**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**FORM 10-K**

 

**(MarkOne)**
| ý                                           |   | **ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934**     |
|--------------------------------------------------|--------|-----------------------------------------------------------------------------------------------|
| **For the fiscal year ended December  31, 2003** |
| **or**                                           |
| **o**                                            |   | **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934** |

** **

**For the transition period from           to          .**

**Commissionfile number 001-16757**

** **

**DJ ORTHOPEDICS, INC.**

**(Exact name of Registrant as specified in its charter)**

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| **Delaware**                                                                |   | **33-0978270**         |
|-----------------------------------------------------------------------------|--------|------------------------|
| (State or other jurisdiction of                                             |   | (I.R.S. Employer       |
| Incorporation or organization)                                              |   | Identification Number) |
|                                                                        |   |                   |
| **2985  Scott Street**                                                      |   |                   |
| **Vista, California**                                                       |   | **92081**              |
| (Address of principal executive offices)                                    |   | (Zip Code)             |
|                                                                        |   |                   |
| Registrant’s telephone number, including area code:**(760)  727-1280** |

** **

**Securities registered pursuant to Section 12(b) of the Act:**

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

** **

**Securities registered pursuant to Section 12(g) of the Act:**

**None**

 

**Indicate by check mark whether theRegistrant (1) has filed all reports required to be filed by Section 13 or15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (orfor such shorter period that the registrant was required to file such reports),and (2) has been subject to such filing requirements for the past 90 days.**

**Yes****ý  No****o**

** **

**Indicateby check mark if disclosure of delinquent filers pursuant to Item 405 ofRegulation S-K is not contained herein, and will not be contained, to the bestof registrant’s knowledge, in definitive proxy or information statementsincorporated by reference in Part III of this Form 10-K or any amendment tothis Form 10-K. ****o**

 

**Indicated by check mark whether theRegistrant is an accelerated filer (as defined in Exchange Act Rule 12b-2).**

**Yes****ý  No****o**

 

**The aggregate market value of alloutstanding common equity held by non-affiliates of the Registrant based on theclosing price of common stock as reported on the New York Stock Exchange onJune 27, 2003 was $96,160,124.**

 

**The number of shares of theRegistrant’s common stock outstanding at February 25, 2004 was 21,581,779shares.**

 

**Documents Incorporated by Reference**

**Portions of the Proxy Statement forthe Registrant’s 2003 Annual Meeting of Stockholders to be filed with theCommission on or before April 30, 2004 are incorporated by reference in PartIII of this Annual Report on Form 10-K. With the exception of those portions that are specifically incorporatedby reference in this Annual Report on Form 10-K, such Proxy Statement shall notbe deemed filed as part of this Report or incorporated by reference herein.**

 

 

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**DJ ORTHOPEDICS, INC.**

**FORM10-K**

**TABLE OF CONTENTS**

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

 

***Explanatory Notes***

 

This annual reporton Form 10-K is filed for dj Orthopedics, Inc. (dj Orthopedics), a Delawarecorporation.  It is also filed for djOrthopedics, LLC (dj Ortho), a Delaware limited liability company and DJOrthopedics Capital Corporation (dj Capital), a Delaware corporation, withrespect to the 12 5/8% senior subordinated notes (the notes) due in 2009 in anoriginal aggregate principal amount at maturity of $100.0 million that wereco-issued by dj Ortho and dj Capital. dj Orthopedics owns 100% of the equity interest of dj Ortho and does nototherwise own any material assets or business operations.  The financial position and operating resultsof dj Orthopedics and dj Ortho are, therefore, substantially the same and arereflected in the consolidated financial information contained in thisreport.  dj Capital was formed solely toact as co-issuer of the notes and does not hold any assets or conduct anybusiness operations of its own. Financial information for dj Capital would notbe meaningful and is not included in this annual report.

 

Unless the contextrequires otherwise, in this annual report the terms “we,” “us” and “our” referto dj Orthopedics, Inc., dj Orthopedics, LLC, a wholly-owned subsidiary of djOrthopedics, Inc., and our other wholly-owned and indirect subsidiaries.  When we refer to “we,” “us” and “our” fordates prior to November 20, 2001, the date of our reorganization, the terms aremeant to refer to our predecessor, DonJoy, L.L.C.  In November 2003, we acquired the bone growth stimulation devicebusiness of OrthoLogic Corp. We refer to this business as Regentek and theacquisition as the Regentek acquisition. In this annual report, pro forma revenue data for the year endedDecember 31, 2003 give effect to the Regentek acquisition as if it had occurredon January 1, 2003.

 

This annual reportincludes market share and industry data and forecasts that we obtained fromindustry publications and surveys, primarily by Frost & Sullivan, and internalcompany surveys. Frost & Sullivan was commissioned by us to provide certainindustry and market data. Industry publications and surveys and forecastsgenerally state that the information contained therein has been obtained fromsources believed to be reliable, but there can be no assurance as to theaccuracy or completeness of included information. We have not independentlyverified any of the data from third-party sources nor have we ascertainedthe underlying economic assumptions relied upon therein. While we are not awareof any misstatements regarding the industry and market data presented herein,such data involve risks and uncertainties and are subject to change based onvarious factors, including those discussed under the heading “Risk Factors” inthis annual report.

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

 

This annual reporton Form 10-K contains, in addition to historical information, statements by uswith respect to our expectations regarding financial results and other aspectsof our business that involve risks and uncertainties and may constituteforward-looking statements within the meaning of Section 27A of theSecurities Act and Section 21E of the Exchange Act.  These statements reflect our current viewsand are based on certain assumptions. Actual results could differ materiallyfrom those currently anticipated as a result of a number of factors, including,in particular, risks and uncertainties associated with the Regentekacquisition, the growth of the bone growth stimulation market, our high levelof indebtedness and other material risks discussed under the heading “RiskFactors” in this annual report  If theexpectations or assumptions underlying our forward-looking statements proveinaccurate or if risks or uncertainties arise, actual results could differmaterially from those predicted in any forward-looking statement.

 

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**Part I**

**Item 1. Business**

 

**Overview**

 

We are a globalmedical device company specializing in rehabilitation and regeneration productsfor the non-operative orthopedic and spine markets.  We have a leading market share in the estimated $1.6 billionsegment of the non-operative orthopedic and spine markets that we target.  From 2002 to 2003, our pro forma combinedrevenues grew 8.5% to $240.4 million.

 

Our broad range ofover 600 rehabilitation products, including rigid knee braces, soft goods andpain management products, are used to prevent injury, to treat chronicconditions and to aid in recovery after surgery or injury.  Our regeneration products consist of bonegrowth stimulation devices that are used to treat nonunion fractures and as anadjunct therapy after spinal fusion surgery.

 

We sell ourproducts in the United States and in more than 30 other countries throughnetworks of agents, distributors and our direct sales force that market ourproducts to orthopedic and spine surgeons, podiatrists, orthopedic andprosthetic centers, third-party distributors, hospitals, surgery centers,physical therapists, athletic trainers and other healthcare professionals.  We believe that we have one of the largestdistribution networks for non-operative orthopedic products.  We believe that this distribution network,along with our recognized brand name, reputation for quality and innovation,and our strong relationships with orthopedic professionals have contributed toour leading market position.

 

We wereincorporated in Delaware in August 2001. We are the successor to DonJoy, Inc., a business started in 1978 inCarlsbad, California.  In 1987, DonJoywas acquired by Smith & Nephew, Inc. and on June 30, 1999, DonJoyconsummated a recapitalization pursuant to which J.P. Morgan DJ Partners, LLCobtained a controlling interest in DonJoy from Smith & Nephew.  Concurrently with the completion of ourinitial public offering on November 20, 2001, DonJoy merged with us through aseries of transactions, which we refer to as the reorganization.  Our headquarters are located at 2985 ScottStreet, Vista, California 92081.  Ourtelephone number is (800) 336-5690.  Ourwebsite address is *www.djortho.com*.

 

We file annualreports, such as this Form 10-K, as well as quarterly reports on Form 10-Q andcurrent reports on Form    8-K, with theU.S. Securities and Exchange Commission (SEC). We make these reports available free of charge on our website under theinvestor relations page.  These reportscan be accessed the same day as they are filed with the SEC.  All such reports were made available in thisfashion during 2003.

 

4TITUDE®,Defiance®, dj Ortho®, DonJoy®, IceMan®,OfficeCare®, ProCare®, SpinaLogic®, UltraSling®, LegendTM,UltraSling ERTM, Knee GuaranteeTM, OL1000TM,OL1000 SCTM, OrthoFrameTM, DonJoy VistaTM,DonJoy Pain Control DeviceTM and RegentekTM are certainof our registered trademarks and trademarks for which we have applicationspending or common law rights.  All otherbrand names, trademarks and service marks appearing in this annual report arethe property of their respective holders.

** **

**Public Offering of Common Stock**

 

On February 24,2004, we completed an offering of 8,625,000 shares of common stock.  The offering consisted of 3,162,500 sharesof common stock sold by us at $19.00 per share for net proceeds of $56.7million and 5,462,500 shares sold by certain of our stockholders.  We intend to purchase and/or redeem all ofthe outstanding senior subordinated notes with the net proceeds from the saleof the shares by us plus existing cash. We may purchase the notes in the open market, in privately negotiatedtransactions, or, on or after June 15, 2004, redeem these notes pursuant to theterms of the indenture governing the notes. In the event we redeem the notes,in addition to the write-off of the call premium, we will write-off unamortizeddebt issuance costs and discounts related to the notes.  If we redeem all of the notes on June 15,2004, the call premium will be $4.7 million and the unamortized debt issuancecosts and discounts will be approximately $3.0 million.  In the event we purchase the notes on theopen market before June 15, 2004, these unamortized debt issuance costsand discounts will be higher.  We havereceived the consents necessary under our new credit agreement to use the proceedsfrom the sale of shares by us and cash on hand to purchase and/or redeem thesenior subordinated notes.

 

**The RegentekAcquisition**

 

In November 2003,we acquired the bone growth stimulation device business of OrthoLogic, which wenow operate as our Regentek division, for approximately $93.0 million incash.  We financed the purchase withcash on hand of $12.1 million and a portion of the proceeds of a$100.0 million term loan pursuant to a new credit agreement. Proceeds fromthe term loan were also used to repay our existing bank debt amounting to approximately$15.5 million. The new credit agreement also provides us with availableborrowings under a $30.0 million revolving credit facility.

 

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The bone growthstimulation products we acquired, which utilize proprietary combined magneticfield technology to deliver a highly specific, low-energy signal, include theOL1000 for the non-invasive treatment of an established nonunion fracture andSpinaLogic, a device used as an adjunct therapy after primary lumbar spinalfusion surgery.  For the year endedDecember 31, 2003, pro forma revenues for the Regentek division were$46.4 million, representing growth of approximately 19% from 2002.

 

The Regentekacquisition enabled us to enter the regeneration market and offer our firstproduct that targets the spine.  Frost& Sullivan projects that the bone growth stimulation segment of thenon-operative orthopedic and spine markets will double between 2002 and 2008,from $325 million to $640 million, which represents approximately a12% compounded annual growth rate.  Webelieve the Regentek acquisition provides us with the opportunity to accelerateour revenue growth and to expand our gross margins.  We intend to leverage our existing distribution channels andpursue cross-selling opportunities for our rehabilitation and regenerationproducts.

 

**Our Strategy**

 

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

 

•                  *FurtherPenetrate Our Existing Customer Base.*  We are focused on increasing the number and variety of productssold to our existing customers.  Webelieve that our OfficeCare program provides us with a strong platform forselling additional products to our existing customers because of the amount ofcontact our sales representatives have with the orthopedic practices whoparticipate in the program.  We alsobelieve that the addition of the bone growth stimulation products to our existingproduct line will further this goal by providing significant cross-sellingopportunities.  We believe thisacquisition will provide us the opportunity to further penetrate our customerbase by providing additional products to satisfy our customers’ orthopedicneeds.

 

•                  *Continue to Introduce New Products and Product Enhancements.*  We havea history of developing and introducing innovative products into themarketplace, and are committed to continuing that tradition by introducing newproducts across our product platform. We believe that product innovation through effective and focusedresearch and development will provide a sustainable competitive advantage.  We are currently a technology leader inseveral product categories and we intend to continue to develop next generationtechnologies.

 

•                  *Expand Our OfficeCare Channel.*  OurOfficeCare channel currently includes over 540 physician offices encompassingapproximately 1,900 physicians.  Weestimate that there are approximately 10,000****orthopedicphysicians in the United Statespracticing in offices with three or more physicians.  We believe that our OfficeCare channel serves a growing needamong orthopedic practices to have a number of products readily available forimmediate distribution to patients and represents an opportunity forsignificant sales growth.  We intend toexpand our OfficeCare channel into more “high-volume” orthopedic offices,thereby increasing the number of potential customers to whom we sell our products.

 

•                  *Maximize Existing and Secure Additional National Accounts.*  We planto capitalize on the growing practice in healthcare in which hospitals andother large healthcare providers seek to consolidate their purchasingactivities to national buying groups. Executing on this strategy, in May 2003,we were awarded a contract from Broadlane, Inc., and in December 2003 we wereawarded an account with Premier, Inc. Contracts with these national accounts represent a significantopportunity for sales growth. We believe that our broad range of products arewell suited to the goals of these buying groups and intend to pursue thesecontracts aggressively.

 

•                  *Expand Product Offerings forthe Spine*.  SpinaLogic is our first product thattargets the spine.  According to Frost& Sullivan, back pain is the number one cause of healthcare expenditure inthe United States.  The spine segment ofthe orthopedics market is estimated to grow in excess of 18% from 2001 to2005.  As a result, we believe thatexpanding our product offerings in this market represents a significant growthopportunity.

 

•                  *Pursue Selective Strategic Acquisitions.* We believe that strategic acquisitions representan attractive and efficient means to broaden our product lines. The productsacquired in the Regentek acquisition, for example, which generated pro formarevenues of approximately $46.4 million during the twelve months endedDecember 31, 2003, enabled us to enter the regeneration market, which ispredicted to grow faster than the rehabilitation market. We intend to pursue acquisitionopportunities that enhance sales growth, are accretive to earnings, increasecustomer penetration and/or provide geographic diversity.

 

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•                  *ExpandInternational Sales*.International sales historically represented less than 15% of our revenues.Although our presence outside the United States has been limited, we havesuccessfully established direct distribution capabilities in majorinternational markets.  We believe thatsales to foreign markets continue to represent a significant growth opportunityand we intend to continue to develop direct distribution capabilities inselected foreign markets.

 

**Our Addressable Markets**

 

According to Frost& Sullivan, the segment of the non-operative orthopedic and spine marketswe target is estimated to generate sales of approximately $1.6 billion in2004 and is expected to grow at approximately 5.4% per annum until 2008.  The non-operative orthopedic and spinemarkets we target are further segmented into rehabilitation products, includingrigid knee braces, soft goods and pain management products, which are used inthe prevention of injury, in the treatment of chronic conditions and forrecovery after surgery or injury, and regeneration products, including bonegrowth stimulation devices, which are used to treat nonunion fractures and asan adjunct therapy after spinal fusion surgery.

 

We believe that the growth of the markets we target isbeing driven by the following factors:

 

•                  *Growing elderly populations with broad medicalcoverage, increased disposable income and longer life expectancy.*  People over 65 years old currently representabout 13% of the U.S. population, yet are estimated to account for nearly 40%of healthcare expenditures.  Thispopulation segment is expected to increase as a result of aging “baby boomers”(people born between 1946 and 1965) and longer life expectancies.

 

•                  *Growing emphasis on physical fitness, leisure sportsand conditioning, which has led to increased injuries, especially among women.*  A U.S. Consumer Product Safety Commissionsurvey determined that from 1990 to 1996 there was an 18% increase in thenumber of sports-related injuries among the 25 to 64 population segment.  From 1991-1998, “baby boomers” likewiseexperienced significant increases in sports-related injuries: 64% for those wholift weights, 240% for golfers and more than four times for those that engagein general exercise and running.  Inaddition, according to industry studies, female athletes are six to eight timesmore likely than their male counterparts to suffer ACL injuries.

 

•                  *Increasing awareness and use of non-invasive devicesfor prevention, treatment and rehabilitation purposes.*  The growing awareness and clinicalacceptance by patients and healthcare professionals of the benefits ofnon-invasive solutions continues to drive demand for non-operativerehabilitation and regeneration products.

