involve a combination of self-assessment by the manufacturer anda third-party assessment by a Notified Body, which is an independent andneutral institution appointed by the member states to conduct the conformityassessment. This third-party assessment may consist of an audit of the manufacturer’squality system and specific testing of the manufacturer’s devices. Anassessment by a Notified Body in one country within the European Economic Areais generally required in order for a manufacturer to commercially distributethe product throughout the European Economic Area.*

The European Standardization Committees have adoptednumerous harmonized standards for specific types of medical devices. Compliancewith relevant standards establishes the presumption of conformity with theessential requirements for a CE marking. Our quality system relating to thedevelopment, production and distribution of rigid and soft orthopedic bracing,cold therapy and regeneration products is certified to international standardsthrough September 28, 2008 for our facilities in Vista, California and Tijuana,Mexico. Our regeneration, sterile cold therapy pads and CCMI (leg contourmeasuring devices and angle reference bending tools) in our facilities inVista, California have been certified and the existing certificates have beenor are in the process of being extended. The existing certificate remains validuntil the issue of a new certificate.

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In many countries, thenational health or social security organizations require our products to bequalified before they can be marketed with the benefit of reimbursementeligibility. To date, we have not experienced difficulty in complying withthese regulations. Due to the movement towards harmonization of standards inthe European 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. The timing of this harmonizationand its effect on us cannot currently be predicted.

*Federal Privacy andTransaction Law and Regulations*

Other federal legislationrequires major changes in the transmission and retention of health informationby us. The Health Insurance Portability and Accountability Act of 1996, orHIPAA, mandates, among other things, the adoption of standards for theelectronic exchange of health information that has required significant andcostly changes to prior practices. Sanctions for failure to comply with HIPAAinclude civil and criminal penalties. The U.S. Department of Health and HumanServices, or HHS, has released three rules to date mandating the use ofnew standards with respect to certain healthcare transactions and healthinformation. The first rule requires the use of uniform standards forcommon healthcare transactions, including healthcare claims information, planeligibility, referral certification and authorization, claims status, planenrollment and disenrollment, payment and remittance advice, plan premiumpayments, and coordination of benefits. The second rule released by HHSimposes new standards relating to the privacy of individually identifiablehealth information. These standards not only require our compliance with rules governingthe use and disclosure of protected health information, but they also requireus to obtain satisfactory assurances that any business associate of ours towhom such information is disclosed will safeguard the information. The third rule releasedby HHS establishes minimum standards for the security of electronic healthinformation. We were required to comply with the transaction standards by October 16,2003 and the privacy standards by April 14, 2003, and were required tocomply with the security standards by April 21, 2005.

*Third-Party Reimbursement*

Our products generally are prescribed by physiciansand are eligible for third-party reimbursement. An important consideration forour business is whether third-party coverage and payment amounts will beadequate, since this is a factor in our 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. Medicarepolicies are important to our business because third-party payors often modeltheir policies after the Medicare program’s coverage and reimbursementpolicies.

Healthcare reform legislation in the Medicare area hasfocused on containing healthcare spending. For example, the MedicarePrescription Drug, Improvement and Modernization Act of 2003, or theModernization Act, provides for a number of revisions to payment methodologiesand other standards for items of durable medical equipment and orthotic devicesunder the Medicare program.

First, under the Modernization Act, the paymentamounts for orthotic devices (2004 through 2006) and certain durable medicalequipment (2004 through 2008) will no longer be increased on an annual basis. Thefreeze does not affect Class III devices such as bone growth stimulators,however.

Second, a competitive bidding program is scheduled tobe phased in to replace the existing fee schedule payment methodology beginningin 2007. Under the Modernization Act, off-the-shelf orthotic devices and othernon-Class III devices are subject to the program. The competitive biddingprogram is scheduled to begin in ten high-population metropolitan statisticalareas during 2007 and, in 2009, is to be expanded to 80 metropolitanstatistical areas (and additional areas thereafter). Payments in regions notsubject to competitive bidding may also be adjusted using payment informationfrom regions subject to competitive bidding. On April 24, 2006, theCenters for Medicare and Medicaid Services, or CMS, the 

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agency responsible foradministering the Medicare program, published a proposed rule to implementthe competitive bidding program. The proposed rule includes, among otherthings, proposals regarding how CMS will determine which products and whichmetropolitan statistical areas of the United States will be subject tocompetitive bidding, how CMS plans to award contracts and how it will evaluatebids and set payment rates. The products to be included in the first phase ofbidding were not announced, but a final rule is expected shortly.

Third, pursuant to the Modernization Act, CMSpublished quality standards in August 2006 that apply to all supplierssubmitting claims for payment for items of durable medical equipment,prosthetics, orthotics and supplies under Medicare Part B, which includesclaims that we and many of our customers submit for our products. The qualitystandards include business-related standards, such as financial and humanresources management standards, which would be applicable to all durablemedical equipment, orthotics and prosthetics suppliers, as well asproduct-specific standards, such as those for customized orthotics products,which focus on product specialization and service standards for such items. Thesequality standards will be applied by recognized independent accreditationorganizations. In November 2006, CMS published a list of the selectedaccreditation organizations that may accredit suppliers. We will be required tobecome accredited to continue to bill Medicare as a supplier, and we have begunthat process.

Fourth, the Modernization Act authorizes clinicalconditions for payment to be established.

Fifth, the Modernization Act mandated that theGovernment Accountability Office (GAO) make a recommendation to Medicare in2006 regarding the 2007 fee schedule update for bone growth stimulators. In2006, the GAO issued a recommendation that no increase in reimbursement levelsfor these devices should be made in 2007, and CMS has not made any suchincrease.

In recent years, efforts to control Medicare costshave included the heightened scrutiny of reimbursement codes and paymentmethodologies. Under Medicare, certain devices used by outpatients areclassified using reimbursement codes, which in turn form the basis for eachdevice’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, CMS made effective aninterim final regulation implementing “inherent reasonableness” authority,which allows the agency and its contractors to adjust payment amounts by up to15% per year for certain items and services when the existing payment amount isdetermined to be grossly excessive or grossly deficient. CMS may make a largeradjustment each year if it undertakes prescribed procedures. The ModernizationAct clarified that the use of inherent reasonableness authority is precludedfor devices provided under competitive bidding. CMS finalized the inherentreasonableness regulation in December 2005, with an effective date of February 13,2006, and essentially kept in place the policies in the interim finalregulation. We do not know what impact inherent reasonableness and competitivebidding will have on us or the reimbursement of our products.

Beyond changes inreimbursement codes and payment methodologies, the movement, both domesticallyand in foreign countries, toward healthcare reform and managed care maycontinue to result in downward pressure on product pricing. Net revenues fromthird-party reimbursement accounted for approximately 26%, 32% and 31% of ourhistorical net revenues for the years ended December 31, 2006, 2005 and2004, respectively. Medicare reimbursement consisted of approximately 13% ofour historical net revenues from third-party reimbursement or approximately 3%of our total historical net revenues for the year ended December 31, 2006.

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*Fraud and Abuse*

We are subject tovarious federal and state laws pertaining to healthcare fraud and abuse,including anti-kickback laws and physician self-referral laws. Violations ofthese laws are punishable by criminal and civil sanctions, including, in someinstances, exclusion from participation in federal and state healthcareprograms, including Medicare, Medicaid, Veterans Administration health programsand TRICARE. We believe that our operations are in material compliance withsuch laws. However, because of the far-reaching nature of these laws, there canbe no assurance that we would not be required to alter one or more of ourpractices to be in compliance with these laws. In addition, there can be noassurance that the occurrence of one or more violations of these laws orregulations would not result in a material adverse effect on our financialcondition and results of operations.

*Anti-kickback and Fraud Laws.**  *Our operations are subject to federal and state anti-kickback laws. Certainprovisions of the Social Security Act, which are commonly known collectively asthe Medicare Fraud and Abuse Statute, prohibit persons from knowingly andwillfully soliciting, receiving, offering or providing remuneration directly orindirectly to induce either the referral of an individual, or the furnishing,recommending, or arranging for a good or service, for which payment may be madeunder a federal healthcare program such as Medicare and Medicaid. Thedefinition of “remuneration” has been broadly interpreted to include anythingof value, including such items as gifts, discounts, waiver of payments, andproviding anything at less than its fair market value. HHS has issuedregulations, commonly known as safe harbors, that set forth certain provisionswhich, if fully met, will assure healthcare providers and other parties thatthey will not be prosecuted under the Medicare Fraud and Abuse Statute. Inaddition, the HHS Office of Inspector General is authorized to issue advisoryopinions regarding the interpretation and applicability of the Medicare Fraudand Abuse Statute, including whether an activity constitutes grounds for theimposition of civil or criminal sanctions. The penalties for violating the MedicareFraud and Abuse Statute include imprisonment for up to five years, fines of upto $25,000 per violation and possible exclusion from federal healthcareprograms such as Medicare and Medicaid. 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. In conjunction with the OfficeCare program, wemay pay participating physicians a fee for rental space and support servicesprovided by such physicians to us. In a Special Fraud Alert issued by HHS’Office of Inspector General, or OIG, in February 2000, the OIG indicatedthat it may scrutinize stock and bill programs involving excessive rentalpayments or rental space for possible violation of the Medicare Fraud and AbuseStatute, but noted that legitimate arrangements, including fair market valuerental arrangements, will not be considered violations of the statute. Webelieve we have structured the OfficeCare program to comply with the MedicareFraud and Abuse Statute.

HIPAA created two new federal crimes: healthcare fraudand false statements relating to healthcare matters. The healthcare fraudstatute prohibits knowingly and willfully executing or attempting to execute ascheme or artifice to defraud any healthcare benefit program, including privatepayors. The false statements statute prohibits knowingly and willfullyfalsifying, concealing or covering up a material fact or making any materiallyfalse, fictitious or fraudulent statement or representation in connection with thedelivery of or payment for healthcare benefits, items or services. This statuteapplies to any health benefit plan, not just Medicare and Medicaid. Additionally,HIPAA granted expanded enforcement authority to HHS and the U.S. Department ofJustice, or DOJ, and provided enhanced resources to support the activitiesand responsibilities of the OIG and DOJ by authorizing large increases infunding for investigating fraud and abuse violations relating to healthcaredelivery and payment. In addition, HIPAA mandates the adoption of standards forthe electronic exchange of health information.

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*PhysicianSelf-Referral Laws.**  *We are also subject to federal andstate 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 alsoprohibits the entity receiving the referral from billing any good or servicefurnished pursuant to an unlawful referral, and any person collecting anyamounts in connection with an unlawful referral is obligated to refund suchamounts. A person who engages in a scheme to circumvent the Stark Law’sreferral prohibition may be fined up to $100,000 for each such arrangement orscheme. The penalties for violating the Stark Law also include civil monetarypenalties of up to $15,000 per referral and possible exclusion from federalhealthcare programs such as Medicare and Medicaid. Various states havecorollary laws to the Stark Law, including laws that require physicians todisclose any financial interest they may have with a healthcare provider totheir patients when referring patients to that provider. Both the scope andexceptions for such laws vary from state to state.

*False Claims Laws.**  *Under separate statutes,submission of claims for payment that are “not provided as claimed” may lead tocivil money penalties, criminal fines and imprisonment, and/or exclusion fromparticipation in Medicare, Medicaid and other federally funded state healthprograms. These false claims statutes include the federal False Claims Act,which prohibits the knowing filing of a false claim or the knowing use of falsestatements to obtain payment from the federal government. When an entity isdetermined to have violated the False Claims Act, it must pay three times theactual damages sustained by the government, plus mandatory civil penalties ofbetween $5,500 and $11,000 for each separate false claim. Suits filed under theFalse Claims Act, known as “qui tam” actions, can be brought by any individualon behalf of the government and such individuals (known as “relators” or, morecommonly, as “whistleblowers”) may share in any amounts paid by the entity tothe government in fines or settlement. In addition, certain states have enactedlaws modeled after the federal False Claims Act. Qui tam actions have increasedsignificantly in recent years, causing greater numbers of healthcare companiesto have to defend a false claim action, pay fines or be excluded from theMedicare, Medicaid or other federal or state healthcare programs as a result ofan investigation arising out of such action.

*Governmental Audits*

Because we participate in governmental programs as asupplier of medical devices, our operations are subject to periodic surveys andaudits by governmental entities or contractors to assure compliance withMedicare and Medicaid standards and requirements. To maintain our billingprivileges, we are required to comply with certain supplier standards,including, by way of example, licensure and documentation requirements for ourclaims submissions. From time to time in the ordinary course of business, we,like other healthcare companies, are audited by or receive claims documentationrequests from governmental entities, which may identify certain deficienciesbased on our alleged failure to comply with applicable supplier standards orother requirements. We review and assess such audits or reports and attempt totake appropriate corrective action.

We also are subject tosurveys of our physical location for compliance with applicable supplierstandards. The failure to effect corrective action to address identifieddeficiencies, or to obtain, renew or maintain any of the required regulatoryapprovals, certifications or licenses could adversely affect our business,results of operations or financial condition and could result in our inabilityto offer our products and services to patients insured by the programs.

**Item 1A.**                RiskFactors

Our ability to achieve ouroperating and financial goals is subject to a number of risks, including risksrelating to our 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 be materially and 

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adverselyaffected. The risks described below are not the only ones that we face.Additional risks not presently known to us or that we currently deem immaterialmay also affect our business operations.

**Risks Related toOur Business**

**We may have difficultyintegrating the operations and growing the business of Aircast Incorporated.**

In April 2006,we acquired Aircast Incorporated, a New Jersey based orthopedics company thatmanufactures and markets ankle and other orthopedic bracing products, cold therapyproducts and vascular therapy systems. We have recently completed the processof integrating all of the manufacturing operations of Aircast into our existingfacility in Tijuana, Mexico, and absorbing or relocating the U.S. general andadministrative, product development and marketing functions of Aircast to ourfacilities in Indianapolis, Indiana and Vista, California. The sales anddistribution resources of Aircast have been integrated into our sales anddistribution network, and we have combined Aircast operations in Europe withour existing operations of ours in various countries. Our ability to managethese integrated activities and to realize any synergies from the transactionare subject to numerous risks and uncertainties, including the following:

·       we may experiencedifficulty in managing the production of Aircast products in our Mexicofacility and training our work force in these new products;

·       we may have difficulty inestablishing new or revised arrangements with the sources of supply ofcomponents and raw material for the Aircast products;

·       our existing resources incustomer support, product development, quality and billing and collections mayprove to be  inadequate to address theAircast business, and new or relocated employees may need to be trained andintegrated into our systems and processes;

·       we may experience issuesrelated to our recent integration of the Aircast business into our existinginformation technology systems;

·       we may have difficultyretaining the sales and distribution resources of Aircast within our sales anddistribution   organization;

·       we may experience problemsrelated to the recent integration of our operations with those of Aircast inseveral countries in Europe; and

·       we may not be able toretain the loyalty and business of Aircast customers or realize sellingsynergies between the two companies.

Our ability to avoid therisk factors listed above and others will determine our success in realizingthe cost savings and other synergies we expect from the acquisition. Ourfailure to realize those synergies, or to grow the Aircast business along withour business in the manner that we expect, will adversely impact our operatingresults.

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

Our growth strategywill continue to include the pursuit of acquisitions, both domestically and, inparticular, internationally. We may not be able to identify acceptableopportunities or complete acquisitions of targets identified in a timely manneror on acceptable terms. Acquisitions involve a number of risks, including thefollowing:

·       ourmanagement’s attention will be diverted from our existing business whileevaluating acquisitions and thereafter while integrating the operations andpersonnel of the new business into our business;

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·       wemay experience adverse short-term effects on our operating results;

·       wemay be unable to successfully and rapidly integrate the new businesses,personnel and products with our existing business, including financialreporting, management and information technology systems;

·       wemay experience higher than anticipated costs of integration and unforeseenoperating difficulties and expenditures;

·       anacquisition may be in a market or geographical area in which we have littleexperience;

·       wemay have difficulty in retaining key employees, including employees who mayhave been instrumental to the success or growth of the acquired business; and

·       wemay use a substantial amount of our cash and other financial resources toconsummate an acquisition.

In addition, we mayrequire additional debt or equity financing for future acquisitions, and suchfinancing may not be available or on favorable terms, if available at all. Wemay not be able to successfully integrate or operate profitably any newbusiness we acquire, and we cannot assure you that any such acquisition willmeet our expectations. Finally, in the event we decide to discontinue pursuitof a potential acquisition, we will be required to immediately expense allcosts incurred in pursuit of the possible acquisition that could have anadverse effect on our results of operations in the period in which the expenseis recognized

**Weaknesses in our internal control over financialreporting could result in material misstatements in our financial statements.**

Our management is responsible for establishing andmaintaining adequate internal control over financial reporting. Our internalcontrols are processes designed to provide reasonable assurance regarding thereliability of financial reporting and the preparation of financial statementsin accordance with U.S. generally accepted accounting principles. A materialweakness is a control deficiency, or combination of control deficiencies, thatresults in a more than remote likelihood that a material misstatement of annualor interim financial statements will not be prevented or detected.

Management determined that a material weakness in ourinternal control over financial reporting existed as of December 31, 2006with regard to inventory that was in transit from the Aircast facilities in NewJersey to our facilities in Indianapolis and Tijuana, Mexico as a part of theintegration of the Aircast business into our business operations. We did notperform adequate detailed procedures with respect to such inventory and failedto adequately reconcile the related intercompany transactions. See “Item 9A—Controlsand Procedures” for a more complete description of this material weakness.

We have remediated this materialweakness with a detailed analysis and reconciliation of the in-transitinventory and related intercompany accounts. We cannot assure you thatadditional control deficiencies or material weaknesses will not be identifiedby our management or independent registered public accounting firm in thefuture, including in connection with the integration of our Aircastacquisition, Axmed acquisition or other acquisitions we may consummate in thefuture. In addition, even after having taken these remediation steps, ourinternal controls may not prevent all potential errors or fraud. Any controlsystem, no matter how well designed and implemented, can only providereasonable and not absolute assurance that the objectives of the control systemwill be achieved. Failure to achieve adequate internal control over financialreporting could adversely affect our business operations and financialposition.

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

The growth that we haveexperienced, and in the future may experience, including due to acquisitionsmay provide challenges to our organization, requiring us to expand ourpersonnel, manufacturing and distribution operations. Future growth may strainour infrastructure, operations, product development and other managerial andoperating resources. If our business resources become strained, we may beunable to increase sales of our products or generate revenue growth.

**Changes in the regulatory status of our BGS productscould adversely affect the operations and financial results of our Regenerationbusiness.**

In February 2005, apetition was filed with the US Food and Drug Administration (“FDA”) seeking toreclassify non-invasive bone growth stimulator devices from Class III to Class II.Although our BGS products that utilize combined magnetic field technology weresubsequently excluded from the petition, if the petition were to succeed, newmarket entrants could seek clearance of a BGS device using other technologiesthrough the 510(k) process (as opposed to the PMA process). This wouldlikely increase competition from new products in the electrical bone growthstimulation device business which could result in downward price pressures onour products and business. The FDA referred the petition to the Orthopaedic andRehabilitation Devices Advisory Panel (the Panel), which consists of medicalprofessionals with recognized expertise in BGS technology, and requested thePanel’s recommendation regarding whether the FDA should deny or approve thepetition. On June 2, 2006, the Panel held a public meeting regarding thepetition. At the close of the meeting, the Panel, by a vote of 4 to 2,recommended that the FDA deny the petition, meaning that the Panel believesthat BGS devices should remain in Class III and should continue to besubject to the PMA process. In a Federal Register notice issued on January 17,2007, FDA indicated that, based on the currently available information, theAgency concurred with the recommendations of the Advisory Panel, but also askedfor public comments on the matter. We therefore continue to actively oppose thereclassification of BGS products until the FDA renders a final decision on thepetition. We cannot be certain of the outcome of this regulatory matter, and anadverse outcome could impact our ability to grow sales and realize profits inour Regeneration business. Furthermore, we cannot be sure that other regulatorychanges will not be proposed or implemented that adversely impact ourRegeneration business. See additional risk factors under the heading “RisksRelating to Government Regulation” below.

**We have outsourced certain administrative functionsrelating to our OfficeCare and Insurance channels to a third-party contractorand this arrangement may not prove successful.**

Our OfficeCare saleschannel maintains an inventory of products (mostly soft goods) on hand atorthopedic practices for immediate distribution to patients. In our Insurance channel,we provide products, principally custom-made rigid knee braces, directly topatients. In both situations, we bill patients or their third-party payorsafter the product is provided to the patient. We outsource the revenue cycle ofthis program, from billing to collections, to an independent third-partycontractor. Our outsource contractor has undergone significant changes in theirbusiness operations in the last year, including locating some administrativefunctions overseas, in order to improve performance from order entry tocollections.  We are also working closelywith them to upgrade the software system used in these revenue cycleprocesses.  The inability of thisprovider to upgrade its processes and demonstrate improved billing andcollection results could have an adverse effect on our operations and financialresults in the OfficeCare and Insurance channels.

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**We rely on intellectual property to develop andmanufacture our products and our business could be adversely affected if andwhen we lose our intellectual property rights.**

We hold or license U.S. and foreign patents relatingto a number of our components and products and have patent applications pendingwith respect to other components and products. We also expect to apply foradditional patents as we deem appropriate. We believe that many of our patentsare, and will continue to be, extremely important to our success.

However, we cannotassure 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 dependson non-patented proprietary know-how, trade secrets, processes and otherproprietary information. We employ various methods to protect our proprietaryinformation, including confidentiality agreements and proprietary informationagreements with vendors, employees, consultants and others who have access toour proprietary information. However, these methods may not provide us withadequate protection. Our proprietary information may become known to, or beindependently developed by, competitors, or our proprietary rights inintellectual property may be challenged, any of which could have an adverseeffect on our business.

**If we are not able to develop, license or acquire andmarket new products or product enhancements we may not remain competitive.**

Our future successand the ability to grow our revenues and earnings require the continueddevelopment, licensing or acquisition of new products and the enhancement ofour existing products. We may 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 remaincompetitive if we fail to develop, license or acquire and market new productsand product enhancements. In addition, if any of our new or enhanced productscontain undetected errors or design defects, especially when first introduced,our ability to market these products could be substantially delayed, resultingin lost revenue, potential damage to our reputation and/or delays in obtainingacceptance of the product by orthopedic and spine surgeons and other healthcareprofessionals.

**We rely heavily on our relationships with orthopedicprofessionals who prescribe and dispense our products and our failure to maintainthese relationships could adversely affect our business.**

The sales of our products depend significantly on theprescription or recommendation of such products by orthopedic and spinesurgeons and other healthcare professionals. We have developed and maintainclose relationships with a number of widely recognized orthopedic surgeons andspecialists who support and recommend our 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.

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**The majority of our sales force consists ofindependent agents and distributors who maintain close relationships with ourhospital and physician customers.**

Our success also dependslargely upon arrangements with independent agents and distributors and theirrelationships with our hospital and physician customers in the marketplace.These agents and distributors are not our employees, and our ability toinfluence their actions and performance is limited. Our inability toeffectively manage these agents and distributors or our failure generally tomaintain relationships with these independent agents and distributors couldhave an adverse effect on our business.

**We operate in avery competitive business environment.**

The non-operative orthopedic and spine markets arehighly competitive and fragmented. Our competitors include several large,diversified general orthopedic products companies and numerous smaller nichecompanies. Some of our competitors are part of corporate groups that havesignificantly greater financial, marketing and other resources than we have. Accordingly,we may be at a competitive disadvantage with respect to these 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 competitorsin the soft goods products market include Biomet, Inc., DeRoyalIndustries, Ossur hf. and Zimmer Holdings, Inc. Our primary competitors inthe pain management products market include I-Flow Corp., Orthofix andStryker Corporation.

In the regenerationmarket, our primary competitors selling bone growth stimulation productsapproved by the FDA for the treatment of nonunion fractures are Orthofix,Biomet, Inc. and Smith & Nephew. Biomet and Orthofix also sellbone growth stimulation products for use by spinal fusion patients. We estimatethat Biomet has dominant shares of the U.S. markets for bone growth stimulationproducts used both to treat nonunion fractures and as adjunct therapy afterspinal fusion surgery.

**Our quarterly operating results are subject tosubstantial fluctuations and you should not rely on them as an indication ofour future results.**

Our quarterlyoperating results may vary significantly due to a combination of factors, manyof which are beyond our control. These factors include:

·       thenumber of business days in each quarter;

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

·       ourability to meet the demand for our products;

·       thedirect distribution of our products in foreign countries;

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

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

·       theimpact of any acquisitions that occur in a quarter;

·       theimpact of any changes in generally accepted accounting principles;

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

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·       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 results may vary significantly in the futureand period-to-period comparisons of our results of operations may not bemeaningful and should not be relied upon as indications 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 plan relies on certain assumptions forthe market for our products, which, if incorrect, may adversely affect ourprofitability.**

We**believe that various demographics and industry specifictrends will help drive growth in the rehabilitation 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 andtrends are beyond our control. The projected demand for our products couldmaterially differ from actual demand if our assumptions regarding these factorsprove to be incorrect or do not materialize or if alternative treatments tothose offered by our products gain widespread acceptance.

**Our business, operating results and financialcondition could be adversely affected if we become involved in litigationregarding our patents or other intellectual property rights.**

The orthopedicproducts industry has experienced extensive litigation regarding patents andother intellectual property rights. We or our products may become subject topatent infringement claims or litigation or interference proceedings declaredby the U.S. Patent and Trademark Office, or USPTO, or the foreign equivalentsthereto to determine the priority of inventions. The defense and prosecution ofintellectual property suits, USPTO interference proceedings or the foreignequivalents thereto and related legal and administrative proceedings are bothcostly and time consuming. An adverse determination in litigation orinterference proceedings to which we may become a party could:

·       subjectus to significant liabilities to third-parties;

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

·       requireus to cease using such technology.

Any one of these outcomes could have an adverse effecton us. Furthermore, we may not be able to obtain necessary licenses onsatisfactory terms, if at all. Accordingly, adverse determinations in ajudicial or administrative proceeding or our failure to obtain necessarylicenses could prevent us from manufacturing and selling our products, whichwould have a material adverse effect on our business, operating results andfinancial condition. Moreover, even if we are successful in such litigation,the expense of defending such claims could be material.

In addition, we have fromtime to time needed to, and may in the future need to, litigate to enforce ourpatents, to protect our trade secrets or know-how or to determine theenforceability, scope and validity 

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of theproprietary rights of others. Such enforcement of our intellectual propertyrights could involve counterclaims against us. Any future litigation orinterference proceedings will result in substantial expense to us andsignificant diversion of effort by our technical and management personnel.

**We have limited suppliers for some of our componentsand products which makes us susceptible to supply shortages and could disruptour operations.**

Some of our important suppliers are in China and otherparts of Asia and provide us predominately finished soft goods products. Infiscal year 2006, we obtained approximately 15% of our total purchasedmaterials from suppliers in China and other parts of Asia. Political andeconomic instability and changes in government regulations in these areas couldaffect our ability to continue to receive materials from our suppliers there.The loss of our suppliers in China and other parts of Asia, any otherinterruption or delay in the supply of our required materials or our inabilityto obtain these materials at acceptable prices and within a reasonable amountof time could impair our ability to meet scheduled product deliveries to ourcustomers and could hurt our reputation and cause customers to cancel orders.

In addition, we purchasethe microprocessor used in the OL1000® and SpinaLogic devices from a singlemanufacturer. Although there are feasible alternate microprocessors that mightbe used immediately, all are produced by a single supplier. In addition, thereare single suppliers for other components used in the OL1000 and SpinaLogicdevices and only two suppliers for the magnetic field sensor employed in them. Establishmentof additional or replacement suppliers for these components cannot beaccomplished quickly.

**Our international sales and profitability may beadversely affected by foreign currency exchange fluctuations and other risks.**

We sell products in foreign currency through ourforeign subsidiaries. The U.S. dollar equivalent of international salesdenominated in foreign currencies in fiscal years 2006, 2005 and 2004 werefavorably impacted by foreign currency exchange rate fluctuations with theweakening of the U.S. dollar against the foreign currencies of our subsidiaries.The U.S. dollar equivalent of the related costs denominated in these foreigncurrencies was unfavorably impacted during the same periods. In addition, thecosts associated with our Mexico-based manufacturing operations are incurred inMexican pesos. As we continue to distribute and manufacture our products inselected foreign countries, we expect that future sales and costs associatedwith our activities in these markets will continue to be denominated in theapplicable foreign currencies, which could cause currency fluctuations tomaterially impact our operating results.

We are also subject toother risks inherent in international operations such as political and economicconditions, foreign regulatory requirements, exposure to different legalrequirements and standards, exposure to different approaches to treatinginjuries, potential difficulties in protecting intellectual property, importand export restrictions, increased costs of transportation or shipping,currency fluctuations, difficulties in staffing and managing internationaloperations, labor disputes, difficulties in collecting accounts receivable andlonger collection periods and potentially adverse tax consequences. Forexample, in Germany, our largest foreign market, orthopedic professionals beganre-using our bracing devices on multiple patients during 2004, which adverselyimpacted our sales of these devices in this market in 2004. As we continue toexpand our international business, our success will be dependent, in part, onour ability to anticipate and effectively manage these and other risks. If weare unable to do so, these and other factors may have an adverse effect on ourinternational operations.

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**The direct distribution of our products in selectedforeign countries involves financial and operational risks.**

Since 2002, we have beenimplementing a strategy to selectively replace our third-party internationaldistributors with wholly owned distributorships, and in 2006 we increased theportion of our revenues that is international to approximately 20% as a resultof the Axmed and Aircast acquisitions and growth generally in internationalmarkets. We have subsidiaries in several foreign countries and plan to continueto expand our international business.  Our foreign activities require experiencedmanagement in each subsidiary who are familiar with the market dynamics in theparticular country and overall operational, financial, administrative and salesmanagement to oversee the international business. We have added significantcapability in this regard during 2006, but are still in the process of addingcertain of the management resources we need. We also are in the process ofidentifying and securing additional financial and operational controls for theinternational business. We cannot assure you that we will be able tosuccessfully complete our international management team on a timely basis orsecure and maintain adequate organizational controls in our foreign operationsor that our international strategy will result in increased revenues orprofitability.

**Our concentrationof manufacturing operations in Mexico increases our business and competitiverisks.**

Other than a relativelysmall manufacturing operation in Tunisia acquired in the recent Axmedacquisition and other than the manufacturing of our BGS products, our customrigid knee braces and certain of our vascular products that is conducted inVista, California, all of our manufacturing activities are carried out in ourfacility in Tijuana, Mexico. These operations are subject to risks of politicaland economic instability inherent in activities conducted in foreign countries.In addition, as a result of this concentration of manufacturing activities, oursales in foreign markets may be at a competitive disadvantage to productsmanufactured locally due to freight costs, custom and import duties andfavorable tax rates for local businesses. In order to reduce the risk involvedin the concentration of most of our manufacturing activities in one foreignjurisdiction and to compete successfully with foreign manufacturers, we may berequired to open or expand manufacturing operations abroad, which would becostly to implement and may not effectively reduce the risk of doing businessin foreign countries. We may not be able to successfully operate additionaloffshore manufacturing operations.

**Product liability claims may harm our business if ourinsurance proves inadequate or the number of 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 aKnee Guarantee program since 2001 in relation 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 TechnologyYou Can Trust program was introduced in connection with our BGS products. If apatient has a nonunion fracture that fails to heal while using a BGS product,the Technology You Can Trust program will, if the patient meets the specifiedrequirements of the program, refund the costs for treatment using the BGSproduct. If there is a significant increase in claims under these programs, ourbusiness could be adversely affected.

We maintain productliability insurance with coverage of an annual aggregate maximum of$20 million. The policy is provided on a claims made basis and is subjectto annual renewal. There can be no assurance that liability claims will notexceed the coverage limit of such policy or that such insurance will continueto be available on commercially reasonable terms or at all. If we do not orcannot maintain sufficient liability insurance, our ability to market ourproducts may be significantly impaired.

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**We may be adverselyaffected if we lose the services of any member of our senior management team.**

We are dependent on thecontinued services of our senior management team, who have made significantcontributions to our growth and success. Leslie H. Cross, our President andChief Executive Officer, for example, has worked for us for nearly 17 years andhelped lead our 1999 recapitalization and transition from ownership 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.