 

**Products**

** **

*Rigid Knee Bracing*

 

We design,manufacture and market a broad range of rigid knee braces, including ligamentbraces, which are designed to provide support for knee ligament instabilities,post-operative braces, which are designed to provide both knee immobilizationand a protected range of motion, and osteoarthritic braces, which are designedto provide relief of knee pain due to osteoarthritis. These products aregenerally prescribed to a patient by an orthopedic physician or provided byathletic trainers for use in preventing injury. Our rigid knee braces areeither customized braces, utilizing basic frames which are thencustom-manufactured to fit a patient’s particular measurements, or are standardbraces which are available “off-the-shelf” in various sizes and can be easilyadjusted to fit the patient in the orthopedic professional’s office.  Sales of rigid knee braces representedapproximately 38% and 32%, respectively,****ofour historical and pro forma revenues for 2003.

 

We introduced ourfirst rigid knee brace in 1980, and in 1985 we introduced the first rigid kneebrace using our patented “Four Points of Leverage” system.  Since 1991, we have introduced ten newligament braces, including our flagship brace, Defiance, in 1992, six newpost-operative knee braces and five new osteoarthritic braces.  Our rigid knee braces have achieved leadingmarket share, which we attribute to our design improvement, strong brand namerecognition and product quality.

* *

*LigamentBraces. *Ligamentbraces are designed to provide durable support for moderate to severe kneeligament instabilities to help patients regain range of motion capability sothey can successfully complete rehabilitation and resume daily activities afterknee surgery or injury. Ligament braces are generally prescribed six to eightweeks after knee surgery, often after use of a more restrictive post-operativebrace. Our ligament braces can also be used to support the normal functioningof the knee to prevent injury. Our ligament bracing product line includescustomized braces generally designed for strenuous athletic activity andoff-the-shelf braces generally designed for use in less rigorous activity.  According to Frost & Sullivan, in 2002we were #1 in the United States in non-retail sales of ligament braces with a39% market share.

 

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In 2001, weintroduced the Knee Guarantee program in connection with our Defiance ligamentbrace. We believe that we are the only orthopedic company in the United Statesthat provides such a guarantee.  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 Defiance ligamentbrace. Since we introduced this guarantee, claims under the program have beenminimal.

 

*Post-operative Braces.*Post-operativebraces are designed to limit a patient’s range of motion after knee surgery andprotect the repaired ligaments and/or joints from stress and strain that wouldslow or prevent a healthy healing process. The products within this lineprovide both immobilization and a protected range of motion, depending on therehabilitation protocol prescribed by the orthopedic surgeon. Ourpost-operative bracing product line includes a range of premium to lower pricedoff-the-shelf braces and accessory products. According to Frost & Sullivan, in 2002 we were #1 in the UnitedStates in non-retail sales of post-operative braces with a 33% market share.

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*Osteoarthritic Braces.*Osteoarthriticbraces are used to treat patients suffering from osteoarthritis. Our line of customizedand off-the-shelf osteoarthritic braces is designed to redistribute weightthrough the knee, providing additional stability and reducing pain, and in somecases may serve as a cost-efficient alternative to total knee replacement.  Frost & Sullivan estimates that sales ofosteoarthritic braces are expected to grow at a 12.9% annual rate between 2002and 2006.  According to Frost &Sullivan, in 2002 we were #2 in the United States in non-retail sales of osteoarthriticbraces with a 23% market share.

 

*SoftGoods*

 

Our soft goodsproduct line originally consisted of simple neoprene braces for the knee,thigh, elbow and ankle.  We now haveover 400 soft goods products, including fracture boots, shoulder and elbowbraces, as well as a range of products that offer immobilization and supportfrom head to toe.  Our soft goodsproducts represented approximately 50% and 41%, respectively,****of our historical and pro forma revenuesfor 2003.

* *

*SoftBracing. *Theseproducts are generally constructed from fabric or neoprene materials and aredesigned to provide support, immobilization and/or heat retention andcompression of the knee, ankle, back and upper extremities, including theshoulder, elbow, neck and wrist.  Wecurrently offer products ranging from simple neoprene knee sleeves to moreadvanced products that incorporate materials and features such as air-inflatedcushions and metal alloy hinge components. According to Frost & Sullivan, in 2002 we were #2 in the UnitedStates in non-retail sales of both knee soft goods, with a 17% market share,and ankle braces and supports, with a 20% market share, the two largestsegments of the soft goods market.

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*Lower Extremity FractureBoots.*These products are boots that fit on apatient’s foot and provide comfort and stability for ankle and foot injuriesranging from ankle sprains and soft tissue and stress fractures in the lowerleg to stable fractures of the ankle. Fracture boots are used as an alternative to traditional casts. * **In 2003, w*eintroduced a line of fracture boots designed for patients suffering frompre-ulcerative and ulcerative foot conditions, primarily related tocomplications from diabetes.  Accordingto Frost & Sullivan, in 2002 we were #1 in the United States in sales offracture boots, with a 28% market share.

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*Shoulder and ElbowBraces.*We offer a line of shoulder and elbow bracesand slings, which are designed for immobilization after surgery and allow forcontrolled motion. For example, the UltraSling is a durable oversized sling,which offers immobilization and support for mild shoulder sprains and strains.In 2003, we introduced the UltraSling ER that externally rotates the injuredshoulder for improved healing. According to Frost & Sullivan, in 2002 we were #2 in the UnitedStates in non-retail sales of upper-extremity soft goods, with a 25% marketshare.

* *

*Pain Management Products*

 

Our portfolio ofpain management products includes cold therapy products to assist in thereduction of pain and swelling and a system that employs ambulatory infusion pumpsfor the delivery of local anesthetic to the surgical site.  Our pain management products accounted forapproximately 10% and 8%, respectively, of our historical and pro formarevenues for 2003.

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*Cold Therapy Products.**Cold therapy products*are designedto *help reduce swelling, minimize the needfor post-operative pain medications and generally accelerate the rehabilitationprocess. *Wemanufacture, market and sell the IceMan****device,as well as other cold therapy products such as ice packs and wraps. The IceManproduct is a portable device used after surgery or injury.  The product consists of a durable quiet pumpand control system used to circulate cold water from a reservoir to a paddesigned to fit the injured area, such as the ankle, knee or shoulder. TheIceMan product uses a patented circulation system to provide constant fluidflow rates, thereby minimizing temperature fluctuations. We recently introduceda manual cold therapy product that involves a simple, gravity based means ofapplying cold therapy.  According toFrost & Sullivan, in 2002 we were #3 in the United States in non-retailsales of cold therapy products with a 12% market share.

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* *

*Ambulatory InfusionPumps.**Ambulatoryinfusion pumps*are designed to provide a continuous infusionof local anesthetic dispensed by a physician directly into a surgical sitefollowing surgical procedures.  We arethe exclusive North American distributor of a pain management systemmanufactured by McKinley Medical, LLLP called the DonJoy Pain ControlDevice.  This portable device consistsof a range of introducer needles, catheters for easy insertion and connectionduring surgery and pumps for continuous infusion for up to 72 hours. The paincontrol systems are intended to provide direct pain relief, reduce hospitalstays and allow earlier and greater ambulation. Our exclusive distributionrights for these products continue until 2007 and may be extendedthereafter.  According to Frost &Sullivan, in 2002 we were #3 in the United States in non-retail sales ofambulatory infusion pumps with a 20% market share.

 

*Bone Growth Stimulation Products*

 

Bone growthstimulation devices are designed to promote the healing of musculoskeletal boneand tissue through electromagnetic field technology.  The bone growth stimulation products we acquired utilizeproprietary combined magnetic field 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.  Approximately3-5% of fractures are nonunion.  TheSpinaLogic product is used as an adjunct therapy after primary lumbar spinalfusion surgery for at-risk patients.  Patientsare considered at-risk when the natural healing process of the bone may becompromised by other health conditions of the patient, such as diabetes,smoking habits, weight, age and the severity and location of the fracture.  Our bone growth stimulation productsaccounted for approximately 2% and 19%, respectively, of our historical and proforma revenues for 2003.

 

Patients usingbone growth stimulation devices generally receive a prescription for theproduct from their physician.  Afterinsurance approval, the patient receives the device and starts therapy,typically at home.  The patient isusually instructed to wear our bone growth stimulators for only 30 minutes eachday, a significantly shorter period than competing products, which may requireup to 24 hours of daily therapy.  Webelieve the reduced treatment time leads to increased patient compliance withtreatment protocol.  The length oftherapy with our products varies, but usually is between 25 and 40 weeks.

* *

*OL1000.*  The OL1000 product is a FDA approved devicethat comprises two magnetic field treatment transducers, or coils, and amicroprocessor-controlled signal generator that delivers a highly specific,low-energy signal to the injured area. This signal is designed to stimulate bone growth and healing.  This unique system has a micro-controllerthat tracks the patient’s daily treatment compliance.  The OL1000 is used for the non-invasive treatment of an establishednonunion fracture in all major long bones, such as the tibia, femur and humerus.

 

The OL1000 deviceis designed to be attached to the patient’s arm, leg or other area where thereis a nonunion fracture.  The OL1000 isdesigned to evenly distribute a magnetic field 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 SCproduct is a FDA approved single coil device, which utilizes the same combinedmagnetic field as the OL1000.  Thisproduct is available in three sizes and is designed to be more comfortable forpatients with certain types of fractures, such as clavicle and hip fractures,where only a single coil can be applied.

* *

*SpinaLogic*.  The SpinaLogic product is a FDA approved,portable, non-invasive, electromagnetic bone growth stimulator that is designedto enhance the healing process as an adjunct therapy after spinal fusionsurgery.

 

With theSpinaLogic product, the patient attaches the device to the lumbar injurylocation where it is designed to provide localized magnetic field treatment tothe fusion site.  Similar to the OL1000product, the SpinaLogic device contains a micro-controller that tracks thepatient’s daily treatment compliance and can be checked by the surgeon duringfollow-up visits.

** **

**Sales, Marketingand Distribution**

 

We distribute ourproducts through five sales channels: DonJoy, ProCare, OfficeCare, Regentek andInternational.  Our products aredistributed in the United States and international markets primarily throughnetworks of agents and distributors. These agents and distributors sell to orthopedic and spine surgeons,podiatrists, orthopedic and prosthetic centers, third-party distributors,hospitals, surgery centers, physical therapists, athletic trainers and otherhealthcare professionals.  Our DonJoy,ProCare and OfficeCare channels are managed by five regional general managerswho are responsible for managing the sale of all of our products across thesechannels.  Our bone growth stimulationproducts are sold to orthopedic surgeons and podiatrists in private practice,hospitals and clinics, as well as to general orthopedic physicians via directsales and marketing efforts.  Inaddition, our SpinaLogic product is marketed by Johnson & Johnson’s DePuySpine to orthopedic spine surgeons and neurosurgeons who perform spineprocedures.  Our international channelconsists of sales by our wholly-owned foreign

 

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subsidiaries and foreign independent distributors.  For the year ended December 31, 2003, nosingle customer represented more than 10% of our historical revenues.

 

*DonJoy*

 

The DonJoy sales channel, which is responsible forsales of rigid knee braces, pain management products and certain soft goods,accounted for approximately 48% and 40%, respectively, of our historical andpro forma revenues for 2003. The channel consists of approximately 270independent commissioned sales representatives who are employed byapproximately 40 independent sales agents and a few of our direct salesrepresentatives. These representatives are primarily dedicated to the sale ofour products to orthopedic surgeons, podiatrists, orthopedic and prostheticcenters, hospitals, surgery centers, physical therapists, athletic trainers andother healthcare professionals.  Becausethe DonJoy product lines generally require customer education on theapplication and use of the product, our sales representatives are technicalspecialists who receive extensive training both from us and the agent and usetheir expertise to help fit the patient with the product and assist theorthopedic professional in choosing the appropriate product to meet thepatient’s needs.

 

After a sales representative receives a product order,we generally ship and bill the product directly to the orthopedic professional,paying a sales commission to the agent. We enjoy long-standing relationshipswith most of our agents and sales representatives. Under the arrangements withthe agents, each agent is granted an exclusive geographic territory for salesof our products and is not permitted to market products, or representcompetitors who sell or distribute products, that compete with our existingproducts. The agents receive a commission, which varies based on the type ofproduct being sold. If an agent fails to achieve specified sales quotas, we mayterminate the agent.

* *

*ProCare*

 

The ProCare channel employs approximately 30 directand independent representatives that manage over 320 dealers focused on primaryand acute facilities.  This channelaccounted for approximately 24% and 20%, respectively, of our historical andpro forma revenues for 2003.  Productsin this channel consist primarily of our soft goods line, which are generallysold in non-exclusive territories to third-party distributors. Thesedistributors include large, national third-party distributors such as Owens& Minor Inc., McKesson/HBOC, Allegiance Healthcare and Physican Sales andService Inc., regional medical surgical dealers, and medical products buyinggroups that consist of a number of dealers who make purchases through thebuying group.  These distributorsgenerally resell the products to large hospital chains, hospital buying groups,primary care networks and orthopedic physicians for use by the patient. Unlikethe rigid brace products, our soft goods products generally do not requiresignificant customer education for their use.

 

In response to the emergence of managed care and theformation of buying groups, national purchasing contracts and various biddingprocedures imposed by hospitals and buying groups, we have entered intonational contracts primarily for the sale of soft goods products, but oftenalso covering rigid knee braces, with large healthcare providers and buyinggroups, such as AmeriNet Inc., US Government/Military hospitals, NationalPurchasing Alliance, Magnet, Managed Healthcare Associates, Inc., Broadlane andPremier. Under these contracts, we provide favorable pricing to the buyinggroup and, as a result, are generally designated a preferred purchasing sourcefor the members of the buying group for specified products.  Members, however, are not obligated topurchase our products. We are also a supplier for HealthTrust Purchasing Group,Magnet, Managed Healthcare Associates, Inc. and Novation.  As part of our strategy, we seek to secureadditional national contracts with other healthcare providers and buying groupsin the future.

 

*OfficeCare*

 

Through OfficeCare, wemaintain an inventory of product (mostly soft goods) on hand at orthopedicpractices for immediate distribution to the patient.  For these products, we arrange billing to the patient orthird-party payor after the product is provided to the patient.  The OfficeCare sales channel accounted forapproximately 13% and 11%,respectively, of our historical and pro forma revenues for 2003.  Asof December 31, 2003, the OfficeCare program was located at over 540 physicianoffices throughout the United States. We have contracts with over 350 third-party payors for our OfficeCareproducts.

 

We currently outsource the revenue cycle portion ofthis program, from billing to collecting, to an independent third-partycontractor.  As a result of the growthof this program, our working capital needs have increased due to higher levelsof accounts receivable and inventories necessary to operate the program. Thecollection period for these receivables as compared to other portions of ourbusiness is significantly longer.

 

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*Regentek*

 

We conduct our sales efforts for the OL1000 through acombination of approximately 40 direct sales representatives and approximately25 regional sales agents who employ over 60 independent commissioned salesrepresentatives.  The SpinaLogic productis sold by DePuy Spine under a 10-year exclusive worldwide sales agreement,which can be unilaterally terminated by DePuy Spine with four months notice andexpires in 2010.  The agreement requiresDePuy Spine to meet annual sales minimums in order to maintainexclusivity.  Five Area Vice Presidentsmanage territory sales and coordinate marketing and sales efforts for the bonegrowth stimulation products.  OrthoLogichad approximately 380 third-party payor contracts in place for the OL1000 andSpinaLogic products when we acquired the business.  We are in the process of having these contracts issued in ourname and to date only have done so with approximately 168 contracts.  This channel accounted for approximately 2%and 19%, respectively, of our historical and pro forma revenues for 2003.

 

*International*

 

We market our products in over 30 countries outsidethe United States, primarily countries in Europe as well as in Australia,Canada and Japan. The International sales channel accounted for approximately13% and 10%, respectively, of our historical and pro forma revenues for 2003.International sales are currently made through two distinct channels:independent third-party distributors and through wholly-owned foreignsubsidiaries in Germany and the United Kingdom (in each case since January 1,2002), Canada (since May 2002) and France (since October 2003).

 

We believe that future opportunities for sales growthwithin international markets are significant. To this end, we established direct distributorship subsidiaries inforeign countries in 2002 and 2003. These wholly-owned subsidiaries have enabled us to obtain higher grossmargins on our products than we would have obtained on sales throughthird-party distributors.  In addition,we believe that more direct control of the distribution network in thesecountries will allow us to accelerate the launch of new products and productenhancements.

 

**Manufacturing**

 

Nearly all of ourrehabilitation products are manufactured in three buildings in a campus settingin Tijuana, Mexico.  We have signed alease for a 200,000 square foot built-to-suit facility in Tijuana where weintend to relocate all of our Mexico-based manufacturing operations in late2004.  The products that are stillmanufactured in Vista, California consist of our custom rigid bracing products,to facilitate 24-hour turn-around on custom orders, as well as our cold therapyproducts.  The OL1000 and SpinaLogicproduct lines are assembled and calibrated in Tempe, Arizona. Within our Vistaand Tijuana facilities, we operate a vertically integrated manufacturing andcleanroom packaging operation and are capable of producing a majority of oursubassemblies and components in-house. These include metal stamped parts,injection molding components and fabric-strapping materials. We also haveextensive in-house tool and die fabrication capabilities, which provide savingsin the development of typically expensive tools and molds as well asflexibility to respond to and capitalize on market opportunities as they areidentified.

 

Our Vista,California facility has achieved ISO 9001 certification, EN46001 certificationand certification to the European Medical Device Directive and our Mexicofacility has achieved ISO 9001 certification. In 2002, our list of certificationsfor both the Vista, California and Tijuana, Mexico facilities was expanded toadd the new Canadian Medical Device Regulation (ISO 13485). Thesecertifications are internationally recognized quality standards formanufacturing and assist us in marketing our products in certain foreignmarkets.

 

Most of the rawmaterials that we use in the manufacture of our products are available frommore than one source and are generally readily available on the open market. Wesource some of our finished products from manufacturers in China as well asother third-party manufacturers.

 

**Research and Development**

 

Our internalresearch and development program is aimed at developing and enhancing products,processes and technologies.  Theresearch and development activities for our rehabilitation products areconducted in our Vista, California facility by a group of product engineers anddesigners who have substantial experience in developing and designing productsusing advanced technologies, processes and materials. The research anddevelopment team uses computational tools and computer aided design, orCAD, systems during the development process that allow a design to bedirectly 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 also maintain a smallengineering team in Tempe, Arizona to support our bone growth stimulationproducts.

 

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We have developedand maintain 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 these surgeons and specialists whoparticipate in the design of products or provide consulting services havecontractual relationships with us under which they receive royalty payments orconsultant fees in connection with the development of particular products withwhich they have been involved. Our medical advisory board, consisting of fiveorthopedic surgeons, also assists in our product development by advising us ontechnological advances in orthopedics, along with competitive and reimbursementupdates within the orthopedic industry.

 

We maintain aclinical education research laboratory in our Vista, California facility, whichis used by orthopedic surgeons to evaluate our soft tissue repair products in asimulated surgical setting and practice surgical technique. These surgeonsoften provide us with feedback, which assists us in the development andenhancement of our products. In addition, we utilize our biomechanicallaboratory in our Vista, California facility to test the effectiveness of ourproducts. U.S. based and international surgeons and researchers collaboratewith our research staff to perform biomechanical testing. The tests aredesigned to demonstrate the functionality of new products and the effectivenessof new surgical procedures.  Mechanicalmodels are used to simulate behavior of normal, injured and osteoarthriticknees and observe the performance of new product designs as well as competitiveproducts. We host numerous orthopedic surgeons at our biomechanical andsurgical technique laboratories, which allows professionals to practiceprocedures and measure the effectiveness of those procedures.

 

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 ourproducts.  Finally, we act as thedistributor of a number of products that are manufactured by others.

 

**Competition**

 

The non-operativeorthopedic and spine markets are highly competitive and fragmented. Ourcompetitors include several large, diversified orthopedic companies andnumerous smaller niche companies. Some of our competitors are part of corporategroups that have significantly greater financial, marketing and other resourcesthan we do. Our primary competitors in the rigid knee brace market includecompanies such as Orthofix International, N.V.,  Bledsoe Brace Systems, Innovation Sports Incorporated, GenerationII USA, Inc. and Townsend Industries Inc. In the soft goods products market,our competitors include Aircast, Biomet, Inc., DeRoyal Industries, EncoreMedical Corporation, Royce Medical Co. and Zimmer Holdings, Inc.  In the pain management products market, ourcompetitors include Aircast, I-Flow Corp., Orthofix and StrykerCorporation.  In the bone growthstimulation market, our competitors include Orthofix, Biomet and Smith &Nephew.

 

Competition in therigid knee brace market is primarily based on product technology, quality andreputation, relationships with customers, service and price. Competition in thesoft goods market is less dependent on innovation and technology and isprimarily based on product range, service and price. Several competitors haveinitiated stock and bill programs similar to our OfficeCare program.  Competition in bone growth stimulationdevices is more limited as higher regulatory thresholds provide a barrier to marketentry.  International competition isprimarily from foreign manufacturers whose costs may be lower due to theirability to manufacture products within their respective countries.

 

We believe thatour extensive product lines, advanced product design, strong distributionnetworks, reputation with leading orthopedic professionals and customer serviceprovide us with an advantage over our competitors. In particular, we believethat our broad product lines provide us with a competitive advantage over thesmaller companies, while our established distribution networks andrelationship-based selling efforts provide us with a competitive advantage overlarger manufacturers.

 

**IntellectualProperty**

 

Our mostsignificant intellectual property rights are our patents and trademarks,including our brand names, and proprietary know-how.

 

We own or havelicensing rights to approximately 120 U.S. and foreign patents andapproximately 70 pending patent applications. We anticipate that we will applyfor additional patents in the future as we develop new products and productenhancements. One of our most significant patents, which is registered only inthe United States, involves the bracing technology and design called the “FourPoints of Leverage” system. A majority of our ligament bracing products andcertain of our osteoarthritic braces have been designed using the “Four Pointsof Leverage” system which exerts a force on the upper portion of the tibia,which, in turn, reduces strain on the damaged, reconstructed or torn ligament.Our patent covering the “Four Points of Leverage” system expires in January2005.  Revenues generated from productsusing our “Four Points of Leverage” system accounted for approximately 25%, 25%and 26% of our historical net revenues for 2003, 2002, and 2001, respectively.

 

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Our othersignificant patents include the custom contour measuring instrument, whichserves as an integral part of the measurement process for patients using ourcustomized ligament and osteoarthritic braces. In addition, we own patents covering a series of hinges for our rigidknee braces, as well as pneumatic pad design and production technologies (whichutilize air inflatable cushions that allow the patient to vary the location anddegree of support) used in rigid knee braces such as the Defiance ligamentbrace.  We also have patents relating toour osteoarthritic braces and specific mechanisms in a number of our products.

 

In addition tothese patents, we rely on non-patented know-how, trade secrets, processes andother proprietary 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 believethat our patents, trademarks and other proprietary rights are important to thedevelopment and conduct of our business and the marketing of our products. As aresult, we intend to continue to aggressively protect our intellectual propertyrights.

 

# ***Employees***

 

As of December 31,2003, we had approximately 1,300 employees. Approximately 50% of our employees work in Mexico. Our employees are notunionized.  We have not experienced anystrikes or work stoppages, and management considers its relationships with ouremployees to be good.

 

**GovernmentRegulation**

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*Medical Device Regulation*

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*United States. *Our products andoperations are subject to regulation by the FDA, state authorities andcomparable authorities in foreign jurisdictions.  The FDA regulates the research, testing, manufacturing, safety,labeling, storage, recordkeeping, premarket clearance or approval, promotion,distribution and production of medical devices in the United States to ensurethat medical products distributed domestically are safe and effective for theirintended uses.  In addition, the FDAregulates the export of medical devices manufactured in the United States tointernational markets.

 

Under the FederalFood, Drug, and Cosmetic Act, or FFDCA, medical devices are classified into oneof three classes—Class I, Class II or Class III—depending on thedegree of risk associated with each medical device and the extent of controlneeded to ensure safety and effectiveness. Our currently marketed rehabilitation products are all Class I orClass II medical devices.  Ourcurrently marketed bone growth stimulator products are Class III medicaldevices.

 

Class Idevices are those for which safety and effectiveness can be assured byadherence to a set of guidelines called General Controls, including compliancewith the applicable portions of the FDA’s Quality System Regulation, or QSR,facility registration and product listing, reporting of adverse medical events,and appropriate, truthful and non-misleading labeling, advertising, and promotionalmaterials.

 

Class IIdevices also are subject to the General Controls, and most require premarketdemonstration of adherence to certain performance standards or other specialcontrols and clearance by the FDA. Premarket review and clearance by the FDA for these devices may beaccomplished through the 510(k) premarket notification procedure.  Unless a specific exemption applies, 510(k)premarket notification submissions are subject to user fees.  Certain Class I and Class II devices areexempt from this premarket review process. When a 510(k) is required, the manufacturer must submit to the FDA apremarket notification submission demonstrating that the device is“substantially equivalent” to either a device that was legally marketed priorto May 28, 1976 (the date upon which the Medical Device Amendments of 1976 wereenacted) or another commercially available, similar device that wassubsequently cleared through the 510(k) process.

 

If the FDA agreesthat the device is substantially equivalent, it will grant clearance tocommercially market the device.  Byregulation, the FDA is required to clear a 510(k) premarket notification within90 days of submission of the application. As a practical matter, clearance often takes longer; however, ourproducts have generally been cleared within the 90-day time period.  If the FDA determines that the device, orits 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 premarketing requirements.

 

A Class IIIdevice is a product which has a new intended use or uses advanced technologythat is not substantially equivalent to a use or technology with respect to alegally marketed device.  The safety andefficacy of Class III devices cannot be assured solely by the General Controlsand the other requirements described above. These devices almost always require formal clinical studies todemonstrate safety and effectiveness.

 

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Submission and FDAapproval of a premarket approval application, or PMA, is required beforemarketing of a Class III product can proceed. Unless an exemption applies, PMA submissions also are subject to userfees.  The PMA process is much moredemanding than the 510(k) premarket notification process.  A PMA application, which is intended todemonstrate that the device is safe and effective, must be supported byextensive data, including data from preclinical studies and human clinicaltrials.  The PMA must also contain afull description of the device and its components, a full description of themethods, facilities and controls used for manufacturing, and proposedlabeling.  Following receipt of a PMAapplication, once the FDA determines that the application is sufficientlycomplete to permit a substantive review, the FDA will accept the applicationfor review.  The FDA, by statute and byregulation, has 180-days to review an “accepted” PMA application, although thereview of an application more often occurs over a significantly longer periodof time, and can take up to several years. In approving a PMA application or clearing a 510(k) application, the FDAmay also require some form of post-market surveillance when necessary toprotect the public health or to provide additional safety and effectivenessdata for the device.  In such cases, themanufacturer might be required to follow certain patient groups for a number ofyears and to make periodic reports to the FDA on the clinical status of thosepatients.

 

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

 

Our manufacturingprocesses are required to comply with the applicable portions of the QSR, whichcovers the methods and documentation of the design, testing, production,processes, controls, quality assurance, labeling, packaging and shipping of ourproducts.  The QSR also, among otherthings, requires maintenance of a device master record, device history record,and complaint files.  Our domesticfacility records and manufacturing processes are subject to periodicunscheduled inspections by the FDA.  OurMexican facilities, which export products to the United States, may also beinspected by the FDA.  Based on internalaudits of our domestic and Mexican facilities, we believe that our facilitiesare in substantial compliance with the applicable QSR regulations.  We also are required to report to the FDA ifour products cause or contribute to a death or serious injury or malfunction ina way that would likely cause or contribute to death or serious injury were themalfunction to recur.  Although medicaldevice reports have been submitted in the past 5 years, none have resulted in arecall of our products or other regulatory action by the FDA.  The FDA and authorities in other countriescan require the recall of products in the event of material defects ordeficiencies in design or manufacturing. The FDA can also withdraw or limit our product approvals or clearancesin the event of serious, unanticipated health or safety concerns.

 

The FDA has broadregulatory 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 to suspensionor delayed issuance of approvals, seizure or recall of our products, total orpartial shutdown of production, withdrawal of approvals or clearances alreadygranted, and criminal prosecution.  TheFDA can also require us to repair, replace or refund the cost of devices thatwe manufactured or distributed.  If anyof these events were to occur, it could materially adversely affect us.

 

Legal restrictionson the export from the United States of any medical device that is legallydistributed in the United States are limited. However, there are restrictions under U.S. law on the export from theUnited States of medical devices that cannot be legally distributed in theUnited States.  If a Class I orClass II device does not have 510(k) clearance, and the manufacturerreasonably believes that the device could obtain 510(k) clearance in the UnitedStates, then the device can be exported to a foreign country for commercialmarketing without the submission of any type of export request or prior FDAapproval, if it satisfies certain limited criteria relating primarily tospecifications of the foreign purchaser and compliance with the laws of thecountry to which it is being exported (Importing Country Criteria).  We believe that all of our current productswhich are exported to foreign countries currently comply with theserestrictions.

 

An unapprovedClass III device can be exported if: (1) it is in substantial compliance withthe QSR or an FDA-recognized foreign standard; (2) the device satisfies theImporting Country Criteria; (3) the device is being exported to certain listedcountries or the importing country has accepted the marketing authorization ofone of those listed countries; and (4) the device is not being exported forinvestigational use.  Otherwise, theunapproved Class III device may be exported if the FDA determines that theexportation would not be contrary to public health, approval is obtained froman appropriate authority in the importing country, and the device satisfies theImporting Country Criteria.  We do notcurrently export any unapproved Class III devices.

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*International. **In many of the foreign countries in which we marketour products, we are subject to regulations affecting, among other things,product standards, packaging requirements, labeling requirements, importrestrictions, tariff regulations, duties and tax requirements.  Many of the regulations applicable to ourdevices and products in such countries are essentially similar to those of theFDA, including those in Germany, our largest foreign market.  The regulation of our products in Europefalls primarily within the European Economic Area, which consists of thefifteen member states of the European Union as well as Iceland, Liechtensteinand Norway.  The legislative bodies ofthe European Union have adopted three directives in order to harmonize nationalprovisions regulating the design, manufacture, clinical trials, labeling andadverse event reporting for medical devices: the Council Directives 90/385/EEC (Actives Implantables Directive);93/42/EEC (Medical Device Directive); and 98/79/EC (In-Vitro-DiagnosticsDirective).  The member states of theEuropean Economic Area have implemented the directives into their respectivenational law.  Medical devices thatcomply with the essential 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 CEmarking may be marketed within the European Economic Area.  The European Commission has adopted numerousguidelines relating to the medical devices directives to ensure their uniformapplication.  The method of assessingconformity varies depending on the class and type of the medical device and caninvolve a combination of self-assessment by the manufacturer and a third-partyassessment by a Notified Body, which is an independent and neutral institutionappointed by the member states to conduct the conformity assessment.  This third-party assessment may consist ofan audit of the manufacturer’s quality system and specific testing of themanufacturer’s devices.  An assessmentby a Notified Body in one country within the European Economic Area isgenerally required in order for a manufacturer to commercially distribute theproduct throughout the European Economic Area.*

* *

*TheEuropean Standardization Committees have adopted numerous harmonized standardsfor specific types of medical devices. Compliance with relevant standards establishes the presumption ofconformity with the essential requirements for a CE marking.  Our quality system relating to thedevelopment, production and distribution of rigid and soft orthopedic bracing,cold therapy products and orthopedic fixation devices/instruments is certifiedthrough April 30, 2004 for our two facilities in Vista, California and ourfacility in Tijuana, Mexico.  Ourquality system relating to the manufacturing of leg contour measuring devicesand angle reference bending tools in our facilities in Vista, California hasbeen certified and the existing certificate is currently in the process ofbeing extended. The existing certificate remains valid until the issue of a newcertificate.*

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*Postmarket surveillance of medical devices in the European Economic Area isgenerally conducted on a country-by-country basis.  The requirement within the member states of the European EconomicArea vary.  Due to the movement towardsharmonization of standards in the European Union and the expansion of theEuropean Union, we expect a changing regulatory environment in Europecharacterized by a shift from a country-by-country regulatory system to aEuropean Union-wide single regulatory system. The timing of this harmonization and its effect on us cannot currently bepredicted.*

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

 

*Federal Privacy and Transaction Law and Regulations*

 

Other federallegislation requires major changes in the transmission and retention of healthinformation by us.  The Health InsurancePortability and Accountability Act of 1996, or HIPAA, mandates, among otherthings, the adoption of standards for the electronic exchange of healthinformation that may require significant and costly changes to currentpractices.  Sanctions for failure tocomply with HIPAA include civil and criminal penalties.  The U.S. Department of Health and Human Services, or HHS, has released threerules to date mandating the use of new standards with respect to certainhealthcare transactions and health information.  The first rule requires the use of uniform standards for commonhealthcare transactions, including healthcare claims information, planeligibility, referral certification and authorization, claims status, planenrollment and disenrollment, payment and remittance advice, plan premiumpayments, and coordination of benefits. The second rule released by HHS imposes new standards relating to theprivacy of individually identifiable health information.  These standards not only require ourcompliance with rules governing the use and disclosure of protected healthinformation, but they also require us to obtain satisfactory assurances thatany business associate of ours to whom such information is disclosed willsafeguard the information.  The thirdrule released by HHS establishes minimum standards for the security ofelectronic health information.  We wererequired to comply with the transaction standards by October 16, 2003 andthe privacy standards by April 14, 2003, and are required to comply withthe security standards by April 21, 2005.