**Any claims relating to our improper handling, storageor disposal of wastes could be time consuming and costly.**

Our facilities andoperations are subject to federal, state and local environmental andoccupational health and safety requirements of the United States and foreigncountries, including those relating to discharges of substances to the air,water, and land, the handling, storage and disposal of wastes and the cleanupof properties affected by pollutants. In the future, federal, state, local orforeign governments could enact new or more stringent laws or issue new or morestringent regulations concerning environmental and worker health and safetymatters that could affect our operations. We became the tenant of a New Jerseyfactory as a result of the Aircast acquisition and that factory is the site ofan environmental clean-up project that is currently being performed by a priortenant. Also, contamination may be found to exist at our current, former orfuture facilities, including the facility in Tempe, Arizona that we occupiedfollowing the Regeneration acquisition, or off-site locations where we havesent wastes. We could be held liable for such contamination, which could have amaterial adverse effect on our business or financial condition. In addition,changes in environmental and worker health and safety requirements orliabilities from newly discovered contamination could have a material effect onour business or financial condition.

**If a natural or man-made disaster strikes ourmanufacturing facilities, we will be unable to manufacture our products for asubstantial amount of time and our sales will decline.**

Nearly all of ourrehabilitation products are manufactured in our new facility in Tijuana,Mexico, with a number of products for the European market manufactured in ourrecently-acquired Tunisian facility. The products that are still manufacturedin Vista, California consist of our custom rigid bracing products, which remainin the U.S. to facilitate quick turn-around on custom orders and theRegeneration product line. These facilities and the manufacturing equipment weuse to produce our products would be difficult to repair or replace. Ourfacilities may be affected by natural or man-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 manufacturing facility.In such an event, we would face significant delays in manufacturing which wouldprevent us from being able to sell our products. In addition, our insurance maynot be sufficient to cover all of our potential losses and may not continue tobe available to us on acceptable terms, or at all.

**Because we have various mechanisms in place todiscourage takeover attempts, a change in control of our company that astockholder may consider favorable could be prevented.**

Provisions of ourcertificate of incorporation and bylaws may discourage, delay or prevent achange in control of our company that a stockholder may consider favorable.These provisions could also discourage proxy contests and make it moredifficult for stockholders to elect directors and 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;

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·       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, theseprovisions could limit the price that investors are willing to pay in thefuture for shares of our common stock.

**Risks Related toGovernment Regulation**

**Our failure to comply with regulatory requirements orreceive regulatory clearance or approval for our products or operations in theUnited States or abroad would adversely affect our revenues and potential forfuture growth.**

Our products are medical devices that are subject toextensive regulation in the United States by the Food and Drug Administration,or FDA, and by respective authorities in foreign countries where we do business.The FDA regulates virtually all aspects of a medical device’s design andtesting, manufacture, safety, labeling, storage, recordkeeping, reporting,clearance and approval, promotion and distribution. The FDA also regulates theexport of medical devices to foreign countries. Failure to comply with theregulatory requirements of the FDA and other applicable U.S. regulatoryrequirements may subject a company to administrative or judicially imposedsanctions ranging from warning letters to criminal penalties or productwithdrawal. Unless an exemption applies, a medical device must receive eitherclearance or premarket approval from the FDA before it can be marketed in theUnited 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 process for Class III devices generallytakes from one to three years from the time the application is filed with theFDA, but also can be significantly longer. Premarket approval typicallyrequires extensive clinical data and can be significantly longer, moreexpensive and more uncertain than the 510(k) clearance process. Despitethe time, effort and expense expended, there can be no assurance that aparticular device will be approved or cleared by the FDA through either the 510(k) clearanceprocess or the premarket approval process.

Medical devices may only be marketed for theindications for which they are approved or cleared. We may be required toobtain additional new premarket approvals, premarket approval supplements or510(k) clearances to market additional products or for new indications foror modifications to our existing products. We cannot be certain that we wouldobtain additional premarket approvals or 510(k) clearances in a timelymanner or at all. We have modified various aspects of our devices in the pastand we determined that new approvals, supplements or clearances were notrequired. The FDA may not agree 

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with our decisions not toseek approvals, supplements or clearances for particular device modifications. Ifthe FDA requires us to obtain premarket approvals, supplement approvals or 510(k) clearancesfor any modification to a previously cleared or approved device, we may berequired to cease manufacturing and marketing the modified device or to recallsuch modified device until we obtain FDA clearance or approval and we may besubject to significant regulatory fines or penalties. In addition, there can beno assurance that the FDA will clear or approve such submissions in a timelymanner, 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 foreigncountries in which we market our products, we are subject to extensiveregulations essentially the same as those of the FDA, including those inGermany, 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 European Union (formerly the Council of theEuropean Communities) and the Council of the European Parliament have adoptedthree directives in order to harmonize national provisions regulating thedesign, manufacture, clinical trials, labeling and adverse event reporting formedical devices to ensure that medical devices marketed are safe and effectivefor their intended uses. The member states of the European Economic Area haveimplemented the directives into their respective national law. Medical devicesthat comply with the conformity requirements of the national provisions and thedirectives will be entitled to bear a CE marking. Unless an exemption applies,only medical devices which bear a CE marking may be marketed within theEuropean Economic Area. Switzerland also allows the marketing of medicaldevices that bear a CE marking. Due to the movement towards harmonization ofstandards in the European Union and the expansion of the European Union, weexpect a changing regulatory environment in Europe characterized by a shiftfrom a country-by-country regulatory system to a European Union-wide singleregulatory system. Failure to receive, or delays in the receipt of, relevantforeign qualifications, such as the CE marking, could have a material adverseeffect on our international operations.

**Our products are subject to recalls even afterreceiving FDA clearance or approval, or after receiving CE-markings, whichwould harm our reputation and business.**

We are subject to medicaldevice reporting, or MDR, regulations that require us to report to the FDA orgovernmental authorities in other countries if our products cause or contributeto a death or serious injury or malfunction in a way that would be reasonablylikely to contribute to death or serious injury if the malfunction were torecur. The FDA and similar governmental authorities in other countries have theauthority to require the recall of our products in the event of materialdeficiencies or defects in design or manufacturing, and we have been subject toproduct recalls in the past. A government mandated, or voluntary, recall by uscould occur as a result of component failures, manufacturing errors or designdefects, including defects in labeling. Any recall would divert managerial andfinancial resources and could harm our reputation with customers. There can beno assurance 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 to comply with the FDA’s Quality SystemRegulation, our manufacturing could be delayed, and our product sales andprofitability could suffer.**

Our manufacturingprocesses are required to comply with the FDA’s Quality System Regulation,which covers the procedures concerning (and documentation of) the design,testing, production processes, controls, quality assurance, labeling,packaging, storage and shipping of our devices. We also are subject to staterequirements and licenses applicable to manufacturers of medical devices. Inaddition, we must 

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engagein extensive recordkeeping and reporting and must make available ourmanufacturing facilities and records for periodic unscheduled inspections bygovernmental agencies, including the FDA, state authorities and comparableagencies in other countries. Moreover, failure to pass a Quality SystemRegulation inspection or to comply with these and other applicable regulatoryrequirements could result in disruption of our operations and manufacturingdelays. Failure to take adequate corrective action could result in, among otherthings, significant fines, suspension of approvals, seizures or recalls ofproducts, operating restrictions and criminal prosecutions. We have previouslyreceived warning letters and untitled letters from the FDA regarding regulatorynon-compliance. We cannot assure you that the FDA or other governmentalauthorities would agree with our interpretation of applicable regulatoryrequirements or that we have in all instances fully complied with allapplicable requirements. Any failure to comply with applicable requirementscould adversely affect our product sales and profitability.

**If the FDA or another regulatory agency determinesthat we have promoted off-label use of our products, we may be subject tovarious penalties, including civil or criminal penalties, and the off-label useof our products may result in injuries that lead to product liability suits,which could be costly to our business.**

The FDA and otherregulatory agencies actively enforce regulations prohibiting the promotion of amedical device for a use that has not been cleared or approved by FDA. Use of adevice outside its cleared or approved indications is known as “off-label” use.Physicians may use our products for off-label uses, as the FDA does notrestrict or regulate a physician’s choice of treatment within the practice ofmedicine. However, if the FDA or another regulatory agency determines that ourpromotional materials or training constitutes promotion of an off-label use, itcould request that we modify our training or promotional materials or subjectus to regulatory enforcement actions, including the issuance of a warningletter, injunction, seizure, civil fine and criminal penalties. Although ourpolicy is to refrain from statements that could be considered off-labelpromotion of our products, the FDA or another regulatory agency could disagreeand conclude that we have engaged in off-label promotion. In addition, theoff-label use of our products may increase the risk of injury to patients, and,in turn, the risk of product liability claims. Product liability claims areexpensive to defend and could divert our management’s attention and result insubstantial damage awards against us.

**Changes in United States coverage and reimbursementpolicies for our products by third-party payors or reductions in reimbursementrates for our products could adversely affect our business and results ofoperations.**

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 certain circumstances, such as for ourRegeneration products and the products sold through our OfficeCare program, wesubmit claims to third-party payors for reimbursement. Our ability to sell ourproducts successfully will depend in part on the purchasing and practicepatterns of healthcare providers and physicians, who are influenced by costcontainment measures taken by third-party payors. Limitations or reductions inthird-party coverage and reimbursement of our products can have a materialadverse effect on our sales and profitability.

The United States Congress and state legislatures fromtime-to-time consider reforms in the healthcare industry that may modifyreimbursement methodologies and practices, including controls on spending bythe Medicare and Medicaid programs. It is not clear at this time whatproposals, if any, will be adopted or, if adopted, what effect these proposalswould have on our business. Many private health insurance plans model theircoverage and reimbursement policies after Medicare policies. Therefore,congressional or regulatory measures that reduce Medicare reimbursement ratescould cause private health insurance plans to reduce their reimbursement ratesfor our products, which could have an adverse 

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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 that affect Medicare payment methodology andconditions for coverage for our orthotic devices and durable medical equipment,including our bone growth stimulators. These changes include a freeze inreimbursement levels for certain medical devices from 2004 through 2008,competitive bidding requirements, new clinical conditions for payment andquality standards. The changes affect our products generally, although specificproducts may be affected by some but not all of the Modernization Act’sprovisions. Our Class III bone growth stimulator devices, for example, arenot affected by the reimbursement level freeze and are not subject tocompetitive bidding. The Modernization Act, however, does subject off-the-shelforthotic devices to competitive bidding. Under competitive bidding, which isscheduled to be phased in during 2007, Medicare will change its approach toreimbursing certain items and services of durable medical equipment, orthotics,prosthetics and supplies covered by Medicare from the current fee scheduleamount to an amount established through a bidding process between thegovernment and suppliers. Competitive bidding may reduce the number ofsuppliers providing certain items and services to Medicare beneficiaries andthe amounts paid for such items and services. Also, Medicare payments inregions not subject to competitive bidding may be reduced using paymentinformation from regions subject to competitive bidding. Any payment reductionsor the inclusion of certain of our orthotic devices in competitive bidding, inaddition to the other changes to Medicare reimbursement and standards containedin the Modernization Act, could have a material adverse effect on our resultsof operations.

The Centers for Medicare and Medicaid Services, orCMS, issued proposed regulations regarding the implementation of competitivebidding on April 24, 2006. The proposed regulations include, among otherthings, proposals regarding how CMS will determine which products and whichmetropolitan statistical areas of the United States will be subject tocompetitive bidding. The proposed regulations also describe how CMS plans toaward contracts and how it will evaluate bids and set payment rates. CMS alsoproposed a regulation to revise the methodology the agency would use to pricenew products not included in competitive bidding. In addition, the proposedregulations define off-the-shelf orthotics as orthotics that “require minimalself-adjustment for appropriate use and do not require expertise in trimming,bending, molding, assembling, or customizing to fit the individual.” CMSfurther proposes that “minimal self-adjustment” would mean “adjustments thatthe beneficiary, caretaker for the beneficiary, or supplier of the device canperform without the assistance of a certified orthotist.” CMS has not yetpublished a final regulation or list of reimbursement codes subject tocompetitive bidding and, until the agency does so, significant uncertaintyremains as to how the competitive bidding program will be implemented andwhich, if any, of our products will be subject to competitive bidding. Theproposed regulations do not provide us with sufficient details to assess theimpact that competitive bidding and other elements of the rule would haveon our business.

In addition, on December 13, 2005, CMS finalizedits interim final regulation implementing “inherent reasonableness” authority,effective February 13, 2006. The final inherent reasonableness regulationessentially keeps in place policies first announced in 2002 in the earlierinterim final regulation. The regulation allows the agency and its contractorsto make adjustments to payment amounts for certain items and services coveredby Medicare when the existing payment amount is determined to be grosslyexcessive or grossly deficient. The regulation lists factors that may be usedto determine whether an existing reimbursement rate is grossly excessive orgrossly deficient and to determine what is a realistic and equitable paymentamount. Also, under the regulation, a payment amount will not be consideredgrossly excessive or grossly deficient if an overall payment adjustment of lessthan fifteen percent would be necessary to produce a realistic and equitablepayment amount. The Modernization Act clarified that the use of inherentreasonableness authority is precluded for devices provided under competitivebidding. 

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When using the inherentreasonableness authority, CMS may reduce reimbursement levels for certain itemsand services, which could have a material adverse effect on our results ofoperations.

We cannot assure you thatthird-party coverage or reimbursement for our products will continue to beavailable or at what rate such products will be reimbursed. Failure by users ofour products to obtain sufficient coverage and reimbursement from third-partypayors for our products or adverse changes in governmental and private payors’policies toward coverage and reimbursement for our products could have amaterial adverse effect on our results of operations.

**Changes in international regulations regardingcoverage and reimbursement for our products could adversely affect our businessand results of operations.**

Similar to our domesticbusiness, our success in international markets also depends upon coverage andreimbursement of our products through government-sponsored healthcare paymentsystems and third-party payors, the portion of cost subject to reimbursement,and the cost allocation between the patient and government-sponsored healthcarepayment systems and third-party payors. Coverage and reimbursement practicesvary significantly by country, with certain countries requiring products toundergo a lengthy regulatory review in order to be eligible for third-partycoverage and reimbursement. In addition, healthcare cost containment effortssimilar to those that we face in the United States are prevalent in many of theforeign countries in which our products are sold, and these efforts areexpected to continue in the future, possibly resulting in the adoption of morestringent standards. Any developments in our foreign markets that eliminate orreduce reimbursement rates for our products could have an adverse effect on ourability to sell our products or cause our orthopedic professional customers touse less expensive products in these markets.

**Medicare laws mandating new supplier quality standardsand conditions for coverage could adversely 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 theModernization Act, any entity or individual that bills Medicare for durablemedical equipment, such as bone growth stimulators and orthotics and that has asupplier number will also be subject to new quality standards as a condition ofreceiving payment from the Medicare program. On August 14, 2006, CMSfinalized its supplier quality standards, and in November 2006, CMSpublished a list of recognized independent accreditation organizations that mayaccredit suppliers as meeting the quality standards. We will be required tobecome accredited to continue to bill Medicare as a supplier, and we have begunthat process.

The final qualitystandards include business-related standards, such as financial and humanresources management standards, which would be applicable to all durablemedical equipment, orthotics and prosthetics suppliers. The final qualitystandards also contain certain product-specific standards, including severalstandards related to customized orthotics products, which focus on productspecialization and service standards for such items. The Modernization Act alsoauthorizes CMS to establish clinical conditions for payment for durable medicalequipment, including establishing types or classes of covered items thatrequire a prescription and a face-to-face examination of the individual by aphysician or practitioner. CMS has proposed to expand the face-to-face visitrequirement for clinical conditions of coverage to prosthetics, orthotics andsupplies (POS), because the agency believes that items of POS require the samelevel of medical intervention and skill as durable medical equipment. These newsupplier quality standards and proposed clinical conditions for payment couldaffect our ability to bill Medicare, could limit or reduce the number ofindividuals who can fit, sell or provide our products and could restrictcoverage for our products. We also cannot assure you that we will becomeaccredited under the new quality standards on a timely basis or at a reasonablecost.

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**Healthcare reform, managed care and buying groups haveput downward pressure on the prices of our products.**

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. Oneresult has been, and is expected to continue to be, a shift toward lower-pricedproducts, and any such shift in our product mix to lower margin, off-the-shelfproducts could have an adverse impact on our operating results. For example, inour rigid knee-bracing segment, we and many of our competitors are offeringlower-priced, off-the-shelf products in response to managed care customers.

A further result of managed care and the relatedpressure on costs has been the advent of buying groups in the United States. Suchbuying groups enter into preferred supplier arrangements with one or moremanufacturers of orthopedic or other medical products in return for pricediscounts. The extent to which such buying groups are able to obtain complianceby their members with such preferred supplier agreements varies considerablydepending on the particular buying groups. In response to the organization ofnew buying groups, we have entered into national contracts with selected groupsand believe that the high levels of product sales to such groups and theopportunity for increased market share have the potential to offset the financialimpact of discounting. We believe that our ability to maintain our existingarrangements will be important to our future success and the growth of ourrevenues. In addition, we may not be able to obtain new preferred suppliercommitments for major buying groups, in which case we could lose significantpotential sales, to the extent these groups are able to command a high level ofcompliance by their members. On the other hand, if we receive preferredsupplier commitments from particular groups which do not deliver high levels ofcompliance, we may not be able to offset the negative impact of lower per unitprices or lower margins with any increases in unit sales or in market share.

In international markets,we have experienced downward pressure on product pricing and other effects ofhealthcare reform similar to that which we have experienced in the UnitedStates. We expect healthcare reform and managed care to continue to develop inour primary international markets, which we expect will result in furtherdownward pressure in product pricing. The timing and effects on us ofhealthcare reform and the development of managed care in international marketscannot currently be predicted.

**Proposed laws that would limit the types of orthopedicprofessionals who can fit, sell or seek reimbursement for our products could,if adopted, adversely affect our business.**

In response to pressure from certain groups (mostlyorthopedic practitioners), the United States Congress and state legislatureshave periodically considered proposals that limit the types of orthopedicprofessionals who can fit or sell our orthotic device products or who can seekreimbursement for them. Several states have adopted legislation which imposescertification or licensing requirements on the measuring, fitting and adjustingof certain orthotic devices. Although some of these state laws exemptmanufacturers’ representatives, other states’ laws subject the activities ofsuch representatives to certification or licensing requirements. Additionalstates may be considering similar legislation. Such laws could limit ourpotential customers in those jurisdictions in which such legislation orregulations are enacted. We may not be successful in opposing the adoption ofsuch legislation or regulations and, therefore, such laws could have a materialadverse effect on our business.

In addition, efforts havebeen made to establish similar requirements at the federal level for theMedicare program. For example, in 2000, Congress passed the Medicare, Medicaid,and SCHIP Benefits Improvement and Protection Act of 2000 (BIPA). BIPAcontained a provision requiring, as a condition for payment by the Medicareprogram, that certain certification or licensing requirements be met forindividuals and suppliers furnishing certain, but not all, custom-fabricatedorthotic devices. Although CMS 

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has notimplemented this requirement, we cannot predict the effect of implementation ofBIPA or implementation of other such laws will have on our business.

**We may need to change our business practices to complywith healthcare fraud and abuse laws and regulations.**

We are subject to variousfederal and state laws pertaining to healthcare fraud and abuse, includinganti-kickback laws and physician self-referral laws. Violations of these lawsare punishable by criminal and civil sanctions, including, in some instances,imprisonment and exclusion from participation in federal and state healthcareprograms, including Medicare, Medicaid, Veterans Administration health programsand TRICARE. Because of the far-reaching nature of these laws, we may berequired to alter one or more of our practices. Healthcare fraud and abuseregulations are complex and even minor, inadvertent irregularities insubmissions can potentially give rise to claims that a fraud and abuse law orregulation has been violated. Any violations of these laws or regulations couldresult in a material adverse effect on our business, financial condition andresults of operations. If there is a change in law, regulation or administrativeor judicial interpretations, we may have to change our business practices orour existing business practices could be challenged as unlawful.

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

As part of our business structure, we submit claimsdirectly to and receive payments directly from the Medicare and Medicaidprograms. Therefore, we are subject to extensive government regulation,including requirements for maintaining certain documentation to support ourclaims. Medicare contractors and Medicaid agencies periodically conduct pre-and post-payment review and other audits of claims, and are under increasingpressure to scrutinize more closely healthcare claims and supportingdocumentation generally. We periodically receive requests for documentationduring governmental audits of individual claims either on a pre-payment orpost-payment basis. As a result of such audits, we may be subject to requestsfor refunds. We cannot assure you that such reviews and/or other audits of ourclaims will not result in material delays in payment, material recoupments ordenials, which could reduce our revenue or profits.

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**Risks Related toour Debt**

**We substantiallyincreased our indebtedness in connection with the Aircast acquisition.**

In order to finance thepurchase price of the Aircast acquisition and to cover related acquisitioncosts as well as repay our existing bank debt, we entered into a new creditfacility on April 7, 2006, consisting of a term loan of $350 million whichwas fully drawn at closing and up to $50 million available under a revolvingcredit facility, under which no amounts were borrowed and of which $45.8million was available at closing, net of outstanding letters of credit. Followingthe transaction, we are a much more highly leveraged company, and ourflexibility in conducting business operations and continuing to invest ingrowth opportunities could be reduced as a result of this increasedindebtedness. Our increased indebtedness could limit our ability to obtainfuture additional financing we may need to fund future working capital, capitalexpenditures, product development or acquisitions. As of December 31,2006, the balance outstanding under the term loan was $327.3 million and $47.8million was available under the revolving credit facility, net of outstandingletters of credit.

**Our debt agreements contain operating and financialrestrictions, which restrict our business and financing activities.**

The operating andfinancial restrictions and covenants in our credit agreement and any futurefinancing agreements may adversely affect our ability to finance futureoperations, meet our capital needs or engage in our business activities.Currently, our existing credit agreement restricts 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 tomergers or acquisitions, our credit agreement limits our ability to financeacquisitions through additional borrowings. In addition, our credit agreementprohibits us from acquiring assets or the equity of another company unless:

·       weare not in default under the credit agreement;

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

·       ifthe acquisition price is greater than $15 million, the company we are acquiringhas positive EBITDA;

·       theacquisition price is less than $75 million individually and less than $200million in the aggregate with all other permitted acquisitions consummatedduring the term of the credit agreement; and

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·       ifthe acquisition involves assets outside the United States, the acquisitionprice is less than $40 million in the aggregate with all other permittedacquisitions consummated outside the United States during the term of theagreement.

Restrictionscontained 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 thesecovenants, ratios, tests or other restrictions could result in an event ofdefault under the credit agreement. Upon the occurrence of an event of defaultunder the credit agreement, the lenders could elect to declare all amountsoutstanding under the credit agreement, together with accrued interest, to beimmediately due and payable. If we were unable to repay those amounts, thelenders could proceed against the collateral granted to them to secure suchindebtedness. If the lenders under the credit agreement accelerate the paymentof the indebtedness, there can be no assurance that our assets would besufficient to repay in full such indebtedness and our other indebtedness.

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

We may not havesufficient cash to service our indebtedness. Our ability to satisfy ourobligations will depend upon, among other things:

·       ourfuture financial and operating performance, which will be affected byprevailing economic conditions and financial, business, regulatory and other factors,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 ourindebtedness, we will be forced to take actions such as reducing or delayingacquisitions, investments, strategic alliances and/or capital expenditures,selling assets, restructuring or refinancing our indebtedness, or seekingadditional equity capital or bankruptcy protection. We cannot assure you thatany of these remedies can be effected on satisfactory terms, if at all. Inaddition, the terms of existing or future debt agreements may restrict us fromadopting any of these alternatives.

**Item 1B.**               UnresolvedStaff Comments

We have received nowritten comments from the Commission staff regarding our periodic or currentreports under the Exchange Act of 1934 less than 180 days before the end of ourfiscal year ended December 31, 2006 that remain unresolved.

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**Item 2.**                        Properties

We areheadquartered in Vista, California and operate manufacturing locations inVista, California, Tijuana, Mexico and Sfax, Tunisia. We are party to a 15-yearlease for our corporate headquarters in Vista, California. Our manufacturingfacility located in Tijuana, Mexico is approximately 60 miles from Vista andconsists of a 225,000 square foot built-to-suit factory. We lease distributionfacilities in Indianapolis, Indiana, Tijuana, Mexico and several Europeancountries to distribute our products to our customers. The following tablesummarizes the largest properties we lease as of December 31, 2006.

| **Location**               | ** ** | ** **                                       | ** ** | **Use(1)** | ** ** | **Owned/Leased**    | ** ** | **Lease Termination  Date** | ** ** | **Size (Square Feet)** |
|----------------------------|------------|--------------------------------------------------|------------|------------|------------|---------------------|------------|-----------------------------|------------|------------------------|
| Vista, California          |       | Corporate  Headquarters & Manufacturing |       | Leased     |       | August 2021    |       | 111,639                     |
| Tijuana, Mexico            |       | Manufacturing  Facility                          |       | Leased     |       | September 2014 |       | 225,000                     |
| Tijuana, Mexico            |       | Distribution                                     |       | Leased     |       | September 2016 |       | 58,400                      |
| Indianapolis, Indiana      |       | Distribution                                     |       | Leased     |       | October 2016   |       | 109,782                     |
| Sfax, Tunisia              |       | Manufacturing  Facility                          |       | Leased     |       | December 2008  |       | 24,500                      |
| Anglet, France             |       | Office &  Distribution                  |       | Leased     |       | January 2012   |       | 16,000                      |
| Neudrossenfeld, Germany    |       | Office &  Distribution                  |       | Leased     |       | December 2007  |       | 14,300                      |
| Guildford, United  Kingdom |       | Office &  Distribution                  |       | Leased     |       | July 2016      |       | 8,234                       |
| Mississauga, Canada        |       | Office &  Distribution                  |       | Leased     |       | March 2010     |       | 8,628                       |

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(1)          Our leases in Vista,California serve all of our business segments and our Tijuana, Mexico leaseserves our Domestic Rehabilitiation and International segments. TheIndianapolis, Indiana distribution center is used for our DomesticRehabilitation segment and the Canadian portion of our International segment.Our German, French, United Kingdom, Canadian and Tunisian facilities are usedfor our International segment only.

We also lease a total ofapproximately 32,500 square feet of aggregate warehouse and office space inPhoenix, Arizona; Mystic, Connecticut; Bolzano, Italy; Irun, Spain; Brussels,Belgium and Horsholm, Denmark. All of our facilities are leased, except for ourformer Aircast manufacturing facility in New Jersey and our former AircastGermany facility, both of which were held-for-sale as of December 31,2006. These held-for-sale facilities were vacated in connection with our integrationof the Aircast business and are no longer in use.

**Item 3.**                        LegalProceedings

From time to time, we areinvolved in lawsuits arising in the ordinary course of business. This includespatent and other intellectual property disputes between our various competitorsand us. With respect to these matters, we believe that we have adequateinsurance coverage or have made adequate accruals for related costs, and we mayalso have effective legal defenses.

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**Item 4.**                        Submissionof Matters to a Vote of Security Holders

No matters were submittedto a vote of security holders during the quarter ended December 31, 2006.

**Executive Officers**

Thefollowing table sets forth information with respect to our executive officers:

| **Name**          | ** ** | ** ** | ** ** | **Age**                                                          | ** ** | **Position with DJO Incorporated** |
|-------------------|------------|------------|------------|------------------------------------------------------------------|------------|------------------------------------|
| Leslie H. Cross   |       | 56         |       | President, Chief  Executive Officer and Director                 |
| Vickie L. Capps   |       | 45         |       | Executive Vice  President, Chief Financial Officer and Treasurer |
| Luke T. Faulstick |       | 43         |       | Chief Operating Officer                                          |
| Louis T. Ruggiero |       | 47         |       | Chief Sales and  Marketing Officer                               |
| Donald M. Roberts |       | 58         |       | Senior Vice President, General Counsel and Secretary             |

 

*Leslie H. Cross* has been our Chief Executive Officer and Presidentand a member of our board of directors since our incorporation in August 2001.He served as the Chief Executive Officer and a Manager of DonJoy, L.L.C., ourpredecessor, from June 1999 until November 2001, and has served asPresident of DJO, LLC, our wholly owned operating subsidiary, or itspredecessor, the Bracing & Support Systems division of Smith &Nephew, Inc. since June 1995. From 1990 to 1994, Mr. Cross heldthe position of Senior Vice President of Marketing and Business Development ofthe Bracing & Support Systems division of Smith & Nephew. Hewas a Managing Director of two different divisions of Smith & Nephewfrom 1982 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 ourExecutive Vice President, Chief Financial Officer and Treasurer. From September 2001until July 2002, Ms. Capps was employed by AirFiber, a privately heldprovider of broadband wireless solutions, where she served as Senior VicePresident, Finance and Administration and Chief Financial Officer. From July 1999to July 2001, Ms. Capps served as Vice President of Finance andAdministration and Chief Financial Officer for Maxwell Technologies, Inc.,a publicly traded technology company. From 1992 to 1999, Ms. Capps servedin various positions, including Chief Financial Officer, with Wavetek WandelGoltermann, Inc., a multinational communications equipment company.Ms. Capps also served as a senior audit and accounting professional forErnst & Young LLP from 1982 to 1992. Ms. Capps is a CaliforniaCertified Public Accountant and received a B.S. degree in businessadministration/accounting from San Diego State University.

*Luke T. Faulstick* currentlyserves as our Chief Operating Officer. He joined us as Vice President ofManufacturing 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 board of directors of Power Partners, Inc.,a privately held power transmission manufacturer. Mr. Faulstick received aB.S. in engineering from Michigan State University and an M.S. in engineeringfrom Rochester Institute of Technology.

*Louis T. Ruggiero* currentlyserves as our Chief Sales and Marketing Officer. Mr. Ruggiero joined us asSenior Vice President of Selling and Marketing in August 2003. Mr. Ruggierobrings more than 20 years of sales experience in medical devices, with morethan half of his tenure in management roles. From 2000 to 2003, Mr. Ruggieroserved as President and Chief Executive Officer of Titan Scan Technologies, asubsidiary of Titan Corporation, a leader in electron beam technology formedical device sterilization, mail 

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sanitization andindustrial processes. From 1990 to 2000, Mr. Ruggiero was employed by GEMedical Systems, 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 2002and currently serves as Senior Vice President, General Counsel and Secretary. From1994 to December 2002, Mr. Roberts served as Vice President,Secretary and General Counsel for Maxwell Technologies, Inc., a publiclyheld technology company. Previous to that, he was with the Los Angeles-basedlaw firm of Parker, Milliken, Clark, O’Hara & Samuelian for 21 years.Mr. Roberts was a shareholder in the firm, having served as partner in apredecessor partnership. Mr. Roberts received his undergraduate degree inpolitical science from Yale University and earned his J.D. at the University ofCalifornia, Berkeley, Boalt Hall School of Law.

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**PART II**

**Item 5.**                        Marketfor the Registrant’s Common Equity, Related Stockholder Matters and IssuerPurchases of Equity Securities

Ourcommon stock is listed on the New York Stock Exchange under the symbol DJO. Thefollowing table sets forth, for the calendar quarters indicated, the high andlow sales prices per share of our common stock as reported on the New YorkStock Exchange:

| ** **                              | ** ** | **High** | ** ** | **Low** | ** ** |
|-----------------------------------------|------------|----------|------------|---------|------------|
| **Year ended December 31,  2006:** |       |     |       |    |       |
| First Quarter                           |       | $        | 41.30      |    | $          | 26.69 |   |
| Second Quarter                          |       | 43.35    |       | 35.00   |       |
| Third Quarter                           |       | 43.74    |       | 34.20   |       |
| Fourth Quarter                          |       | 45.50    |       | 37.35   |       |
| **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   |       |

 

As of February 23, 2007, there were approximately10 stockholders of record of our common stock.

We have not declared or paid any cash dividends sinceour inception. We currently intend to retain our future earnings, if any, tofinance the further expansion and continued growth of our business. Inaddition, our ability to pay cash dividends on our common stock is currentlyrestricted under the terms of our credit agreement. Future dividends, if any,will be determined by our board of directors.

Information about ourequity compensation plans is incorporated by reference in Item 12 of Part IIIof this Annual Report on Form 10-K.

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**Item 6.**                        SelectedFinancial Data

Theselected financial data set forth below with respect to our consolidatedfinancial statements has been derived from our audited financial statements. Thedata set forth below should be read in conjunction with “Management’sDiscussion and Analysis of Financial Condition and Results of Operations” andour audited financial statements and Notes thereto appearing elsewhere herein.

| ** **                                                                         | ** ** | **Years Ended December 31,**                        | ** ** |
|------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                                         | ** ** | **2006**                                                           | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                                                         | ** ** | **(In thousands, except per share data)** | ** ** |
| **Statement  of Operations Data:**                                                 |       |                                                               |       |   |   |   |   |   |   |   |   |
| Net revenues                                                                       |       | $                                                                  | 413,058    |   | $ | 286,167 |   | $ | 255,999 |   | $ | 197,939 |   | $ | 182,636 |   |
| Costs of goods sold(a)                                                             |       | 166,106                                                            |       | 105,289 |   | 95,164 |   | 85,927 |   | 95,878 |   |
| Gross profit                                                                       |       | 246,952                                                            |       | 180,878 |   | 160,835 |   | 112,012 |   | 86,758 |   |
| Operating  expenses:                                                               |       |                                                               |       |   |   |   |   |   |   |   |   |
| Sales and marketing(b)                                                             |       | 129,081                                                            |       | 86,241 |   | 78,984 |   | 54,067 |   | 56,216 |   |
| General and administrative(c)                                                      |       | 48,176                                                             |       | 29,432 |   | 27,727 |   | 21,767 |   | 26,414 |   |
| Research and development(d)                                                        |       | 8,988                                                              |       | 6,350 |   | 5,627 |   | 4,442 |   | 2,922 |   |
| Amortization of acquired intangibles                                               |       | 15,166                                                             |       | 4,996 |   | 4,731 |   | 464 |   | — |   |
| Impairment of long-lived assets                                                    |       | —                                                             |       | — |   | — |   | — |   | 3,666 |   |
| Performance improvement, restructuring and other  costs(e)                         |       | —                                                             |       | — |   | 4,693 |   | (497 | ) | 10,008 |   |
| Total operating expenses                                                           |       | 201,411                                                            |       | 127,019 |   | 121,762 |   | 80,243 |   | 99,226 |   |
| Income (loss) from operations                                                      |       | 45,541                                                             |       | 53,859 |   | 39,073 |   | 31,769 |   | (12,468 | ) |
| Prepayment premium and other costs related to debt  prepayment(f)        |       | (2,347                                                             | )          | — |   | (7,760 | ) | — |   | — |   |
| Interest expense and other, net                                                    |       | (19,079                                                            | )          | (5,398 | ) | (8,276 | ) | (11,718 | ) | (12,088 | ) |
| Income (loss) before income taxes                                                  |       | 24,115                                                             |       | 48,461 |   | 23,037 |   | 20,051 |   | (24,556 | ) |
| Benefit (provision) for income taxes(g)                                            |       | (11,474                                                            | )          | (19,263 | ) | (9,022 | ) | (7,980 | ) | 9,361 |   |
| Net income (loss)                                                                  |       | $                                                                  | 12,641     |   | $ | 29,198 |   | $ | 14,015 |   | $ | 12,071 |   | $ | (15,195 | ) |
| Net income (loss)  per share:                                                      |       |                                                               |       |   |   |   |   |   |   |   |   |
| Basic                                                                              |       | $                                                                  | 0.55       |   | $ | 1.34 |   | $ | 0.66 |   | $ | 0.67 |   | $ | (0.85 | ) |
| Diluted                                                                            |       | $                                                                  | 0.54       |   | $ | 1.29 |   | $ | 0.63 |   | $ | 0.64 |   | $ | (0.85 | ) |
| Weighted average  shares outstanding used to calculate per share information: |       |                                                               |       |   |   |   |   |   |   |   |   |
| Basic                                                                              |       | 22,810                                                             |       | 21,786 |   | 21,221 |   | 17,963 |   | 17,873 |   |
| Diluted                                                                            |       | 23,522                                                             |       | 22,699 |   | 22,209 |   | 18,791 |   | 17,873 |   |
| **Balance  Sheet Data (at end of period):**                                        |       |                                                               |       |   |   |   |   |   |   |   |   |
| Cash                                                                               |       | $                                                                  | 7,006      |   | $ | 1,107 |   | $ | 11,182 |   | $ | 19,146 |   | $ | 32,085 |   |
| Total assets                                                                       |       | 668,334                                                            |       | 304,664 |   | 306,850 |   | 320,504 |   | 237,724 |   |
| Long-term obligations                                                              |       | 327,451                                                            |       | 47,500 |   | 95,000 |   | 174,156 |   | 109,816 |   |
| Total  stockholders’ equity                                                   |       | 270,269                                                            |       | 226,069 |   | 183,038 |   | 117,333 |   | 100,913 |   |

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(a)           The year ended December 31,2006 included $1.0 million of stock-based compensation expense associated withthe adoption of SFAS No.123(R) as of January 1, 2006, $1.5 million ofpurchase accounting adjustments to write up acquired inventories to fair value,$8.0 million of expenses related to the integration of our Axmed and Aircastacquisitions that are not deemed to be reflective of ongoing operations, and$0.9 million of expenses related to our move to our new corporate headquarters.The year ended December 31, 2002 included aggregate charges of $5.1million to 

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provide reserves forexcess inventories, substantially related to product lines that we discontinuedin connection with our 2002 performance improvement program.

(b)          The year ended December 31,2006 included $4.5 million of stock-based compensation expense associated withthe adoption of SFAS No.123(R) as of January 1, 2006, $2.2 million ofexpenses related to the integration of our Axmed and Aircast acquisitions thatare not deemed to be reflective of ongoing operations, and $0.4 million of expensesrelated to our move to our new corporate headquarters. 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 31,2006 included $3.6 million of stock-based compensation expense associated withthe adoption of SFAS No.123(R) as of January 1, 2006, $1.2 million ofexpenses related to the integration of our Axmed and Aircast acquisitions thatare not deemed to be reflective of ongoing operations, $0.7 million related toan arbitration concluded during the second quarter of 2006, and $0.3 million ofexpenses related to our move to our new corporate headquarters.

(d)          The year ended December 31,2006 included $0.5 million of stock-based compensation expense associated withthe adoption of SFAS No.123(R) as of January 1, 2006 and $0.2 millionof expenses related to our move to our new corporate headquarters.

(e)           The year ended December 31,2004 included $4.7 million in restructuring charges related to the integrationof our Regeneration business and the relocation of certain manufacturingoperations to Mexico. The year ended December 31, 2002 included $10.0million in charges related to our 2002 performance improvement program,including an accrual for estimated future net rent for vacated facilities. In2003, we decided to retain the vacant space for future expansion and reversedthe remaining accrual of $0.5 million.

(f)             The year ended December 31,2006 included charges of $2.3 million to write-off the net carrying value ofdebt issuance costs capitalized in connection with our previous creditagreement. The year ended December 31, 2004 included charges aggregating$7.8 million related to the redemption of all of our outstanding seniorsubordinated notes in June 2004. The $7.8 million charge included aprepayment premium and unamortized debt issuance costs and original issuediscounts.

(g)           We recorded a taxbenefit (provision) at a worldwide effective tax rate of 47.6%, 39.8%, 39.2%,39.8% and (38.1%) on our income (loss) before income taxes for the years ended December 31,2006, 2005, 2004, 2003 and 2002, respectively. Our worldwide effective tax rateincreased in connection with our adoption of SFAS No. 123(R) as of January 1,2006. The stock-based compensation expense recorded in accordance with SFAS No. 123(R) inthe year ended December 31, 2006 results in a tax benefit rate of only20.9% related to our pre-tax stock-based compensation expense of $9.7 milliondue to the mix of our outstanding and unvested incentive stock options andnon-qualified stock options.

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**Item 7.**                        Management’sDiscussion and Analysis of Financial Condition and Results of Operations

*Overview*

We are a global providerof solutions for musculoskeletal and vascular health, specializing inrehabilitation and regeneration products for the non-operative orthopedic,spine and vascular markets. Marketed under the DonJoy, ProCare and Aircastbrands, our broad range of over 700 rehabilitation products, including rigidknee braces, soft goods, and pain management products, are used in theprevention of injury, in the treatment of chronic conditions and for recoveryafter surgery or injury. Our regeneration products consist of bone growthstimulation devices that are used to treat nonunion fractures and as an adjuncttherapy after spinal fusion surgery. Our vascular systems products help preventdeep vein thrombosis and pulmonary embolism that can occur after orthopedic andother surgeries. We sell our products in the United States and in more than 70other countries through networks of agents, distributors and our direct salesforce that market our products to orthopedic and spine surgeons, podiatrists,orthopedic and prosthetic centers, third-party distributors, hospitals, surgerycenters, physical therapists, athletic trainers and other healthcare professionals.

***Recent Acquisitions***

On April 7, 2006, we completed the acquisition,under an agreement signed on February 27, 2006, of all the outstandingcapital stock of Aircast Incorporated (Aircast) for approximately $291.6million in cash, funded with the proceeds of a new credit agreement. We alsoincurred approximately $4.9 million in transaction costs and other expenses inconnection with the acquisition and accrued approximately $11.1 million ofestimated costs in connection with our plan to integrate the acquired business,including severance expenses. Aircast is a leading designer and manufacturer ofankle and other orthopedic bracing products, cold therapy products and vasculartherapy systems.

On January 2, 2006, we completed the acquisition,under an agreement originally signed on December 15, 2005, of the sharesof Newmed SAS (Axmed) for cash payments aggregating 13 million Euros(approximately $15.8 million), which included payment of certain debts of Axmed.We expect to make additional payments of 0.9 million Euros (approximately $1.2million) to certain sellers in early 2007 based on achievement of certainrevenue targets for 2006 and profitability targets for the second half of 2006.We also incurred certain transaction costs and other expenses in connectionwith the acquisition of approximately $0.4 million. Axmed, through wholly ownedsubsidiaries in France and Spain, is engaged in the design, manufacture andsale of orthopedic rehabilitation devices including rigid knee braces and softgoods. Axmed also owned 70% of a manufacturing subsidiary in Tunisia, whichprovides low cost manufacturing capabilities to the Axmed group. In May 2006,we purchased the minority stockholders’ proportionate share of the net assetsof our subsidiary in Tunisia for approximately $0.5 million and the Tunisiansubsidiary became a wholly owned subsidiary.

***Segments***

·  *DomesticRehabilitation* consists of the sale of our rehabilitation products(rigid knee braces, soft goods and pain management products) in the UnitedStates through three sales channels, DonJoy, ProCare/Aircast and OfficeCare.

Throughthe DonJoy sales channel, we sell our rehabilitation products utilizinga few of our direct sales representatives and a network of approximately 340independent commissioned sales representatives who are employed byapproximately 40 independent sales agents. These sales representatives areprimarily dedicated to the sale of our products to orthopedic surgeons,podiatrists, orthopedic and prosthetic centers, hospitals, surgery centers,physical therapists, athletic trainers and other healthcare professionals. Becausecertain of the DonJoy product lines require customer education on theapplication and use of the product, our sales representatives are 

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technicalspecialists who receive extensive training both from us and the agent and usetheir expertise to help fit the patient with the product and assist theorthopedic professional in choosing the appropriate product to meet the patient’sneeds. After a product order is received by a sales representative, wegenerally ship the product directly to the orthopedic professional and pay asales commission to the agent. These commissions are reflected in sales andmarketing expense in our consolidated financial statements. For certain custom rigidbraces and other products, we sell directly to the patient and bill athird-party payor, if applicable, on behalf of the patient.  We refer to this portion of our DonJoychannel as our Insurance channel.

Throughthe ProCare/Aircast sales channel, which is comprised of approximately100 direct and independent representatives that manage over 380 dealers focusedon primary and acute facilities, we sell our rehabilitation and vascularsystems products to national third-party distributors, other regional medicalsupply dealers and medical product buying groups, generally at a discount fromlist prices. The majority of these products are soft goods which require littleor no patient education. The distributors and dealers generally resell theseproducts to large hospital chains, hospital buying groups, primary carenetworks and orthopedic physicians for use by the patients.

Throughthe OfficeCare sales channel, we maintain an inventory of rehabilitationproducts (mostly soft goods) on hand at orthopedic practices for immediatedistribution to the patient. For these products, we arrange billing to thepatient or third-party payor after the product is provided to the patient. Asof December 31, 2006, the OfficeCare program was located at over 1,000physician offices throughout the United States. We have contracts with over 700third-party payors.

·       *Regeneration*consists of the sale of our bone growth stimulation products in the UnitedStates. Our OL1000 product is sold through a combination of the DonJoychannel direct sales representatives and approximately 124 additional salesrepresentatives dedicated to selling our OL1000 product, of which approximately57 are employed by us. The SpinaLogic product is sold in the U.S. through acombination of direct sales representatives and sales agents, including DePuySpine. These products are sold either directly to the patient or to independentdistributors. We arrange billing to the third-party payors or patients, forproducts sold directly to the patient.

·       *International* consists of the sale of our products inforeign countries through wholly owned subsidiaries or independent distributors.We sell our products in over 70 foreign countries, primarily in Europe, Canada,Japan and Australia.

Set forth below is net revenues, gross profit andoperating income information for our reporting segments for the years ended December 31(in thousands). This information excludes the impact of other expenses notallocated to segments, which are comprised of (i) general corporateexpenses for all periods presented and (ii) restructuring costs associatedwith certain manufacturing moves in 2004. Information for the DomesticRehabilitation and International segments includes the impact of purchaseaccounting and related amortization of acquired intangible assets related tothe Aircast acquisition on April 7, 2006. Information for theInternational segment also includes the impact of purchase accounting andrelated amortization of acquired intangible assets related to the Axmedacquisition on January 2, 2006. For the years ended December 31, 2006and 2005, Domestic Rehabilitation income from operations was reduced byamortization of acquired intangible assets amounting to $5.8 million and $0.3million, respectively. For the years ended December 31, 2006 and 2005,International income from operations was reduced by amortization of acquiredintangible assets amounting to $4.8 million and $0.1 million, respectively. Forthe years ended December 31, 2006, 2005 and 2004, information for theRegeneration income from operations was reduced by amortization of acquiredintangible assets amounting to $4.6 million, $4.6 million and $4.7 million,respectively. For the year ended December 31, 2004, Regeneration incomefrom operations was 

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also reduced by restructuringcharges of $3.8 million related to the integration of the business operationsof the segment.

| ** **                                     | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| **Domestic  Rehabilitation:**                  |       |     |       |     |       |     |       |
| Net revenues                                   |       | $        | 267,083    |     | $          | 197,279  |       | $ | 177,481 |   |
| Gross profit                                   |       | 137,316  |       | 109,752  |       | 100,200  |       |
| Gross profit margin                            |       | 51.4     | %          | 55.6     | %          | 56.5     | %          |
| Operating income                               |       | 35,905   |       | 41,878   |       | 36,341   |       |
| Operating income as a percent of net revenues  |       | 13.4     | %          | 21.2     | %          | 20.5     | %          |
| **Regeneration:**                              |       |     |       |     |       |     |       |
| Net revenues                                   |       | $        | 64,507     |     | $          | 55,474   |       | $ | 49,658 |   |
| Gross profit                                   |       | 59,531   |       | 49,710   |       | 43,032   |       |
| Gross profit margin                            |       | 92.3     | %          | 89.6     | %          | 86.7     | %          |
| Operating income                               |       | 14,436   |       | 14,623   |       | 7,836    |       |
| Operating income as a percent of net revenues  |       | 22.4     | %          | 26.4     | %          | 15.8     | %          |
| **International:**                             |       |     |       |     |       |     |       |
| Net revenues                                   |       | $        | 81,468     |     | $          | 33,414   |       | $ | 28,860 |   |
| Gross profit                                   |       | 50,105   |       | 21,416   |       | 17,603   |       |
| Gross profit margin                            |       | 61.5     | %          | 64.1     | %          | 61.0     | %          |
| Operating income                               |       | 11,947   |       | 8,430    |       | 5,398    |       |
| Operating income  as a percent of net revenues |       | 14.7     | %          | 25.2     | %          | 18.7     | %          |

 

***Domestic Sales***

Domestic sales, includingall sales of our Domestic Rehabilitation and Regeneration segments, accountedfor approximately 80%, 88% and 89% of our net revenues in 2006, 2005 and 2004,respectively.

***International***

International sales accounted for approximately 20%, 12%and 11% of our net revenues in 2006, 2005 and 2004, respectively. Thefollowing table sets forth our international net revenues as a percentage ofour total net revenues, by country for the years ended December 31:

| ** **                 | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|----------------------------|------------|----------|------------|----------|------------|----------|------------|
| Germany                    |       | 5.9      | %          | 3.9      | %          | 4.3      | %          |
| France                     |       | 4.4      |       | 0.5      |       | 0.4      |       |
| Canada                     |       | 2.3      |       | 2.0      |       | 1.9      |       |
| United Kingdom             |       | 2.0      |       | 1.2      |       | 1.0      |       |
| Italy                      |       | 0.7      |       | 0.4      |       | 0.6      |       |
| Japan                      |       | 0.5      |       | 0.7      |       | 0.7      |       |
| Other countries            |       | 3.9      |       | 3.0      |       | 2.4      |       |
| Total international  sales |       | 19.7     | %          | 11.7     | %          | 11.3     | %          |

 

The “Other countries” category consists primarily ofsales in Denmark, Belgium, Sweden, Australia and Spain.

Internationalsales are made primarily through two distinct channels: independentthird-party distributors and through ourwholly owned foreign subsidiaries. Through our wholly ownedinternational subsidiaries, we sell products in several foreign currencies,primarily Euros, Pounds Sterling and Canadian Dollars. The U.S. dollarequivalent of our international sales denominated in foreign currencies in2006, 2005 and 2004 were favorably impacted by foreign currency exchange ratefluctuations with the weakening 

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of theU.S. dollar against the foreign currencies of our subsidiaries. The U.S. dollarequivalent of the related costs denominated in these foreign currencies wereunfavorably impacted during the same periods. In addition, the costs associatedwith our Mexico-based manufacturing operations are incurred in Mexican pesos. Aswe continue 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. We had nosuch hedges at December 31, 2006.

***Our Strategy***

Our strategy is toincrease revenues and profitability and enhance cash flow by strengthening ourmarket leadership position. Our key initiatives to implement this strategyinclude:

·       *Increase our Lead in the Domestic RehabilitationMarket Segment.  *We believe we are the market leader in theDomestic Rehabilitation markets in which we compete. We believe we will be ableto continue to grow our Domestic Rehabilitation business segment and increaseour market share further by focusing on 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:

–       *Introduce New Products and Product Enhancements.  *We have a history of developing and introducinginnovative products into the marketplace, and are committed to continuing thattradition by introducing new products across our product platform. In the yearended December 31, 2006, we launched 20 new products. We believe thatproduct innovation through effective and focused research and development willprovide a sustainable competitive advantage. We believe we are currently atechnology leader in several product categories and we intend to continue todevelop next generation technologies.

–       *IncreaseSales Force Productivity.  *We have integrated the Aircast salesforce into our existing sales organization and focused its various elements onspecific targeted customers. Our sales representatives will generally have atargeted customer base and a broad product offering for those customers. Forexample, the DonJoy sales force focuses on orthopedic and podiatry offices,orthotists, and athletic trainers, while the Aircast and ProCare sales forceconcentrates primarily on hospitals and third party distributors. With ourfocused sales organization and a sales compensation plan in place toincentivize all the sales representatives to sell the full range of products weoffer, we believe that we can encourage cross-selling and increase theproductivity of the entire sales force.

–       *Expand Our OfficeCare and Insurance Channels.  *ThroughOfficeCare, we maintain an inventory of product (mostly soft goods) on hand atorthopedic practices for immediate distribution to the patient. For theseproducts, we bill the patient or third-party payor after the product isprovided to the patient. Through our Insurance channel, we also provide ourcustom knee braces and certain other products directly to patients and bill thepatient or the patient’s third party payor. OurOfficeCare and Insurance channels currently cover over 1,000 physician officesencompassing over 4,000 physicians. We believe that our OfficeCare andInsurance channels serve a growing need among orthopedic practices to improveinventory management and patient service. Expanding our OfficeCare andInsurance channels also permits us to increase our weighted-average sellingprices, as the units sold through these channels are billed to insurancecompanies and other third-party payors at higher prices than units sold throughmost of our other sales channels. Accordingly, our OfficeCare and Insuranceinitiatives represent an opportunity for sales growth based on increases inboth unit volume and average 

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sellingprices. We intend to expand our OfficeCare and Insurance channels into morelarge orthopedic offices, thereby increasing the number of potential customersto whom we sell our products. In the year ended December 31, 2006, weadded approximately 214 new offices to our OfficeCare and Insurance channels,net of account terminations.

–       *Maximize Existing and Secure Additional National Accounts.  *We plan to capitalize on the growing practice inhealthcare in which hospitals and other large healthcare providers seek toconsolidate their purchasing activities to national buying groups. Contractswith these national accounts represent a significant opportunity for salesgrowth. We believe that our broad range of products is well suited to the goalsof these buying groups and intend to aggressively pursue these contracts. Inthe year ended December 31, 2006, we signed or renewed five significantnational contracts; including a new three-year sole source contract withConsorta, Inc. for all of our bracing and soft goods products, a newprivate label contract with Amerinet, Inc. for our pain management andcold therapy products, a renewal of our sole source contract with Broadlane, Inc.for all of our soft goods, bracing and cold therapy products, a renewal of ourmulti-source agreement with Premier Purchasing Partners, L.P. for all of ourbracing, soft goods, cold therapy and BGS products, and a renewal of our solesource bracing agreement with Healthtrust Purchasing Group, L.P. In addition,we successfully added Aircast products to each of these national contracts.

·       *Grow Our Regeneration Business.*   Wehave increased the number of regeneration sales specialists dedicated toselling our OL1000 BGS product, and we have aligned these specialists with ourDonJoy sales force. We believe these specialists will be able to use theestablished relationships of our DonJoy sales representatives to enhance salesof the OL1000 product. Our distribution arrangement with DePuy Spine becamenon-exclusive beginning in March 2006, permitting us to sell ourSpinaLogic BGS product through our own sales representatives or otherindependent sales representatives in all territories where we choose to do so. Wehave added additional selling resources in those geographical parts of thecountry where sales were not meeting our expectations. We believe our patentedCombined Magnetic field technology has features that make our BGS productssignificantly easier for patients to use than our competitors’ products. Webelieve that our new selling strategies for our Regeneration segment and ourtechnology advantages will permit us to maintain or improve our growth in thisbusiness.

·       *Expand International Sales*.   Since 2002, we have successfully established direct distributioncapabilities in several major international markets. We believe that sales toforeign markets continue to represent a significant growth opportunity, and weintend to continue to develop direct distribution capabilities in selectedadditional foreign markets. We also believe we can increase our internationalrevenues by expanding the number of our products we sell in internationalmarkets. Historically, we have sold only a limited range of our products in ourinternational markets. Beginning in 2005, we began to focus on selling anexpanded range of soft goods, our cold therapy products and our BGS products inour International segment. In January 2006,we completed the Axmed acquisition, as discussed in Note 3 to the consolidatedfinancial statements included in Part II, Item 8, herein, which increasedour international revenues in France. The Aircast acquisition in April 2006(discussed below and in Note 3 to the consolidated financial statementsincluded in Part II, Item 8, herein) also substantially increased ourinternational revenues, especially in Germany, France, the United Kingdom andCanada. For the year ended December 31, 2006, international salesincreased to 19.7% of our revenues, compared to 11.7% for the year ended December 31,2005.

·       *Pursue SelectiveAcquisitions*.   We believethat acquisitions represent an attractive and efficient means to broaden ourproduct lines, expand our geographic reach and increase our revenues and profitability.We intend to pursue acquisition opportunities that enhance sales growth, areaccretive 

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to earnings, increase customer penetration and/or provide geographicdiversity. Since the beginning of 2005, we have completed four acquisitions,all of which meet  or are expected tomeet these criteria: our acquisition of substantially all of the assetsof Superior Medical Equipment, LLC (SME acquisition) and our acquisition ofsubstantially all of the assets of the orthopedics soft goods business ofEncore Medical, L.P. (OSG acquisition), both of which were completed in 2005,as well as the Axmed acquisition in January 2006 and the Aircastacquisition in April 2006.

***Critical AccountingPolicies 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. The preparation of these financial statementsrequires us to make estimates and judgments that affect the reported amounts ofassets, liabilities, revenues and expenses, and related disclosure ofcontingent assets and liabilities. On an on-going basis, we evaluate ourestimates including those related to contractual allowances, doubtful accounts,inventories, rebates, product returns, warranty obligations, income taxes,intangible assets and stock-based compensation. We base our estimates onhistorical experience and on various other assumptions that we believe to bereasonable under the circumstances, the results of which form the basis formaking judgments about the carrying values of assets and liabilities that arenot readily apparent from other sources. 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:

*Provisionfor Contractual Allowances and Doubtful Accounts.**  *We maintain provisions for estimated contractualallowances for reimbursement amounts from our third-party payor customers basedon negotiated contracts and historical experience for non-contracted payors. Wealso maintain provisions for doubtful accounts for estimated losses resultingfrom the failure of our customers to make required payments. We have contractswith certain third-party payors for our third-party reimbursement billings,which call for specified reductions in reimbursement of billed amounts basedupon contractual reimbursement rates. For 2006 and 2005, we reserved for andreduced gross revenues from third-party payors, excluding those related to ourRegeneration business, by between 30% and 38% for estimated allowances relatedto 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 33% to 39% 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 74% of our net revenues for the year ended December 31, 2006and approximately 55% of our net accounts receivable at December 31, 2006.We have historically experienced write-offs of less than 2% of related netrevenues and, for 2006, such write-offs were less than 1%. Our third-partyreimbursement customers including insurance companies, managed care companiesand certain governmental payors, such as Medicare, include all of ourOfficeCare customers and certain other customers of our Domestic Rehabilitationbusiness segment and the majority of our Regeneration customers. Ourthird-party payor customers represented approximately 26% of our net revenuesfor the year ended December 31, 2006 and 45% of our net accountsreceivable at December 31, 2006. For 2006, we estimate bad debt expense tobe approximately 4% to 12% of gross revenues from these third-partyreimbursement customers, which reflects an increase from prior years. In 2005,such bad debt expense was approximately 4% to 8% of related gross revenues, andin 2004, such bad debt expense was approximately 4% to 10% of related gross 

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revenues. If the financialcondition of our customers were to deteriorate resulting in an impairment oftheir ability to make payments or if third-party payors were to deny claims forlate filings, incomplete information or other reasons, additional provisionsmay 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. Based oninformation currently available to us, we believe we have provided adequatereserves for our third-party payor accounts receivable. If claims are denied,or amounts are otherwise not paid, in excess of our estimates, the recoverabilityof our net accounts receivable could be reduced by a material amount. Inaddition, if our third-party insurance billing service provider does notperform to our expectations we may be required to increase our reserveestimates.

*Reservefor Excess and 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. Iffuture demand is less favorable than currently projected by management,additional inventory write-downs may be required. In addition, reserves forinventories on hand in our OfficeCare locations are provided based onhistorical shrinkage rates of approximately 16%. If actual shrinkage ratesdiffer from our estimated shrinkage rates, revisions to the reserve may berequired. We also provide reserves for newer product inventories, asappropriate, based on any minimum purchase commitments and our level of salesof the new products.

*Rebates.**  *We offer certain of our distributors rebates based onsales volume, sales growth and to reimburse the distributor for certaindiscounts. We record estimated reductions to revenues for customer rebateprograms based upon historical experience and estimated revenue levels.

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

*ValuationAllowance for Deferred Tax Asset.*   As of December 31,2006, we have approximately $29.0 million of net deferred tax assets on ourbalance sheet related primarily to tax deductible goodwill arising at the dateof our reorganization in 2001 and not recognized for book purposes, goodwillacquired in connection with our Regeneration acquisition and net losscarryforwards, offset by approximately $11.2 million in deferred taxliabilities related to non-tax deductible intangible assets acquired inconnection with the Aircast and Axmed stock acquisitions during 2006. Realizationof our net deferred tax assets is dependent on our ability to generate futuretaxable income prior to the expiration of our net operating loss carryforwards.Our management believes that it is more likely than not that the deferred taxassets will be realized based on forecasted future taxable income. However,there can be no assurance that we will meet our expectations of future taxableincome. Management will evaluate the realizability of the deferred tax assetson a quarterly basis to assess any need for valuation allowances.

*Goodwilland Other Intangibles.*   In accordance withStatement of Financial Accounting Standards No. 142, or SFAS No. 142,*Goodwill and Other Intangible Assets*,we do not amortize goodwill. In lieu of amortization, we are required toperform an annual review for impairment. Goodwill is considered to be impairedif we determine that the carrying value of the segment or reporting unitexceeds its fair value.  At October 1,2006, our goodwill acquired through December 31, 2005 was evaluated forimpairment and we determined that no impairment existed at that date. With theexception of goodwill related to our Regeneration acquisition of $39 million,we believe that the goodwill acquired through December 31, 2005 

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benefits the entireenterprise and since our reporting units share the majority of our assets, wecompared the total carrying value of our consolidated net assets (includinggoodwill) to the fair value of the Company. With respect to goodwill related toour Regeneration acquisition, we compared the carrying value of the goodwillrelated to the Regeneration segment to the fair value of the Regenerationsegment.

At December 31, 2006, other intangibles wereevaluated for impairment as required by SFAS No. 144, *Accounting for Impairment or Disposal of Long-LivedAssets*. The determination of the fair value of certain acquiredassets and liabilities is subjective in nature and often involves the use ofsignificant estimates and assumptions. Determining the fair values and usefullives of intangible assets requires the exercise of judgment. Upon initiallyrecording certain of our other intangible assets, including the intangibleassets that were acquired in connection with the Regeneration acquisition, weused independent valuation firms to assist us in determining the appropriatevalues for these assets. Subsequently, we have used the same methodology andupdated our assumptions. While there are a number of different generallyaccepted valuation methods to estimate the value of intangible assets acquired,we primarily used the undiscounted cash flows expected to result from the useof the assets. This method requires significant management judgment to forecastthe future operating results used in the analysis. In addition, othersignificant estimates are required such as residual growth rates and discountfactors. The estimates we have used are consistent with the plans and estimatesthat we use to manage our business and are based on available historicalinformation and industry averages.

We recorded an impairment charge for certainlong-lived assets in 2002 as a result of certain new products not achievinganticipated revenues and estimated recovery values of assets being disposed ofbeing less than anticipated. The value of our goodwill and other intangibleassets is exposed to future impairments if we experience future declines inoperating results, if negative industry or economic trends occur or if ourfuture performance is below our projections or estimates.

*Stock-BasedCompensation.*   Prior to the adoption of SFAS No. 123 (revised 2004), *Share-Based Payment* (SFAS No. 123(R)) on January 1, 2006, we accountedfor our employee stock option plans and employee stock purchase plan using therecognition and measurement principles of Accounting Principles Board (APB)Opinion No. 25, *Accounting for StockIssued to Employees*and its related interpretations, and had adoptedthe disclosure only provisions of SFAS No. 123, *Accounting for Stock-Based Compensation*and its relatedinterpretations. Accordingly, no compensation expense was recognized in netincome for our fixed stock option plans or its employee stock purchase plan(ESPP), as all options granted under those plans had an exercise price equal tothe market value of the underlying common stock on the date of grant (or withinpermitted discounted prices as it pertains to the ESPP).

As of January 1, 2006, we began recordingcompensation expense associated with stock options and other equity-basedcompensation in accordance with SFAS No. 123(R), using the modified prospective transition method andtherefore we have not restated results for prior periods. Under the modifiedprospective transition method, stock-based compensation expense for 2006includes: 1) compensation expense for all stock-based awards granted on orafter January 1, 2006 as determined based on the grant date fair valueestimated in accordance with the provisions of SFAS No. 123(R) and 2)stock-based compensation awards granted prior to, but not yet vested as of January 1,2006, based on the grant date fair value estimated in accordance with theoriginal provisions of SFAS No. 123. We recognize these compensation costson a straight-line basis over the requisite service period of the award, whichis generally four years. As a result of the adoption of SFAS No. 123(R),our net income for the year ended December 31, 2006 has been reduced bystock-based compensation expense, net of taxes, of approximately $7.7 million.

The fair value of eachequity award is estimated on the date of grant using the Black-Scholesvaluation model for option pricing using management’s assumptions. Expectedvolatility rates are based on the historical volatility (using daily pricing)of our stock. In accordance with SFAS No. 123(R), we reduce the 

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calculatedBlack-Scholes value by applying a forfeiture rate, based upon historicalpre-vesting option cancellations. The expected term of options granted isestimated based on a number of factors, including the vesting term of theaward, historical employee exercise behavior for both options that have runtheir course and outstanding options, the expected volatility of our stock andan employee’s average length of service. The risk-free interest rate isdetermined based upon a constant U.S. Treasury security rate with a contractuallife that approximates the expected term of the option award.

***Results of Operations***

We operate our business ona manufacturing calendar, with our fiscal year always ending on December 31.Each quarter is 13 weeks, consisting of one 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.