 

*Third-PartyReimbursement*

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*Ourproducts generally are prescribed by physicians and are eligible forthird-party reimbursement.  An importantconsideration for our business is whether third-party payment amounts will beadequate, since this is a factor in our customers’*

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*selection of our products.  We believe that third-party payors willcontinue to focus on measures to contain or reduce their costs through managedcare and other efforts.  Medicarepolicies are important to our business because third-party payors often modeltheir policies after the Medicare program’s coverage and reimbursement policies.*

 

Healthcare reformlegislation in the Medicare area has focused on containing healthcarespending.  Most recently, on December 8,2003, President *Bush*signed the Medicare Prescription Drug, Improvement and Modernization Act of2003, or Modernization Act, which provides for revisions to paymentmethodologies and other standards for items of durable medical equipment andorthotic devices under the Medicare program. First, beginning in 2004 through 2008, the payment amounts for orthoticdevices (2004 through 2006) and durable medical equipment (2004 through 2008)will no longer be increased on an annual basis.  The freeze does not affect Class III devices such as bone growthstimulators, however.  Second, beginningin 2007, a competitive bidding program will be phased in to replace the existingfee schedule payment methodology. Off-the-shelf orthotic devices and other non-Class III devices aresubject to the program.  The competitivebidding program will begin in ten high population metropolitan statisticalareas and in 2009 will be expanded to 80 metropolitan statistical areas (andadditional areas thereafter).  Paymentsin regions not subject to competitive bidding may also be adjusted usingpayment information from regions subject to competitive bidding.  Third, supplier quality standards are to beestablished which will be applied by independent accreditationorganizations.  Fourth, clinicalconditions for payment will be established for certain products.

 

In recent years,efforts to control Medicare costs have included the heightened scrutiny ofreimbursement codes and payment methodologies. Under Medicare, certain devices used by outpatients are classified usingreimbursement codes, which in turn form the basis for each device’s Medicarepayment levels.  Changes to thereimbursement codes describing our products can result in reduced paymentlevels or the breadth of products for which reimbursement can be sought underrecognized codes.  In January 2003,Medicare introduced a new reimbursement code relating to tibial ankle-footfracture boot products.  Because webelieved that the new code, which provides for a lower payment value on theapplicable devices, may have applied to some or all of our lower extremityfracture boot products, we disputed this change.  As of January 2004, the reimbursement code was redefined, but thepayment levels remained the same.  Weare in the process of disputing the accuracy of the payment levels.

 

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

 

Beyond changes 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 from third-party reimbursementaccounted for approximately 19%, 17% and 17% of our historical net revenues forthe years ended December 31, 2003, 2002 and 2001, respectively.  Medicare reimbursement consisted ofapproximately 13% of our historical net revenues from third-party reimbursementor approximately 2% of our total historical net revenues for the year endedDecember 31, 2003.

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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 of these laws are punishable bycriminal and civil sanctions, including, in some instances, exclusion fromparticipation in federal and state healthcare programs, including Medicare,Medicaid, Veterans Administration health programs and TRICARE.  We believe that our operations are inmaterial compliance with such laws. However, because of the far-reaching nature of these laws, there can beno 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 no assurance that the occurrence of one ormore violations of these laws or regulations would not result in a materialadverse effect on our financial condition and results of operations.

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*Anti-kickback and FraudLaws. *Ouroperations are subject to federal and state anti-kickback laws.  Certain provisions of the Social SecurityAct, which are commonly known collectively as the Medicare Fraud and AbuseStatute, prohibit persons from knowingly and willfully soliciting, receiving,offering or providing remuneration directly or indirectly to induce either thereferral of an individual, or the furnishing, recommending, or arranging for agood or service, for which payment may be made under a federal healthcareprogram such as Medicare and Medicaid. The definition of “remuneration” has been broadly interpreted to includeanything of value, including such items as gifts, discounts, waiver ofpayments, and providing anything at less than its fair

 

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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.  Although full compliance with theseprovisions ensures against prosecution under the Medicare Fraud and AbuseStatute, the failure of a transaction or arrangement to fit within a specificsafe harbor does not necessarily mean that the transaction or arrangement isillegal or that prosecution under the Medicare Fraud and Abuse Statute will bepursued.  The penalties for violatingthe Medicare Fraud and Abuse Statute include imprisonment for up to five years,fines of up to $25,000 per violation and possible exclusion from federal healthcareprograms such as Medicare and Medicaid. Many states have adopted prohibitions similar to the Medicare Fraud andAbuse Statute, some of which apply to the referral of patients for healthcareservices reimbursed by any source, not only by the Medicare and Medicaidprograms.

 

Our OfficeCare programis a stock and bill arrangement through which we make our products and servicesavailable in the offices of physicians or other providers.  In conjunction with the OfficeCare program,we may pay participating physicians a fee for rental space and support servicesprovided by such physicians to us.  In aSpecial Fraud Alert issued by HHS’ Office of Inspector General, or OIG, inFebruary 2000, the OIG indicated that it may scrutinize stock and bill programsinvolving excessive rental payments or rental space for possible violation ofthe Medicare Fraud and Abuse Statute, but noted that legitimate arrangements,including fair market value rental arrangements, will not be consideredviolations of the statute.  We believewe have structured the OfficeCare program to comply with the Medicare Fraud andAbuse Statute.

 

HIPAA created twonew federal crimes: healthcare fraud and false statements relating tohealthcare matters.  The healthcarefraud statute prohibits knowingly and willfully executing or attempting toexecute a scheme or artifice to defraud any healthcare benefit program,including private payors.  The falsestatements statute prohibits knowingly and willfully falsifying, concealing orcovering up a material fact or making any materially false, fictitious orfraudulent statement or representation in connection with the delivery of orpayment for healthcare benefits, items or services.  This statute applies to any health benefit plan, not justMedicare 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 for the electronic exchange of healthinformation.

* *

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

* *

*False Claims Laws. *Under separatestatutes, submission of claims for payment that are “not provided as claimed”may lead to civil money penalties, criminal fines and imprisonment, and/orexclusion from participation in Medicare, Medicaid and other federally fundedstate health programs.  These falseclaims statutes include the federal False Claims Act, which prohibits theknowing filing of a false claim or the knowing use of false statements toobtain payment from the federal government. When an entity is determined to have violated the False Claims Act, itmust pay three times the actual damages sustained by the government, plusmandatory civil penalties of between $5,500 and $11,000 for each separate falseclaim.  Suits filed under the FalseClaims Act, known as “qui tam” actions, can be brought by any individual onbehalf of the government and such individuals (known as “relators” or, morecommonly, as “whistleblowers”) may share in any amounts paid by the entity tothe government in fines or settlement. In addition, certain states have enacted laws modeled after the federalFalse Claims Act.  Qui tam actions haveincreased significantly in recent years, causing greater numbers of healthcarecompanies to have to defend a false claim action, pay fines or be excluded fromthe Medicare, Medicaid or other federal or state healthcare programs as aresult of an investigation arising out of such action.

 

*Governmental Audits*

 

Becausewe participate in governmental programs as a supplier of medical devices, ouroperations are subject to periodic surveys and audits by governmental entitiesor contractors to assure compliance with Medicare and Medicaid standards andrequirements. To maintain our billing privileges, we are required to complywith certain supplier standards, including, by way of example, licensure anddocumentation requirements for our claims submissions.  From time to time in the ordinary course ofbusiness, we, like other healthcare companies, are audited by or receive claimsdocumentation requests from governmental entities,

 

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which may identifycertain deficiencies based on our alleged failure to comply with applicablesupplier standards or other requirements. We currently are under pre-paymentreview for certain claims we submit to one Medicare contractor (of the fourMedicare contractors processing our claims). This means that our claims must be submitted manually and withsupporting documentation.  Pre-paymentreview results in longer processing times. We review and assess such audits or reports and attempt to takeappropriate corrective action. We also are subject to surveys of our physicallocation for compliance with supplier standards.  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.

 

**Risk Factors**

 

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

* *

***Risks Related to Our Business***

*** ***

**We recently completed theRegentek acquisition and we may be unable to implement our business strategyrelative to this acquisition.**

** **

We completed theRegentek acquisition in November 2003. The business we acquired develops, manufactures and markets bone growthstimulation products designed to promote the healing of musculoskeletal boneand tissue through electromagnetic field technology.  As part of our strategy relative to this acquisition, we intendto market the bone growth stimulation products we acquired, particularly theOL1000 product, through our existing distribution channels in addition toRegentek’s existing direct sales force. Our ability to implement this strategy is, however, subject to a varietyof factors, many of which are beyond our control, including the following:

 

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

 

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

 

•                  wemay not be able to successfully integrate our distribution channels with theestablished channels for bone growth stimulation products.

 

In addition, OrthoLogic had approximately 380 third-party payorcontracts in place for the OL1000 and SpinaLogic products when we acquired thebusiness.  We are in the process ofhaving these contracts issued in our name and to date only have done so withapproximately 168 contracts.  We cannotassure you we will be successful in having these third-party payor contractsissued in our name, which could adversely affect our ability to obtain timelypayment or any payment for our sales of the OL1000 and SpinaLogicproducts.  Finally, we may not be ableto integrate the bone growth stimulation products or OrthoLogic personnel intoour existing business in a timely and cost-effective manner, or at all.

 

Because of theseand other factors, we may not be successful in implementing our strategyrelative to the Regentek acquisition. Furthermore, the implementation of our strategy may not improve ouroperating results.

** **

**Prior to the Regentek acquisition, we did not haveexperience operating in the regeneration segment of the non-operativeorthopedic and spine markets.**

 

Historically, ourprincipal focus has been the market for orthopedic rehabilitationproducts.  We attempted to enter thebone growth stimulation market in 2001 by licensing technology, calledOrthoPulse, under development by I.M.D., b.v. However, regulatory delays for the licensed technology prompted us toabandon this project.  Accordingly,prior to our acquisition of the bone growth stimulation device business fromOrthoLogic in November 2003, we did not have any experience operating in theregeneration segment of the non-operative orthopedic and spine markets.  The regeneration segment of the non-operativeorthopedic and spine markets may have different competitive characteristicsfrom those we have experienced in the market for our rehabilitationproducts.  In addition, the products weacquired from OrthoLogic are subject to Class III Food and Drug Administration,or FDA, review.  This level of review ismore stringent than that required for our rehabilitation products.

 

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In addition, we donot have any products other than the SpinaLogic bone growth stimulator thattarget the spine and do not have relationships with any spine surgeons thatcould facilitate our ability to market and sell this device.  Furthermore, DePuy Spine acts as theexclusive worldwide distributor of the SpinaLogic device and can unilaterallyterminate its arrangement with us on four months notice.  If this were to occur, we may not be able tofind a replacement distribution channel for this product in a timely manner.

 

As a result ofthese factors, we cannot assure you that we will be successful in operating inthe regeneration segment of the non-operative orthopedic and spine markets.

 

**If we do not effectively manage ourgrowth, our existing infrastructure may become strained, and we may be unableto increase sales of our products or generate revenue growth.**

 

In connection withthe Regentek acquisition, we hired approximately 140 additional employees, mostof whom are located in Tempe, Arizona. We currently intend to operate the bone growth stimulation devicebusiness as a stand-alone division.  Thegrowth that we have experienced, and in the future may experience, may providechallenges to our organization, requiring us to expand our personnel,manufacturing and distribution operations. Future growth may strain our infrastructure, operations, productdevelopment and other managerial and operating resources.  If our business resources become strained,we may be unable to increase sales of our products or generate revenue growth.

** **

**We have recently outsourced certain administrative functionsrelating to our OfficeCare sales channel to a third-party contractor and thistransition may not prove successful.**

 

Our OfficeCaresales channel maintains an inventory of products (mostly soft goods) on hand atorthopedic practices for immediate distribution to patients.  For these products, we arrange billing to apatient or third-party payor after the product is provided to the patient.  In March 2003, we began outsourcing therevenue cycle of this program, from billing to collections, to an independentthird-party contractor with an objective to reduce collection time and increasecollection amounts. The transition to this provider may not be successful inachieving these goals and there can be no assurance that we will not have toresume these administrative functions in the future.

** **

**Our principal stockholderowns a significant portion of our common stock and its interests may differfrom the interests of our other stockholders.**

 

J.P. Morgan DJPartners, LLC, or JPMDJ Partners, and its affiliates, beneficially ownapproximately 14% of our outstanding common stock.  As a result, JPMDJ Partners is able to influence all mattersrequiring the approval of our stockholders, including the election of directorsand the approval of significant corporate transactions, such asacquisitions.  This concentration ofownership could delay, defer or prevent a change in control of our company orimpede a merger, consolidation, takeover or other business combination, which astockholder may otherwise view favorably.  The interests of JPMDJ Partners may differ from the interests ofour other stockholders.

** **

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

 

We hold or licenseU.S. and foreign patents relating to a number of our components and productsand have patent applications pending with respect to other components andproducts. We also expect to apply for additional patents as we deem appropriate.

 

The patent for our“Four Points of Leverage” system is registered only in the United States andexpires in January 2005.  Revenuesgenerated from products using our “Four Points of Leverage” system representedapproximately 25%, 25% and 26% of our historical net revenues for 2003, 2002and 2001, respectively. The majority of our anterior cruciate ligament, or ACL,braces, including Defiance, Legend and 4TITUDE, and certain of ourosteoarthritic braces use this system. We believe a number of our competitorswill introduce ligament braces that incorporate aspects of our “Four Points ofLeverage” system once the patent expires. In such event, our competitors may be able to sell products that aresimilar to ours at lower prices than we currently sell our products, whichcould adversely affect our revenue and profitability.

 

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

 

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

 

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•                  seriesof hinges for our rigid braces;

 

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

 

•                  osteoarthritisbracing concepts;

 

•                  anklebracing, both rigid and soft;

 

•                  rigidshoulder bracing; and

 

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

 

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 alsodepends on non-patented proprietary know-how, trade secrets, processes andother proprietary information. We employ various methods to protect ourproprietary information, including confidentiality agreements and proprietaryinformation agreements with vendors, employees, consultants and others who haveaccess to our proprietary information. However, these methods may not provideus with adequate protection. Our proprietary information may become known to,or be independently developed by, competitors, or our proprietary rights inintellectual property may be challenged, any of which could have an adverseeffect on our business.

 

**Our transition todirect distribution of our products in selected foreign countries involvesfinancial and operational risks.**

 

We haveimplemented a strategy to selectively replace our third-party internationaldistributors with wholly-owned distributorships.  In 2002, we began to distribute our products in Germany/Austria,the United Kingdom and Canada through wholly-owned subsidiaries.  We established a wholly-owned distributorshipin France in September 2003.  We havelittle experience in managing a large international operation, and the creationof direct distribution capabilities in Germany/Austria, the United Kingdom,Canada and France has required changes in our organization and theimplementation of additional financial and operational controls.  We cannot assure you that we will be able tosuccessfully maintain organizational changes and controls or that ourinternational strategy will result in increased revenues or profitability.

** **

**If we are not ableto develop, license or acquire and market new products or product enhancementswe will 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 pursueacquisitions of other companies or product lines to expand our productportfolio.  Our ability to grow throughacquisitions depends on our ability to identify, negotiate, complete andintegrate suitable acquisitions.  Evenif we complete acquisitions we may experience:

 

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

 

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

 

•                  diversionof our management’s time and attention;

 

•                  limitedor no direct prior experience in new markets or countries we may enter;

 

•                  highercosts of integration than we anticipated; or

 

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

 

In addition, wemay require additional debt or equity financing for future acquisitions.  Such financing may not be available onfavorable terms, if at all.  Finally, inthe event we decide to discontinue pursuit of a potential acquisition, we wouldbe required to immediately expense all costs incurred in pursuit of thepossible acquisition which could have an adverse effect on our results ofoperations in the period in which the expense is recognized.  We had discontinued acquisition costs of$0.2 million and $0.4 million for the years ended December 31, 2002 and 2000,respectively.

 

We will be unableto remain competitive if we fail to develop, license or acquire and market newproducts and product enhancements.  Inaddition, if any of our new or enhanced products contain undetected errors ordesign defects, especially when first introduced, our ability to market theseproducts could be substantially delayed, resulting in lost revenue, potentialdamage to our reputation and/or delays in obtaining acceptance of the productby orthopedic and spine surgeons and other healthcare professionals.

** **

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

 

The sales of ourproducts depend significantly on the prescription or recommendation of suchproducts by orthopedic and spine surgeons and other healthcareprofessionals.  We have developed andmaintain close relationships with a number of widely recognized orthopedicsurgeons and specialists who assist in product research, development and marketing.  Failure of our products to retain thesupport of these surgeons and specialists, or the failure of our products tosecure and retain similar support from leading surgeons and specialists, couldhave an adverse effect on our business.

 

Our marketingsuccess also depends largely upon arrangements with independent agents anddistributors.  Our success depends uponour agents’ and distributors’ sales and service expertise and theirrelationships with the customers in the marketplace. Our failure to maintainrelationships with agents and distributors for marketing our products couldhave an adverse effect on our business.

** **

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

 

The non-operativeorthopedic and spine markets are highly 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 competitivedisadvantage with respect to these competitors.

 

In therehabilitation market, our primary competitors in the rigid knee bracingproduct line include Orthofix International, N.V., Bledsoe Brace Systems,Innovation Sports Incorporated, Generation II USA, Inc. and Townsend IndustriesInc.  Our competitors in the soft goodsproducts segment include Aircast, Biomet, Inc., DeRoyal Industries, EncoreMedical Corporation, Royce Medical Co. and Zimmer Holdings, Inc.  Our primary competitors in the painmanagement products market include I-Flow Corp., Orthofix and StrykerCorporation.

 

In theregeneration market, our primary competitors selling bone growth stimulationproducts approved 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 estimate that Biomet has a dominant shareof the market for bone growth stimulation products for nonunion fractures inthe United States and a dominant share of the market for use of its product asan adjunct therapy after spinal fusion surgery.

** **

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** **

**Our quarterlyoperating results are subject to substantial fluctuations and you should notrely on them as an indication of our future results.**

 

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

 

•                  the number ofbusiness days in each quarter;

 

•                  demand for ourproducts, which historically has been higher in the fourth quarter whenscholastic sports and ski injuries are more frequent;

 

•                  our ability tomeet the demand for our products;

 

•                  our transitionto direct distribution of our products in foreign countries;

 

•                  the number,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;

 

•                  our ability todevelop, introduce and market new and enhanced versions of our products on atimely basis;

 

•                  the impact ofany acquisitions that occur in a quarter;

 

•                  the impact ofany changes in generally accepted accounting principles;

 

•                  changes inpricing policies by us and our competitors and reimbursement rates bythird-party payors, including government healthcare agencies;

 

•                  the loss of anyof our distributors;

 

•                  changes in thetreatment practices of orthopedic and spine surgeons and their allied healthcareprofessionals; and

 

•                  the timing ofsignificant orders and shipments.

 

Accordingly, ourquarterly sales and operating results may vary significantly in the future andperiod-to-period comparisons of our results of operations may not be meaningfuland should not be relied upon as indications of future performance.  We cannot assure you that our sales willincrease or be sustained in future periods or that we will be profitable in anyfuture period.

 

**Our business planrelies on certain assumptions for the market for our products, which, ifincorrect, may adversely affect our profitability.**

 

We**believethat various demographics and industry specific trends will help drive growthin the rehabilitation and regeneration markets, including:

 

•                  a growingelderly population with broad medical coverage, increased disposable income andlonger life expectancy;

 

•                  a growingemphasis on physical fitness, leisure sports and conditioning, which has leadto increased injuries, especially among women; and

 

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

 

**These demographics and trends arebeyond our control.  The projecteddemand for our products could materially differ from actual demand if ourassumptions regarding these factors prove to be incorrect or do not materializeor if alternative treatments to those offered by our products gain widespreadacceptance.**

** **

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** **

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

** **

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

 

•                  subjectus to significant liabilities to third parties;

 

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

 

•                  requireus to cease using such technology.

 

Any one of theseoutcomes could have an adverse effect on 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, theexpense of defending such claims could be material.

 

We have been suedin the past few years by competitors who alleged, in one case, that ourosteoarthritis braces infringed their patents and in another case that certainof our lower extremity fracture boots infringed their patents.  We resolved the first matter through asettlement agreement involving the payment by us of license fees and are in theprocess of resolving the second matter through a settlement involving thepayment by us of royalties.  Inaddition, we have recently been sued for patent infringement relating to ourmanual cold therapy product, introduced in 2003.  We can provide no assurance that these matters will be settled orthat similar allegations will not be made with respect to other products ofours or that we will not have to make similar payments in the future.

 

In addition, wehave from time to time needed to, and may in the future need to, litigate toenforce our patents, to protect our trade secrets or know-how or to determinethe enforceability, scope and validity of the proprietary rights of others.Such enforcement of our intellectual property rights could involvecounterclaims against us. Any future litigation or interference proceedingswill result in substantial expense to us and significant diversion of effort byour technical and management personnel.

** **

**We have limitedsuppliers for some of our components and products which makes us susceptible tosupply shortages and could disrupt our operations.**

 

Some of ourimportant suppliers are in China and other parts of Asia and provide uspredominately finished soft goods products. In fiscal year 2003, we obtained approximately 17% of our totalpurchased materials from suppliers in China and other parts of Asia. Politicaland economic instability and changes in government regulations in these areascould affect our ability to continue to receive materials from our suppliersthere. 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, wepurchase the microprocessor used in the OL1000 and SpinaLogic devices from asingle manufacturer. Although there are feasible alternate microprocessors thatmight be used immediately, all are produced by a single supplier.  In addition, there are single suppliers forother components used in the OL1000 and SpinaLogic devices and only twosuppliers for the magnetic field sensor employed in them.  Establishment of additional or replacementsuppliers for these components cannot be accomplished quickly.

** **

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

 

CommencingJanuary 1, 2002, we began selling products through our subsidiaries inGermany in Euros and the United Kingdom in Pounds Sterling.  Commencing May 7, 2002, we beganselling products through our subsidiary in Canada in Canadian Dollars andcommencing in October 2003, we began selling products through oursubsidiary in France in Euros. The U.S. dollar equivalent of internationalsales denominated in foreign currencies both in fiscal years 2003 and 2002 werefavorably impacted by

 

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foreign currency exchange rate fluctuations with the weakening of theU.S. dollar against the Euro and the Pound Sterling.  The U.S. dollar equivalent of the related costs denominated inthese foreign currencies was unfavorably impacted during the same periods.  In addition, the costs associated with ourMexico-based manufacturing operations are incurred in Mexican pesos.  As we continue to distribute and manufactureour products in selected foreign countries, we expect that future sales andcosts associated with our activities in these markets will continue to bedenominated in the applicable foreign currencies, which could cause currencyfluctuations to materially impact our operating results.

 

We occasionallyengage in hedging transactions and may obtain in the future one or more formsof currency protection — in the form of forward exchange contracts, options orsimilar agreements — to “hedge” against the possible negative effects ofexchange rate fluctuations.  However, wecannot assure you that any hedging will adequately relieve the adverse effectsof exchange rate increases or that counterparties under these agreements willhonor their obligations thereunder.  Inaddition, we may be subject to risks of default by hedging counterparties.

 

We are alsosubject to other risks inherent in international operations such as politicaland economic conditions, foreign regulatory requirements, exposure to differentlegal requirements and standards, exposure to different approaches to treatinginjuries, potential difficulties in protecting intellectual property, import andexport restrictions, increased costs of transportation or shipping, currencyfluctuations, difficulties in staffing and managing international operations,labor disputes, difficulties in collecting accounts receivable and longercollection periods and potentially adverse tax consequences.  For example, in Germany, our largest foreignmarket, orthopedic professionals have started to re-use our bracing devices onmultiple patients, which could adversely impact our sales of these devices inthis market.  As we continue to expandour international business, our success will be dependent, in part, on ourability to anticipate and effectively manage these and other risks.  If we are unable to do so, these and otherfactors may have an adverse effect on our international operations.

 

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

 

We currently haveno manufacturing operations in any foreign country other than Mexico. For ourinternational sales to third-party distributors, the cost of transporting ourproducts to foreign countries is currently borne by our third-partydistributors who are also often required to pay foreign import duties on ourproducts. As a result, the cost of our products to our third-party distributorsis often greater than products manufactured by our competitors in that country.In addition, foreign manufacturers of competitive products may receive variouslocal tax concessions that lower their overall manufacturing costs. In order tocompete successfully in international markets, we may be required to open oracquire manufacturing operations abroad, which would be costly to implement andwould increase our exposure to the risks of doing business in foreign countries.We may not be able to successfully operate offshore manufacturing operations.

** **

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

 

We face aninherent business risk of exposure to product liability claims in the eventthat the use of our technology or products is alleged to have resulted inadverse effects. We have, from time to time, been subject to product liabilityclaims.  In addition, we have operated aKnee Guarantee program since 2001 in relation to our Defiance knee brace.  The Knee Guarantee program will, inspecified instances, cover a patient’s insurance deductible up to $1,000, orgive uninsured patients $1,000, towards surgery should an ACL re-injury occurwhile wearing the brace.  If there is asignificant increase in claims under this program, our business could beadversely affected.

 

We maintainproduct liability insurance with coverage of an annual aggregate maximum of$20 million.  The policy isprovided on a claims made basis and is subject to annual renewal. There can beno assurance that liability claims will not exceed the coverage limit of suchpolicy or that such insurance will continue to be available on commerciallyreasonable terms or at all.  If we donot or cannot maintain sufficient liability insurance, our ability to marketour products may be significantly impaired.

** **

**Wemay be adversely affected if we lose the services of any member of our seniormanagement team.**

** **

**We aredependent on the continued services of our senior management team, who havemade significant contributions to our growth and success.  Leslie H. Cross, our President and ChiefExecutive Officer, for example, has worked for us for 14 years and helped leadour 1999 recapitalization and transition from ownership by Smith & Nephewto a stand-alone company.  The loss ofany one or more members of our senior management team could have a materialadverse effect on us.**

** **

**Anyclaims relating to our improper handling, storage or disposal of wastes couldbe time consuming and costly.**

** **

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** **

**Ourfacilities and operations are subject to federal, state and local environmentaland occupational 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 cleanup ofproperties affected by pollutants.  Inthe future, federal, state, local or foreign governments could enact new ormore stringent laws or issue new or more stringent regulations concerningenvironmental and worker health and safety matters that could affect ouroperations.  Also, contamination may befound to exist at our current, former or future facilities, including ourfacility in Tempe, Arizona that was acquired in the Regentek acquisition, oroff-site locations where we have sent 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 andworker health and safety requirements or liabilities from newly discoveredcontamination could have a material effect on our business or financialcondition.**

** **

**If anatural or man-made disaster strikes our manufacturing facilities, we will beunable to manufacture our products for a substantial amount of time and oursales will decline.**

 

Nearly all of ourrehabilitation products are manufactured in three buildings in a campusenvironment in Tijuana, Mexico.  We havesigned a lease for a built-to-suit facility in Tijuana where we intend torelocate all of our Mexico-based manufacturing operations in late 2004.  The products that are still manufactured inVista, California consist of our custom rigid bracing products, to facilitate24-hour turn-around on custom orders, and our cold therapy products.  The OL1000 and SpinaLogic product lines areassembled and calibrated in Tempe, Arizona. These facilities and the manufacturing equipment we use to produce ourproducts would be difficult to repair and replace.  Our facilities may be affected by natural or man-madedisasters.  If one of our facilitieswere affected by a disaster, we would be forced to rely on third-partymanufacturers or shift production to another manufacturing facility.  In addition, our insurance may not besufficient to cover all of our potential losses and may not continue to beavailable to us on acceptable terms, or at all.

** **

**Becausewe have various mechanisms in place to discourage takeover attempts, a changein control of our company that a stockholder may consider favorable could beprevented.**

 

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

 

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

 

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

 

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

 

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

 

•                  limitationson who may call special meetings of stockholders;

 

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

 

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

 

In addition,Section 203 of the Delaware General Corporation Law prohibits a publicly heldDelaware corporation from engaging in a business combination with an interestedstockholder, generally defined as a person that together with its affiliatesowns or within the last three years has owned 15% of the corporation’s votingstock, for a period of three years after the date of the transaction in whichthe person became an interested stockholder, unless the business combination isapproved in a prescribed manner. Accordingly, Section 203 may discourage,delay or prevent a change in 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.

 

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***RisksRelated to our Debt Level***

*** ***

**Our substantialindebtedness, a significant portion of which is subject to variable interestrates, could limit our ability to operate our business, obtain additionalfinancing and pursue other business opportunities.**

 

We have a largeamount of indebtedness. The $100.0 million term loan outstanding under ourcredit facility has a variable rate of interest.  In the event that interest rates increase, the amount of moneynecessary to pay the interest on our indebtedness will increase and thisincrease could be material. In addition, we may incur additional indebtednessfrom time to time to finance acquisitions, investments or strategic alliancesor capital expenditures or for other purposes.

 

Our level ofindebtedness could have negative consequences for us, including the following:

•                  ourability to obtain additional financing, if necessary, for working capital,capital expenditures, acquisitions or other purposes may be impaired or suchfinancing may not be available on favorable terms;

 

•                  wewill need a substantial portion of our cash flow to pay the principal andinterest on our indebtedness, including indebtedness that we may incur in thefuture;

 

•                  paymentson our indebtedness will reduce the funds that would otherwise be available forour operations and future business opportunities;

 

•                  asubstantial decrease in our net operating cash flows could make it difficultfor us to meet our debt service requirements and force us to modify ouroperations;

 

•                  wemay be more highly leveraged than our competitors, which may place us at acompetitive disadvantage;

 

•                  ourdebt level may make us more vulnerable than our competitors to a downturn inour business or the economy generally;

 

•                  ourdebt level reduces our flexibility in responding to changing business andeconomic conditions; and

 

•                  therewould be an adverse effect on our business and financial condition if we areunable to service our indebtedness or obtain additional financing, as needed.

 

**Weoccasionally engage in hedging transactions and may obtain in the future one ormore forms of interest rate protection, in the form of swap agreements,interest rate cap contracts or similar agreements — to “hedge” against thepossible negative effects of interest rate fluctuations.  However, we cannot assure you that anyhedging will adequately relieve the adverse effects of interest rate increasesor that counterparties under these agreements will honor their obligationsthereunder.  In addition, we may besubject to risks of default by hedging counterparties.**

** **

**Our debt agreements containoperating and financial restrictions, which restrict our business and financingactivities.**

 

The operating and financial restrictions and covenantsin our new credit agreement, the indenture governing the 12 5/8% seniorsubordinated notes and any future financing agreements may adversely affect ourability to finance future operations, meet our capital needs or engage in ourbusiness activities. Currently, our existing debt agreements restrict ourability 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;

 

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•                  makeinvestments;

 

•                  sellassets; or

 

•                  enterinto mergers or consolidations.

 

With respect tomergers or acquisitions, our credit agreement and the indenture governing thesenior subordinated notes limit our ability to finance acquisitions throughadditional borrowings.  In addition, ourcredit agreement prohibits us from acquiring assets or the equity of anothercompany 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 $5,000,000 and our leverage is greaterthan 3.0 to 1.0, the company we are acquiring has positive earnings beforeinterest, taxes, depreciation and amortization, or EBITDA;

 

•                  theacquisition price is less than $20,000,000 individually and less than$30,000,000 in the aggregate with all other permitted acquisitions consummatedduring the same fiscal year; and

 

•                  ifthe acquisition involves assets outside the United States, the acquisitionprice is less than $15,000,000 individually and less than $25,000,000 in theaggregate with all other permitted acquisitions consummated outside the UnitedStates during the term of the agreement.

 

Restrictionscontained in the indenture and the 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 ofthese covenants, ratios, tests or other restrictions could result in an eventof default under the credit agreement and/or the indenture. Upon the occurrenceof an event of default under the credit agreement, the lenders could elect todeclare all amounts outstanding under the credit agreement, together withaccrued interest, to be immediately due and payable. If we were unable to repaythose amounts, the lenders could proceed against the collateral granted to themto secure such indebtedness. If the lenders under the credit agreementaccelerate the payment of the indebtedness, there can be no assurance that ourassets would be sufficient to repay in full such indebtedness and our otherindebtedness, including the senior subordinated notes.