***Year Ended December 31, 2006 Compared To YearEnded December 31, 2005***

**Net Revenues.*****  ***Set forthbelow are net revenues for our reporting segments (in thousands):
|                              | ** ** | **Years Ended**        | ** ** | ** **                       | ** ** | ** **                  | ** ** |
|------------------------------|------------|-----------------------------|------------|----------------------------------|------------|-----------------------------|------------|
| ** **                   | ** ** | **December 31,  2006** | ** ** | **% of Net  Revenues** | ** ** | **December 31,  2005** | ** ** | **% of Net  Revenues** | ** ** | **Increase** | ** ** | **%  Increase** | ** ** |
| Domestic Rehabilitation |       |                        | $          | 267,083                          |       |                        |       | 64.7 |   |   |   | $ | 197,279 |   |   |   | 68.9 |   |   | $ | 69,804 |   |   | 35.4 |   |   |
| Regeneration                 |       |                        | 64,507     |                             |       |                        | 15.6       |   |   |   | 55,474 |   |   |   | 19.4 |   |   | 9,033 |   |   | 16.3 |   |   |
| International                |       |                        | 81,468     |                             |       |                        | 19.7       |   |   |   | 33,414 |   |   |   | 11.7 |   |   | 48,054 |   |   | 143.8 |   |   |
| Consolidated net  revenues   |       |                        | $          | 413,058                          |       |                        |       | 100.0 |   |   |   | $ | 286,167 |   |   |   | 100.0 |   |   | $ | 126,891 |   |   | 44.3 |   |   |

 

The year ended December 31, 2006 included oneless operating day than the year ended December 31, 2005. Net revenues inour Domestic Rehabilitation and Regeneration segments decreased as a percentageof total net revenues due to a proportionately higher increase in ourInternational segment revenues related to the acquisitions of Axmed inJanuary 2006 and Aircast in April 2006. Net revenues in our DomesticRehabilitation segment increased due to normal market growth in existing productlines, sales of new products, sales attributed to our recent acquisitions, anincrease in the number of units billed to third-party payors, which are sold athigher average selling prices than units sold through our other channels, andgrowth in sales related to national contracts in our ProCare\Aircast saleschannel. We also gained incremental revenue from the addition of approximately214 net new OfficeCare locations in the year ended December 31, 2006. Netrevenues in our Regeneration segment increased due to selling resources addedfor our SpinaLogic products in territories that became non-exclusive in 2006and an increased number of sales specialists selling our OL1000 product.International net revenues increased in the year ended December 31, 2006compared to the year ended December 31, 2005, due to our recentacquisitions, increased sales volume due to market growth and the impact offavorable changes in foreign exchange rates. Excluding the impact of exchangerates, local currency international revenues increased 142.3% in the year endedDecember 31, 2006 compared to the year ended December 31, 2005.

**Gross Profit.**   Setforth below is gross profit information for our reporting segments (inthousands):
|                            | ** ** | **Years Ended**        | ** ** | ** **                       | ** ** | ** **                  | ** ** |
|----------------------------|------------|-----------------------------|------------|----------------------------------|------------|-----------------------------|------------|
| ** **                 | ** ** | **December 31,  2006** | ** ** | **% of Net  Revenues** | ** ** | **December 31,  2005** | ** ** | **% of Net  Revenues** | ** ** | **Increase** | ** ** | **%  Increase** | ** ** |
| Domestic  Rehabilitation   |       |                        | $          | 137,316                          |       |                        |       | 51.4 |   |   |   | $ | 109,752 |   |   |   | 55.6 |   |   | $ | 27,564 |   |   | 25.1 |   |   |
| Regeneration               |       |                        | 59,531     |                             |       |                        | 92.3       |   |   |   | 49,710 |   |   |   | 89.6 |   |   | 9,821 |   |   | 19.8 |   |   |
| International              |       |                        | 50,105     |                             |       |                        | 61.5       |   |   |   | 21,416 |   |   |   | 64.1 |   |   | 28,689 |   |   | 134.0 |   |   |
| Consolidated gross  profit |       |                        | $          | 246,952                          |       |                        |       | 59.8 |   |   |   | $ | 180,878 |   |   |   | 63.2 |   |   | $ | 66,074 |   |   | 36.5 |   |   |

 

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The increase in gross profit for year ended December 31,2006 compared to the year ended December 31, 2005 is due to incrementalgross profit from an increase in revenues, partially offset by an increase incost of goods sold due to $1.0 million of stock-based compensation expenseassociated with the adoption of SFAS No. 123(R) as of January 1,2006, approximately $1.5 million of purchase accounting adjustments to write upacquired inventories to fair value and approximately $8.0 million of certainother charges and expenses related to our recent acquisitions and relatedintegrations that we do not believe are reflective of our ongoing operations. Inaddition, we incurred approximately $0.9 million of expenses related to ourmove to our new corporate headquarters in 2006. The decrease in consolidatedgross profit as a percentage of net revenues is primarily due to theseincreased costs of goods sold. The decrease in consolidated gross profit as apercentage of net revenues is also due to a change in product mix to includemore lower gross profit margin soft goods due to our recent acquisitions andincreased costs related to freight and certain materials. Gross profitdecreased as a percentage of net revenues in the Domestic Rehabilitationsegment primarily due to a change in product mix to include more lower grossprofit soft goods due to our recent acquisitions, increased freight costs andthe charges and expenses related to our recent acquisitions that we do notbelieve are reflective of our ongoing operations. The Regeneration segmentgross profit increased as a percentage of revenues due to reduced costs ofgoods sold for these products and a higher mix of insurance sales, which havehigher average selling prices and therefore generate higher gross profit marginsthan sales to wholesale customers. The decrease in the International segmentgross profit as a percentage of net revenues is primarily related to a changein product mix to include more lower gross profit margin soft goods due to ourrecent acquisitions and the charges and expenses related to our recentacquisitions that we do not believe are reflective of our ongoing operations.

**Operating Expenses.****  **Set forth below is operating expenseinformation (in thousands):
|                                       | ** ** | **Years Ended**        | ** ** | ** **                       | ** ** | ** **                  | ** ** |
|---------------------------------------|------------|-----------------------------|------------|----------------------------------|------------|-----------------------------|------------|
| ** **                            | ** ** | **December 31,  2006** | ** ** | **% of Net  Revenues** | ** ** | **December 31,  2005** | ** ** | **% of Net  Revenues** | ** ** | **Increase** | ** ** | **%  Increase** | ** ** |
| Sales and  marketing                  |       |                        | $          | 129,081                          |       |                        |       | 31.3 |   |   |   | $ | 86,241 |   |   |   | 30.1 |   |   | $ | 42,840 |   |   | 49.7 |   |   |
| General and  administrative           |       |                        | 48,176     |                             |       |                        | 11.7       |   |   |   | 29,432 |   |   |   | 10.3 |   |   | 18,744 |   |   | 63.7 |   |   |
| Research and  development             |       |                        | 8,988      |                             |       |                        | 2.2        |   |   |   | 6,350 |   |   |   | 2.2 |   |   | 2,638 |   |   | 41.5 |   |   |
| Amortization of  acquired intangibles |       |                        | 15,166     |                             |       |                        | 3.7        |   |   |   | 4,996 |   |   |   | 1.7 |   |   | 10,170 |   |   | 203.6 |   |   |
| Consolidated operating  expenses      |       |                        | $          | 201,411                          |       |                        |       | 48.8 |   |   |   | $ | 127,019 |   |   |   | 44.3 |   |   | $ | 74,392 |   |   | 58.6 |   |   |

 

***Sales and MarketingExpenses.******  ***The increase in sales and marketingexpenses is primarily due to $4.5 million of stock-based compensationexpense associated with the adoption of SFAS No. 123(R) as of January 1,2006 and the addition of expenses related to our recent acquisitions. Theexpenses related to our recent acquisitions include approximately $2.2 millionof expenses that are not deemed to be reflective of ongoing operations. Inaddition, we incurred approximately $0.4 million of selling and marketingexpenses related to our move to our new corporate headquarters in 2006. Theincrease in sales and marketing expenses is also partly due to costs associatedwith increased commissions, bad debt and sales incentives on increased salesand increased headcount.

***General andAdministrative Expenses.******  ***The increasein general and administrative expenses is primarily due to $3.6 million ofstock-based compensation expense associated with the adoption of SFAS No. 123(R) asof January 1, 2006 and the addition of expenses related to our recentacquisitions. The expenses related to our recent acquisitions includeapproximately $1.2 million of expenses that are not deemed to be reflective ofongoing operations. The increase in general and administrative expenses is also

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partly due to certainincreased personnel costs. General and administrative expenses for the yearended December 31, 2006 also include $0.7 million related to anarbitration concluded during 2006 and approximately $0.3 million of general andadministrative expenses related to our move to our new corporate headquartersin 2006.

***Research andDevelopment Expenses.******  ***The increase in research anddevelopment expense is due to the addition of expenses related to our recentacquisitions, $0.5 million of stock-based compensation expense associated withthe adoption of SFAS No. 123(R) as of January 1, 2006, andcertain increased personnel costs. In addition, we incurred approximately $0.2million of research and development expenses related to our move to our newcorporate headquarters in 2006.

***Amortization ofAcquired Intangibles.******  ***Amortization of acquiredintangibles includes amortization expense related to intangible assets acquiredin connection with the Regeneration acquisition, which are being amortized overlives ranging from four months to ten years, intangible assets acquired inconnection with the Axmed acquisition, which are being amortized over livesranging from one to nine years, and intangible assets acquired in connectionwith the Aircast acquisition which are being amortized over lives ranging fromseven to 20 years. The increase in amortization of acquired intangibles is dueto amortization expense related to the January 2006 acquisition of Axmedand the April 2006 acquisition of Aircast.

**Incomefrom Operations.**  ******Set forth below is income from operationsinformation for our reporting segments (in thousands):**
|                                                | ** ** | **Years Ended**        | ** ** | ** **                       | ** ** | **%**                       | ** ** |
|------------------------------------------------|------------|-----------------------------|------------|----------------------------------|------------|-----------------------------|------------|
| ** **                                     | ** ** | **December 31,  2006** | ** ** | **% of Net  Revenues** | ** ** | **December 31,  2005** | ** ** | **% of Net  Revenues** | ** ** | **Increase  (Decrease)** | ** ** | **Increase  (Decrease)** | ** ** |
| Domestic  Rehabilitation                       |       |                        | $          | 35,905                           |       |                        |       | 13.4 |   |   |   | $ | 41,878 |   |   |   | 21.2 |   |   |   | $ | (5,973 | ) |   |   | (14.3 | ) |   |
| Regeneration                                   |       |                        | 14,436     |                             |       |                        | 22.4       |   |   |   | 14,623 |   |   |   | 26.4 |   |   |   | (187 | ) |   |   | (1.3 | ) |   |
| International                                  |       |                        | 11,947     |                             |       |                        | 14.7       |   |   |   | 8,430 |   |   |   | 25.2 |   |   |   | 3,517 |   |   |   | 41.7 |   |   |
| Income from  operations of reportable segments |       |                        | 62,288     |                             |       |                        | 15.1       |   |   |   | 64,931 |   |   |   | 22.7 |   |   |   | (2,643 | ) |   |   | (4.1 | ) |   |
| Expenses not  allocated to segments            |       |                        | (16,747    | )                                |       |                        | (4.1       | ) |   |   | (11,072 | ) |   |   | (3.9 | ) |   |   | 5,675 |   |   |   | 51.3 |   |   |
| Consolidated income from  operations           |       |                        | $          | 45,541                           |       |                        |       | 11.0 |   |   |   | $ | 53,859 |   |   |   | 18.8 |   |   |   | $ | (8,318 | ) |   |   | (15.4 | ) |   |

 

The decrease in income from operations for ourDomestic Rehabilitation segment is due to increased expenses including $4.3million of stock-based compensation expense associated with the adoption ofSFAS No. 123(R) as of January 1, 2006, purchase accountingadjustments to write up acquired inventories to fair value and certain othercosts and expenses incurred in connection with our recent acquisitions,including approximately $9.9 million of expenses that are not deemed to be reflectiveof our ongoing operations. The decrease in income from operations for ourRegeneration segment is primarily due to $1.7 million of stock-basedcompensation expense associated with the adoption of SFAS No. 123(R) asof January 1, 2006. The increase in income from operations for ourInternational segment is due to increased net revenues and gross profit, whichoffset increased operating expenses including $0.9 million of stock-basedcompensation expense associated with the adoption of SFAS No. 123(R) asof January 1, 2006, purchase accounting adjustments to write up acquiredinventories to fair value and certain other costs and expenses incurred inconnection with our recent acquisitions, including approximately $4.4 millionof expenses that are not deemed to be reflective of our ongoing operations.

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**InterestExpense, Net of Interest Income and Prepayment Premium and Other Costs Relatedto Debt Prepayment.*****  ***Interest expense, net of interestincome, was $19.4 million in the year ended December 31, 2006 compared to$4.4 million in year ended December 31, 2005. Interest expense, net ofinterest income, increased in the year ended December 31, 2006 compared tothe year ended December 31, 2005 due to an increase in outstanding debtbalances due to the financing of the Aircast acquisition. For the year ended December 31,2006 we also incurred $2.3 million related to a write-off of net deferred debtissuance costs in connection with the repayment of our former credit facility.

**OtherIncome (Expense).*****  ***Otherincome was $0.3 million in the year ended December 31, 2006 compared toother expense of ($1.0 million) in the year ended December 31, 2005. Otherincome for the year ended December 31, 2006 reflects a write-off of costsrelated to a potential acquisition that was abandoned in the first quarter of2006, offset by net foreign exchange transaction gains. Other expense for theyear ended December 31, 2005 reflects write-off of costs related topotential acquisitions that were abandoned in third quarter of 2005 and netforeign exchange transaction losses.

**Provisionfor Income Taxes.*****  ***Our estimated worldwide effective taxrate was 47.6% for the year ended December 31, 2006 compared to 39.8% forthe year ended December 31, 2005. Our worldwide effective tax rateincreased in connection with our adoption of SFAS No. 123(R) as of January 1,2006. The stock-based compensation expense recorded in accordance with SFAS No. 123(R) resultsin a tax benefit rate of only 20.9% related to our pre-tax stock-basedcompensation expense aggregating $9.7 million for the year ended December 31,2006 due to the mix of our outstanding and unvested incentive stock options andnon-qualified stock options.

**Net Income.*****  ***Net income was$12.6 million for the year ended December 31, 2006 compared to net incomeof $29.2 million for the year ended December 31, 2005 as a result of thechanges discussed above.

***Year Ended December 31, 2005 Compared To YearEnded December 31, 2004***

**Net Revenues.*****  ***Set forthbelow 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 segmentincreased due to normal market growth in existing product lines, sales of newproducts, sales attributed to the OSG acquisition, an increase in the number ofunits billed to third-party payors, which are sold at higher average sellingprices, and growth in sales related to national contracts in our ProCare saleschannel. We also gained incremental revenue from the addition of approximately200 new OfficeCare locations in 2005, net of account terminations, includingapproximately 45 accounts added in connection with our March 2005 SMEacquisition. Net revenues in our Regeneration segment increased, in part, fromour sales force integration and an increased number of sales specialistsselling our OL1000 product. Sales of our SpinaLogic product also increased dueto selling resources added in territories that became non-exclusive in 2005. Internationalnet revenues increased partly due to favorable changes in exchange ratescompared to the rates in effect in 2004, an increase in the number of productswe 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. 

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Excluding the impact ofexchange rates, local currency international revenues increased 14.6% in theyear ended December 31, 2005 compared to the year ended December 31,2004.

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

| ** **                 | ** ** | **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 in consolidated gross profit and grossprofit margin is related partly to increased revenues from the higher grossmargin products sold in our Regeneration segment and partly due to certainmanufacturing cost reductions, offset by increased freight costs and increasedexpenses related to employee bonuses.  Gross profit decreased as a percentage of netrevenues in our Domestic Rehabilitation segment primarily due to increasedfreight costs and a change in product mix including incremental sales from theOSG acquisition, which are primarily sold to third-party distributors at areduced gross margin. The Regeneration segment gross profit increased as apercentage of revenues due to increased sales volume, an increase in theproportion of unit sales sold to third-party payors, which are sold at higheraverage selling prices, and certain cost benefits realized upon theconsolidation of the Regeneration product manufacturing into our facility inVista, California. The increase in the International segment gross profit isprimarily related to the favorable impact of changes in exchange rates and theaddition of the incremental in-market gross margin from our direct sales in theNordic countries since September 1, 2004.

**Operating Expenses.****  **Set forth below is operating expenseinformation (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 MarketingExpenses.******  ***The increase in sales and marketingexpenses is due to costs associated with additional sales personnel in ourRegeneration segment and increases in commissions on increased sales,advertising and marketing programs, employee bonus expenses and costs relatedto the businesses we acquired in 2005.

***General andAdministrative Expenses.******  ***The increasein general and administrative expenses is primarily due to increases in legalcosts, employee bonus expenses and costs associated with the businesses weacquired in 2005, partially offset by savings related to the integration of theRegeneration business.

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***Research andDevelopment Expenses.******  ***The increase in research anddevelopment expenses is primarily due to an increase in costs associated withprototyping new products, increased employee bonus expenses and certainseverance costs incurred in 2005.

***Amortization ofAcquired Intangibles.******  ***The increase in amortization ofacquired intangibles relates to intangible assets acquired in 2005 inconnection with the SME acquisition, which are being amortized over livesranging 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. For 2004, all amortization of acquiredintangibles related to intangible assets acquired in connection with theRegeneration acquisition, which are being amortized over lives ranging fromfour months to ten years.

***Restructuringcosts.****In 2004, we incurred restructuring charges related toour Regeneration integration and certain manufacturing moves, including chargesfor severance, recruiting, training and other related exit costs.*

**Income from Operations.**   Setforth below is income from operations information for our reporting segments(in thousands):

| ** **                                     | ** ** | **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 Debt Prepayment.***  *Interest expense, net of interestincome, 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 toreduced debt levels following the June 2004 redemption of our seniorsubordinated notes and other debt repayments made after the third quarter of2004. We incurred pre-tax charges aggregating $7.8 million in the secondquarter of 2004 related to the redemption of our senior subordinated notes.

**OtherIncome (Expense).*****  ***Other income (expense) for the yearended December 31, 2005 reflects a write-off of costs related to potentialacquisitions that were abandoned in 2005 and net foreign exchange transactionlosses. 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.*****  ***Our estimated worldwide effective taxrate was 39.8% for the year ended December 31, 2005 and 39.2% for the yearended December 31, 2004. Our tax rate for 2005 increased compared to 2004primarily due to a higher average effective state tax rate in 2004.

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

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***Liquidity andCapital Resources***

Our principal liquidity requirementsare to service our debt and meet our working capital and capital expenditureneeds. Total indebtedness was $327.3 million at December 31, 2006.Total cash and cash equivalents were $7.0 million at December 31,2006.

Net cash provided byoperating activities was $41.2 million and $47.1 million for the yearsended December 31, 2006 and 2005, respectively. The net cash provided byoperations in 2006 primarily reflected positive operating results offset by anincrease in net accounts receivable and net inventories and payments made inconnection with the integration of our recently acquired businesses. Asrequired by SFAS No. 123(R), our cash flow provided by operatingactivities for the year ended December 31, 2006 is shown net of $2.7million of excess tax benefits from stock options exercised, the amount deemedto be realized for tax purposes in 2006. These excess tax benefits are includedin cash flows provided by financing activities for the year endedDecember 31, 2006. The net cash provided by operations in 2005 primarilyreflected positive operating results partially offset by an increase in netaccounts receivable and by cash of approximately $1.9 million paid in 2005 forrestructuring costs accrued in 2004.

Cash flows used ininvesting activities were $329.3 million and $19.3 million for the yearsended December 31, 2006 and 2005, respectively. Cash used in investingactivities in 2006 included $16.6 million used for the acquisition of Axmed,$299.7 million used for the acquisition of Aircast, $0.1 million additionalconsideration to KD Innovation A/S (KDI) for meeting operating income targets,and $16.0 million used for capital expenditures and $1.1 million used topurchase rights to distributor territories, net of amounts repaid to us by thenew distributors, offset by $4.2 million of net proceeds from the sale of theformer Aircast headquarters building, land and certain furniture in the fourthquarter of 2006. Capital expenditures in 2006 included $8.5 million related totenant improvements and equipment for our new corporate headquarters and theexpansion of our Indianapolis distribution center. Cash used in investingactivities in 2005 included $3.1 million used for the SME acquisition, $9.5million used for the OSG acquisition, $0.1 million additional consideration toKD Innovation A/S (KDI) for meeting operating income targets, $5.1 million usedfor capital expenditures and $1.5 million used to purchase rights todistributor territories, net of amounts repaid to us by the new distributors. Wemay be required to pay up to an additional $0.3 million to KDI through 2009, ifcertain net operating income targets are met.

Cash flows provided by(used in) financing activities were $293.6 million and ($37.7) million for theyears ended December 31, 2006 and 2005, respectively. Cash provided byfinancing activities in 2006 included $279.8 million of net proceeds fromlong-term debt, $15.8 million of net proceeds received from the exercise ofstock options, $1.7 million from the issuance of stock under our Employee StockPurchase Plan and $2.7 million of excess tax benefits from stock optionsexercised offset by $6.4 million paid for debt issuance costs incurred inconnection with the financing of the Aircast acquisition in April 2006. Cashused in financing activities in 2005 included $55.5 million of repayments onlong-term debt and $0.7 million of debt issuance costs, offset by proceeds of$8.7 million received from the issuance of common stock through our EmployeeStock Purchase Plan and the exercise of stock options, $1.8 million receivedfrom collection of stockholder notes receivable and $8.0 million received fromborrowing.

*Contractual Obligations and Commercial Commitments*

*New Credit Agreement*

On April 7, 2006, weentered into a new credit agreement with a syndicate of lenders and withWachovia Bank, National Association, as administrative agent, to finance theAircast acquisition. The new credit agreement provided for total borrowings of$400 million, consisting of a term loan of $350 million, which was fully drawnat closing and up to $50 million available under a revolving credit facility. Asof December 31, 2006, the balance outstanding under the term loan was$327.3 million and $47.8 million was available under the revolving credit facility,net of outstanding letters of credit. The new credit agreement 

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replacedour previously existing credit agreement and approximately $46.3 million ofdebt outstanding under the former agreement was paid off by borrowings underthe new agreement. Under the new credit agreement, up to $25 million ofoutstanding borrowings may be denominated in British Pounds or Euros.

Borrowings under the newterm loan and on the new revolving credit facility bear interest at variablerates (either a LIBOR rate or the lenders’ base rate, as elected by us) plus amargin. Under the new agreement, the interest rate for the term loan is LIBORplus a margin of 1.50%, or the lenders’ base rate plus a margin of 0.50%. Theapplicable margin on the revolving credit facility varies based on our leverageratio. The interest rate for the revolving credit facility is 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 on the revolving credit facility is either LIBOR plus1.5% or the lender’s base rate plus 0.5%.

Subsequent to December 31,2006, we borrowed an aggregate of $5.0 million under the revolving creditfacility to provide funds needed to pay certain costs of the integration ofAircast.

*Interest Rate SwapAgreement.**  *Inconnection with the new credit agreement, on April 11, 2006 we enteredinto an interest rate swap agreement with Wachovia Bank for a notional amountof $250 million of the term loan. The interest rate swap agreement converts thevariable LIBOR rate to a fixed LIBOR rate of 5.29% for a term of five years. Accordingly,with respect to a notional amount of $250 million of the term loan, ourinterest rate is fixed at 6.79% (5.29% plus applicable margin of 1.50%) for theterm of the swap. The notional amount of $250 million is scheduled to amortizeto zero over the term of the swap in proportion to expected future cash flows. Asof December 31, 2006, the outstanding notional amount of the interest rateswap was $250 million and the fair market value of the swap reflected a loss ofapproximately $0.9 million. Our interest rate swap qualifies as a cash flowhedge under SFAS No. 133, *Accountingfor Derivative Instruments and Hedging Activities*. In accordancewith SFAS No. 133, the fair market value of the swap at December 31,2006 was recorded as a long-term liability, with the change in such fair valueaccounted for in accumulated other comprehensive income (loss) included in thestockholders’ equity in the accompanying consolidated balance sheet. Theweighted average interest rate applicable to our total borrowings as of December 31,2006 was 6.81%.

*Repayment.*   We were initially required to makequarterly principal payments of $0.9 million on the term loan, beginning in June 2006.The balance of the term loan, if any, is due in full on April 7, 2013. In2006 we made $21.0 million of prepayments on the term loan. Under the newcredit agreement, prepayments are applied to reduce outstanding principle balancein direct order of maturity to payments scheduled over next twelve months andthereafter to remaining scheduled principal payments on a prorated basis. Accordingly,our required principal payments have been reduced to $0.8 million per quarterand begin in December 2007  Anyborrowings under the revolving credit facility are due in full on April 7,2012. We are also required to make annual mandatory prepayments on the termloan in an amount equal to 50% of our excess cash flow if our ratio of totaldebt to consolidated EBITDA exceeds 2.50 to 1.00. Excess cash flow represents our net income adjusted for extraordinarygains or losses, depreciation, amortization and other non-cash charges,changes in working capital, changes indeferred revenues, payments for capital expenditures and permitted acquisitionsand repayment of certain indebtedness. In addition, the term loan issubject to mandatory prepayments in an amount equal to (a) 100% of the netcash proceeds of certain debt issuances by us; (b) 50% of the net cashproceeds of certain equity issuances by us if our ratio of total debt toconsolidated EBITDA exceeds 2.50 to 1.00; (c) 100% of the net cashproceeds of certain insurance, condemnation awards or other compensation inrespect to any casualty event; and (d) 100% of the net cash proceeds ofcertain asset sales or other dispositions of property by us, in each casesubject to certain exceptions. We are not required to make any mandatoryprepayments for the year ended December 31, 2006.

*Security; Guarantees.*   Ourobligations under the new credit agreement are irrevocably guaranteed, jointlyand severally, by us, and all of our current and future U.S. subsidiaries. Inaddition, the credit 

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agreement and theguarantees thereunder are secured by substantially all of our U.S. assets,including real and personal property, inventory, accounts receivable,intellectual property and other intangibles.

*Covenants.*   Thenew credit agreement imposes certain restrictions on us, including restrictionson the ability to incur indebtedness, incur or guarantee obligations, prepayother indebtedness or amend other debt instruments, pay dividends or make otherdistributions (except for certain tax distributions), redeem or repurchaseequity, make investments, loans or advances, make acquisitions, engage inmergers or consolidations, change the business conducted by us and oursubsidiaries, make capital expenditures, grant liens, sell assets and engage incertain other activities. The new credit agreement requires us to maintain: a ratioof total debt to consolidated EBITDA of no more than 4.50 to 1.00 and graduallydecreasing to 2.50 to 1.00 for the first quarter of 2010 and thereafter; and aratio of consolidated EBITDA to fixed charges of at least 1.50 to 1.00. Materialviolations of these covenants and restrictions, or the payment terms describedabove, can result in an event of default and acceleration of the entireindebtedness. We were in compliance with all covenants as of December 31,2006.

*Debt issuance costs.**  *We capitalized debt issuance costsof approximately $6.4 million in association with the new credit agreement,which will be amortized over the term of the agreement. Remaining debt issuancecosts of $5.6 million, net of accumulated amortization, were included in theaccompanying balance sheet at December 31, 2006. We wrote offapproximately $2.3 million in April 2006, representing the net carryingvalue of debt issuance costs capitalized in connection with our previous creditagreement.

As part of our strategy,we may pursue additional acquisitions, investments and strategic alliances. Wemay require new sources of financing to consummate any such transactions,including additional debt or equity financing. We cannot assure you that suchadditional sources of financing will be available on acceptable terms, if atall. In addition, we may not be able to consummate any such transactions due tothe operating and financial restrictions and covenants in our credit agreement.

The following tablelists our contractual obligations as of December 31, 2006 (in thousands):

| ** **                          | ** ** | **Payments Due by Period** | ** ** |
|-------------------------------------|------------|-------------------------------------------|------------|
| ** **                          | ** ** | ** **                                | ** ** | **2007** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Contractual Obligations**    | ** ** | ** **                                | ** ** | **Total** | ** ** | **Less than 1  Year** | ** ** | **2008-2010  1-3 Years** | ** ** | **2011-2012  4-5 Years** | ** ** | **2013+  After 5 years** | ** ** |
| Long-Term Debt                      |       | $                                         | 327,250    |   |   | $ | 831 |   |   |   | $ | 9,967 |   |   |   | $ | 6,644 |   |   |   | $ | 309,808 |   |   |
| Operating Leases                    |       | 57,842                                    |       |   | 6,186 |   |   |   | 14,981 |   |   |   | 9,089 |   |   |   | 27,586 |   |   |
| Total Contractual Cash  Obligations |       | $                                         | 385,092    |   |   | $ | 7,017 |   |   |   | $ | 24,948 |   |   |   | $ | 15,733 |   |   |   | $ | 337,394 |   |   |
|                                     |            |                                           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

In late 2004, we enteredinto a lease agreement with Professional Real Estate Services, Inc. (PRES)under which PRES undertook to build a new 110,000 square foot corporateheadquarters facility for us on vacant land in Vista, California. We occupy thefacility under a 15-year lease, which commenced in August 2006 uponcompletion of the facility, with two five-year options to extend the term. Wevacated our former facilities in Vista. Rent expense for the new facility willbe recorded on a straight-line basis over the lease term at approximately $1.9million per year.

In February 2005,PRES purchased our former facilities as well as the vacant real propertyunderlying the new lease. Effective on the purchase date, our lease for thevacant land was terminated. In connection with our new lease, our leases forour former Vista facilities were terminated early in August 2006. Thoseleases would otherwise have continued until February 2008. In August 2006,we made a lump sum rent payment to PRES of approximately $1.5 million,representing 40% of the rent that would have been due under the formerfacilities leases from the early termination date through the originalexpiration date. If PRES is able to lease our former facilities during whatwould have remained of the term of our existing leases, a portion of that summay be refunded to us. The lump sum rent payment, net of a remaining $0.4 millionaccrual related to lease termination costs originally accrued in 2002 (see Note4 to the consolidated financial statementsincluded in Part II, Item 8 herein), is being accounted for asadditional 

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rentexpense over the term of the new lease and is included in the annual rentexpense amount noted above. The contractual obligations table above includesthe rent for our new facility beginning in August 2006.

Our ability to payprincipal and interest on our indebtedness, fund working capital requirementsand make anticipated capital expenditures will depend on our futureperformance, which is subject to general economic, financial and other factors,some of which are beyond our control. We believe that based on current levelsof operations and anticipated growth, cash flow from operations, together withother available sources of funds including the availability of borrowings underour revolving credit facility, will be adequate for at least the next twelvemonths to make required payments of principal and interest on our indebtedness,to fund anticipated capital expenditures and for working capital requirements. Therecan be no assurance, however, that our business will generate sufficient cashflow from operations or that future borrowings will be available under therevolving credit facility in an amount sufficient to enable us to service ourindebtedness or to fund our other liquidity needs. In such event, we may needto raise additional funds through public or private equity or debt financings. Wecannot assure you that any such funds will be available to us on favorableterms or at all.

We do not currently haveand have never had any relationships with unconsolidated entities or financialpartnerships, such as entities often referred to as structured finance orspecial purpose entities, which would have been established for the purpose offacilitating off-balance sheet arrangements or other contractually narrow orlimited purposes. In addition, we do not engage in trading activities involvingnon-exchange traded contracts. As such, we are not materially exposed to anyfinancing, liquidity, market or credit risk that could arise if we had engagedin these relationships.

As of December 31,2006, we had available liquidity of approximately $7.0 million in cash and cashequivalents and $47.8 million available under our revolving credit facility,net of $2.2 million of outstanding letters of credit. For 2007, we have alreadyspent or expect to spend total cash of approximately $47.5 million for thefollowing requirements:

·       upto approximately $22.7  million forscheduled principal and estimated interest payments on our new credit facility;

·       approximately$6.2 million scheduled payments for noncancellable operating leases;

·       upto approximately 0.9 million Euros (approximately $1.2 million) to certainsellers of Axmed based on achievement of certain revenue targets for 2006 andoperating income targets for the second half of 2006, in connection with theAxmed acquisition, as discussed in Note 3 to the consolidated financialstatements included in Part II, Item 8, herein;

·       upto approximately $7.4 million in severance payments to certain Aircastemployees as part of the Aircast integration plan as discussed in Note 3 to the unaudited condensed consolidated financialstatements included in Part II, Item 8, herein; and

·       upto approximately $10.0 million for capital expenditures.

In addition, we expect tomake other general corporate payments in 2007. We also expect to continue tomake payments related to integration activities completed in 2006 with respectto the acquired Aircast business.

***Seasonality***

We generally record ourhighest net revenues per day in the fourth quarter due to a greater number oforthopedic surgeries and injuries resulting from increased sports activity,particularly football and skiing. In addition, during the fourth quarter, apatient has a greater likelihood of having satisfied his or her annual insurancedeductible than in the first three quarters of the year, and thus there is anincrease in the number of elective orthopedic surgeries. We follow amanufacturing calendar that has a varied number of 

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shippingdays in each quarter. Although on a per day basis net revenues may be higher ina certain quarter, total net revenues may be higher or lower based upon thenumber of shipping days in such quarter. Conversely, we generally have lowernet revenues per day during our second quarter as a result of decreased sportsactivity.

***Recent Accounting Pronouncements***

For information on therecent accounting pronouncements impacting our business, see Note 1 of thenotes to our consolidated financial statements included in Part II, Item8, herein.

**Item7A.**                Quantitative andQualitative Disclosures About Market Risk

We are exposed to certainmarket risks as part of our ongoing business operations. Our primary exposuresinclude changes in interest rates and foreign exchange rates.

We are exposed to interestrate risk in connection with the term loan and borrowings under our revolvingcredit facility, which bear interest at floating rates based on the LondonInter-Bank Offered Rate (LIBOR) or the prime rate plus an applicable borrowingmargin. For variable rate debt, interest rate changes generally do not affectthe fair market value of the underlying debt, but do impact future earnings andcash flows, assuming other factors are held constant.

As ofDecember 31, 2006 we had $77.3 million of variable rate debt representedby borrowings under our new credit facility (at a weighted-average interestrate of 6.88% at December 31, 2006) which are not covered by the interestrate swap agreement entered into in connection with the new credit agreement.Based on the balance outstanding under the credit facility as of December 31,2006, an immediate change of one percentage point in the applicable interestrate would have caused an increase or decrease in interest expense ofapproximately $0.8  million on an annual basis. At December 31, 2006,up to $47.8 million of variable rate borrowings were available under ournew $50.0 million revolving credit facility. We may use derivativefinancial instruments, where appropriate, to manage our interest rate risks.However, as a matter of policy, we do not enter into derivative or otherfinancial investments for trading or speculative purposes. On April 11,2006, in connection with our new credit agreement, we entered into an interestrate swap agreement for a notional amount of $250 million of the new term loan.The interest rate swap agreement converts the variable LIBOR rate to a fixedLIBOR rate of 5.29% for a term of five years. Accordingly, with respect to thenotional amount of $250 million, our interest rate is fixed at 6.79% (5.29% plusapplicable margin of 1.50%) for the term of the swap. The notional amount of$250 million is scheduled to amortize to zero over the term of the swap inproportion to expected cash flows. As of December 31, 2006, theoutstanding notional amount of the interest rate swap was $250 million. At December 31,2006, the fair market value reflected a loss of $0.9 million and was recordedas a long-term liability, with the change in such fair value accounted for as areduction of accumulated other comprehensive income (loss) included instockholders’ equity in the accompanying consolidated balance sheet.

Throughour wholly owned international subsidiaries, we sell products in severalforeign currencies, primarily Euros, Pounds Sterling and Canadian Dollars. TheU.S. dollar equivalent of our international sales denominated in foreigncurrencies in 2006, 2005 and 2004 were favorably impacted by foreign currencyexchange rate fluctuations with the weakening of the U.S. dollar against theforeign currencies of our subsidiaries. The U.S. dollar equivalent of therelated costs denominated in these foreign currencies were unfavorably impactedduring the same period. In addition, the costs associated with our Mexico-basedmanufacturing operations are incurred in Mexican 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. We had no suchhedges at December 31, 2006.

63

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**Item 8.**                        FinancialStatements and Supplementary Data

Thefollowing documents are filed as part of this report: 

|                                                                                                                            | ** ** | **Page** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|
| Report of Independent Registered Public Accounting  Firm                                                                   |       |     | 65         |   |   |
| Consolidated  Balance Sheets as of December 31, 2006 and 2005                                                         |       |     | 66         |   |   |
| Consolidated Statements of Income for the years ended  December 31, 2006, 2005 and 2004                               |       |     | 67         |   |   |
| Consolidated Statements of Changes in Stockholders’  Equity for the Years ended December 31, 2006, 2005 and 2004 |       |     | 68         |   |   |
| Consolidated Statements of Cash Flows for the years ended  December 31, 2006, 2005 and 2004                           |       |     | 69         |   |   |
| Notes to Consolidated Financial Statements                                                                                 |       |     | 70         |   |   |

 

64

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**REPORT OFINDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

To the Board of Directors and StockholdersDJO Incorporated

We have audited the accompanying consolidated balancesheets of DJO Incorporated as of December 31, 2006 and 2005, and therelated consolidated statements of income, changes in stockholders’ equity andcash flows for each of the three years in the period ended December 31,2006. Our audits also included the financial statement schedule listed in theIndex at Item 15(a). These financial statements and schedule are theresponsibility of the Company’s management. Our responsibility is to express anopinion on these financial statements and schedule based on our audits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States). Thosestandards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements. An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred toabove present fairly, in all material respects, the consolidated financialposition of DJO Incorporated at December 31, 2006 and 2005, and theconsolidated results of its operations and its cash flows for each of the threeyears in the period ended December 31, 2006, in conformity with U.S.generally accepted accounting principles. Also, in our opinion, the relatedfinancial statement schedule, when considered in relation to the basicfinancial statements taken as a whole, presents fairly in all material respectsthe information set forth therein.

As discussed in Note 1 to the consolidated financialstatements, DJO Incorporated changed its method of accounting for share-basedpayments in accordance with Statement of Financial Accounting Standards No. 123(revised 2004) on January 1, 2006.

Wealso have audited, in accordance with the standards of the Public CompanyAccounting Oversight Board (United States), the effectiveness of DJOIncorporated’s internal control over financial reporting as of December 31,2006, based on criteria established in Internal Control—Integrated Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commissionand our report dated February 26, 2007 expressed an unqualified opinion onmanagement’s assessment and an adverse opinion on the effectiveness of internalcontrol over financial reporting.
|                         | /s/ ERNST & YOUNG LLP |
|-------------------------|--------------------------------|
| San Diego,  California  |                           |
| February 26,  2007 |                           |

 

65

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**DJO IncorporatedCONSOLIDATED BALANCE SHEETS(In thousands, except share and par value data)**

| ** **                                                                                                                                                                     | ** ** | **December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                     | ** ** | **2006**              | ** ** | **2005** | ** ** |
| **Assets**                                                                                                                                                                     |       |                  |       |   |   |
| Current assets:                                                                                                                                                                |       |                  |       |   |   |
| Cash and cash  equivalents                                                                                                                                                     |       | $                     | 7,006      |   | $ | 1,107 |   |
| Accounts receivable, net  of provisions for contractual allowances and doubtful accounts of $38,602 and  $26,792 at December 31, 2006 and 2005, respectively              |       | 90,236                |       | 62,068 |   |
| Inventories, net                                                                                                                                                               |       | 47,214                |       | 24,228 |   |
| Deferred tax asset, net                                                                                                                                                        |       | 10,797                |       | 7,066 |   |
| Prepaid expenses and  other current assets                                                                                                                                     |       | 14,521                |       | 4,387 |   |
| Total current assets                                                                                                                                                           |       | 169,774               |       | 98,856 |   |
| Property, plant and  equipment, net                                                                                                                                            |       | 32,699                |       | 15,396 |   |
| Goodwill                                                                                                                                                                       |       | 277,495               |       | 101,235 |   |
| Intangible assets, net                                                                                                                                                         |       | 160,124               |       | 51,242 |   |
| Debt issuance costs, net                                                                                                                                                       |       | 5,634                 |       | 2,479 |   |
| Deferred tax asset, net                                                                                                                                                        |       | 18,251                |       | 32,437 |   |
| Other assets                                                                                                                                                                   |       | 4,357                 |       | 3,019 |   |
| Total assets                                                                                                                                                                   |       | $                     | 668,334    |   | $ | 304,664 |   |
| **Liabilities and stockholders’ equity**                                                                                                                                  |       |                  |       |   |   |
| Current liabilities:                                                                                                                                                           |       |                  |       |   |   |
| Accounts payable                                                                                                                                                               |       | $                     | 17,338     |   | $ | 10,270 |   |
| Accrued compensation                                                                                                                                                           |       | 14,171                |       | 6,310 |   |
| Accrued commissions                                                                                                                                                            |       | 4,133                 |       | 3,483 |   |
| Long-term debt, current  portion                                                                                                                                               |       | 831                   |       | 5,000 |   |
| Accrued interest                                                                                                                                                               |       | 3,984                 |       | 385 |   |
| Accrued taxes                                                                                                                                                                  |       | 3,738                 |       | 550 |   |
| Accrued restructuring  costs                                                                                                                                                   |       | —                |       | 417 |   |
| Other accrued  liabilities, current portion                                                                                                                                    |       | 22,967                |       | 9,680 |   |
| Total current  liabilities                                                                                                                                                     |       | 67,162                |       | 36,095 |   |
| Long-term debt, less  current portion                                                                                                                                          |       | 326,419               |       | 42,500 |   |
| Accrued pension                                                                                                                                                                |       | 201                   |       | — |   |
| Other accrued  liabilities, long-term                                                                                                                                          |       | 4,283                 |       | — |   |
| Commitments and contingencies                                                                                                                                                  |       |                  |       |   |   |
| Stockholders’ equity:                                                                                                                                                     |       |                  |       |   |   |
| Preferred stock, $0.01  par value; 1,000,000 shares authorized, none issued and outstanding at  December 31, 2006 and 2005                                                |       | —                |       | — |   |
| Common stock, $0.01 par  value; 39,000,000 shares authorized, 23,317,934 shares and 22,137,860 shares  issued and outstanding at December 31, 2006 and 2005, respectively |       | 233                   |       | 221 |   |
| Additional paid-in  capital                                                                                                                                                    |       | 163,711               |       | 133,656 |   |
| Accumulated other  comprehensive income                                                                                                                                        |       | 1,984                 |       | 492 |   |
| Retained earnings                                                                                                                                                              |       | 104,341               |       | 91,700 |   |
| Total stockholders’  equity                                                                                                                                               |       | 270,269               |       | 226,069 |   |
| Total liabilities and stockholders’ equity                                                                                                                                |       | $                     | 668,334    |   | $ | 304,664 |   |

 

See accompanying Notes.

66

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**DJO IncorporatedCONSOLIDATED STATEMENTS OF INCOME(In thousands, except per share data)**

| ** **                                                                    | ** ** | **Years Ended December 31,** | ** ** |
|-------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                    | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net revenues                                                                  |       | $                                           | 413,058    |   | $ | 286,167 |   | $ | 255,999 |   |
| Costs of goods  sold                                                          |       | 166,106                                     |       | 105.289 |   | 95,164 |   |
| Gross profit                                                                  |       | 246,952                                     |       | 180,878 |   | 160,835 |   |
| Operating expenses:                                                           |       |                                        |       |   |   |   |   |
| Sales and marketing                                                           |       | 129,081                                     |       | 86,241 |   | 78,984 |   |
| General and administrative                                                    |       | 48,176                                      |       | 29,432 |   | 27,727 |   |
| Research and development                                                      |       | 8,988                                       |       | 6,350 |   | 5,627 |   |
| Amortization of acquired intangibles                                          |       | 15,166                                      |       | 4,996 |   | 4,731 |   |
| Restructuring costs                                                           |       | —                                      |       | — |   | 4,693 |   |
| Total operating  expenses                                                     |       | 201,411                                     |       | 127,019 |   | 121,762 |   |
| Income from  operations                                                       |       | 45,541                                      |       | 53,859 |   | 39,073 |   |
| Other income (expense):                                                       |       |                                        |       |   |   |   |   |
| Interest expense                                                              |       | (20,181                                     | )          | (4,667 | ) | (9,431 | ) |
| Interest income                                                               |       | 802                                         |       | 249 |   | 472 |   |
| Prepayment premium and other costs related to debt  prepayment                |       | (2,347                                      | )          | — |   | (7,760 | ) |
| Other income (expense)                                                        |       | 300                                         |       | (980 | ) | 683 |   |
| Other income  (expense), net                                                  |       | (21,426                                     | )          | (5,398 | ) | (16,036 | ) |
| Income before  income taxes                                                   |       | 24,115                                      |       | 48,461 |   | 23,037 |   |
| Provision for  income taxes                                                   |       | (11,474                                     | )          | (19,263 | ) | (9,022 | ) |
| Net income                                                                    |       | $                                           | 12,641     |   | $ | 29,198 |   | $ | 14,015 |   |
| Net income per share:                                                         |       |                                        |       |   |   |   |   |
| Basic                                                                         |       | $                                           | 0.55       |   | $ | 1.34 |   | $ | 0.66 |   |
| Diluted                                                                       |       | $                                           | 0.54       |   | $ | 1.29 |   | $ | 0.63 |   |
| Weighted average  shares outstanding used to calculate per share information: |       |                                        |       |   |   |   |   |
| Basic                                                                         |       | 22,810                                      |       | 21,786 |   | 21,221 |   |
| Diluted                                                                       |       | 23,522                                      |       | 22,699 |   | 22,209 |   |

 

See accompanying Notes.

67

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**DJO IncorporatedCONSOLIDATED 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, 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 |   |   |
| Stock options  granted for services                                            |       |                  | —     |        |       |                           | —     |                     |       |            | 54         |                   |       |       | —     |   |   |   | — |   |   |   | — | ** ** |   |   | 54 |   |   |
| Net proceeds from  issuance of common stock under Employee Stock Purchase Plan |       |                  | 63,964     |        |       |                           | 1          |                     |       |            | 1,709      |                   |       |       | —     |   |   |   | — |   |   |   | — | ** ** |   |   | 1,710 |   |   |
| Net proceeds from  exercise of stock options                                   |       |                  | 1,116,110  |        |       |                           | 11         |                     |       |            | 15,820     |                   |       |       | —     |   |   |   | — |   |   |   | — | ** ** |   |   | 15,831 |   |   |
| Tax benefit of  stock option exercises                                         |       |                  | —     |        |       |                           | —     |                     |       |            | 2,709      |                   |       |       | —     |   |   |   | — |   |   |   | — | ** ** |   |   | 2,709 |   |   |
| Stock-based  compensation                                                      |       |                  | —     |        |       |                           | —     |                     |       |            | 9,763      |                   |       |       | —     |   |   |   | — |   |   |   | — | ** ** |   |   | 9,763 |   |   |
| Comprehensive income:                                                          |       |                  |       |        |       |                           |       |                     |       |            |       |                   |       |       |       |   |   |   |   |   |   |   |   | ** ** |   |   |   |   |   |
| Foreign currency  translation adjustment                                       |       |                  | —     |        |       |                           | —     |                     |       |            | —     |                   |       |       | —     |   |   |   | 2,420 |   |   |   | — | ** ** |   |   | 2,420 |   |   |
| Change in fair  value of derivative                                            |       |                  | —     |        |       |                           | —     |                     |       |            | —     |                   |       |       | —     |   |   |   | (928 | ) |   |   | — | ** ** |   |   | (928 | ) |   |
| Net income                                                                     |       |                  | —     |        |       |                           | —     |                     |       |            | —     |                   |       |       | —     |   |   |   | — |   |   |   | 12,641 | ** ** |   |   | 12,641 |   |   |
| Total  comprehensive income                                                    |       |                  |       |        |       |                           |       |                     |       |            |       |                   |       |       |       |   |   |   |   |   |   |   |   | ** ** |   |   | 14,133 |   |   |
| **Balance  at December 31, 2006**                                         |       |                  | 23,317,934 |        |       |                           | $          | 233                      |       |            |       | $                      | 163,711    |       |       |   | $ | — |   |   |   | $ | 1,984 |   |   |   | $ | 104,341 | ** ** |   |   | $ | 270,269 |   |   |

 

See accompanyingNotes.

68

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**DJO IncorporatedCONSOLIDATED STATEMENTS OF CASH FLOWS(In thousands)**

| ** **                                                                          | ** ** | **Years Ended December 31,** | ** ** |
|-------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                          | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Operating activities**                                                            |       |                                        |       |   |   |   |   |
| Net income                                                                          |       | $                                           | 12,641     |   | $ | 29,198 |   | $ | 14,015 |   |
| Adjustments to reconcile  net income to net cash provided by operating activities:  |       |                                        |       |   |   |   |   |
| Provision for contractual allowances and doubtful  accounts                         |       | 42,546                                      |       | 34,594 |   | 30,556 |   |
| Provision for excess and obsolete inventories                                       |       | 1,432                                       |       | 983 |   | (113 | ) |
| Restructuring costs                                                                 |       | —                                      |       | — |   | 4,693 |   |
| Depreciation and amortization                                                       |       | 26,288                                      |       | 13,320 |   | 13,070 |   |
| Step-up to fair value of inventory charged to costs  of goods sold                  |       | 1,498                                       |       | 404 |   | 438 |   |
| Amortization of debt issuance costs and discount on  senior subordinated notes      |       | 867                                         |       | 560 |   | 808 |   |
| Write-off of debt issuance costs and discount on  senior subordinated notes         |       | 2,347                                       |       | — |   | 3,025 |   |
| Liquidation preference on redemption of senior  subordinated notes                  |       | —                                      |       | — |   | 4,735 |   |
| Write-off of property, plant and equipment                                          |       | 852                                         |       | — |   | — |   |
| Excess tax benefits from stock options exercised                                    |       | (2,709                                      | )          | — |   | — |   |
| Stock-based compensation                                                            |       | 9,674                                       |       | — |   | — |   |
| Other                                                                               |       | 52                                          |       | 219 |   | 63 |   |
| Changes  in operating assets and liabilities:                                       |       |                                        |       |   |   |   |   |
| Accounts receivable                                                                 |       | (56,115                                     | )          | (49,681 | ) | (33,353 | ) |
| Inventories                                                                         |       | (15,465                                     | )          | (2,599 | ) | (3,635 | ) |
| Other assets                                                                        |       | 155                                         |       | 912 |   | 856 |   |
| Accounts payable                                                                    |       | 498                                         |       | 2,970 |   | (1,403 | ) |
| Accrued compensation                                                                |       | (819                                        | )          | 826 |   | (1,065 | ) |
| Accrued commissions                                                                 |       | 650                                         |       | (942 | ) | (214 | ) |
| Accrued interest                                                                    |       | 3,599                                       |       | (333 | ) | (15 | ) |
| Deferred income taxes, including excess stock option  exercise benefits in 2006     |       | 8,766                                       |       | 17,580 |   | 9,044 |   |
| Accrued restructuring costs                                                         |       | (417                                        | )          | (1,871 | ) | (3,171 | ) |
| Other accrued liabilities                                                           |       | 4,856                                       |       | 924 |   | 1,136 |   |
| Net cash provided by operating activities                                           |       | 41,196                                      |       | 47,064 |   | 39,470 |   |
| **Investing  activities**                                                           |       |                                        |       |   |   |   |   |
| Purchases of property, plant and equipment                                          |       | (16,009                                     | )          | (5,144 | ) | (5,959 | ) |
| Net proceeds from disposals of property, plant and  equipment                       |       | 4,221                                       |       | — |   | — |   |
| Purchase of Axmed business                                                          |       | (16,564                                     | )          | — |   | — |   |
| Purchase of Aircast business                                                        |       | (299,702                                    | )          | — |   | — |   |
| Purchase of Superior Medical Equipment business                                     |       | —                                      |       | (3,045 | ) | — |   |
| Purchase of Encore Medical OSG business                                             |       | —                                      |       | (9,491 | ) | — |   |
| Purchase of dj Nordic business and related earn-out  payments, net of cash acquired |       | (125                                        | )          | (125 | ) | (578 | ) |
| Purchases of intangible assets                                                      |       | —                                      |       | (76 | ) | (3,277 | ) |
| Change in other assets, net                                                         |       | (1,140                                      | )          | (1,454 | ) | (360 | ) |
| Net cash used in investing activities                                               |       | (329,319                                    | )          | (19,335 | ) | (10,174 | ) |
| **Financing  activities**                                                           |       |                                        |       |   |   |   |   |
| Proceeds from long-term debt                                                        |       | 366,000                                     |       | 8,000 |   | — |   |
| Repayment of long-term debt                                                         |       | (86,250                                     | )          | (55,500 | ) | (5,000 | ) |
| Net proceeds from exercise of stock options                                         |       | 15,831                                      |       | 7,721 |   | 4,133 |   |
| Net proceeds from issuance of common stock under  Employee Stock Purchase Plan      |       | 1,710                                       |       | 1,028 |   | 1,617 |   |
| Excess tax benefits from stock options exercised                                    |       | 2,709                                       |       | — |   | — |   |
| Debt issuance costs                                                                 |       | (6,369                                      | )          | (665 | ) | (313 | ) |
| Proceeds from payment of notes receivable                                           |       | —                                      |       | 1,749 |   | 331 |   |
| 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 provided by (used in) financing activities                                 |       | 293,631                                     |       | (37,667 | ) | (37,469 | ) |
| Effect of exchange rate changes on cash and cash  equivalents                       |       | 391                                         |       | (137 | ) | 209 |   |
| Net increase (decrease) in cash and cash equivalents                                |       | 5,899                                       |       | (10,075 | ) | (7,964 | ) |
| Cash and cash equivalents at beginning of year                                      |       | 1,107                                       |       | 11,182 |   | 19,146 |   |
| Cash and cash equivalents at end of year                                            |       | $                                           | 7,006      |   | $ | 1,107 |   | $ | 11,182 |   |
| **Supplemental  disclosure of cash flow information:**                              |       |                                        |       |   |   |   |   |
| Interest paid                                                                       |       | $                                           | 15,220     |   | $ | 4,436 |   | $ | 3,844 |   |
| Income taxes paid,  net                                                             |       | $                                           | 1,984      |   | $ | 1,263 |   | $ | 618 |   |

 

See accompanying Notes.

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**DJO IncorporatedNOTES TO CONSOLIDATED FINANCIAL STATEMENTS(In thousands)**

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

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

*Basis ofPresentation and Principles of Consolidation*

The accompanyingconsolidated financial statements present the historical financial position andresults of operations of the Company and include the accounts of its operatingsubsidiary, DJO, LLC, formerly dj Orthopedics, LLC, (DJO), DJO’s wholly ownedMexican subsidiary that manufactures a majority of DJO’s products under Mexico’smaquiladora program and DJO’s wholly owned subsidiaries in Canada, Germany,France, the United Kingdom, Denmark, Spain and Tunisia. These consolidatedfinancial statements also include the accounts of Aircast Incorporated and itswholly owned domestic and international subsidiaries from and subsequent to April 7,2006, the date on which the Company acquired Aircast Incorporated (see Note 3).All intercompany accounts and transactions have been eliminated inconsolidation. In May 2006, the Company purchased the minority stockholders’proportionate share of the net assets of the Company’s subsidiary in Tunisiaand the Tunisian subsidiary became a wholly owned subsidiary (see Note 3).

*Use of Estimates inthe Preparation of Financial Statements*

The preparation of thesefinancial statements requires that the Company make estimates and judgmentsthat affect the reported amounts of assets, liabilities, revenues and expensesand related disclosure of contingent assets and liabilities. On an ongoingbasis, the Company evaluates its estimates, including those related tocontractual allowances, doubtful accounts, inventories, rebates, productreturns, warranty obligations, income taxes, intangible assets and stock-basedcompensation. The Company bases its estimates on historical experience and onvarious other assumptions that are believed to be reasonable under thecircumstances, the results of which form the basis for making judgments aboutthe carrying values of assets and liabilities that are not readily apparentfrom other sources. Actual results may differ from these estimates.

*Cash Equivalents*

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

*Fair Value ofFinancial Instruments*

In accordance withFinancial Accounting Standards Board (FASB) Statement of Financial AccountingStandards (SFAS) No. 107, *Disclosures about FairValue of Financial Instruments*, the following methods andassumptions were used in estimating fair value disclosures:

·       *Cash and Cash Equivalents and Accounts Receivable.  *Thecarrying amounts approximate fair values because of the short maturities ofthese instruments and the reserves for contractual allowances and doubtfulaccounts which, in the opinion of management, are adequate to state accountsreceivable at their fair value.

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·       *Long-Term Debt.  *Based on the borrowing rates currentlyavailable to the Company for loans with similar terms and average maturities,management of the Company believes the fair value of long-term debtapproximates its carrying value at December 31, 2006.

·       *DerivativeInstruments.*   The Company utilizes derivative instruments,specifically an interest rate swap agreement and forward contracts, to manageits exposure to market risks such as interest and foreign currency exchangerate risks. In accordance with the Financial Accounting Standards Board (FASB)Statement of Financial Accounting Standards (SFAS) No. 133, *Accounting for Derivative Instruments and HedgingActivities*, the Company records derivative instruments as assets orliabilities in the consolidated balance sheet, measured at fair value.

*Accrued Pension*

The Company assumedliabilities related to certain pension plans in connection with the acquisitionof Aircast Incorporated in April 2006. The pension plans cover two currentinternational employees and one former international employee of the Companywho are entitled to pension benefits as part of the terms of their employmentagreements. The accrued pension costs were $0.2 million as of December 31,2006.

*Discounts andAllowances*

Accounts receivable in theaccompanying consolidated balance sheets are presented net of reserves forestimated payment discounts and allowances for doubtful accounts. Accountsreceivable is also presented net of contractual allowances for reimbursementamounts from our third-party payor customers based on negotiated contracts andhistorical experience for non-contracted payors.

*Long-Lived Assets*

Property, plant andequipment and intangible assets are recorded at cost. The Company provides fordepreciation of property, plant and equipment (three to seven years) andamortization of intangible assets (four months to 20 years) using thestraight-line method over the estimated useful lives of the assets. Leaseholdimprovements are amortized over the lesser of their estimated useful lives orthe terms of the related leases.

*Computer SoftwareCosts*

The Company applies theAmerican Institute of Certified Public Accountants Statement of Position 98-1,*Accounting for Costs of Computer Software Developedor Obtained for Internal Use*. This standard requires companies tocapitalize qualifying computer software costs, incurred during the applicationdevelopment stage and then amortizes the costs over the estimated useful lifeof the software. The Company is amortizing computer software costs over livesof three to seven years. The Company has unamortized capitalized computersoftware costs aggregating $2.1 million and $2.2 million at December 31,2006 and 2005, respectively. Capitalized computer software amortization expensewas approximately $1.3 million, $1.1 million and $1.3 million for the yearsended December 31, 2006, 2005 and 2004, respectively.

*Debt Issuance Costs*

Debt issuance costs arecapitalized. The Company amortizes these costs over the lives of the relateddebt instruments (currently, five years) and classifies the amortizationexpense with interest expense in the accompanying consolidated statements ofincome.

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*Inventories*

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

*Revenue Recognition*

The Company distributes its products in the UnitedStates 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 recognizesrevenue pursuant to Staff Accounting Bulletin (SAB) No. 104, *Revenue Recognition*. Accordingly, revenue is recognized whenall four of the following criteria are met: (i) persuasive evidence thatan arrangement exists; (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 includes amounts billed to customers for freight inrevenue.

*Warranty Costs*

Some products have a limited warranty and estimatedwarranty costs are accrued based on historical experience in the period salesare recognized. Warranty costs are included in costs of goods sold and were$0.6 million, $0.9 million and $1.3 million for the years ended December 31,2006, 2005 and 2004, respectively.

Changesin accrued warranty during the three years ended December 31, 2006, 2005and 2004 are as follows (in thousands):

| Balance at  December 31, 2003 |   | $      | 424    |   |
|------------------------------------|--------|--------|--------|--------|
| Warranty expense accrued           |   | 1,261  |   |
| Warranty costs incurred            |   | (1,284 | )      |
| Balance at  December 31, 2004 |   | 401    |   |
| Warranty expense accrued           |   | 872    |   |
| Warranty costs incurred            |   | (880   | )      |
| Balance at  December 31, 2005 |   | 393    |   |
| Warranty expense accrued           |   | 583    |   |
| Warranty costs incurred            |   | (548   | )      |
| Balance at  December 31, 2006 |   | $      | 428    |   |

 

*Advertising Expense*

Advertising costs areexpensed as incurred. The Company incurred $1.1 million, $0.7 million and $0.5 millionin advertising expenses for the years ended December 31, 2006, 2005 and2004, respectively.

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*Foreign CurrencyTranslation*

The financial statementsof the Company’s international operations where the local currency is thefunctional currency are translated into United States (U.S.) dollars usingperiod-end exchange rates for assets and liabilities and average exchange ratesduring the period for revenues and expenses. Cumulative translation gains andlosses are excluded from results of operations and recorded as a separatecomponent of consolidated stockholders’ equity. Gains and losses resulting fromforeign currency transactions (transactions denominated in a currency otherthan the entity’s local currency) are included in the consolidated statementsof operations as either a component of costs of goods sold or other income orexpense, depending on the nature of the transaction. The aggregate exchangerate gain or (loss) included in determining net income for the years ended December 31,2006, 2005 and 2004 was $0.2 million, ($0.6) million and $0.6 million,respectively.

*Concentration ofCredit Risk*

The Company sells the majority of its products in theUnited States to orthopedic professionals, distributors, specialty dealers,buying groups, insurance companies, managed care companies and certaingovernmental payors such as Medicare. International sales comprised 20%, 12%and 11% of the Company’s net revenues for the years ended December 31,2006, 2005 and 2004, 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 45% and 49% of the Company’s net receivables at December 31,2006 and 2005, respectively, are from third-party payors. Management reviewsand revises its estimates for credit losses from time to time and such creditlosses have been within management’s estimates.

During the three yearsended December 31, 2006, the Company had no individual customer ordistributor that accounted for 10% or more of total annual revenues.

*Per ShareInformation*

Earningsper share are computed in accordance with SFAS No. 128, *Earnings Per Share*. Basic earnings per share are computedusing the weighted average number of common shares outstanding during eachperiod. Diluted earnings per share include the dilutive effect of weightedaverage common share equivalents potentially issuable upon the exercise ofstock options. For purposes of computing diluted earnings per share, weightedaverage common share equivalents (computed using the treasury stock method) donot include stock options with an exercise price that exceeds the average fairmarket value of the Company’s common stock during the periods presented. Dilutivesecurities totaling 0.3 million, 0.2 millon and 1.6 million shares for theyears ended December 31, 2006, 2005 and 2004, respectively, were excludedfrom diluted earnings per share because of their anti-dilutive effect. For theyears ended December 31, the weighted average shares outstanding used tocalculate basic and diluted share information consist of the following (inthousands):

| ** **                                                                          | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|-------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Shares used in  basic net income per share—weighted average shares outstanding |       | 22,810   |       | 21,786   |       | 21,221   |       |
| Net effect of  dilutive common share equivalents based on treasury stock method     |       | 712      |       | 913      |       | 988      |       |
| Shares used in  computations of diluted net income per share                        |       | 23,522   |       | 22,699   |       | 22,209   |       |

 

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*Stock-BasedCompensation*

Prior to the adoption of SFAS No. 123 (revised 2004), *Share-Based Payment* (SFAS No. 123(R)) on January 1, 2006, the Companyaccounted for its employee stock option plans and employee stock purchase planusing the recognition and measurement principles of Accounting Principles Board(APB) Opinion No. 25, *Accounting forStock Issued to Employees*and its related interpretations, and hadadopted the disclosure only provisions of SFAS No. 123, *Accounting for Stock-Based Compensation*andits related interpretations. Accordingly, no compensation expense wasrecognized in net income for the Company’s fixed stock option plans or itsemployee stock purchase plan (ESPP), as all options granted under those planshad an exercise price equal to the market value of the underlying common stockon the date of grant (or within permitted discounted prices as it pertains tothe ESPP).

As of January 1, 2006, the Company beganrecording compensation expense associated with stock options and otherequity-based compensation in accordance with SFAS No. 123(R), using the modified prospectivetransition method and therefore has not restated results for prior periods. Underthe modified prospective transition method, stock-based compensation expensefor 2006 includes: 1) compensation expense for all stock-based awards grantedon or after January 1, 2006 as determined based on the grant date fairvalue estimated in accordance with the provisions of SFAS No. 123(R) and2) stock-based compensation awards granted prior to, but not yet vested as of January 1,2006, based on the grant date fair value estimated in accordance with theoriginal provisions of SFAS No. 123. The Company recognizes thesecompensation costs on a straight-line basis over the requisite service periodof the award, which is generally four years. As a result of the adoption ofSFAS No. 123(R), the Company’s net income for the year ended December 31,2006, has been reduced by stock-based compensation expense, net of taxes, ofapproximately $7.7 million. See Note 7 for additional information regardingstock-based compensation.

Through December 31,2006, the Company accounted for its employee stock option plans and employeestock purchase plan under the recognition and measurement principles ofAccounting Principles Board (APB) Opinion No. 25, *Accountingfor Stock Issued to Employees*and its related interpretations, andhas adopted the disclosure only provisions of SFAS No. 123, *Accounting for Stock-Based Compensation*and its relatedinterpretations. Accordingly, no compensation cost has been recognized for theCompany’s fixed stock option plans or stock purchase plan. In accordance withEITF 96-18, *Accounting for EquityInstruments That Are Issued to Other Than Employees for Acquiring, or inConjunction with Selling, Goods or Services*, stock options andwarrants issued to consultants and other non-employees as compensation forservices provided to the Company are accounted for based upon the fair value ofthe services provided or the estimated fair market value of the option orwarrant, whichever can be more clearly determined. The Company recognizes thisexpense over the period the services are provided; however, the amount ofexpense related to these types of arrangements has never been significant.