 

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

 

We may not have sufficient cash to service ourindebtedness. Our ability to pay principal and interest on the seniorsubordinated notes and to satisfy our other obligations will depend upon, amongother things:

 

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

 

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

 

If we cannotservice our indebtedness, we will be forced to take actions such as reducing ordelaying acquisitions, investments, strategic alliances and/or capitalexpenditures, selling assets, restructuring or refinancing our indebtedness, orseeking additional equity capital or bankruptcy protection. We cannot assureyou that any of these remedies can be effected on satisfactory terms, if atall. In addition, the terms of existing or future debt agreements, includingthe credit agreement and the indenture, may restrict us from adopting any ofthese alternatives.

 

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***We have broad discretion in how weuse the net proceeds of our recently completed stock offering, and we may notuse these proceeds effectively.***

 

We currentlyintend to use all of the net proceeds from our recently completed stockoffering to purchase and/or redeem a portion of the outstanding seniorsubordinated notes.  We can purchasethese notes in the open market, in privately negotiated transactions or, on orafter June 15, 2004, redeem these notes pursuant to the terms of theindenture governing the notes.  In theevent we redeem the notes on June 15, 2004, the redemption price will be106.313% of the principal amount, or $79.7 million, plus accrued andunpaid interest.  In the event we redeemthe notes, in addition to the write-off of the call premium, we will write-offunamortized debt issuance costs and discounts related to the notes.  If we redeem the notes on June 15, 2004, thecall premium will be $4.7 million and the unamortized debt issuance costs anddiscounts will be approximately $3.0 million. In the event we purchase the notes on the open market beforeJune 15, 2004, these unamortized debt issuance costs and discounts will behigher.  However, we are not obligatedto purchase and/or redeem any of the senior subordinated notes and ourmanagement will have broad discretion as to the application of the net proceedsreceived by us from the offering. Our stockholders may not agree with themanner in which our management chooses to allocate and spend the net proceedsreceived by us.  Moreover, ourmanagement may use the net proceeds received by us for corporate purposes thatmay not increase our profitability or our market value.

 

***RisksRelated to Government 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 aremedical devices that are subject to extensive regulation in the United Statesby the Food and Drug Administration, or FDA, and by respective authorities inforeign countries where we do business. The FDA regulates virtually all aspects of a medical device’s testing,manufacture, safety, labeling, storage, recordkeeping, reporting, promotion anddistribution.  The FDA also regulatesthe export of medical devices to foreign countries.  Failure to comply with the regulatory requirements of the FDA andother applicable U.S. regulatory requirements may subject a company toadministrative or judicially imposed sanctions which could have a materialadverse effect on our business, financial condition and results ofoperations.  These sanctions include:

 

•                  warning letters;

 

•                  civil penalties;

 

•                  criminal penalties;

 

•                  injunctions;

 

•                  product seizure or detention;

 

•                  product recalls; and

 

•                  total or partial suspension ofproduction.

 

Unless an exemptionapplies, a medical device must receive either approval or premarket clearancefrom the FDA before it can be marketed in the United States.  The FDA’s 510(k) clearance process for ClassII devices usually takes from three to twelve months, but may take significantlylonger.  The premarket approval processfor Class III devices generally takes from one to three years from the time theapplication is filed with the FDA, but also can be significantly longer.  Premarket approval typically requiresextensive clinical data and can be significantly longer, more expensive andmore uncertain than the 510(k) clearance process.  Despite the time, effort and expense expended, there can be noassurance that a particular device will be approved or cleared by the FDA througheither the 510(k) clearance process or the premarket approval process.

* *

*Modifications*

 

Medical devicesmay only be marketed for the indications for which they are approved orcleared.  We may be required to obtainadditional new premarket approvals, premarket approval supplements or 510(k)clearances to market additional products or for new indications for ormodifications to our existing products. We cannot be certain that we would obtain additional premarket approvalsor 510(k) clearances in a timely manner or at all.  Modifications to a previously cleared or approved device thatcould significantly affect its safety or effectiveness or that would constitutea major change in its design, intended use or manufacturing require a premarketapproval, a premarket approval supplement, or a 510(k) clearance.  The FDA requires device manufacturersthemselves to make and document a determination of whether or not amodification requires an approval, supplement or clearance; however, the FDAcan review a manufacturer’s decision. We have modified various aspects of our devices in the past and we

 

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determined that new approvals, supplements or clearances either werenot required or we filed a PMA supplement. The FDA may not agree with our decisions not to seek approvals,supplements or clearances for particular device modifications.  If the FDA requires us to obtain premarketapprovals, supplement approvals or 510(k) clearances for any modification to apreviously cleared or approved device, we may be required to ceasemanufacturing and marketing the modified device or to recall such modifieddevice until we obtain FDA clearance or approval and we may be subject tosignificant regulatory fines or penalties. In addition, there can be no assurance that the FDA will clear orapprove such submissions in a timely manner, if at all.

 

We currently havenew products, new indications, or product modifications under development orunder review by the FDA.  Our failure toobtain FDA clearance or approvals of new products, new indications or productmodifications that we develop in the future, any limitations imposed by the FDAon such products’ development or use, or the costs of obtaining FDA clearanceor approvals could have a material adverse effect on our business.

* *

*International Regulation*

 

In many of theforeign countries 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 Europe falls primarily within theEuropean Economic Area, which consists of the fifteen member states of theEuropean Union, as well as Iceland, Liechtenstein and Norway.  The Council of the European Union (formerlythe Council of the European Communities) and the Council of the EuropeanParliament have adopted three directives in order to harmonize nationalprovisions regulating the design, manufacture, clinical trials, labeling andadverse event reporting for medical devices to ensure that medical devicesmarketed are safe and effective for their intended uses.  The member states of the European EconomicArea have implemented the directives into their respective national law.  Medical devices that comply with theconformity requirements of the national provisions and the directives will beentitled to bear a CE marking.  Unlessan exemption applies, only medical devices which bear a CE marking may bemarketed within the European Economic Area. Switzerland also allows the marketing of medical devices that bear a CEmarking.  Failure to receive, or delaysin the receipt of, relevant foreign qualifications, such as the CE marking,could have a material adverse effect on our international operations.

 

The EuropeanStandardization Committees CEN (European Committee for Standardization),CENELEC (European Committee for Electrotechnical Standardization) and ETSI(European Telecommunications Standards Institute) have adopted numerousharmonized standards for specific types of medical devices.  Although the application by a company ofsuch standards remains voluntary, compliance establishes the presumption ofconformity with the essential requirements for a CE marking.  In the event of non-compliance with the standards,we must demonstrate to independent and neutral institutions appointed by themember states of the European Economic Area the conformity of our products withthe essential requirements by other means, such as displaying adherence toestablished technical specifications. Non-compliance with the conformity assessment in the European EconomicArea or other foreign countries could adversely affect our internationalproduct sales.

 

Post marketsurveillance of medical devices in the European Economic Area is generallyconducted on a country-by-country basis. The requirement within the member states of the European Economic Areavary.  Due to the movement towardsharmonization of standards in the European Union and the expansion of theEuropean Union, we expect a changing regulatory environment in Europecharacterized by a shift from a country-by-country regulatory system to aEuropean Union-wide single regulatory system. The timing of this harmonization and its effect on us cannot currentlybe predicted.  Any such developmentscould have a material adverse effect on our business, financial condition andresults of 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 tomedical device reporting regulations that require us to report to the FDA orrespective governmental authorities in other countries if our products cause orcontribute to a death or serious injury or malfunction in a way that would bereasonably likely to contribute to death or serious injury if the malfunctionwere to recur.  The FDA and similargovernmental authorities in other countries have the authority to require therecall of our products in the event of material deficiencies or defects indesign or manufacturing, and we have been subject to product recalls in thepast.  A government mandated, orvoluntary, recall by us could occur as a result of component failures,manufacturing errors or design defects, including defects in labeling.  Any recall would divert managerial andfinancial resources and could harm our reputation with customers.  There can be no assurance that there willnot be product recalls in the future or that such recalls would not have amaterial 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 manufacturing processes are required to complywith the FDA’s Quality System Regulation, which covers the proceduresconcerning (and documentation of) the design, testing, production processes,controls, quality assurance, labeling,

 

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packaging, storageand shipping of our devices.  We alsoare subject to state requirements and licenses applicable to manufacturers ofmedical devices.  In addition, we mustengage in 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 System Regulation inspection or to comply with theseand other applicable regulatory requirements could result in disruption of ouroperations and manufacturing delays. 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 previously received warning lettersand untitled letters from the FDA regarding regulatory non-compliance.  We cannot assure you that the FDA or othergovernmental authorities would agree with our interpretation of applicableregulatory requirements or that we have in all instances fully complied withall applicable requirements.  Anyfailure to comply with applicable requirements could adversely affect ourproduct sales and profitability.

 

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

** **

Our products aresold to healthcare providers and physicians who may receive reimbursement forthe cost of our products from private third-party payors and, to a lesserextent, from Medicare, Medicaid and other governmental programs.  In certain circumstances, such as for our OfficeCareprogram, we submit claims to third-party payors for reimbursement. Our abilityto sell our products successfully will depend in part on the purchasing andpractice patterns of healthcare providers and physicians, who are influenced bycost containment measures taken by third-party payors.  Limitations or reductions in third-partyreimbursement for our products can have a material adverse effect on our salesand profitability.

 

Congress and statelegislatures consider reforms in the healthcare industry that may modifyreimbursement methodologies and practices, including controls on healthcarespending of the Medicare and Medicaid programs.  It is not clear at this time what proposals, if any, will beadopted or, if adopted, what effect the proposals would have on ourbusiness.  Many private health insuranceplans model their coverage and reimbursement policies after Medicarepolicies.  Congressional or regulatorymeasures that reduce Medicare reimbursement rates could cause private healthinsurance plans to reduce their reimbursement rates for our products, whichcould have an adverse effect on our ability to sell our products or cause ourorthopedic professional customers to prescribe less expensive productsintroduced by us and our competitors.

 

With the passageof the Medicare Prescription Drug, Improvement, and Modernization Act of 2003,or Modernization Act, a number of changes have been mandated to the Medicarepayment methodology and conditions for coverage for our orthotic devices anddurable medical equipment, including our bone growth stimulators.  These changes include a freeze in paymentsfor certain medical devices from 2004 through 2008, competitive biddingrequirements, new clinical conditions for payment and quality standards.  The changes affect our products generally,although specific products may be affected by some but not all of theModernization Act’s provisions.  OurClass III bone growth stimulator devices, for example, are not affected by thepayment freeze and are not subject to competitive bidding.  Off-the-shelf orthotic devices are subjectto competitive bidding.  Off-the-shelforthotics are products requiring minimal self-adjustment for appropriate useand do not require expertise in trimming, bending, molding, assembling, orcustomizing to fit the patient.  Under competitivebidding, which will be phased in beginning in 2007, Medicare will change itsapproach to reimbursing certain items and services covered by Medicare from thecurrent fee schedule amount to an amount established through a bidding processbetween the government and suppliers. Competitive bidding may reduce the number of suppliers providing certainitems and services to Medicare beneficiaries and the amounts paid for suchitems and services.  Also, Medicarepayments in regions not subject to competitive bidding may be reduced usingpayment information from regions subject to competitive bidding.  Any payment reductions or the inclusion ofcertain of our orthotic devices in competitive bidding, in addition to theother changes to Medicare reimbursement and standards contained in theModernization Act, could have a material adverse effect on our results ofoperations.

 

In addition, onFebruary 11, 2003, the Centers for Medicare and Medicaid Services, or CMS,the agency responsible for implementing the Medicare program, made effective aninterim final regulation implementing “inherent reasonableness” authority,which allows adjustments to payment amounts for certain items and servicescovered by Medicare when the existing payment amount is determined to begrossly excessive or grossly deficient. The regulation lists factors that may be used to determine whether anexisting reimbursement rate is grossly excessive or grossly deficient and todetermine what is a realistic and equitable payment amount.  Also, under the regulation, a payment amountwill not be considered grossly excessive or grossly deficient if an overallpayment adjustment of less than fifteen percent would be necessary to produce arealistic and equitable payment amount. The regulation remains in effect after the Modernization Act, althoughthe new legislation precludes the use of inherent reasonableness authority fordevices subject to competitive bidding. When using the inherent reasonableness authority, CMS may reducereimbursement levels for certain items and services, which could have amaterial adverse effect on our results of operations.

 

Beginning January1, 2004, a new definition for a reimbursement code went into effect thatimpacts our fracture boot products. This code definition was corrected after discussions with CMS.  However, the payment level associated withthe code

 

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was not changed, and we are continuing to pursue discussions to addressthe pricing with CMS.  If the reimbursementlevel under the new code is not changed, our revenue from the sale of theseproducts through the OfficeCare channel could be reduced. Sales of fractureboots through our OfficeCare channel represented approximately 4% and 5% of ourconsolidated historical net revenues for the fiscal years ended December 31,2003 and 2002, respectively. We cannot assure you that third-partyreimbursement for our products will continue to be available or at what ratesuch products will be reimbursed. Failure by users of our products to obtain sufficient reimbursement fromthird-party payors for our products or adverse changes in governmental andprivate payors’ policies toward reimbursement for our products could have amaterial adverse effect on our results of operations.

 

**Changes in international regulations regardingreimbursement for our products could adversely affect our business and resultsof operations.**

 

Similar to ourdomestic business, our success in international markets also depends upon theeligibility of our products for reimbursement through government sponsoredhealthcare payment systems and third-party payors, the portion of cost subjectto reimbursement, and the cost allocation between the patient and governmentsponsored healthcare payment systems and third-party payors.  Reimbursement practices vary significantlyby country, with certain countries requiring products to undergo a lengthyregulatory review in order to be eligible for third-party reimbursement.  In addition, healthcare cost containmentefforts similar to those we face in the United States are prevalent in many ofthe foreign countries in which our products are sold, and these efforts areexpected to continue in the future, possibly resulting in the adoption of morestringent standards.  For example, inGermany, our largest foreign market, effective since January 1, 2004, eachGerman adult patient must pay between five and ten Euros for each medicaltechnical device prescribed.  The exactamount of the co-payment is defined as 10% of the price of the device if itfalls within the payment corridor. Patients may be exempted from this co-payment obligation if theaggregate co-payments in the course of a calendar year exceeds 2% (1% forchronically ill) of the untaxed income of the patient.  This new formula replaces the formerco-payment rule which imposed a 20% contribution on the patient.

 

In Italy, ourrigid knee bracing products and cold therapy *products,* among others, are nolonger eligible for reimbursement.  Inthe United Kingdom, while reimbursement for our products through the NationalHealth Service, or NHS, is currently available, the cost of our products is notreimbursed by private health insurance plans and orthopedic professionals arebeing pressured by the NHS to reduce or eliminate the number of rigid kneebraces prescribed for orthopedic patients. Any developments in our foreign markets that eliminate or reducereimbursement rates for our products could have an adverse effect on our abilityto sell our products or cause our orthopedic professional customers to use lessexpensive products in these markets.

 

**Medicare laws mandating new supplier standards andconditions for coverage could adversely impact our business.**

 

Medicareregulations require entities or individuals submitting claims and receivingpayment to obtain a supplier number, which in turn is predicated on compliancewith a number of supplier standards. Under the Modernization Act, any entity or individual that bills Medicarefor durable medical equipment and orthotics and that has a supplier number forsubmission of such bills will be subject to new quality standards as acondition of receiving payment from the Medicare program.  The new standards are to be met by suppliersof orthotics and durable medical equipment, such as bone growthstimulators.  New standards are to bedeveloped by CMS and applied by independent accreditation organizations.  The Modernization Act also authorizes CMS toestablish clinical conditions for payment for durable medical equipment.  These new supplier standards and clinicalconditions for payment could limit or reduce the number of individuals who canfit, sell or provide our products and could restrict coverage for ourproducts.  In addition, because we are aMedicare supplier, and therefore also subject to any new supplier standards,our failure to meet any new supplier standards could affect our ability tobill, and therefore could have a material adverse effect on our business,financial condition and results of operations.