*Income Taxes*

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

*ComprehensiveIncome (Loss)*

The Company has adoptedSFAS No. 130, *Reporting ComprehensiveIncome*, which requires that all components of comprehensive income(loss), including net income (loss), be reported in the financial statements inthe period in which they are recognized. Comprehensive income (loss) is definedas the change in equity during a period from transactions and other events andcircumstances from non-owner 

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sources.Net income (loss) and other comprehensive income (loss), including foreigncurrency translation adjustments, and unrealized gains and losses oninvestments, are reported, net of related tax, to arrive at comprehensiveincome (loss).

*Recently IssuedAccounting Standards*

In June 2006, the FASB issued FASB InterpretationNo. 48, *Accounting for Uncertainty in Income Taxes—aninterpretation of SFAS No. 109, Accounting for Income Taxes*,(FIN 48). FIN 48 prescribes a comprehensive model for how companies shouldrecognize, measure, present, and disclose in their financial statementsuncertain tax positions taken or expected to be taken on a tax return. UnderFIN 48, tax positions shall initially be recognized in the financial statementswhen it is more likely than not the position will be sustained upon examinationby the tax authorities. Such tax positions shall initially and subsequently bemeasured as the largest amount of tax benefit that is greater than 50% likelyof being realized upon ultimate settlement with the tax authority assuming fullknowledge of the position and all relevant facts. FIN 48 also revisesdisclosure requirements to include an annual tabular rollforward ofunrecognized tax benefits. The provisions of this interpretation are requiredto be adopted for fiscal periods beginning after December 15, 2006. TheCompany will be required to apply the provisions of FIN 48 to all taxpositions upon initial adoption with any cumulative effect adjustment to berecognized as an adjustment to retained earnings. Management is currentlydetermining the impact to the Company’s financial statements of the adoption ofFIN 48.

In September 2006, the FASB issued SFAS No. 157,*Fair Value Measurements*, which providesa single definition of fair value, a framework for measuring fair value, andexpanded disclosures concerning fair value. Previously, different definitionsof fair value were contained in various accounting pronouncements creatinginconsistencies in measurement and disclosures. SFAS No. 157 appliesunder those previously issued pronouncements that prescribe fair value as therelevant measure of value, except Statement No. 123(R) and relatedinterpretations and pronouncements that require or permit measurement similarto fair value but are not intended to measure fair value. This pronouncement iseffective for fiscal years beginning after November 15, 2007. The Companydoes not expect the adoption of SFAS No. 157 to have a material impact onits consolidated financial statements.

In February 2007, theFASB issued SFAS No. 159, *The FairValue Option for Financial Assets and Financial Liabilities—Including anAmendment of FASB Statement No. 115.* This standard permits anentity to choose to measure many financial instruments and certain other itemsat fair value. Most of the provisions in SFAS No. 159 are elective;however, the amendment to SFAS No. 115, *Accountingfor Certain Investments in Debt and Equity Securities,* applies toall entities with available-for-sale and trading securities. The fair valueoption established by SFAS No. 159 permits all entities to choose tomeasure eligible items at fair value at specified election dates. A businessentity will report unrealized gains and losses on items for which the fairvalue option has been elected in earnings (or another performance indicator ifthe business entity does not report earnings) at each subsequent reportingdate. The fair value option: (a) may be applied instrument by instrument,with a few exceptions, such as investments otherwise accounted for by theequity method; (b) is irrevocable (unless a new election date occurs); and(c) is applied only to entire instruments and not to portions ofinstruments. SFAS No. 159 is effective as of the beginning of an entity’sfirst fiscal year that begins after November 15, 2007. The Company doesnot expect the adoption of SFAS No. 159 to have a material impact on itsconsolidated financial statements.

*Purchase of Rightsto Distributor Territories*

From time to time theCompany purchases rights to certain distributor territories in the U.S. andthen sells the distribution rights to another party for similar amounts. Thesedistribution reorganizations are intended to achieve several objectives,including improvement of sales results within the affected territories. TheCompany generally receives promissory notes for the resale amounts, which arerecorded 

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as notesreceivable and included in other current and long-term assets in theaccompanying consolidated balance sheets. For the years ended December 31,2006 and December 31, 2005, the Company purchased and resold territoryrights for amounts aggregating $3.3 million and $2.1 million, respectively, anddid not record any gains or losses from the transfer of these distributionrights. For the years ended December 31, 2006 and 2005, purchase priceaggregating $3.3 million and $2.0 million, respectively, was recorded as notesreceivable and is included in other current or long-term assets, depending onmaturity, and will be repaid over periods ranging from three years to fiveyears. For the year ended December 31, 2005, purchase price aggregating$0.1 million, 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 other intangibleassets in accordance with SFAS No. 142, *Goodwilland Other Intangible Assets*. Under SFAS No. 142, goodwill istested annually and whenever events or circumstances occur indicating thatgoodwill might be impaired. On an ongoing basis, absent any indicators of impairment,the Company performs an annual impairment evaluation during the fourth quarter,as of October 1 each year of its goodwill balances that were acquiredthrough the end of the previous fiscal year. 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 goodwill related to the Regenerationacquisition, the Company compares the carrying value of the goodwill related tothe Regeneration segment to the fair value of the Regeneration segment.

The Company has acquired licenses to certain patentsaggregating $4.2 million. These amounts are recorded as intangible assets andare amortized over the remaining life of the patents, through June 2010.

Componentsof intangible assets acquired in business combinations and acquired asindividual assets are as follows (in thousands):

| ** **                                      | ** ** | **December 31, 2006** | ** ** | **December 31, 2005** | ** ** |
|-------------------------------------------------|------------|---------------------------------|------------|---------------------------------|------------|
| ** **                                      | ** ** | **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                            |       | $                               | 83,701     |   |   | $ | (27,209 | ) |   | $ | 56,492 |   | $ | 53,887 |   |   | $ | (20,722 | ) |   | $ | 33,165 |   |
| Customer base                                   |       | 15-20                           |       | 69,457                          |       |   | (16,005 | ) |   | 53,452 |   | 21,173 |   |   | (8,125 | ) |   | 13,048 |   |
| Trademarks                                      |       | 20                              |       | 47,511                          |       |   | (1,911 | ) |   | 45,600 |   | — |   |   | — |   |   | — |   |
| Licensing agreements                            |       | 5                               |       | 4,200                           |       |   | (1,498 | ) |   | 2,702 |   | 4,200 |   |   | (1,076 | ) |   | 3,124 |   |
| Other                                           |       | 0.3-20                          |       | 2,984                           |       |   | (1,106 | ) |   | 1,878 |   | 4,465 |   |   | (2,560 | ) |   | 1,905 |   |
|                                            |       |                            |       | $                               | 207,853    |   |   | $ | (47,729 | ) |   | $ | 160,124 |   | $ | 83,725 |   |   | $ | (32,483 | ) |   | $ | 51,242 |   |
| Intangible assets not  subject to amortization: |       |                            |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Goodwill                                        |       | N/A                             |       | $                               | 291,443    |   |   | $ | (13,948 | ) |   | $ | 277,495 |   | $ | 115,183 |   |   | $ | (13,948 | ) |   | $ | 101,235 |   |

 

Amortization expense related to intangible assets was$17.2 million, $7.6 million and $7.0 million for the years ended December 31,2006, 2005 and 2004, respectively.

Future amortization expense of intangible assets isestimated to be $160.1 million, as follows: 2007 - $19.8million, 2008 - $19.0 million, 2009 - $17.7 million, 2010 - $17.6 million, 2011- $17.4 million and thereafter - $68.6 million.

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Thechange in the carrying value of goodwill from December 31, 2004 throughDecember 31, 2006 is as follows (in thousands):

| Balance at  December 31, 2004           |   | $              | 96,639  |   |
|----------------------------------------------|--------|----------------|---------|--------|
| Acquired Superior Medical Equipment goodwill |   | 2,373          |    |
| Acquired Encore Medical goodwill             |   | 2,301          |    |
| Other, primarily purchase price adjustments  |   | (78            | )       |
| Balance at  December 31, 2005           |   |   101,235 |    |
| Acquired Axmed goodwill (see Note 3)         |   | 14,637         |    |
| Acquired Aircast goodwill (see Note 3)  |   | 159,384        |    |
| Other, primarily purchase price adjustments  |   | 2,239          |    |
| Balance at  December 31, 2006           |   | $              | 277,495 |   |

 

**2.**                 FinancialStatement Information

*Inventories.*   Inventoriesconsist of the following at December 31 (in thousands):

| ** **                                                    | ** ** | **2006** | ** ** | **2005** | ** ** |
|---------------------------------------------------------------|------------|----------|------------|----------|------------|
| Raw materials                                                 |       | $        | 17,920     |     | $          | 7,335 |   |
| Work-in-progress                                              |       | 753      |       | 1,010    |       |
| Finished goods                                                |       | 30,615   |       | 18,203   |       |
|                                                          |       | 49,288   |       | 26,548   |       |
| Less reserves,  primarily for excess and obsolete inventories |       | (2,074   | )          | (2,320   | )          |
|                                                          |       | $        | 47,214     |     | $          | 24,228 |   |

 

*Prepaid Expenses and OtherCurrent Assets.*   Prepaid expenses and othercurrent assets consist of the following at December 31 (in thousands): 

| ** **                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
|-------------------------------------------------|------------|----------|------------|----------|------------|
| Held-for-sale  assets                           |       | $        | 6,960      |     | $          | — |   |
| Prepaid expenses                                |       | 4,050    |       | 2,992    |       |
| Other current  assets                           |       | 3,511    |       | 1,395    |       |
| Prepaid expenses and  other current assets, net |       | $        | 14,521     |     | $          | 4,387 |   |

 

Held-for-sale assets consist of the Aircastmanufacturing facility in New Jersey and the Aircast Germany facility. Theseheld-for-sale facilities were vacated in connection with the Company’sintegration of the Aircast business and are no longer in use.

*Property, Plant andEquipment.*   Property, plant and equipmentconsists of the following at December 31 (in thousands):

| ** **                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
|-------------------------------------------------|------------|----------|------------|----------|------------|
| Leasehold  improvements                         |       | $        | 10,703     |     | $          | 5,514 |   |
| Furniture,  fixtures and equipment              |       | 60,540   |       | 43,537   |       |
|                                            |       | 71,243   |       | 49,051   |       |
| Less accumulated  depreciation and amortization |       | (38,544  | )          | (33,655  | )          |
|                                            |       | $        | 32,699     |     | $          | 15,396 |   |

 

Depreciation expense was approximately $8.4 million,$5.1 million and $5.3 million for the years ended December 31, 2006, 2005and 2004, respectively, and amortization of leasehold improvements 

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included in property,plant and equipment was approximately $0.7 million, $0.6 million and $0.7million for the years ended December 31, 2006, 2005 and 2004,respectively.

AccruedCompensation*.*Accrued compensation consists of thefollowing at December 31 (in thousands):

| ** **                                        | ** ** | **2006** | ** ** | **2005** | ** ** |
|---------------------------------------------------|------------|----------|------------|----------|------------|
| Accrued vacation                                  |       | $        | 2,894      |     | $          | 1,884 |   |
| Accrued bonus                                     |       | 1,398    |       | 1,874    |       |
| Accrued workers’  compensation               |       | 854      |       | 1,558    |       |
| Accrued severance  related to Aircast acquisition |       | 7,427    |       | —   |       |
| Other accrued  compensation                       |       | 1,598    |       | 994      |       |
|                                              |       | $        | 14,171     |     | $          | 6,310 |   |

 

*Other AccruedLiabilities*

Otheraccrued liabilities, current portion, consists of the following at December 31(in thousands):

| ** **                                  | ** ** | **2006** | ** ** | **2005** | ** ** |
|---------------------------------------------|------------|----------|------------|----------|------------|
| Accrued contract  fees                      |       | $        | 2,626      |     | $          | 1,743 |   |
| Accrued  professional fees                  |       | 1,326    |       | 750      |       |
| Deferred rent,  current portion             |       | 453      |       | 250      |       |
| Other accrued  liabilities, current portion |       | 18,562   |       | 6,937    |       |
|                                        |       | $        | 22,967     |     | $          | 9,680 |   |

 

Otheraccrued liabilities, long-term, consists of the following at December 31(in thousands):

| ** **                        | ** ** | **2006** | ** ** | **2005** | ** ** |
|-----------------------------------|------------|----------|------------|----------|------------|
| Deferred rent,  long-term         |       | $        | 3,355      |     |       | $ | — |   |   |
| Fair value of  interest rate swap |       | 928      |       |     | —     |   |   |
|                              |       | $        | 4,283      |     |       | $ | — |   |   |

 

Deferred rent relatesprimarily to the Company’s new headquarters in Vista, California (see Note 10).

**3.**                 Acquisitions

TheCompany accounts for acquisitions in accordance with SFAS No. 141, *Business Combinations*. SFAS No. 141replaced prior accounting standards and eliminated pooling-of-interestsaccounting prospectively. It also provides guidance on purchase accountingrelated to the recognition of intangible assets and accounting for negativegoodwill.

*Aircast Acquisition*

On April 7, 2006, the Company completed theacquisition, under an agreement signed on February 27, 2006, of all theoutstanding capital stock of Aircast Incorporated (Aircast) for approximately$291.6 million in cash, funded with the proceeds of a new credit agreement asdescribed in Note 5. The Company also incurred approximately $4.9 million intransaction costs and other expenses in connection with the acquisition andaccrued approximately $11.1 million of estimated costs in connection with theCompany’s plan to integrate the acquired business, including severanceexpenses. Of this total estimated amount, approximately $7.4 million is relatedto severance and retention payments that had not been paid out as of December 31,2006. This amount is included in accrued compensation in the accompanyingunaudited consolidated balance sheet at December 31, 2006. Aircast is aleading designer and 

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manufacturer of ankle andother orthopedic bracing products, cold therapy products and vascular therapysystems.

In April 2006, the Company began its integration ofthe Aircast business.  The integrationplan consisted of: 1) integrating the Aircast sales force into the Company’sexisting sales force, 2) closing the Aircast New Jersey manufacturing facilityand moving the manufacturing of the Aircast products to the Company’s Tijuana,Mexico manufacturing facility, other than the vascular systems products, whichwere moved to the Company’s Vista, California facility, 3) closing the AircastNew Jersey corporate headquarters and integrating the administrative functionsinto the Company’s Vista facility and the Company’s distribution facility inIndianapolis, Indiana, and 4) closing various international Aircast locations andintegrating their operations into the Company’s existing locations in thosecountries, including France, Germany and the United Kingdom.  In conjunction with this integration plan,the Company accrued approximately $11.4 million in severance costs for approximately300 Aircast employees.  The Companyexpects to complete the termination of the affected Aircast employees by March2007.

Severance costs accrued in2006 for Aircast employees as a result of the Company’s integration of theacquired business are as follows (in thousands):

| ** **         | ** ** | **Total Costs  Incurred** | ** ** | **Cash Payments** | ** ** | **Accrued Liability   At December 31,  2006** | ** ** |
|--------------------|------------|--------------------------------|------------|------------------------|------------|-------------------------------------------------------------------|------------|
| Employee severance |       |                           | $          | 11,371                 |       |                                                              |       | $ | (3,944 | ) |   |   | $ | 7,427 |   |   |
|                    |            |                                |            |                        |            |                                                                   |            |  |  |  |  |  |  |  |  |  |

 

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Thefair values of the assets acquired and the liabilities assumed in connectionwith the Aircast acquisition were estimated in accordance with SFAS No. 141,*Business Combinations* and SFAS No. 142,*Goodwill and Other Intangible Assets*. The Company used a third-partyvaluation firm to assist management in estimating these fair values. The purchaseprice remains preliminary as of December 31, 2006 and may be subject toadjustment as the Company finalizes its estimates of certain items, including severanceamounts for Aircast employees terminated as a result of the Company’sintegration of the acquired business, values of held-for-sale assets, certainacquired inventories and accounts receivable and accruals for certain contingentliabilities that existed on the acquisition date. The purchase price wasallocated as follows to the fair values of the net tangible and intangibleassets acquired, including thecumulative impact of adjustments made to such allocations through December 31,2006:

| Fair value of net  tangible assets acquired and liabilities assumed (in thousands): |   |   |   |    |    |
|-------------------------------------------------------------------------------------|--------|--------|--------|---------|---------|
| Cash                                                                                |   | $      | 508    |    |    |   |
| Accounts receivable, net                                                            |   | 12,957 |   |    |    |
| Inventories, net                                                                    |   | 8,134  |   |    |    |
| Prepaid expenses and other current assets                                           |   | 2,730  |   |    |    |
| Fixed assets, net                                                                   |   | 17,787 |   |    |    |
| Deferred tax asset                                                                  |   | 3,371  |   |    |    |
| Other assets                                                                        |   | 33     |   |    |    |
| Accounts payable                                                                    |   | (3,134 | )      |    |    |
| Accrued compensation                                                                |   | (986   | )      |    |    |
| Deferred tax liability                                                              |   | (6,706 | )      |    |    |
| Other accrued liabilities                                                           |   | (8,041 | )      |    |    |
| Accrued pension                                                                     |   | (300   | )      |    |    |
|                                                                                |   |   |   | 26,353  |    |
| Fair value of  identifiable intangible assets acquired:                             |   |   |   |    |    |
| Patents and existing technology                                                     |   | 28,700 |   |    |    |
| Customer contracts and related relationships—GPO                               |   | 6,900  |   |    |    |
| Customer contracts and related relationships—Other                             |   | 38,300 |   |    |    |
| Trade names and trademarks                                                          |   | 47,400 |   |    |    |
| Favorable leasehold interest in Germany                                             |   | 600    |   |    |    |
|                                                                                |   |   |   | 121,900 |    |
| Goodwill                                                                            |   |   |   | 159,384 |    |
| Total purchase price  allocation                                                    |   |   |   | $       | 307,637 |   |
|                                                                                     |        |        |        |         |         |  |  |

 

The identifiable intangible assets are being amortizedover their estimated useful lives, which range from seven to twenty years.

The purchase price allocation included values assignedto certain specific identifiable intangible assets aggregating $281.3 million.An aggregate value of $28.7 million was assigned to patents and existingtechnology, determined primarily by estimating the present value of futureroyalty costs that will be avoided due to the Company’s ownership of thepatents and technology acquired. An aggregate value of $6.9 million wasassigned to certain Aircast customer relationships for group purchaseorganization (GPO) customers and an aggregate value of $38.3 million wasassigned to certain Aircast customer relationships for other customers existingon the acquisition date based upon an estimate of the future discounted cashflows that would be derived from those GPO and other customers. A value of $47.4million was assigned to trade names and trademarks, determined primarily byestimating the present value of future royalty costs that will be avoided dueto the Company’s ownership of the trade names and trademarks acquired. A valueof $0.6 million was assigned to favorable leasehold interest in Germany,determined by estimating the 

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present value of futurerent expense that will be avoided due to the favorable lease rate on the Germanproperty. A value of $159.4 million, representing the difference between thetotal purchase price and the aggregate fair values assigned to the net tangibleassets acquired and liabilities assumed and the identifiable intangible assetsacquired, was assigned to goodwill.

The Company acquired Aircast to expand its product offerings,increase the size of its international business and increase its revenues. TheCompany also believes there are significant cost reduction synergies that maybe realized when the acquired business is integrated. These are among thefactors that contributed to a purchase price for the Aircast acquisition thatresulted in the recognition of goodwill.

Theaccompanying consolidated statements of income reflect the operating results ofthe Aircast business since April 7, 2006. Assuming the acquisition ofAircast had occurred on January 1 of the respective years, the pro formaunaudited results of operations would have been as follows (in thousands):

| ** **                                                                    | ** ** | **Year Ended**        | ** ** |
|-------------------------------------------------------------------------------|------------|----------------------------|------------|
| ** **                                                                    | ** ** | **December 31, 2006** | ** ** | **December 31, 2005** | ** ** |
| Net revenues                                                                  |       |                       | $          | 437,980 |   |   |   | $ | 382,811 |   |   |
| Net income                                                                    |       |                       | $          | 10,635 |   |   |   | $ | 21,842 |   |   |
| Net income per share:                                                         |       |                       |       |   |   |   |   |   |   |
| Basic                                                                         |       |                       | $          | 0.47 |   |   |   | $ | 1.00 |   |   |
| Diluted                                                                       |       |                       | $          | 0.45 |   |   |   | $ | 0.96 |   |   |
| Weighted average shares  outstanding used to calculate per share information: |       |                       |       |   |   |   |   |   |   |
| Basic                                                                         |       |                       | 22,810     |   |   |   | 21,786 |   |   |
| Diluted                                                                       |       |                       | 23,522     |   |   |   | 22,699 |   |   |

 

The above pro formaunaudited results of operations do not include pro forma adjustments relatingto costs of integration or post-integration cost reductions that might havebeen incurred or realized by the Company prior to or in excess of actualamounts incurred or realized in the period from the actual acquisition date of April 7,2006 through December 31, 2006.

*Axmed Acquisition*

On January 2, 2006, the Company completed theacquisition, under an agreement originally signed on December 15, 2005, ofthe shares of Newmed SAS (Axmed) for cash payments aggregating 13 million Euros(approximately $15.8 million), which included payment of certain debts of Axmed.The Company expects to make additional payments of 0.9 million Euros(approximately $1.2 million) based on achievement of certain revenue targetsfor 2006 and profitability targets for the second half of 2006. The Companyincluded such future earn-out in the allocation of the original purchase price,as shown below, based on the expectation that the 2006 revenue targets will bemet. The Company also incurred $0.4 million in certain transaction costsand other expenses in connection with the acquisition. Axmed, through whollyowned subsidiaries in France and Spain, operating under the trade name Axmed,is engaged in the design, manufacture and sale of orthopedic rehabilitationdevices, including rigid knee braces and soft goods. Axmed also owned 70% of amanufacturing subsidiary in Tunisia, which provides low cost manufacturingcapabilities to the Axmed group. In May 2006, the Company purchased theminority stockholders’ proportionate share of the net assets of the Company’ssubsidiary in Tunisia for approximately $0.5 million and the Tunisiansubsidiary became a wholly owned subsidiary.

Thefair values of the assets acquired and the liabilities assumed in connectionwith the Axmed acquisition were estimated in accordance with SFAS No. 141,*Business Combinations* and SFAS No. 142,*Goodwill and Other Intangible Assets*.The Company used a third-party valuation firm to assist management inestimating these fair values. The total purchase price, including the amountpaid to acquire the minority 

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interest, was allocated as follows to the fair valuesof the net tangible and intangible assets acquired, including the cumulativeimpact of adjustments made to such allocations through December 31, 2006:

| Fair value of net  tangible assets acquired and liabilities assumed (in thousands): |   |   |   |   |   |
|-------------------------------------------------------------------------------------|--------|--------|--------|--------|--------|
| Cash                                                                                |   | $      | 103    |   |   |   |
| Accounts receivable, net                                                            |   | 1,642  |   |   |   |
| Inventories, net                                                                    |   | 2,228  |   |   |   |
| Other current assets                                                                |   | 312    |   |   |   |
| Fixed assets, net                                                                   |   | 691    |   |   |   |
| Other assets                                                                        |   | 47     |   |   |   |
| Accounts payable                                                                    |   | (3,436 | )      |   |   |
| Accrued compensation                                                                |   | (711   | )      |   |   |
| Deferred tax liability                                                              |   | (1,063 | )      |   |   |
| Other accrued liabilities                                                           |   | (498   | )      |   |   |
|                                                                                |   |   |   | (685   | )      |
| Fair value of  identifiable intangible assets acquired:                             |   |   |   |   |   |
| Customer relationships                                                              |   | 2,800  |   |   |   |
| Existing technology                                                                 |   | 1,000  |   |   |   |
| Trade names and trademarks                                                          |   | 100    |   |   |   |
|                                                                                |   |   |   | 3,900  |   |
| Goodwill                                                                            |   |   |   | 14,637 |   |
| Total purchase price  allocation                                                    |   |   |   | $      | 17,852 |   |
|                                                                                     |        |        |        |        |        |  |  |

 

The identifiable intangible assets are being amortizedover their estimated useful lives, which range from one to nine years.

The purchase price allocation included values assignedto certain specific identifiable intangible assets aggregating $3.9 million. Anaggregate value of $2.8 million was assigned to certain Axmed customerrelationships existing on the acquisition date based upon an estimate of thefuture discounted cash flows that would be derived from those customers. Avalue of $1.0 million was assigned to existing technology, determined primarilyby estimating the present value of future royalty costs that will be avoideddue to the Company’s ownership of the technology acquired. A value of $0.1million was assigned to trade names and trademarks, determined primarily byestimating the present value of future royalty costs that will be avoided dueto the Company’s ownership of the trade names and trademarks acquired. A valueof $14.6 million, representing the difference between the total purchaseprice, including the amount paid to acquire the remaining minority interest,and the aggregate fair values assigned to the net tangible assets acquired andliabilities assumed and the identifiable intangible assets acquired, wasassigned to goodwill.

The Company acquired theAxmed business to increase its sales and marketing presence in France andthrough the Axmed subsidiary in Spain, to develop a direct sales presence inSpain. Axmed also adds research and development capabilities in Europe, as wellas manufacturing capabilities in Tunisia which, although on a smaller scale,are very similar to the Company’s manufacturing capabilities in Mexico. Theseare among the factors that contributed to a purchase price for the Axmedacquisition that resulted in the recognition of goodwill.

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**4.**                 RestructuringCosts

Accrued restructuringcosts in the accompanying consolidated balance sheet at December 31, 2005,included $0.4 million of lease termination and other exit costs remaining froman amount accrued in 2002. This amount related to vacant land previously leasedby the Company and was netted against other costs accounted for as deferredrent at December 31, 2006 (see Note 10).

**5.**                 Long-TermDebt

TheCompany’s long-term debt consists of the following at December 31 (inthousands):

| ** **                                                                                         | ** ** | **2006** | ** ** | **2005** | ** ** |
|----------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| New term loan due  in installments through April 7, 2013 bearing interest at LIBOR plus  1.5% |       | $        | 327,250    |     | $          | — |   |
| Old term loan  paid off by new term loan in 2006                                                   |       | —   |       | 47,500   |       |
| Less current  portion                                                                              |       | (831     | )          | (5,000   | )          |
| Long-term portion of  term loan                                                                    |       | $        | 326,419    |     | $          | 42,500 |   |

 

*New CreditAgreement and Interest Rate Swap Agreement*

On April 7, 2006, the Company entered into a newcredit agreement with a syndicate of lenders and with Wachovia Bank, NationalAssociation, as administrative agent, to finance the Aircast acquisitiondescribed in Note 3 and provide available financing for future Companyoperations. The new credit agreement provided for total borrowings of $400million, consisting of a term loan of $350 million, which was fully drawn atclosing and up to $50 million available under a revolving credit facility. Asof December 31, 2006, the balance outstanding under the term loan was$327.3 million and $47.8 million was available under the revolving creditfacility, net of outstanding letters of credit. The new credit agreementreplaced the Company’s previously existing credit agreement and approximately$46.3 million of debt outstanding under the former agreement was paid off byborrowings under the new agreement. Under the new credit agreement, up to $25million of outstanding borrowings may be denominated in British Pounds orEuros.

Borrowings under the new term loan and on the newrevolving credit facility bear interest at variable rates (either a LIBOR rateor the lenders’ base rate, as elected by the Company) plus a margin. Under thenew agreement, the interest rate for the term loan is LIBOR plus a margin of1.50% (6.88% at December 31, 2006), or the lenders’ base rate plus amargin of 0.50%. The applicable margin on the revolving credit facility variesbased on the Company’s leverage ratio. The interest rate for the revolvingcredit facility is LIBOR plus an applicable margin of 1.25% to 2.00%, or thelenders’ base rate plus an applicable margin of 0.25% to 1.00%. At the Company’scurrent leverage ratio, the applicable interest rate on the revolving creditfacility is either LIBOR plus 1.75% or the lender’s base rate plus 0.75%. Inconnection with the new credit agreement, the Company entered into an interestrate swap agreement for a notional amount of $250 million of the term loan.

Subsequent to December 31, 2006, the Companyborrowed an aggregate of $5.0 million under the revolving credit facility toprovide funds needed to pay certain costs of the integration of Aircast.

*InterestRate Swap Agreement.*   On April 11, 2006, theCompany entered into an interest rate swap agreement with Wachovia Bank whichconverts the variable LIBOR rate to a fixed LIBOR rate of 5.29% for a term offive years. Accordingly, with respect to a notional amount of $250 million ofthe term loan, the Company’s interest rate is fixed at 6.79% (5.29% plusapplicable margin of 1.50%) for the term of the swap. The notional amount of$250 million is scheduled to amortize to zero over the term of the swap inproportion to expected future cash flows. As of December 31, 2006, theoutstanding notional amount of the interest rate swap was $250 million and thefair market value of the swap reflected a loss of 

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approximately $0.9 million.The Company’s interest rate swap qualifies as a cash flow hedge under SFAS No. 133,*Accounting for Derivative Instruments andHedging Activities*. In accordance with SFAS No. 133, the fairmarket value of the swap at December 31, 2006 was recorded as a long-termliability, with the change in such fair value accounted for in accumulatedother comprehensive income (loss) included in stockholders’ equity in theaccompanying consolidated balance sheet. The weighted average interest rateapplicable to the Company’s borrowings as of December 31, 2006 was 6.81%.

*Repayment.*   TheCompany was initially required to make quarterly principal payments of $0.9million on the term loan, beginning in June 2006. The balance of the termloan, if any, is due in full on April 7, 2013. In 2006 the Company made$21.0 million of prepayments on the term loan. Under the new credit agreement,prepayments are applied to reduce outstanding principle balance in direct orderof maturity to payments scheduled over next twelve months and thereafter toremaining scheduled principal payments on a prorated basis. Accordingly, theCompany’s required principal payments have been reduced to $0.8 millionper quarter and begin in December 2007. Any borrowings under the revolvingcredit facility are due in full on April 7, 2012. The Company is alsorequired to make annual mandatory prepayments on the term loan in an amountequal to 50% of its excess cash flow if the Company’s ratio of total debt toconsolidated EBITDA exceeds 2.50 to 1.00. Excess cash flow represents theCompany’s net income adjusted for extraordinary gains or losses, depreciation,amortization and other non-cash charges, changes in working capital,changes in deferred revenues, payments for capital expenditures and permittedacquisitions and repayment of certain indebtedness. In addition, the term loanis subject to mandatory prepayments in an amount equal to (a) 100% of thenet cash proceeds of certain debt issuances by the Company; (b) 50% of thenet cash proceeds of certain equity issuances by the Company if the Company’sratio of total debt to consolidated EBITDA exceeds 2.50 to 1.00; (c) 100%of the net cash proceeds of certain insurance, condemnation awards or othercompensation in respect to any casualty event; and (d) 100% of the netcash proceeds of certain asset sales or other dispositions of property by theCompany, in each case subject to certain exceptions. The Company is notrequired to make any mandatory prepayments for the year ended December 31,2006.

Futureminimum annual principal payments for the term loan as of December 31, 2006are as follows (in thousands):

| 2007                 |   | $       | 831     |   |
|----------------------|--------|---------|---------|--------|
| 2008                 |   | 3,323   |    |
| 2009                 |   | 3,322   |    |
| 2010                 |   | 3,322   |    |
| 2011                 |   | 3,322   |    |
| 2012 and  thereafter |   | 313,130 |    |
|                 |   | $       | 327,250 |   |

 

*Security;Guarantees.**  *TheCompany’s obligations under the new credit agreement are irrevocablyguaranteed, jointly and severally, by the Company, all our current and futureU.S. subsidiaries. In addition, the credit agreement and the guaranteesthereunder are secured by substantially all of the Company’s U.S. assets,including real and personal property, inventory, accounts receivable,intellectual property and other intangibles.

*Covenants.*   Thenew credit agreement imposes certain restrictions on the Company, includingrestrictions on the ability to incur indebtedness, incur or guaranteeobligations, prepay other indebtedness or amend other debt instruments, paydividends or make other distributions (except for certain tax distributions),redeem or repurchase equity, make investments, loans or advances, makeacquisitions, engage in mergers or consolidations, change the businessconducted by the Company and its subsidiaries, make capital expenditures, grantliens, sell assets and engage in certain other activities. The new credit 

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agreement requires theCompany to maintain: a ratio of total debt to consolidated EBITDA of no morethan 4.50 to 1.00 and gradually decreasing to 2.50 to 1.00 for the firstquarter of 2010 and thereafter; and a ratio of consolidated EBITDA to fixedcharges of at least 1.50 to 1.00. Material violations of these covenants andrestrictions, or the payment terms described above, can result in an event ofdefault and acceleration of the entire indebtedness. The Company was incompliance with all covenants as of December 31, 2006.

*Debt issuance costs.*   TheCompany capitalized debt issuance costs of approximately $6.4 million inassociation with the new credit agreement, which are being amortized over theterm of the agreement. Remaining debt issuance costs of $5.6 million, net ofaccumulated amortization, were included in the accompanying balance sheet at December 31,2006. At December 31, 2005, the Company had $2.5 million of remaining debtissuance costs related to prior credit agreements, net of accumulated amortization,included in the accompanying balance sheet.

*Write-off of DebtIssuance Costs*

In connection with therepayment of its previous credit agreement, the Company wrote-off approximately$2.3 million in April 2006 representing the net carrying value of debtissuance costs capitalized in connection with the previous agreement.

*Redemption ofSenior Subordinated Notes*

In June 2004, theCompany redeemed all of its outstanding senior subordinated notes for $79.7 million,including a redemption premium of $4.7 million. The redemption was funded bynet proceeds of $56.5 million from the Company’s February 2004 sale ofcommon stock and from existing cash. As a result of the redemption, the Companyrecorded a charge in 2004 of $7.8 million, including a redemption premium of$4.7 million, unamortized debt issuance costs of $2.3 million and originalissue discounts of $0.8 million.

**6.**                 RelatedParty Transactions

In 2005 and 2004, certainmanagement stockholders who previously purchased shares of the Company’s stockin exchange for promissory notes, fully repaid the entire balances of suchnotes, including interest, owed to the Company. Amounts repaid included $1.8million paid in 2005 and $0.3 million paid in 2004.

**7.**                 Commonand Preferred Stock

At December 31, 2006, the Company had a total of23,317,934 shares of common stock outstanding.

In June 2004, the Company completed a publicoffering of 3,072,379 shares of its common stock. All of these shares were soldby certain of the Company’s stockholders and the Company did not receive any ofthe net proceeds. The Company incurred costs of $0.2 million related to thisoffering, which were recorded as a reduction in the Company’s additionalpaid-in capital.

In February 2004, theCompany completed a public offering of 8,625,000 shares of its common stock. Theoffering consisted of 3,162,500 shares of common stock sold by the Company at$19.00 per share for net proceeds, after underwriters’ commissions and othercosts, of $56.5 million and 5,462,500 shares sold by certain of the Company’sstockholders.

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*Stock Options andStock-Based Compensation*

*2001 Omnibus Plan*

The 2001 Omnibus planprovides for awards of stock options, stock appreciation rights, performanceawards, restricted stock, restricted stock units, stock bonuses, stock unitawards and cash bonuses to key personnel, including consultants and advisors. Exceptas hereafter described and subject to equitable adjustments to reflect certaincorporate events, the maximum number of shares of the Company’s common stockwith respect to which awards may be granted under the Omnibus Plan is 7,181,868at December 31, 2006. 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 reserved for but not subject to optionsgranted under the 1999 Option Plan or subject to awards that are forfeited,terminated, canceled or settled without the delivery of common stock under theOmnibus Plan and the 1999 Option Plan will increase the number of sharesavailable for awards under the Omnibus Plan. Also, shares tendered to DJOIncorporated in satisfaction or partial satisfaction of the exercise price ofany award under the Omnibus Plan or the 1999 Option Plan will increase thenumber of shares available for awards under the Omnibus Plan to the extentpermitted by Rule 16b-3 under the Securities Exchange Act of 1934,as amended. The Omnibus Plan is administered by the Compensation Committee ofthe Company’s Board of Directors, which has the sole and complete authority togrant awards under the Omnibus Plan to eligible employees and officers of, andconsultants and advisors to, DJO Incorporated and its subsidiaries. Mostoptions granted under the Omnibus Plan are subject to vesting in equal annualinstallments over four years. Options granted under the Omnibus Plan expire tenyears from the date of grant. At December 31, 2006 options to purchase3,821,204 shares had been granted. At December 31, 2006 and 2005, 646,980and 828,520 shares were exercisable, respectively. On December 31, 2006,3,360,664 shares were available for future grant under the Omnibus Plan. On January 1,2007, the shares available for future grant were increased by 699,538 shares to4,060,202 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 Plan providesfor the grant of nonqualified options to officers, directors and employees of,and consultants and advisors to, DJO Incorporated.

The Company grantedoptions to purchase an aggregate of 944,542 shares of common stock under the1999 Option Plan through 2001. As of December 31, 2006 and 2005, optionsto purchase 57,333 and 236,733 shares issued under the 1999 Option Plan wereoutstanding and all exercisable, respectively. No future options will begranted under the 1999 Option Plan, and all shares of common stock, which wouldotherwise have been available for issuance under the 1999 Option Plan areavailable for issuance under the 2001 Omnibus Plan.

*2001 Non-EmployeeDirector’s Stock Option Plan*

The Company has adoptedthe DJO Incorporated 2001 Non-Employee Directors’ Stock Option Plan. In December 2005,the Company’s Board amended this plan as follows: (1) upon initialelection to the Board, a director will receive an option grant covering 15,000options at an exercise price equal to 100% of the fair market value of thecommon stock as of such date, such options will be fully vested upon date ofgrant; and (2) ongoing director options granted after the effective dateof the amendment will vest over a three-year period, with one-third vesting oneach of the first three anniversary dates of the grant. Options 

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grantedunder this plan expire ten years from the date of grant. A total of 1,500,000shares of the Company’s common stock have been reserved for issuance under theplan. A total of 460,000 and 355,000 options had been granted under the Plan atDecember 31, 2006 and 2005, respectively. No options were granted underthis plan prior to 2002. As of December 31, 2006, options to purchase285,000 shares issued under the Director Plan were exercisable.

*Stock-BasedCompensation*

Expenserecognized under SFAS No. 123(R) is recognized on a straight-linebasis over the vesting period of the underlying equity instruments. As of December 31,2006, approximately 4.4 million shares were available for grant under the Company’sStock Option Plans and 1.2 million shares were available for issuance under theCompany’s ESPP. Effective January 1, 2006, the benefits provided under theCompany’s Stock Option Plans and the Company’s ESPP are considered stock-basedcompensation, subject to the provisions of SFAS No. 123(R). For the yearended December 31, 2006, the application of SFAS No. 123(R) resultedin the following adjustments to amounts that would have been reported underprevious accounting standards (in thousands):

| ** **                    | ** ** | **Year Ended**             | ** ** |
|-------------------------------|------------|---------------------------------|------------|
| ** **                    | ** ** | **December 31, 2006** | ** ** |
| ** **                    | ** ** | **Under  Previous  Accounting** | ** ** | **SFAS No. 123(R)  Adjustments** | ** ** | **As Reported  Under SFAS  No. 123(R)** | ** ** |
| Costs of goods  sold          |       |                            | $          | 165,119 |   |   |   | $ | 987 |   |   |   | $ | 166,106 |   |   |
| Operating expenses:           |       |                            |       |   |   |   |   |   |   |   |   |   |   |
| Sales and marketing           |       |                            | 124,566    |   |   |   | 4,525 |   |   |   | 129,081 |   |   |
| General and administrative    |       |                            | 44,547     |   |   |   | 3,629 |   |   |   | 48,176 |   |   |
| Research and development      |       |                            | 8,455      |   |   |   | 533 |   |   |   | 8,988 |   |   |
| Income from  operations       |       |                            | 55,215     |   |   |   | (9,674 | ) |   |   | 45,541 |   |   |
| Provision for  income taxes   |       |                            | (13,495    | ) |   |   | 2,021 |   |   |   | (11,474 | ) |   |
| Net income                    |       |                            | 20,294     |   |   |   | (7,653 | ) |   |   | 12,641 |   |   |
| Basic net income  per share   |       |                            | $          | 0.89 |   |   |   | $ | 0.34 |   |   |   | $ | 0.55 |   |   |
| Diluted net income per  share |       |                            | $          | 0.87 |   |   |   | $ | 0.33 |   |   |   | $ | 0.54 |   |   |

 

The Company’s worldwide effective tax rate increasedin connection with its adoption of SFAS No. 123(R) as of January 1,2006. The aggregate SFAS No. 123(R) compensation expense results in areduced tax benefit rate due to the required tax accounting for the mix of theCompany’s outstanding and unvested incentive stock options and non-qualifiedstock options and the Company’s ESPP.

Prior to the Company’s adoption of SFASNo. 123(R), the Company presented all tax benefits resulting from theexercise of stock options as operating cash inflows in its consolidatedstatements of cash flows, in accordance with the provisions of the EmergingIssues Task Force (EITF) Issue No. 00-15, *Classification in the Statement of Cash Flows of the Income Tax BenefitReceived by a Company upon Exercise of a Nonqualified Employee Stock Option*.Statement No. 123(R) requires the benefit of tax deductions in excessof the compensation cost recognized for those options to be classified asfinancing cash inflows rather than operating cash inflows, on a prospectivebasis. For the year ended December 31, 2006, the excess tax benefits fromstock options exercised was $2.7 million.

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The fair value of eachequity award is estimated on the date of grant using the Black-Scholesvaluation model for option pricing using the assumptions noted in the followingtable. Expected volatility rates are based on the historical volatility (usingdaily pricing) of the Company’s stock. In accordance with SFAS No. 123(R),the Company reduces the calculated Black-Scholes value by applying a forfeiturerate, based upon historical pre-vesting option cancellations. The expected termof options granted is estimated based on a number of factors, including thevesting term of the award, historical employee exercise behavior for bothoptions that have run their course and outstanding options, the expectedvolatility of the Company’s stock and an employee’s average length of service. Therisk-free interest rate is determined based upon a constant U.S. Treasurysecurity rate with a contractual life that approximates the expected term ofthe option award. For years ended December 31:

| ** **                     | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|--------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Stock Option Plans:            |       |     |       |     |       |     |       |
| Expected volatility            |       | 58.2     | %          | 59.6     | %          | 71.5     | %          |
| Risk-free interest rate        |       | 4.9      | %          | 3.8      | %          | 3.2      | %          |
| Forfeitures                    |       | 7.6      | %          | 7.5      | %          | 10.0     | %          |
| Dividend yield                 |       | —   |       | —   |       | —   |       |
| Expected term (in years)       |       | 3.7      |       | 3.7      |       | 4.0      |       |
| Employee Stock Purchase  Plan: |       |     |       |     |       |     |       |
| Expected volatility            |       | 36.3     | %          | 61.7     | %          | 61.7     | %          |
| Risk-free interest rate        |       | 5.0      | %          | 2.7      | %          | 1.5      | %          |
| Dividend yield                 |       | —   |       | —   |       | —   |       |
| Expected term (in  years)      |       | 0.5      |       | 0.7      |       | 1.3      |       |

 

Thefollowing table illustrates the pro forma effect on net income and earnings pershare for the years ended December 31, 2005 and 2004, under the disclosureonly provisions of SFAS No. 123, as if the fair value method had beenapplied to all outstanding and unvested awards (in thousands, except per shareamounts):

| ** **                                                                                                                                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| Net income as  reported                                                                                                                                       |       | $        | 29,198     |     | $          | 14,015 |   |
| 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   | )          |
| Pro forma net  income                                                                                                                                         |       | $        | 22,205     |     | $          | 7,659 |   |
| Basic net income per  share:                                                                                                                                  |       |     |       |     |       |
| As reported                                                                                                                                                   |       | $        | 1.34       |     | $          | 0.66 |   |
| Pro forma                                                                                                                                                     |       | $        | 1.02       |     | $          | 0.36 |   |
| Diluted net income per  share:                                                                                                                                |       |     |       |     |       |
| As reported                                                                                                                                                   |       | $        | 1.29       |     | $          | 0.63 |   |
| Pro forma                                                                                                                                                     |       | $        | 0.98       |     | $          | 0.34 |   |

 

The pro forma effect on net income as shown above isnot necessarily indicative of potential effects on results for future years. Theweighted average fair value of options granted during 2005 and 2004 was $12.54and $12.09 per share, respectively.

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Thefollowing table summarizes option activity under all plans from December 31,2003 through December 31, 2006:

| ** **                             | ** ** | **Number of  Shares** | ** ** | **Price per Share** | ** **    | **Weighted Average Exercise  Price per Share** | ** ** |
|----------------------------------------|------------|----------------------------|------------|-------------------------------|---------------|--------------------------------------------------------------------|------------|
| 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      |   |   |
| Granted                                |       | 824,900                    |       | 36.57 -  44.09      |          |                                                               | 39.26      |   |   |
| Exercised                              |       | (1,116,110                 | )          | 2.97 -  31.81       |          |                                                               | 14.18      |   |   |
| Cancelled                              |       | (202,083                   | )          | 4.05 -  39.40       |          |                                                               | 23.59      |   |   |
| Outstanding at  December 31, 2006 |       | 2,649,790                  |       | 3.52 -  44.09       |          |                                                               | 25.99      |   |   |
|                                        |            |                            |            |                               |               |                                                                    |            |  |  |  |  |

 

Thefollowing table summarizes information concerning currently outstanding andexercisable options:

| ** **                                  | ** ** | **Options Outstanding** | ** ** | **Options Exercisable**                                      | ** ** |
|---------------------------------------------|------------|------------------------------|------------|-------------------------------------------------------------------|------------|
| **Range of Exercise  Prices**     | ** ** | ** **                   | ** ** | **Options  Outstanding as  of  December 31, 2006** | ** ** | **Weighted  Average  Remaining  Life in  Years** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Options  Exercisable as of  December 31, 2006** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Weighted  Average  Remaining  Life in  Years** | ** ** |
| $  3.52  -$10.80                  |       |                         | 337,213    |                                                              |       |   | 5.7 |   |   |   | $ | 6.21 |   |   |   | 256,463 |   |   |   | $ | 5.75 |   |   |   | 5.5 |   |   |
|   12.25  -  18.00            |       |                         | 77,549     |                                                              |       |   | 5.8 |   |   |   | 15.34 |   |   |   | 58,049 |   |   |   | 14.63 |   |   |   | 5.2 |   |   |
|   19.35  -  31.81            |       |                         | 1,431,728  |                                                              |       |   | 7.6 |   |   |   | 23.78 |   |   |   | 674,801 |   |   |   | 23.99 |   |   |   | 7.6 |   |   |
|   36.57  -  44.09            |       |                         | 803,300    |                                                              |       |   | 9.4 |   |   |   | 39.26 |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
|     3.52  -  44.09 |       |                         | 2,649,790  |                                                              |       |   | 7.9 |   |   |   | 25.99 |   |   |   | 989,313 |   |   |   | 18.72 |   |   |   | 6.9 |   |   |
|                                             |            |                              |            |                                                                   |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The aggregate intrinsicvalue of options outstanding at December 31, 2006 was approximately $44.6 millionand the aggregate intrinsic value of options exercisable at December 31,2006 was approximately $23.8 million. The total intrinsic value of optionsexercised during the year ended December 31, 2006 was approximately $27.2million. The weighted-average fair value per share for options that were notvested at December 31, 2005, not vested at December 31, 2006, vestedduring the year ended December 31, 2006 and cancelled/expired/forfeitedduring the year ended December 31, 2006, were $11.22, $30.33, $17.39 and$23.59, respectively. At December 31, 2006, there was approximately $21.4million of compensation expense that has not yet been recognized related tonon-vested stock-based awards. That expense is expected to be recognized over aweighted-average period of 1.4 years. During the year ended December 31,2006, cash received from options exercised was $15.8 million.

*Employee StockPurchase Plan*

The Employee StockPurchase Plan provides for the issuance of up to 1,576,365 shares of theCompany’s common stock. During each purchase period, eligible employees maydesignate between 1% and 15% of their cash compensation, subject to certainlimitations, to be deducted from their cash compensation for the purchase ofcommon stock under the plan. Through December 31, 2006, the purchase priceof the shares under the plan is equal to 85% of the lesser of the fair marketvalue per share 

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on thefirst 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 offering period of the plan was reduced to six months. On January 1of each year, the aggregate number of shares reserved for issuance under thisplan increases automatically by a number of shares equal to 1.0% of the Company’soutstanding shares on December 31 of the preceding year. The Company’sBoard of Directors or the Compensation Committee may reduce the amount of theincrease in any particular year. The aggregate number of shares reserved forissuance under the Employee Stock Purchase Plan may not exceed 5,000,000 shares.Through December 31, 2006, 561,212 shares had been issued under theEmployee Stock Purchase Plan. On January 1, 2007, the number of sharesreserved for issuance under the Employee Stock Purchase Plan was increased by233,179 shares and total shares reserved for issuance were 1,469,711.

*Repurchases ofCommon Stock*

The Company’s board ofdirectors authorized a stock repurchase program in September 2004 thatallowed the Company to repurchase up to $20 million of its common stock. The sharescould be repurchased at times and prices as determined by management and couldbe completed through open market or privately negotiated transactions. Therepurchase program provided that repurchases would be made in accordance withapplicable state and federal law and in accordance with the terms and subjectto the restrictions of Rule 10b-18 under the Securities Exchange Actof 1934, as amended. Shares would be retired and cancelled upon repurchase.Through December 31, 2004, the Company had repurchased 837,300 shares ofits common stock at an average price of $17.62 per share, for an aggregatetotal cost of approximately $14.8 million. No additional shares were repurchased in 2005 and the stock repurchaseprogram expired in September 2005.

**8.**                 IncomeTaxes

The(provision) benefit for income taxes, including deferred taxes, on incomebefore income taxes is as follows for the years ended December 31 (inthousands):

| ** **                 | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|----------------------------|------------|----------|------------|----------|------------|----------|------------|
| Current                    |       |     |       |     |       |     |       |
| Federal                    |       | $        | (2,245     | )        | $          | (631     | )          | $ | (30 | ) |
| State                      |       | (1,207   | )          | (422     | )          | 184      |       |
| Foreign                    |       | (2,146   | )          | (629     | )          | (268     | )          |
|                       |       | (5,598   | )          | (1,682   | )          | (114     | )          |
| Deferred                   |       |     |       |     |       |     |       |
| Federal                    |       | (3,105   | )          | (14,709  | )          | (7,097   | )          |
| State                      |       | (2,137   | )          | (2,914   | )          | (1,403   | )          |
| Foreign                    |       | (634     | )          | 42       |       | (408     | )          |
|                       |       | (5,876   | )          | (17,581  | )          | (8,908   | )          |
| Provision for income taxes |       | $        | (11,474    | )        | $          | (19,263  | )          | $ | (9,022 | ) |

 

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Deferredtax assets and liabilities are determined based on differences betweenfinancial reporting and tax bases of assets and liabilities, and are measuredusing the enacted tax rates and laws that will be in effect when thedifferences are expected to reverse. Significant components of the Company’sdeferred tax assets and liabilities as of December 31 are as follows (inthousands):

| ** **                                    | ** ** | **2006** | ** ** | **2005** | ** ** |
|-----------------------------------------------|------------|----------|------------|----------|------------|
| Deferred tax  assets (liabilities):           |       |     |       |     |       |
| Amortization of intangible assets             |       | $        | 9,868      |     | $          | 26,766 |   |
| Accrued expenses                              |       | 4,831    |       | 2,169    |       |
| Allowance for doubtful accounts               |       | 2,532    |       | 3,149    |       |
| Provision for excess and obsolete inventories |       | 3,245    |       | 2,167    |       |
| Net operating loss carryforwards              |       | 5,001    |       | 5,627    |       |
| Depreciation of fixed assets                  |       | 2,230    |       | (752     | )          |
| FAS123(R) stock-based compensation       |       | 1,665    |       | —   |       |
| Other, net                                    |       | (323     | )          | 377      |       |
| Net deferred tax assets                       |       | $        | 29,049     |     | $          | 39,503 |   |

 

Realization of the Company’s deferred tax assets isdependent on the Company’s ability to generate future taxable income prior tothe expiration of net operating loss carryforwards. Based on the Company’shistorical and expected future taxable earnings, management believes it is morelikely than not that the Company will realize the benefit of the existing netdeferred tax assets at December 31, 2006. No valuation allowance wasprovided for any of the Company’s deferred tax assets at December 31, 2006or 2005.

The Company utilizes the with-or-without method inorder to determine when excess tax benefits from stock-based compensation arerealized under SFAS No. 123(R).  Underthe with-or-without method, excess tax benefits from stock-based compensationare not deemed to be realized until after the utilization of net operating losscarryforwards from ordinary operations. At December 31, 2006, deferred tax assets do not include $5.6 million ofexcess tax benefits from stock-based compensation.  Upon realization of such benefits, theCompany will increase additional paid-in capital and reduce taxes payable.

As of December 31, 2006, the Company has U.S.federal net operating loss carryforwards of $27.6 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$15.8 million of various state net operating loss carryforwards, which begin toexpire in 2007 and does not have any material foreign net operating losscarryforwards.

Thereconciliation of income tax attributable to income before provision for incometaxes at the U.S. federal statutory rate to income tax provision in theaccompanying statements of income for the years ended December 31 is asfollows:

| ** **                                | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|-------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Federal tax at  statutory rate            |       | 35.0     | %          | 35.0     | %          | 35.0     | %          |
| State income tax,  net of federal benefit |       | 7.0      | %          | 4.2      | %          | 3.4      | %          |
| FAS123(R) stock-based  compensation  |       | 6.0      | %          | —   |       | —   |       |
| Other                                     |       | (0.4     | )%         | 0.6      | %          | 0.8      | %          |
|                                      |       | 47.6     | %          | 39.8     | %          | 39.2     | %          |

 

The Company made income tax payments, net of(refunds), totaling $2.0 million, $1.3 million and $0.6 million in the yearsended December 31, 2006, 2005 and 2004, respectively.

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For the years ended December 31, 2006, 2005 and2004, income tax benefits of $2.7 million, $3.5 million and $4.3 million,respectively, were credited to stockholders’ equity related to the exercise ofemployee stock options.

Incomebefore income taxes includes the following components for the years ended December 31(in thousands):

| ** **    | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|---------------|------------|----------|------------|----------|------------|----------|------------|
| United States |       | $        | 16,113     |     | $          | 46,862   |       | $ | 21,270 |   |
| Foreign       |       | 8,002    |       | 1,599    |       | 1,767    |       |
|          |       | $        | 24,115     |     | $          | 48,461   |       | $ | 23,037 |   |

 

Undistributed earnings of the Company’s foreignsubsidiaries amounted to approximately $9.2 million at December 31, 2006. Thoseearnings are considered to be indefinitely reinvested, and accordingly, noprovision for U.S. federal and state income taxes has been provided thereon. Upondistribution of those earnings in the form of dividends or otherwise, theCompany would be subject to both U.S. income taxes and withholding taxespayable to the foreign countries, but would also be able to generate foreigntax credits. Determination of the amount of unrecognized deferred U.S. incometax liability is not practicable because of the complexities associated withits hypothetical calculation; however, the Company does not believe the amountwould be material.

The Company is subject toongoing audits from various taxing authorities in the jurisdictions in which itdoes business. It does not have a history of significant adjustments to its taxaccruals as a result of these audits. The Company believes that its accrualsfor tax liabilities are adequate for all tax periods subject to audit.

**9.**                 Segmentand Related Information

The following arethe Company’s current reportable segments.

·       *Domestic Rehabilitation* consists of the sale of the Company’srehabilitation products (rigid knee braces, soft goods and pain managementproducts) in the United States through three sales channels, DonJoy,ProCare/Aircast and OfficeCare.

Throughthe DonJoy sales channel, the Company sells its rehabilitation productsutilizing a few of the Company’s direct sales representatives and a network ofapproximately 340 independent commissioned sales representatives who areemployed by approximately 40 independent sales agents. These sales representativesare primarily dedicated to the sale of the Company’s products to orthopedicsurgeons, podiatrists, orthopedic and prosthetic centers, hospitals, surgerycenters, physical therapists, athletic trainers and other healthcareprofessionals. Because certain of the DonJoy product lines require customereducation on the application and use of the product, these salesrepresentatives are technical specialists who receive extensive training bothfrom the Company and the agent and use their expertise to help fit the patientwith the product and assist the orthopedic professional in choosing theappropriate product to meet the patient’s needs. After a product order isreceived by a sales representative, the Company generally ships the productdirectly to the orthopedic professional and pays a sales commission to theagent. These commissions are reflected in sales and marketing expense in theCompany’s consolidated financial statements. For certain custom rigid bracesand other products, we sell directly to the patient and bill a third-partypayor, if applicable, on behalf of the patient. The Company refers to thisportion of its DonJoy channel as its Insurance channel.

Throughthe ProCare/Aircast sales channel, which is comprised of approximately100 direct and independent representatives that manage over 380 dealers focusedon primary and acute 

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facilities,the Company sells its rehabilitation products to national third-partydistributors, other regional medical supply dealers and medical product buying groups,generally at a discount from list prices. The majority of these products aresoft goods which require little or no patient education. The distributors anddealers generally resell these products to large hospital chains, hospitalbuying groups, primary care networks and orthopedic physicians for use by thepatients.

Throughthe OfficeCare sales channel, the Company maintains an inventory ofrehabilitation products (mostly soft goods) on hand at orthopedic practices forimmediate distribution to the patient. For these products, the Company arrangesbilling to the patient or third-party payor after the product is provided tothe patient. As of December 31, 2006, the OfficeCare program was locatedat over 1,000 physician offices throughout the United States. The Company hascontracts with over 700 third-party payors.

·       *Regeneration*consists of the sale of the Company’s bone growth stimulation products in theUnited States. The Company’s OL1000 product is sold through acombination of the DonJoy channel direct sales representatives andapproximately 124 additional sales representatives dedicated to selling theOL1000 product, of which approximately 57 are employed by the Company. TheSpinaLogic product is also included in this segment and was, until the end of2004, sold by DePuy Spine in the U.S. under an exclusive sales agreement. In January 2005,the Company amended the agreement with DePuy to divide the U.S. intoterritories in which DePuy Spine has exclusive sales rights and non-exclusiveterritories in which the Company is permitted to engage in its own salesefforts or retain another sales agent. In early 2006, the agreement was furthermodified to be non-exclusive in all territories. These products are sold eitherdirectly to the patient or to independent distributors. The Company arrangesbilling to the third-party payors or patients, for products sold directly tothe patient.

·       *International*consists of the sale of the Company’s productsin foreign countries through wholly owned subsidiaries or independentdistributors. The Company sells its products in over 70 foreign countries,primarily in Europe, Australia, Canada and Japan.

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Setforth below is net revenues, gross profit and operating income information forthe Company’s reporting segments for the years ended December 31 (inthousands). This information excludes the impact of other expenses notallocated to segments, which are comprised of (i) general corporateexpenses for all periods presented and (ii) restructuring costs associatedwith certain manufacturing moves in 2004. Information for the DomesticRehabilitation and International segments includes the impact of purchaseaccounting and related amortization of acquired intangible assets related tothe Aircast acquisition on April 7, 2006. Information for theInternational segment also includes the impact of purchase accounting andrelated amortization of acquired intangible assets related to the Axmedacquisition on January 2, 2006. For the years ended December 31, 2006and 2005, Domestic Rehabilitation income from operations was reduced byamortization of acquired intangible assets amounting to $5.8 million and $0.3million, respectively. For the years ended December 31, 2006 and 2005,International income from operations was reduced by amortization of acquiredintangible assets amounting to $4.8 million and $0.1 million, respectively. Forthe years ended December 31, 2006, 2005 and 2004, Regeneration income fromoperations was reduced by amortization of acquired intangible assets amountingto $4.6 million, $4.6 million and $4.7 million, respectively. For the yearended December 31, 2004, Regeneration income from operations was alsoreduced by restructuring charges of $3.8 million related to the integration ofthe business operations of the segment.

| ** **                                     | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| **Net Revenues:**                              |       |     |       |     |       |     |       |
| Domestic Rehabilitation                        |       | $        | 267,083    |     | $          | 197,279  |       | $ | 177,481 |   |
| Regeneration                                   |       | 64,507   |       | 55,474   |       | 49,658   |       |
| International                                  |       | 81,468   |       | 33,414   |       | 28,860   |       |
| Consolidated net  revenues                     |       | $        | 413,058    |     | $          | 286,167  |       | $ | 255,999 |   |
| **Gross Profit:**                              |       |     |       |     |       |     |       |
| Domestic Rehabilitation                        |       | $        | 137,316    |     | $          | 109,752  |       | $ | 100,200 |   |
| Regeneration                                   |       | 59,531   |       | 49,710   |       | 43,032   |       |
| International                                  |       | 50,105   |       | 21,416   |       | 17,603   |       |
| Consolidated gross profit                      |       | $        | 246,952    |     | $          | 180,878  |       | $ | 160,835 |   |
| **Income  from operations:**                   |       |     |       |     |       |     |       |
| Domestic Rehabilitation                        |       | $        | 35,905     |     | $          | 41,878   |       | $ | 36,341 |   |
| Regeneration                                   |       | 14,436   |       | 14,623   |       | 7,836    |       |
| International                                  |       | 11,947   |       | 8,430    |       | 5,398    |       |
| Income from  operations of reportable segments |       | 62,288   |       | 64,931   |       | 49,575   |       |
| Expenses not  allocated to segments            |       | (16,747  | )          | (11,072  | )          | (10,502  | )          |
| Consolidated income from  operations           |       | $        | 45,541     |     | $          | 53,859   |       | $ | 39,073 |   |

 

For the years ended December 31, 2006, 2005 and2004, the Company had no individual customer or distributor that accounted for10% or more of total annual revenues.

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

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Netrevenues, attributed to geographic location based on the location of thecustomer, for the years ended December 31, were as follows (in thousands):

| ** **                       | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|----------------------------------|------------|----------|------------|----------|------------|----------|------------|
| United States                    |       | $        | 331,590    |     | $          | 252,753  |       | $ | 227,139 |   |
| Europe                           |       | 64,676   |       | 23,424   |       | 20,369   |       |
| Other countries                  |       | 16,792   |       | 9,990    |       | 8,491    |       |
| Total consolidated net  revenues |       | $        | 413,058    |     | $          | 286,167  |       | $ | 255,999 |   |

 

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

| ** **                | ** ** | **2006** | ** ** | **2005** | ** ** |
|---------------------------|------------|----------|------------|----------|------------|
| United States             |       | $        | 619,599    |     | $          | 295,257 |   |
| International             |       | 48,735   |       | 9,407    |       |
| Total consolidated assets |       | $        | 668,334    |     | $          | 304,664 |   |

 

**10.**          Commitmentsand Contingencies

The Company is obligated under various noncancellableoperating leases for land, buildings, equipment and vehicles throughapproximately June 2021. Certain of the leases provide that the Companypay all or a portion of taxes, maintenance, insurance and other operatingexpenses, and certain of the rents are subject to adjustment for changes asdetermined by certain consumer price indices and exchange rates. The Company isheadquartered in Vista, California and operates manufacturing locations inVista, California, Tijuana, Mexico and Sfax, Tunisia. The Company also leaseswarehouse and office space in Indiana, Connecticut, Arizona, Germany, Canada,France, Spain, the United Kingdom, Italy, Belgium and Denmark.

Minimumannual lease payment commitments for noncancellable operating leases as of December 31,2006 are as follows (in thousands):

| 2007                 |   | $      | 6,186  |   |
|----------------------|--------|--------|--------|--------|
| 2008                 |   | 5,396  |   |
| 2009                 |   | 5,064  |   |
| 2010                 |   | 4,521  |   |
| 2011                 |   | 4,520  |   |
| 2012 and  thereafter |   | 32,155 |   |
|                 |   | $      | 57,842 |   |

 

In late 2004, the Company entered into a leaseagreement with Professional Real Estate Services, Inc. (PRES) under whichPRES undertook to build a new 110,000 square foot corporate headquartersfacility for the Company on vacant land in Vista, California. The Companyoccupies the facility under a 15-year lease, which commenced in August 2006upon completion of the facility, with two five-year options to extend the term.The Company vacated its former facilities in Vista. Included in income fromoperations in the accompanying consolidated statements of income, theCompany wrote-off the net book value of approximately $0.9 million of leaseholdimprovements for the former facilities in the third quarter of 2006. Rentexpense for the new facility will be recorded on a straight-line basis over thelease term at approximately $1.9 million per year.

In February 2005, PRES purchased the Company’sformer facilities as well as the real property underlying the new lease. Effectiveon the purchase date, a lease for the vacant land on which the Company waspreviously obligated was terminated. In connection with the new lease, theCompany’s leases 

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for its former Vistafacilities were terminated early in August 2006. Those leases wouldotherwise have continued until February 2008. In August 2006, theCompany made a lump sum rent payment to PRES of approximately $1.5 million,representing 40% of the rent that would have been due under the formerfacilities leases from the early termination date through the originalexpiration date. If PRES is able to lease the Company’s former facilitiesduring what would have remained of the term of the Company’s existing leases, aportion of that sum may be refunded to the Company. The lump sum rent payment,net of a remaining $0.4 million accrual related to lease termination costsoriginally accrued in 2002 (see Note 4), is being accounted for as additionalrent expense over the term of the new lease and is included in the annual rentexpense amount noted above.