 

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

 

Within the UnitedStates, healthcare reform and managed care have changed and continue to affectthe dynamics of the healthcare industry in responding to rising healthcarecosts.  As a result of healthcarereform, the U.S. healthcare industry has seen a rapid expansion of managed careorganizations.  The development ofmanaged care programs in which the providers contract to provide comprehensivehealthcare to a patient population at a fixed cost per person (referred to ascapitation) has put pressure on, and is expected to continue to cause,healthcare providers to lower costs. The advent of managed care has also resulted in greater attention to thetradeoff between patient need and product cost, so-called demand matching,where patients are evaluated as to age, need for mobility and other parametersand are then matched with an orthopedic product that is cost effective in lightof such evaluation.  One result ofdemand matching has been, and is expected to continue to be, a shift towardlower priced products, and any such shift in our product mix to lower margin,off-the-shelf products could have an adverse impact on our operating results.  For example, in our rigid knee-bracingsegment, we and many of our competitors are offering lower priced,off-the-shelf products in response to managed care customers.

 

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A further resultof managed care and the related pressure on costs has been the advent of buyinggroups 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 suchbuying groups are able to obtain compliance by their members with suchpreferred supplier agreements varies considerably depending on the particularbuying groups.  In response to theorganization of new buying groups, we have entered into national contracts withselected groups and believe that the high levels of product sales to suchgroups and the opportunity for increased market share have the potential tooffset the financial impact of discounting. We believe that our ability to maintain our existing arrangements willbe important to our future success and the growth of our revenues.  In addition, we may not be able to obtainnew preferred supplier commitments for major buying groups, in which case we couldlose significant potential sales, to the extent these groups are able tocommand a high level of compliance by their members.  On the other hand, if we receive preferred supplier commitmentsfrom particular groups which do not deliver high levels of compliance, we maynot be able to offset the negative impact of lower per unit prices or lowermargins with any increases in unit sales or in market share.

 

In internationalmarkets, where the movement toward healthcare reform and the development ofmanaged care are generally not as advanced as in the United States, we haveexperienced downward pressure on product pricing and other effects ofhealthcare reform similar to that which we have experienced in the UnitedStates.  We expect healthcare reform andmanaged care to continue to develop in our primary international markets, whichwe expect will result in further downward pressure in product pricing.  The timing and effects on us of healthcarereform and the development of managed care in international markets cannotcurrently be predicted.

 

**Proposed laws 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 topressure from mostly orthopedic practitioners, Congress and state legislatureshave from time to time considered proposals that limit the types of orthopedicprofessionals who can fit and/or sell our orthotic device products or who canseek reimbursement for them.  Severalstates have adopted legislation, which imposes certification or licensingrequirements on the measuring, fitting and adjusting of certain orthoticdevices.  Some of these laws haveexemptions for manufacturers’ representatives. Other laws apply to the activities of such representatives.  Other states may be considering similarlegislation.  Such laws could limit ourpotential customers in those jurisdictions in which such legislation orregulations are enacted by limiting the measuring and fitting of these devicesto certain licensed individuals.  We maynot be successful in opposing their adoption and, therefore, such laws couldhave a material adverse effect on our business.

** **

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

 

We are subject tovarious federal and state laws pertaining to healthcare fraud and abuse,including anti-kickback laws and physician self-referral laws.  Violations of these laws are punishable bycriminal and/or civil sanctions, including, in some instances, imprisonment andexclusion from participation in federal and state healthcare programs,including Medicare, Medicaid, Veterans Administration health programs andTRICARE.  Because of the far-reachingnature of these laws, we may be required to alter one or more of our practices.  Healthcare fraud and abuse regulations arecomplex and even minor, inadvertent irregularities in submissions canpotentially give rise to claims that a fraud and abuse law or regulation hasbeen violated.  Any violations of theselaws or regulations could result in a material adverse effect on our business,financial condition and results of operations. If there is a change in law, regulation or administrative or judicialinterpretations, we may have to change our business practices or our existingbusiness practices could be challenged as unlawful.

** **

**Audits or denials of our claims by government agenciescould reduce our revenue or profits.**

 

As part of ourbusiness structure, we submit claims directly to and receive payments directlyfrom the Medicare and Medicaid programs. Therefore, we are subject to extensive government regulation, includingrequirements for maintaining certain documentation to support our claims.  Medicare contractors and Medicaid agenciesperiodically conduct pre- and post-payment review and other audits of claims,and are under increasing pressure to scrutinize more closely healthcare claimsand supporting documentation generally. We periodically receive requests for documentation during thegovernmental audits of individual claims either on a pre-payment orpost-payment basis.  In addition, inOctober 2003, we received notice from one Medicare contractor (there are fourcontractors who process our Medicare claims) that, beginning November 26, 2003,certain of our claims filed with that contractor would  be reviewed on a pre-payment basis.  Under pre-payment reviews, our claims mustbe submitted manually and with supporting documentation, resulting in longerprocessing times.  We cannot predict howlong the pre-payment review will be conducted nor the outcome of suchreview.  We cannot assure you that thereview and/or other audits of our claims will not result in material delays inpayment, as well as material recoupments or denials, which could reduce ourrevenue or profits.

 

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**Special Risks Related to Our NoteHolders**

 

Holders of the senior subordinated notes due 2009 ofwhich an aggregate face amount of $75 million are outstanding, are subject toadditional market and repayment risks arising from the terms of the notes andour debt level and corporate structure. The notes were issued in 1999 by dj Orthopedics, LLC, our principaloperating company, and were co-issued by DJ Orthopedics Capital Corporation, acompany formed solely to act as co-issuer of the notes.  dj Orthopedics, Inc, our publicly heldentity, and dj Orthopedics Development Corporation, a company formed solely tohold our intellectual property assets are guarantors of the notes.  None of our foreign subsidiaries hasguaranteed payment of the notes.

 

In the discussion of risks to holders of the notes setforth below, the terms we, us and our refer to dj Orthopedics, LLC and DJOrthopedics Capital Corporation, the co-issuers of the notes.  dj Orthopedics, Inc. is referred to as “djOrthopedics”, and dj Development Corporation is referred to as “djDevelopment.”  The term “indenture” asused below refers to the indenture we entered into that contains the agreementsbetween us and the holders of the notes.

 

**The notesand the guarantees by dj Orthopedics and dj Development are, and guarantees byany of our future subsidiaries will be, effectively subordinated to all seniordebt of our subsidiaries.**

 

The notes aresubordinated in right of payment to the prior payment in full of all ourexisting and future senior indebtedness and the guarantee of the notes by djOrthopedics, dj Development and any future subsidiaries providing a guaranteeof the notes will be subordinated in right of payment to all seniorindebtedness of the applicable guarantor. The indenture requires each of our domestic subsidiaries that is formedor acquired in the future to guarantee the notes, unless we designate thesubsidiary as an Unrestricted Subsidiary (as defined in the indenture).  As of December 31, 2003, we hadapproximately $100.0 million of senior indebtedness outstanding and availableborrowings of $30 million relating to a revolving credit facility, all of whichis secured.  We currently have no borrowedamounts drawn under the revolving credit facility, but are contingently liablefor outstanding letters of credit aggregating $3.0 million. In addition, theindenture permits us and our Restricted Subsidiaries (as defined in theindenture) to incur additional senior indebtedness, including indebtednessunder the credit facility. We or the applicable guarantor may not payprincipal, premium (if any), interest or other amounts on account of the notesor the guarantees by dj Orthopedics and dj Development or any subsidiary in theevent of a payment default on, or another default that has resulted in theacceleration of, certain senior indebtedness (including debt under the creditfacility) unless such indebtedness has been paid in full or the default hasbeen cured or waived.  In the event of certainother defaults with respect to certain senior indebtedness, we or theapplicable guarantor may not be permitted to pay any amount on account of thenotes or the guarantees by dj Orthopedics and dj Development or any subsidiaryfor a designated period of time.  In theevent of a bankruptcy, liquidation, dissolution, reorganization or similarproceeding with respect to us or a guarantor, our assets or a guarantor’sassets, as the case may be, will be available to pay obligations on the notesor the guarantor’s guarantee, as applicable, only after our senior indebtednessor the senior indebtedness of that guarantor has been paid in full, and therecan be no assurance that there will be sufficient assets remaining to payamounts due on all or any of the notes or any guarantee of the notes.

 

Our right toreceive assets of any subsidiary which is not a guarantor upon the liquidationor reorganization of that subsidiary (and thus the rights of the holders ofnotes to realize any value with respect to those assets) will be subject to theprior claims of creditors of that subsidiary (including trade creditors).  Accordingly, since our foreign subsidiariesare not guarantors of the notes, the notes are effectively subordinated to allliabilities (including trade payables and contingent liabilities) of ourforeign subsidiaries and any of our future subsidiaries that do not provide aguarantee of the notes except to the extent that we are recognized as acreditor of such subsidiary.  However,even if we were recognized as a creditor of a subsidiary that does notguarantee the notes, our claims would still be subordinate to any securityinterest in the assets of that subsidiary, and any indebtedness of thatsubsidiary senior to that held by us. As of December 31, 2003, the aggregate amount of the liabilities of ourforeign subsidiaries as reflected on our balance sheet was $1.8 million.

 

**Indebtednessunder our credit facility is secured while our obligations under the notes arenot secured and if we default under our senior debt, our senior lenders canforeclose on the assets we have pledged to secure payment of the senior debt toyour exclusion.**

 

Inaddition to being contractually subordinated to all existing and future seniorindebtedness, our obligations under the notes (and dj Orthopedics’ and djDevelopment’s obligations under their guarantees) are unsecured while ourobligations under the credit facility (and dj Orthopedics’ and dj Development’sobligations under their guarantee of our indebtedness under the creditfacility) are secured by a security interest in substantially all of our assetsand the assets of dj Orthopedics (which consist principally of 100% of ourequity interests) and each of our existing and subsequently acquired ororganized U.S. and, subject to certain limitations, non-U.S. subsidiaries,including a pledge of all of the issued and outstanding equity interests in ourexisting or subsequently acquired or organized U.S. subsidiaries and 65% of theequity interests in each of our subsequently acquired or organized non-U.S.subsidiaries. If we are declared bankrupt or insolvent or if we default underthe credit facility, the lenders could declare all of the funds borrowed

 

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under the credit facility,together with accrued interest, immediately due and payable. If we were unableto repay that indebtedness, the lenders could foreclose on our equity interestspledged by dj Orthopedics, on the pledged equity interests of oursubsidiaries and on the assets in which they have been granted a securityinterest, in each case to your exclusion, even if an event of default existsunder the indenture at such time. Furthermore, if all equity interests of anyfuture subsidiary guarantor are sold to persons pursuant to an enforcement ofthe pledge of equity interests in that subsidiary guarantor for the benefit ofthe senior lenders, then the applicable subsidiary guarantor will be releasedfrom its guarantee of the notes automatically and immediately upon such sale.

 

**We may not havethe ability to raise the funds necessary to finance the change of control offerrequired by the indenture.**

 

Upon a change of control, we are required to offer to purchase all ofthe notes then outstanding at 101% of the principal amount thereof plus accruedinterest. If a change of control were to occur, we may not have sufficientfunds to pay the purchase price for the outstanding notes tendered, and weexpect that we would require third party financing.  However, we may not be able to obtain such financing on favorableterms, if at all. In addition, the credit facility restricts our ability torepurchase the notes, including pursuant to an offer in connection with achange of control. A change of control under the indenture may also result inan event of default under the credit facility and may cause the acceleration ofother senior indebtedness, if any, in which case the subordination provisionsof the notes would require payment in full of the credit facility and any othersenior indebtedness before repurchase of the notes.  Our future indebtedness may also contain restrictions on ourability to repay the notes upon certain events or transactions that couldconstitute a change of control under the indenture. The inability to repay seniorindebtedness upon a change of control or to purchase all of the tendered noteswould each constitute an event of default under the indenture.

 

Thechange of control provision in the indenture will not necessarily afford youprotection in the event of a highly leveraged transaction, includingreorganization, restructuring, merger or other similar transaction involving usthat may adversely affect you. Such a transaction may not involve a change invoting power or beneficial ownership, or, even if it does, may not involve achange of the magnitude required under the definition of change of control inthe indenture to trigger this provision

 

**Federal andstate laws permit a court to void the notes and guarantees under certaincircumstances.**

 

Ourobligations under the indenture and the notes, the obligations incurred byDonJoy L.L.C., under the indenture and its guarantee of the notes and assumedby dj Orthopedics in the reorganization and the obligations incurred by djDevelopment under the indenture and its guarantee of the notes may be subjectto review under federal bankruptcy law or relevant state fraudulent conveyanceand similar statutes in a bankruptcy or reorganization case or lawsuitcommenced by or on behalf of our or dj Orthopedics’ or dj Development’s unpaidcreditors. Under these laws, if a court were to find that, at the time weissued the notes, DonJoy issued its guarantee of the notes or dj Developmentissued its guarantee of the notes, we DonJoy, or dj Development, as the casemay be:

 

**•****                                         **incurred such indebtedness with the intent ofhindering, delaying or defrauding present or future creditors; or

 

•                                          received less than the reasonably equivalent valueor fair consideration for incurring such indebtedness; and

 

•                                          were insolvent or rendered insolvent by reason ofany of the recapitalization transactions;

 

•                                          were engaged or about to engage in a business ortransaction for which our or the applicable guarantors’ assets constitutedunreasonably small capital to carry on our or its business; or

 

•                                          intended to incur, or did incur, or believed thatwe or the applicable guarantor would incur, debts beyond our or the applicableguarantor’s ability to pay as they matured or became due;

 

then,such court might:

 

•                                          subordinate the notes or dj Orthopedics’ and djDevelopment’s guarantee of the notes to our or dj Orthopedics’ and djDevelopment’s presently existing or future indebtedness;

 

•                                          void the issuance of the notes (in our case) orthe guarantees or;

 

•                                          take other actions detrimental to holders of thenotes.

 

The measure of insolvency for purposes of the foregoing will varydepending upon the law of the jurisdiction being applied.  Generally, an entity will be insolvent if:

 

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•                                          the fair salable value of its assets were lessthan the amount required to pay its total existing debts and liabilities(including contingent liabilities) as they become absolute or mature; or

 

•                                          the sum of its debts (including contingentliabilities) were greater than its assets, at fair valuation.

 

We cannot predict:

 

•                                          what standard a court would apply in order todetermine whether we or the applicable guarantor were insolvent as of the datewe or the applicable guarantor issued the old notes or the guarantee, or thatregardless of the method of valuation a court would determine that we or theapplicable guarantor were insolvent on that date; or

 

•                                          whether a court would not determine that thepayments constituted fraudulent transfers on another ground.

 

Inrendering their opinions in connection with the issuance of the notes, ourcounsel and counsel to the initial purchaser of the notes did not express anyopinion as to the applicability of federal bankruptcy or state fraudulenttransfer and conveyance laws.

 

To the extent a court voids a guarantee as a fraudulent conveyance orholds it unenforceable for any other reason, holders of the notes would ceaseto have any claim in respect of the guarantor and would be creditors solely ofus.

 

Basedupon financial and other information available to us, we believe that we issuedthe notes and the guarantors issued the guarantees for proper purposes and ingood faith and that at the time we and the guarantors were not insolvent orrendered insolvent thereby, had sufficient capital to run our businesses, andwere able to pay our debts as they mature or become due. In reaching theseconclusions, we relied on various valuations and estimates of future cash flowthat necessarily involve a number of assumptions and choices of methodology.  However, a court may not adopt theassumptions and methodologies we have chosen or concur with our conclusion asto our solvency.

 

Additionally,under federal bankruptcy or applicable state insolvency law, if certainbankruptcy or insolvency proceedings were initiated by or against us or djOrthopedics or dj Development within 90 days after any payment by us withrespect to the notes or by dj Orthopedics and dj Development under theirguarantees of the notes, or if we or dj Orthopedics or dj Developmentanticipated becoming insolvent at the time of such payment, all or a portion ofsuch payment could be avoided as a preferential transfer and the recipient ofsuch payment could be required to return such payment.

 

Inthe event there are any subsidiary guarantors in the future, the foregoingwould apply to their guarantees.

 

**There is noactive trading market for the notes.**

 

The notes are not listed on a securities exchange or any automateddealer quotation system.  J.P. MorganSecurities, Inc. (JPMSI) makes a market in the notes. JPMSI is notobligated to do so, however, and any market-making activities withrespect to the notes may be discontinued at any time without notice. Inaddition, this market-making activity is subject to limits imposed byfederal securities laws.  Because JPMSIis our affiliate, JPMSI is required to deliver a current market-makingprospectus and otherwise comply with the registration requirements of theSecurities Act of 1933 in any secondary market sale of the notes. Accordingly,the ability of JPMSI to continue to make a market in the notes depends, inpart, on our ability to maintain a current market-making prospectus.