In connection with the new lease, the Company and PRESincurred costs of approximately $7.9 million related to negotiated tenantimprovements and other improvements to the new facility. This amount has beenrecorded as an addition to property and equipment and will be amortized overthe shorter of the estimated useful life or the 15 year lease term, in theamount of approximately $0.5 million per year.

The amounts paid by PRES for tenant improvements ofapproximately $3.9 million, net of the lump sum rent payment made by theCompany and other costs aggregating $0.2 million, have been included indeferred rent at December 31, 2006 and are included in other accruedliabilities, current and long-term, in the accompanying consolidated balancesheet (see Note 2).

Aggregate rent expense wasapproximately $8.4 million, $6.4 million and $5.4 million for the years ended December 31,2006, 2005 and 2004, respectively.

*Contingencies*

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

**11.**          EmployeeBenefit Plan

The Company has aqualified 401(k) profit-sharing plan covering substantially all of itsU.S. employees. Effective January 1, 2006, the Company matches 50 percentof employee contributions up to six percent of total compensation. Through December 31,2005, the Company matched 100% of the first $500 contributed annually by eachemployee and 30 percent of additional employee contributions up to six percentof total compensation. The Company’s matching contributions related to thisplan were $0.7 million, $0.5 million and $0.5 million for the years ended December 31,2006, 2005 and 2004, respectively. The plan also provides for discretionaryCompany contributions as approved by the Board of Directors. There have been nosuch discretionary contributions through December 31, 2006.

**12.**          QuarterlyResults (unaudited)

The Company operates its business on a manufacturingcalendar, with its fiscal year always ending on December 31. Each quarteris 13 weeks, consisting of on five-week and two four-week periods. The firstand fourth quarters may have more or less working days from year to year basedon the days of the week on which holidays and December 31 fall.

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Thefollowing table summarizes certain of the Company’s operating results byquarter for 2006 and 2005:

| ** **                    | ** ** | **Year Ended December 31, 2006**                                                 | ** ** |
|-------------------------------|------------|------------------------------------------------------------------------------------------------------|------------|
| ** **                    | ** ** | **First  Quarter**                                                                                   | ** ** | **Second  Quarter** | ** ** | **Third   Quarter** | ** ** | **Fourth  Quarter** | ** ** | **Total  Year** | ** ** |
| ** **                    | ** ** | **(In thousands, except per share data and operating days)** | ** ** |
| Net revenues                  |       | $                                                                                                    | 82,563     |   | $ | 106,525 |   | $ | 113,205 |   | $ | 110,765 |   | $ | 413,058 |   |
| Gross profit                  |       | 50,854                                                                                               |       | 63,613 |   | 67,865 |   | 64,620 |   | 246,952 |   |
| Income from  operations       |       | 11,812                                                                                               |       | 10,738 |   | 14,302 |   | 8,689 |   | 45,541 |   |
| Net income                    |       | $                                                                                                    | 5,981      |   | $ | 1,292 |   | $ | 4,359 |   | $ | 1,009 |   | $ | 12,641 |   |
| Basic net income  per share   |       | $                                                                                                    | 0.27       |   | $ | 0.06 |   | $ | 0.19 |   | $ | 0.04 |   | $ | 0.55 |   |
| Diluted net  income per share |       | $                                                                                                    | 0.26       |   | $ | 0.06 |   | $ | 0.18 |   | $ | 0.04 |   | $ | 0.54 |   |
| Number of operating days      |       | 64                                                                                                   |       | 64 |   | 63 |   | 61 |   | 252 |   |

 

| ** **                    | ** ** | **Year Ended December 31, 2005**                                                 | ** ** |
|-------------------------------|------------|------------------------------------------------------------------------------------------------------|------------|
| ** **                    | ** ** | **First  Quarter**                                                                                   | ** ** | **Second  Quarter** | ** ** | **Third  Quarter** | ** ** | **Fourth  Quarter** | ** ** | **Total  Year** | ** ** |
| ** **                    | ** ** | **(In thousands, except per share data and operating days)** | ** ** |
| 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 |   |

 

**Item 9.**                        Changesin and Disagreements with Accountants on Accounting and Financial Disclosure

Not applicable.

**Item 9A.**                Controlsand Procedures

***Evaluationof Disclosure Controls and Procedures***

We maintain disclosure controls and procedures thatare designed to ensure that information required to be disclosed in ourExchange Act reports is recorded, processed, summarized and reported within thetimelines specified in the SEC’s rules and forms, and that suchinformation is accumulated and communicated to our management, including ourChief Executive Officer and Chief Financial Officer, as appropriate, to allowtimely decisions regarding required disclosure. In designing and evaluating thedisclosure controls and procedures, management recognized that any controls andprocedures, no matter how well designed and operated, can only providereasonable assurance of achieving the desired control objectives, and inreaching a reasonable level of assurance, management necessarily was requiredto apply its judgment in evaluating the cost-benefit relationship of possiblecontrols and procedures.

Under the supervision andwith the participation of our management, including our Chief Executive Officerand our Chief Financial Officer, we carried out an evaluation of theeffectiveness of the our disclosure controls and procedures (as such term isdefined in SEC Rules 13a-15(e) and 15d-15(e)) as of December 31,2006. Based on such evaluation, such officers have concluded that, as of December 31,2006, our disclosure controls and procedures were not effective because of theidentification of a material weakness in our internal control over financialreporting as described below. Based on a number of factors, including ourperformance of additional procedures as discussed under “Management’sRemediation Efforts” below, our management has concluded that the consolidatedfinancial statements included in Part II, Item 8 of this Form 10-Kfairly present, in all material respects, our financial position, results of 

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operationsand cash flows for the periods presented in conformity with generally acceptedaccounting principles (GAAP). The unqualified opinion of our independentregistered public accounting firm on our financial statements as of and foreach of the years in the three year period ended December 31, 2006 isincluded in Part II, Item 8 of this Form 10-K.

*Management’s Reporton Internal Control over Financial Reporting*

Internalcontrol over financial reporting refers to the process designed by, or underthe supervision of, our Chief Executive Officer and Chief Financial Officer,and effected by our board of directors, management and other personnel, toprovide reasonable assurance regarding the reliability of financial reporting andthe preparation of financial statements for external purposes in accordancewith generally accepted accounting principles, and includes those policies andprocedures that:

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

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

(3)         Provide reasonableassurance regarding prevention or timely detection of unauthorized acquisition,use or disposition of our assets that could have a material effect on thefinancial statements.

Because of its inherent limitations, internal controlover financial reporting cannot provide absolute assurance of achievingfinancial reporting objectives. Internal control over financial reporting is aprocess that involves human diligence and compliance and is subject to lapsesin judgment and breakdowns resulting from human failures. Internal control overfinancial reporting also can be circumvented by collusion or 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.Management is responsible for establishing and maintaining adequate internalcontrol over our financial reporting. Also, projections of any evaluation ofeffectiveness to future periods are subject to the risk that controls maybecome ineffective because of changes in conditions or that the degree ofcompliance with established policies or procedures may deteriorate.

Management assessed the effectiveness of our internalcontrol over financial reporting as of December 31, 2006 using theframework set forth in the report entitled *InternalControl—Integrated Framework* published by the Committee ofSponsoring Organizations (COSO) of the Treadway Commission. We completed theacquisitions of Axmed in January 2006 and Aircast in April 2006, asmore fully described in Note 3 to the consolidated financial statementsincluded in Part II, Item 8 herein. As part of our ongoing integrationactivities, we are in the process of incorporating the operations of Axmed andAircast into our controls and procedures and we expect to complete the processby no later than January 2, 2007 for Axmed and April 7, 2007 forAircast. Management has excluded from its evaluation of the effectiveness ofits internal control over financial reporting as of December 31, 2006certain elements of the internal control over financial reporting of Axmed andAircast, which constituted approximately $19.2 million and $43.9 millionof net revenues for Axmed and Aircast, respectively, for the year ended December 31,2006 and $10.0 million and $16.4 million of total assets for Axmed and Aircast,respectively, as of December 31, 2006. We plan to include these businessesinto our assessment of the effectiveness of our internal controls within oneyear of each respective acquisition.

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In conducting its assessment, management identified amaterial weakness in internal control over financial reporting as of December 31,2006. A material weakness is a control deficiency, or combination of controldeficiencies, that results in more than a remote likelihood that a materialmisstatement of the annual or interim financial statements will not beprevented or detected.

As of December 31, 2006, we had a controldeficiency regarding the transfer and integration of inventory from Aircastwhich took place in the fourth quarter of 2006. During the course of ourindependent registered public accounting firm’s audit of our financialstatements for the year ended December 31, 2006, it was determined that wedid not perform adequate detailed procedures with regards to inventoryin-transit and the reconciliation of the related intercompany transactions. Ourperformance of additional detailed procedures resulted in adjustments to theinventory and costs of goods sold which were material to net income. Suchadjustments have been recorded by us in our financial statements included in Part II,Item 8 of this Form 10-K. This control deficiency results in a morethan remote likelihood that a material misstatement of the annual or interimfinancial statements would not be prevented or detected on a timely basis byemployees during the normal course of performing their assigned functions.Therefore, management has concluded that our internal control over financialreporting was not effective as of December 31, 2006.

Ernst & YoungLLP, our independent registered public accounting firm, has issued anattestation report on management’s assessment of our internal control overfinancial reporting which is included below.

*Management’sRemediation Efforts*

Subsequent to the yearended December 31, 2006, management remediated the control deficiencydescribed above by implementing controls requiring the preparation and reviewof detailed analyses and reconciliations of in-transit inventory and relatedintercompany accounts. These analyses and reconciliations were completed forthe transfer of the Aircast inventory in early February 2007.

*Changes in InternalControl over Financial Reporting*

Other than the operating control deficiency describedabove and other than as set forth above with respect to our recentacquisitions, there has been no change to our internal control over financialreporting during our most recent fiscal quarter that has materially affected,or is reasonably likely to materially affect, our internal control overfinancial reporting.

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**REPORT OFINDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRMON INTERNAL CONTROL OVER FINANCIAL REPORTING**

The Board of Directors and StockholdersDJO Incorporated

We have audited management’s assessment, included inthe accompanying Management’s Report on Internal Control over FinancialReporting, that DJO Incorporated did not maintain effective internal controlover financial reporting as of December 31, 2006, based on criteria established in Internal Control—IntegratedFramework issued by the Committee of Sponsoring Organizations of the TreadwayCommission (the COSO criteria). DJO Incorporated’s management isresponsible for maintaining effective internal control over financial reportingand for its assessment of the effectiveness of internal control over financialreporting. Our responsibility is to express an opinion on management’sassessment and an opinion on the effectiveness of the company’s internalcontrol over financial reporting based on our audit.

We conducted our audit in accordance with the standardsof the Public Company Accounting Oversight Board (United States). Thosestandards require that we plan and perform the audit to obtain reasonableassurance about whether effective internal control over financial reporting wasmaintained in all material respects. Our audit included obtaining anunderstanding of internal control over financial reporting, evaluatingmanagement’s assessment, testing and evaluating the design and operatingeffectiveness of internal control, and performing such other procedures as weconsidered necessary in the circumstances. We believe that our audit provides areasonable basis for our opinion.

A company’s internal control over financial reportingis a process designed to provide reasonable assurance regarding the reliabilityof financial reporting and the preparation of financial statements for externalpurposes in accordance with generally accepted accounting principles. A company’sinternal control over financial reporting includes those policies andprocedures that (1) pertain to the maintenance of records that, inreasonable detail, accurately and fairly reflect the transactions anddispositions of the assets of the company; (2) provide reasonableassurance that transactions are recorded as necessary to permit preparation offinancial statements in accordance with generally accepted accountingprinciples, and that receipts and expenditures of the company are being madeonly in accordance with authorizations of management and directors of thecompany; and (3) provide reasonable assurance regarding prevention ortimely 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 controlover financial reporting may not prevent or detect misstatements. Also,projections of any evaluation of effectiveness to future periods are subject tothe risk that controls may become inadequate because of changes in conditions,or that the degree of compliance with the policies or procedures maydeteriorate.

As indicated in the accompanying DJO Incorporated Inc.Management’s Report on Internal Control over Financial Reporting, management’sassessment of and conclusion on the effectiveness of internal control over financialreporting did not include the internal controls of Newmed SAS (“Axmed”) andAirCast Incorporated (“Aircast”) which were acquired in 2006 and are includedin the 2006 consolidated financial statements of the Company and constituted:approximately $19.2 million and $43.9 million of net revenues for Axmed andAircast, respectively, for the year ended December 31, 2006 and $10.0million and $16.4 million of total assets for Axmed and Aircast, respectively,as of December 31, 2006. Our audit of internal control over financialreporting of the Company also did not include an evaluation of the internalcontrol over financial reporting of Axmed and Aircast.

A material weakness is a control deficiency, orcombination of control deficiencies, that results in more than a remotelikelihood that a material misstatement of the annual or interim financialstatements 

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will not be prevented ordetected. The following material weakness has been identified and included inmanagement’s assessment. The Company experienced control deficiencies regardingthe transfer and integration of inventory from an acquired entity in the fourthquarter of 2006. During the course of the audit, it was determined the Companydid not perform adequate detailed procedures with regards to inventory intransit and the reconciliation of the related intercompany transactions.Performance of additional detailed procedures by the Company resulted inadjustments to the inventory and costs of goods sold balances, which wererecorded by the Company in its financial statements prior to their publicationin this Annual Report. This material weakness was considered in determining thenature, timing, and extent of audit tests applied in our audit of the 2006financial statements, and this report does not affect our report dated February 26,2007 on those financial statements.

In ouropinion, management’s assessment that DJO Incorporated did not maintaineffective internal control over financial reporting as of December 31,2006, is fairly stated, in all material respects, based on the COSO criteria. Also,in our opinion, because of the effect of the material weakness described aboveon the achievement of the objectives of the control criteria, DJO Incorporatedhas not maintained effective internal control over financial reporting as of December 31,2006, based on****the COSO criteria**.**
|                         | /s/ ERNST & YOUNG LLP |
|-------------------------|--------------------------------|
| San Diego,  California  |                           |
| February 26,  2007 |                           |

 

**Item 9B.**               OtherInformation

None.

**PART III**

**Item 10.**                 Directors,Executive Officers and Corporate Governance

The Company’s Code of Business Conduct and Ethics andCorporate Governance Guidelines can be accessed on the Company’s website underthe investor relations page, and are available in print to stockholders whosubmit a written request to the Secretary of the Company at the address of theCompany’s principal executive offices. In addition, the Audit, Compensation andNominating and Corporate Governance Committees have each adopted a chartergoverning the activities of such committee. In accordance with New York StockExchange rules, these documents are also available either on the Company’swebsite or by written request no later than the date of the Company’s 2007Annual Stockholders Meeting.

The other informationunder Item 10 is hereby incorporated by reference from DJO Incorporated’sDefinitive Proxy Statement to be filed with the Securities and ExchangeCommission on or prior to April 30, 2007. See also the identification ofthe Executive Officers following Item 4 of this Form 10-K.

**Item 11.**                 ExecutiveCompensation

Item 11 is herebyincorporated by reference from DJO Incorporated’s Definitive Proxy Statement tobe filed with the Securities and Exchange Commission on or prior to April 30,2007.

**Item 12.**                 SecurityOwnership of Certain Beneficial Owners and Management and Related StockholderMatters

Item 12 is herebyincorporated by reference from DJO Incorporated’s Definitive Proxy Statement tobe filed with the Securities and Exchange Commission on or prior to April 30,2007.

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**Item 13.**                 CertainRelationships and Related Transactions, and Director Independence

Item 13 is herebyincorporated by reference from DJO Incorporated’s Definitive Proxy Statement tobe filed with the Securities and Exchange Commission on or prior toApril 30, 2007.

**Item 14.**                 PrincipalAccounting Fees and Services

Item 14 is herebyincorporated by reference from DJO Incorporated’s Definitive Proxy Statement tobe filed with the Securities and Exchange Commission on or prior toApril 30, 2007.

**PART IV**

**Item 15.**                 Exhibits,Financial Statement Schedules

(a)   The following documents are filed as part ofthis report:

1.                 Thefollowing consolidated financial statements of DJO Incorporated, including thereport thereon of Ernst & Young LLP, are filed as part of this reportunder Item 8. Financial Statements and Supplementary Data:

Report ofIndependent Registered Public Accounting Firm

ConsolidatedBalance Sheets as of December 31, 2006 and 2005

ConsolidatedStatements of Income for the years ended December 31, 2006, 2005 and 2004

ConsolidatedStatements of Changes in Stockholders’ Equity for the years ended December 31,2006, 2005 and 2004

ConsolidatedStatements of Cash Flows for the years ended December 31, 2006, 2005 and2004

Notes to Consolidated Financial Statements

2.      Financial Statement Schedules:

Schedule II—Valuationand Qualifying Accounts

All other financial statement schedules are notrequired under the related instructions or are inapplicable and therefore havebeen omitted.

3.      Exhibits:

| Exhibit   Number | ** ** | **Description**                                                                                                                                                                                                                          |
|------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1              |       | Amended and  Restated Certificate of Incorporation of the Registrant (Incorporated by  reference to Exhibit 4.1 to the Registration Statement of the Registrant  on Form S-8 (Reg. No. 333-73966))                        |
| 3.2              |       | Certificate of  Amendment of Amended and Restated Certificate of Incorporation of the  Registrant (Incorporated by reference to the Registration Statement of the  Registrant on Form S-3 (Reg. No. 333-111465))               |
| 3.3              |       | Amended and  Restated By-laws of the Registrant (Incorporated by reference to  Exhibit 4.2 to the Registration Statement of the Registrant on  Form S-8 (Reg. No. 333-73966))                                        |
| 3.4              |       | Certificate of  Ownership and Merger of DJO Merger Sub, Inc. with and into dj  Orthopedics, Inc. dated May 26, 2006 (Incorporated by reference to the  Registrant’s Report on Form 8-K dated May 26, 2006) |

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| 10.1#  |   | Fifth Amended and  Restated 1999 Option Plan of the Registrant dated October 25, 2001  (Incorporated by reference to Exhibit 4.3 to the Registration Statement  on Form S-8 of the Registrant (Reg. No. 333-73966))                                                                                                                                          |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.2#  |   | dj Orthopedics, Inc.  2001 Omnibus Plan (Incorporated by reference to Exhibit 4.6 to the  Registration Statement on Form S-8 of the Registrant (Reg.  No. 333-73966))                                                                                                                                                                                             |
| 10.3#  |   | dj Orthopedics, Inc.  2001 Non-Employee Directors’ Stock Option Plan (Incorporated by reference to  Exhibit 4.5 to the Registration Statement on Form S-8 of the  Registrant (Reg. No. 333-73966))                                                                                                                                                      |
| 10.4#  |   | dj Orthopedics, Inc.  2001 Employee Stock Purchase Plan (Incorporated by reference to  Exhibit 4.4 to the Registration Statement on Form S-8 of the  Registrant (Reg. No. 333-73966))                                                                                                                                                                        |
| 10.5#  |   | Amendment Number  One to the dj Orthopedics, Inc. 2001 Non-Employee Directors’ Stock Option  Plan, dated May 29, 2003 (Incorporated by reference to the Registrant’s  Report on Form 10-Q for the quarter ended June 28, 2003)                                                                                                                          |
| 10.6   |   | Lease Agreement  between Professional Real Estate Services, Inc. and dj Orthopedics, LLC  (now known as DJO, LLC), dated October 20, 2004 (Incorporated by  reference to the Registrant’s Report on Form 8-K filed on  October 26, 2004)                                                                                                                |
| 10.7   |   | 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 the Registrant’s  Report on Form 8-K filed on October 26, 2004)                                                                            |
| 10.8+  |   | 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 the Registrant’s Report on  Form 10-K for the year ended December 31, 2004) |
| 10.9   |   | Asset Purchase  Agreement, dated March 10, 2005, between dj Orthopedics, LLC, and  Superior Medical Equipment, LLC (Incorporated by reference to the  Registrant’s Report on Form 8-K filed on March 14, 2005)                                                                                                                                               |
| 10.10# |   | Amendment Number  Two to the dj Orthopedics, Inc. 2001 Non-Employee Directors’ Stock Option  Plan, dated May 3, 2005 (Incorporated by reference to the Registrant’s  Report on Form 8-K filed on May 5, 2005)                                                                                                                                           |
| 10.11# |   | dj Orthopedics,  Inc. Executive Deferred Compensation Plan and related Adoption Agreement  (Incorporated by reference to the Registrant’s Report on Form 8-K filed  on August 2, 2005)                                                                                                                                                                            |
| 10.12# |   | Trust Agreement  between dj Orthopedics, LLC and Fidelity Management Trust Company  (Incorporated by reference to the Registrant’s Report on Form 8-K filed  on August 2, 2005)                                                                                                                                                                                   |
| 10.13  |   | Asset Purchase  Agreement, dated August 8, 2005, between dj Orthopedics, LLC and Encore  Medical, L.P. (Incorporated by reference to the Registrant’s Report on  Form 8-K filed on August 10, 2005)                                                                                                                                                          |
| 10.14  |   | Share Purchase  Agreement, dated December 15, 2005, by and among dj Orthopedics, LLC and  the Stockholders of Newmed SAS (Incorporated by reference to the Registrant’s  Report on Form 8-K filed on December 16, 2005)                                                                                                                                      |

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| 10.15  |   | Outsourcing  Agreement, dated as of January 15, 2006, by and between Creditek  LLC, Inc. and dj Orthopedics, LLC (Incorporated by reference to the Registrant’s  Report on Form 10-Q for the quarter ended April 1, 2006)                                                                                                               |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.16  |   | Lease Agreement,  dated February 17, 2006, between MetroAir Partners, LLC, and dj  Orthopedics, LLC (Incorporated by reference to the Registrant’s Report on  Form 10-Q for the quarter ended April 1, 2006)                                                                                                                                 |
| 10.17  |   | Credit Agreement, dated April 7, 2006, among dj  Orthopedics, LLC, certain of its foreign subsidiaries party hereto from time  to time, the Registrant, Wachovia Bank, National Association, as  administrative agent, and lenders party thereto (Incorporated by reference to  the Registrant’s Report on Form 8-K filed on April 13, 2006) |
| 10.18  |   | Stock purchase  agreement by and among dj Orthopedics, LLC, and the Stockholders of Aircast  (Incorporated by reference to the Registrant’s Report on Form 8-K filed  on April 13, 2006)                                                                                                                                                          |
| 10.19# |   | Amendment Number  One to the dj Orthopedics, Inc. 2001 Omnibus Plan dated  December 13, 2006 (Incorporated by reference to the Registrant’s Report  on Form 8-K filed on December 19, 2006)                                                                                                                                             |
| 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.                                                                                                                                                                                   |

----

*                    Filedherewith

+                Confidentialtreatment has been requested with respect to portions of this exhibit.

#                 Indicatesmanagement or compensatory plan or arrangement required to be identifiedpursuant to Item 15(a).

104

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**DJO INCORPORATEDSCHEDULE II—Valuation and Qualifying AccountsFor the Three Years Ended December 31, 2006**

| ** **                             | ** ** | **Allowance for  Doubtful  Accounts and  Sales Returns** | ** ** | **Reserve for  Excess and  Obsolete  Inventory** | ** ** |
|----------------------------------------|------------|-------------------------------------------------------------------------|------------|------------------------------------------------------------|------------|
| Balance at  December 31, 2003     |       | $                                                                       | 20,717,000 |                                                       | $          | 6,369,000 |   |
| Acquired through business acquisitions |       | —                                                                  |       |  —                                               |       |
| 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                                                  |       |
| Acquired through business acquisitions |       | —                                                                  |       |  —                                               |       |
| 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                                                  |       |
| Acquired through business acquisitions |       | 139,000                                                                 |       | 93,000                                                     |       |
| Provision                              |       | 42,407,000                                                              |       | 1,339,000                                                  |       |
| Write-offs and recoveries, net         |       | (30,736,000                                                             | )          | (1,678,000                                                 | )          |
| Balance at  December 31, 2006     |       | $                                                                       | 38,602,000 |                                                       | $          | 2,074,000 |   |

 

105

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**SIGNATURES**

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the registrant has duly caused this report to be signed on itsbehalf by the undersigned, thereunto duly authorized.
| Date:  March 1, 2007 | **DJO INCORPORATED** |
|----------------------|----------------------|
|                 | By:                  | /s/  LESLIE H. CROSS |   |
|                 |                 | Leslie H. Cross |   |
| * *             |                 | *President and Chief Executive Officer* |

 

Pursuantto the requirements of the Securities Exchange Act of 1934, this Report hasbeen signed below by the following persons on behalf of the registrant and inthe capacities and on the dates indicated.

|                          | **Signature** | ** **                                                   | ** ** | ** **          | **Title** | ** ** | ** ** | ** ** | **Date** | ** ** |
|--------------------------|---------------|--------------------------------------------------------------|------------|---------------------|-----------|------------|------------|------------|----------|------------|
| /s/ LESLIE H.  CROSS     |          | President, Chief  Executive Officer and Director             |       | March 1,  2007 |
| Leslie  H. Cross         |          | (Principal Executive  Officer)                               |       |                |
| /s/ VICKIE L.  CAPPS     |          | Executive Vice  President, Chief Financial Officer           |       | March 1,  2007 |
| Vickie  L. Capps         |          | and Treasurer (Principal  Financial and  Accounting Officer) |       |                |
| /s/ JACK R.  BLAIR       |          | Chairman of the  Board of Directors                          |       | March 1,  2007 |
| Jack  R. Blair           |          |                                                         |       |                |
| /s/ MITCHELL  J. BLUTT   |          | Director                                                     |       | March 1,  2007 |
| Mitchell  J. Blutt, M.D. |          |                                                         |       |                |
| /s/ THOMAS  MITCHELL     |          | Director                                                     |       | March 1,  2007 |
| Thomas  Mitchell         |          |                                                         |       |                |
| /s/ LEWIS  PARKER        |          | Director                                                     |       | March 1,  2007 |
| Lewis  Parker            |          |                                                         |       |                |
| /s/ CHARLES T.  ORSATTI  |          | Director                                                     |       | March 1,  2007 |
| Charles  T. Orsatti      |          |                                                         |       |                |
| /s/ LESLEY H.  HOWE      |          | Director                                                     |       | March 1,  2007 |
| Lesley  H. Howe          |          |                                                         |       |                |
| /s/ KIRBY L.  CRAMER     |          | Director                                                     |       | March 1,  2007 |
| Kirby L. Cramer          |          |                                                         |       |                |

 

106

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**INDEX TO EXHIBITS**
| Exhibit   Number | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                        | ** ** | **Description** |
|------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------|
| 3.1              |       | Amended and Restated  Certificate of Incorporation of the Registrant (Incorporated by reference to  Exhibit 4.1 to the Registration Statement of the Registrant on  Form S-8 (Reg. No. 333-73966))                                                                                                                                                                 |
| 3.2              |       | Certificate of  Amendment of Amended and Restated Certificate of Incorporation of the  Registrant (Incorporated by reference to the Registration Statement of the  Registrant on Form S-3 (Reg. No. 333-111465))                                                                                                                                                        |
| 3.3              |       | Amended and  Restated By-laws of the Registrant (Incorporated by reference to  Exhibit 4.2 to the Registration Statement of the Registrant on  Form S-8 (Reg. No. 333-73966))                                                                                                                                                                                      |
| 3.4              |       | Certificate of  Ownership and Merger of DJO Merger Sub, Inc. with and into dj  Orthopedics, Inc. dated May 26, 2006 (Incorporated by reference to the  Registrant’s Report on Form 8-K dated May 26, 2006)                                                                                                                                          |
| 10.1#            |       | Fifth Amended and  Restated 1999 Option Plan of the Registrant dated October 25, 2001  (Incorporated by reference to Exhibit 4.3 to the Registration Statement  on Form S-8 of the Registrant (Reg. No. 333-73966))                                                                                                                                           |
| 10.2#            |       | dj Orthopedics,  Inc. 2001 Omnibus Plan (Incorporated by reference to Exhibit 4.6 to the  Registration Statement on Form S-8 of the Registrant (Reg.  No. 333-73966))                                                                                                                                                                                              |
| 10.3#            |       | dj Orthopedics,  Inc. 2001 Non-Employee Directors’ Stock Option Plan (Incorporated by  reference to Exhibit 4.5 to the Registration Statement on Form S-8  of the Registrant (Reg. No. 333-73966))                                                                                                                                                            |
| 10.4#            |       | dj Orthopedics,  Inc. 2001 Employee Stock Purchase Plan (Incorporated by reference to  Exhibit 4.4 to the Registration Statement on Form S-8 of the  Registrant (Reg. No. 333-73966))                                                                                                                                                                              |
| 10.5#            |       | Amendment Number  One to the dj Orthopedics, Inc. 2001 Non-Employee Directors’ Stock Option  Plan, dated May 29, 2003 (Incorporated by reference to the Registrant’s  Report on Form 10-Q for the quarter ended June 28, 2003)                                                                                                                           |
| 10.6             |       | Lease Agreement  between Professional Real Estate Services, Inc. and dj Orthopedics, LLC  (now known as DJO, LLC), dated October 20, 2004 (Incorporated by  reference to the Registrant’s Report on Form 8-K filed on October  26, 2004)                                                                                                                      |
| 10.7             |       | 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 the  Registrant’s Report on Form 8-K dated filed on October 26,  2004)                                                                     |
| 10.8+            |       | 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 the Registrant’s Report on  Form 10-K for the year ended December 31, 2004) |
| 10.9             |       | Asset Purchase  Agreement, dated March 10, 2005, between dj Orthopedics, LLC, and  Superior Medical Equipment, LLC (Incorporated by reference to the Registrant’s  Report on Form 8-K filed on March 14, 2005)                                                                                                                                                |
| 10.10#           |       | Amendment Number  Two to the dj Orthopedics, Inc. 2001 Non-Employee Directors’ Stock Option  Plan, dated May 3, 2005 (Incorporated by reference to the Registrant’s  Report on Form 8-K filed on May 5, 2005)                                                                                                                                                 |

107

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| 10.11# |   | dj Orthopedics, Inc.  Executive Deferred Compensation Plan and related Adoption Agreement  (Incorporated by reference to the Registrant’s Report on Form 8-K filed  on August 2, 2005)                                                                                                                                                        |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.12# |   | Trust Agreement  between dj Orthopedics, LLC and Fidelity Management Trust Company  (Incorporated by reference to the Registrant’s Report on Form 8-K filed  on August 2, 2005)                                                                                                                                                                    |
| 10.13  |   | Asset Purchase  Agreement, dated August 8, 2005, between dj Orthopedics, LLC and Encore  Medical, L.P. (Incorporated by reference to the Registrant’s Report on  Form 8-K filed on August 10, 2005)                                                                                                                                 |
| 10.14  |   | Share Purchase  Agreement, dated December 15, 2005, by and among dj Orthopedics, LLC and  the Stockholders of Newmed SAS (Incorporated by reference to the Registrant’s  Report on Form 8-K filed on December 16, 2005)                                                                                                                       |
| 10.15  |   | Outsourcing  Agreement, dated as of January 15, 2006, by and between Creditek  LLC, Inc. and dj Orthopedics, LLC (Incorporated by Reference to the  registrant’s report on Form 10-Q for the quarter ended April 1, 2006)                                                                                                                     |
| 10.16  |   | Lease Agreement,  dated February 17, 2006, between MetroAir Partners, LLC, and dj  Orthopedics, LLC (Incorporated by Reference to the registrant’s report on  Form 10-Q for the quarter ended April 1, 2006)                                                                                                                                       |
| 10.17  |   | Credit Agreement,  dated April 7, 2006, among dj Orthopedics, LLC, certain of its foreign  subsidiaries party hereto from time to time, the Registrant, Wachovia Bank,  National Association, as administrative agent, and lenders party thereto  (Incorporated by reference to the Registrant’s Report on Form 8-K filed  on April 13, 2006) |
| 10.18  |   | Stock purchase  agreement by and among dj Orthopedics, LLC, and the Stockholders of Aircast  (Incorporated by reference to the Registrant’s Report on Form 8-K filed  on April 13, 2006)                                                                                                                                                      |
| 10.19# |   | Amendment Number  One to the dj Orthopedics, Inc. 2001 Omnibus Plan dated  December 13, 2006 (Incorporated by reference to the Registrant’s Report  on Form 8-K filed on December 19,2006)                                                                                                                                          |
| 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

+                Confidentialtreatment has been requested with respect to portions of this exhibit.

#                 Indicatesmanagement or compensatory plan or arrangement required to be indentifiedpursuant to Item 15(a).

108

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