 

Theliquidity of the trading market in the notes, and the market price quoted forthe notes may be adversely affected by changes in the overall market for highyield securities and by changes in our financial performance or prospects or inthe prospects for companies in our industry generally. As a result, you cannotbe sure that an active trading market will develop for the notes.

 

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**Item 2. Properties**

 

We areheadquartered in Vista, California and operate manufacturing locations inVista, California; Tijuana, Mexico; and Tempe, Arizona. Our manufacturingfacilities located in Tijuana, Mexico, include three buildings in a campusenvironment and are within 100 miles of Vista. We have signed a lease for a200,000 square foot built-to-suit factory in Tijuana where we intend torelocate all of our Mexico-based manufacturing operations in late 2004.  In connection with the Regentek acquisition,we entered into a sublease for a facility in Tempe, Arizona.  In December 2003, we established a piloteast coast distribution center in Lansing, Michigan.  We also lease warehouse and office space in Germany, Canada,France and the United Kingdom.  All ofour facilities are leased, none are owned.

 

 
| **Location**                 |   | **Use**                                                                             |   | **Owned/Leased** |   | **Lease Termination  Date** |   | **Size (Square Feet)** |
|------------------------------|--------|-------------------------------------------------------------------------------------|--------|------------------|--------|-----------------------------|--------|------------------------|
| Vista, California            |   | Corporate Headquarters Research & Development  Manufacturing & Distribution |   | Subleased        |   | February 2008               |   | 266,041                |
|                         |   |                                                                                |   |             |   |                        |   |                   |
| Tijuana, Mexico              |   | 3 Manufacturing Facilities                                                          |   | Leased           |   | December 2004               |   | 113,000                |
|                         |   |                                                                                |   |             |   |                        |   |                   |
| Tijuana, Mexico              |   | Manufacturing Facility (1)                                                          |   | Leased           |   | August 2014                 |   | 200,000                |
|                         |   |                                                                                |   |             |   |                        |   |                   |
| Tempe, Arizona               |   | Research & Development Manufacturing  & Distribution                        |   | Subleased        |   | November 2004               |   | 33,463                 |
|                         |   |                                                                                |   |             |   |                        |   |                   |
| Neudrossenfeld, Germany      |   | Office & Distribution                                                           |   | Leased           |   | August 2004                 |   | 7,700                  |
|                         |   |                                                                                |   |             |   |                        |   |                   |
| Surrey, United Kingdom       |   | Office & Distribution                                                           |   | Leased           |   | November 2011               |   | 3,111                  |
|                         |   |                                                                                |   |             |   |                        |   |                   |
| Mississauga, Ontario, Canada |   | Office & Distribution                                                           |   | Leased           |   | January 2005                |   | 4,250                  |
|                         |   |                                                                                |   |             |   |                        |   |                   |
| Tournes, France              |   | Distribution                                                                        |   | Leased           |   | October 2005                |   | 3,470                  |
|                         |   |                                                                                |   |             |   |                        |   |                   |
| Lansing, Michigan            |   | Distribution                                                                        |   | Leased           |   | November 2004               |   | 15,000                 |

 

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(1)          Built-to-suit facility to be constructed in2004.  The lease term is ten years fromthe earlier of the date we occupy the facility or August 2004

 

**Item 3****. Legal Proceedings**

 

Several classaction complaints were filed in the United States District Courts for theSouthern District of New York and for the Southern District of California onbehalf of purchasers of our common stock alleging violations of the federalsecurities laws in connection with our initial public offering inNovember 2001.  These actions werelater consolidated into a single action, In re DJ Orthopedics, Inc. SecuritiesLitigation, Case No. 01-CV-2238-K (RBB) (S.D. Cal.).  We are named as a defendant along with Leslie H. Cross, ourPresident and Chief Executive Officer, Cyril Talbot III, our former Senior VicePresident, Finance, Chief Financial Officer, and Secretary, Charles T. Orsatti,former Chairman of our Board of Directors, our outside directors Mitchell J.Blutt, M.D. and Kirby L. Cramer and our former director Damion E. Wicker, M.Dand the underwriters of our initial public offering. The complaint seeksunspecified damages and following the filing of a motion to dismiss thateliminated all but one alleged omission, continues to assert that defendantsviolated Sections 11, 12, and 15 of the Securities Act of 1933 by failing todisclose allegedly material intra-quarterly sales data in the registrationstatement and prospectus. On July 22, 2003, the Court appointed LouisianaSchool Employees’ Retirement System as substitute lead plaintiff following thewithdrawal of Oracle Partners L.P. who was the original lead plaintiff, and onNovember 17, 2003, the Court certified the class. The parties have reached a

 

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tentative settlement of the case and enteredinto a Memorandum of Understanding confirming the settlement and the termsthereof.  The amount of the settlementis within the coverage limits of our directors’ and officers’ liabilityinsurance policies.  The settlement willbecome final upon court approval, provided that, if class members who purchasedmore than a specified number of shares exclude themselves from the class, thedefendants may terminate the settlement.

 

From time to time,we are involved in lawsuits arising in the ordinary course of business. Thisincludes patent and other intellectual property disputes between our variouscompetitors and us.  With respect tothese matters, management believes that it has adequate legal defense,insurance and/or have provided adequate accruals for related costs. We are notaware of any pending lawsuits not mentioned above that could have a materialadverse effect on our business, financial condition and results of operations.

 

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

 

No matterswere submitted to a vote of security holders during the quarter ended December31, 2003.

 

**Item 4A****. Executive Officers**

 

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

 
| **Name**           |   | **Age** |   | **Position with dj Orthopedics**                                       |
|--------------------|--------|---------|--------|------------------------------------------------------------------------|
|               |   |    |   |                                                                   |
| Leslie H.  Cross   |   | 53      |   | President,  Chief Executive Officer and Director                       |
| Vickie L.  Capps   |   | 42      |   | Senior Vice  President, Finance, Chief Financial Officer and Treasurer |
| Luke T.  Faulstick |   | 40      |   | Senior Vice  President, Operations                                     |
| Louis T.  Ruggiero |   | 44      |   | Senior Vice  President, Sales and Marketing                            |
| Donald M.  Roberts |   | 55      |   | Vice President,  General Counsel and Secretary                         |

 

*Leslie H. Cross* hasbeen our Chief Executive Officer and President and a member of our board ofdirectors since our incorporation in August 2001. He served as the ChiefExecutive Officer and a Manager of DonJoy, L.L.C., our predecessor, from June1999 until November 2001, and has served as President of dj Orthopedics, LLC,our wholly owned operating subsidiary, or its predecessor, the Bracing &Support Systems division of Smith & Nephew, Inc. since June 1995.  From 1990 to 1994, Mr. Cross held theposition of Senior Vice President of Marketing and Business Development of theBracing & Support Systems division of Smith & Nephew. He was a ManagingDirector of two different divisions of Smith & Nephew from 1982 to1990. Prior to that time, he worked at American Hospital Supply Corporation.Mr. Cross earned a diploma in medical technology from Sydney TechnicalCollege in Sydney, Australia and studied business at the University of CapeTown in Cape Town, South Africa.

 

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

 

*Luke T. Faulstick*currently serves as our Senior Vice President, Operations. He joined us as VicePresident of Manufacturing in June of 2001. From 1998 to June 2001, Mr. Faulstick served as General Manager for TycoHealthcare. From 1996 to 1998, Mr. Faulstick served as Plant Manager forMitsubishi Consumer Electronics. In 1994, he started a contract manufacturingbusiness that supplied products to the medical, electronic and photographicindustries. Mr. Faulstick began his career in 1985 working for Eastman KodakCompany in Rochester New York where he held various positions in Engineering,Marketing, and Product Research and Development.  He currently serves on the board of directors of Power Partners,Inc., a privately held power transmission manufacturer. Mr. Faulstick receiveda B. S. in engineering from Michigan State University and an M.S. inengineering from Rochester Institute of Technology.

 

*Louis T. Ruggiero*joined us as Senior Vice President, Sales and Marketing in August 2003.  Mr. Ruggiero brings more than 20 years ofsales experience in medical devices, with more than half of his tenure inmanagement roles. From 2000 to 2003,

 

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Mr. Ruggiero served asPresident and Chief Executive Officer of Titan Scan Technologies, a subsidiaryof Titan Corporation, a leader in electron beam technology for medical devicesterilization, mail sanitization and industrial processes. From 1990 to 2000,Mr. Ruggiero was employed by GE Medical Systems, a global leader in medicaldiagnostic imaging, healthcare IT, productivity solutions, services andfinancing. He most recently served as director of corporate alliances. Prior to1990, Mr. Ruggiero was employed by Davol, Inc., a division of C.R. Bard, Inc.,where he served as sales manager in the northeast district. He has also heldfield sales positions with American V. Mueller, a division of American HospitalSupply, and Proctor & Gamble. Mr. Ruggiero received his undergraduatedegree in interpersonal communication/political science from St. John’sUniversity and his M.B.A. from the J.L. Kellogg School of Management,Northwestern University.

 

*Donald M. Roberts*joined us in December 2002 and currently serves as Vice President, GeneralCounsel and Secretary.  From 1994 toDecember 2002, Mr. Roberts served as Vice President, Secretary and GeneralCounsel for Maxwell Technologies, Inc., a publicly held technology company.Previous to that, he was with the Los Angeles-based law firm of Parker,Milliken, Clark, O’Hara & Samuelian for 21 years.  Mr. Roberts was a shareholder in the firm, having served aspartner in a predecessor partnership. Mr. Roberts received his undergraduate degreein political science from Yale University and earned his J.D. at the Universityof California, Berkeley, Boalt Hall School of Law.

** **

**PART II**

 

**Item 5.****   Market forthe Registrant’s Common Equity and Related Stockholder Matters**

 

Our commonstock 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, 2003:** |   |     |   |    |   |
| First Quarter                     |   | $        | 4.22   |    | $      | 3.50 |   |
| Second Quarter                    |   | 11.40    |   | 3.87    |   |
| Third Quarter                     |   | 14.15    |   | 10.23   |   |
| Fourth Quarter                    |   | 29.30    |   | 13.54   |   |
|                              |   |     |   |    |   |
| **Year ended December 31, 2002:** |   |     |   |    |   |
| First Quarter                     |   | $        | 13.67  |    | $      | 6.00 |   |
| Second Quarter                    |   | 9.54     |   | 7.60    |   |
| Third Quarter                     |   | 8.20     |   | 2.70    |   |
| Fourth Quarter                    |   | 4.49     |   | 3.30    |   |

 

As of February25, 2004, there were approximately 13 stockholders of record of our commonstock.

 

We have notdeclared or paid any cash dividends since our inception. We currently intend toretain our future earnings, if any, to finance the further expansion andcontinued growth of our business. In addition, our ability to pay cashdividends on our common stock is currently restricted under the terms of ourcredit agreement. The indenture relating to the senior subordinated notes alsorestricts the payment of dividends by us. Future dividends, if any, will bedetermined by our board of directors.

 

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**Item 6****.Selected Financial Data**

 

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

 
|                                                                |   | **Years Ended December 31,**              |    |
|---------------------------------------------------------------------|--------|-------------------------------------------|---------|
|                                                                |   | **2003**                                  |    | **2002** |   | **2001** |   | **2000** |   | **1999** |   |
|                                                                |   | **(In thousands, except per share data)** |    |
| **Statement of Operations Data:**                                   |   |                                      |    |   |   |   |   |   |   |   |   |
| Net revenues                                                        |   | $                                         | 197,939 |   | $ | 182,636 |   | $ | 169,170 |   | $ | 143,586 |   | $ | 116,418 |   |
| Costs of goods sold (a)                                             |   | 85,927                                    |    | 95,878 |   | 83,079 |   | 69,129 |   | 58,284 |   |
| Gross profit                                                        |   | 112,012                                   |    | 86,758 |   | 86,091 |   | 74,457 |   | 58,134 |   |
| Operating expenses (a):                                             |   |                                      |    |   |   |   |   |   |   |   |   |
| Sales and marketing (b)                                             |   | 54,067                                    |    | 56,216 |   | 36,175 |   | 29,201 |   | 22,884 |   |
| General and administrative                                          |   | 21,767                                    |    | 26,414 |   | 25,042 |   | 19,829 |   | 16,172 |   |
| Research and development                                            |   | 4,442                                     |    | 2,922 |   | 2,285 |   | 2,898 |   | 2,176 |   |
| Amortization of acquired intangibles                                |   | 464                                       |    | — |   | — |   | — |   | — |   |
| Impairment of long-lived assets (c)                                 |   | —                                    |    | 3,666 |   | — |   | — |   | — |   |
| Performance improvement, restructuring and  other costs (d)         |   | (497                                      | )       | 10,008 |   | — |   | 400 |   | — |   |
| Total operating expenses                                            |   | 80,243                                    |    | 99,226 |   | 63,502 |   | 52,328 |   | 41,232 |   |
| Income (loss) from operations                                       |   | 31,769                                    |    | (12,468 | ) | 22,589 |   | 22,129 |   | 16,902 |   |
| Interest expense and other, net (e)                                 |   | (11,718                                   | )       | (12,088 | ) | (22,057 | ) | (16,970 | ) | (7,387 | ) |
| Income (loss) before income taxes                                   |   | 20,051                                    |    | (24,556 | ) | 532 |   | 5,159 |   | 9,515 |   |
| Benefit (provision) for income taxes (e)  (f)                       |   | (7,980                                    | )       | 9,361 |   | 55,958 |   | — |   | (2,387 | ) |
| Net income (loss)                                                   |   | 12,071                                    |    | (15,195 | ) | 56,490 |   | 5,159 |   | 7,128 |   |
| Less: Preferred unit dividends and  accretion ofpreferred unit fees |   | —                                    |    | — |   | (5,667 | ) | (5,415 | ) | (2,343 | ) |
| Net income (loss) available to common  stockholders                 |   | $                                         | 12,071  |   | $ | (15,195 | ) | $ | 50,823 |   | $ | (256 | ) | $ | 4,785 |   |
|                                                                |   |                                      |    |   |   |   |   |   |   |   |   |
| Net income (loss) per share available to  common stockholders:      |   |                                      |    |   |   |   |   |   |   |   |   |
| Basic                                                               |   | $                                         | 0.67    |   | $ | (0.85 | ) | $ | 4.80 |   | N/A |   | N/A |   |
| Diluted                                                             |   | $                                         | 0.64    |   | $ | (0.85 | ) | $ | 4.68 |   | N/A |   | N/A |   |
| Weighted average shares outstanding:                                |   |                                      |    |   |   |   |   |   |   |   |   |
| Basic                                                               |   | 17,963                                    |    | 17,873 |   | 10,593 |   | N/A |   | N/A |   |
| Diluted                                                             |   | 18,791                                    |    | 17,873 |   | 10,858 |   | N/A |   | N/A |   |
| **Balance Sheet Data (at end of period):**                          |   |                                      |    |   |   |   |   |   |   |   |   |
| Cash                                                                |   | $                                         | 19,146  |   | $ | 32,085 |   | $ | 25,814 |   | $ | 4,106 |   | $ | 5,927 |   |
| Total assets                                                        |   | 320,504                                   |    | 237,724 |   | 247,922 |   | 155,672 |   | 89,416 |   |
| Long-term obligations                                               |   | 174,156                                   |    | 109,816 |   | 110,934 |   | 157,222 |   | 113,305 |   |
| Total stockholders’/members’ equity  (deficit)            |   | 117,333                                   |    | 100,913 |   | 115,240 |   | (63,625 | ) | (70,429 | ) |

 

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N/A-As of December 31, 2000 and 1999, we were organized as a limitedliability company and accordingly, had no shares      outstanding.

 

(a)          Amountsin 1999 include various charges and overhead allocations from Smith &Nephew. The year ended December 31, 2002 included aggregate charges of $5.1million to provide reserves for excess inventories, substantially related toproduct lines that we discontinued (see Note 4 of the notes to our consolidatedfinancial statements).

 

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

 

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

 

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(d)         Forthe year ended December 31, 2002, we recorded $10.0 million in charges relatedto our performance improvement program (see Note 4 of the notes to ourconsolidated financial statements), including an accrual for estimated futurenet rent for vacated facilities. In 2003, we decided to retain the vacant spacefor future expansion and reversed the remaining accrual of $0.5 million. Werecorded $0.4 million of merger and integration costs in 2000 associated withthe consolidation of the Orthotech operations into our existing facilities.

 

(e)          Discontinuedacquisition costs of $0.2 million and $0.4 million for the years ended December31, 2002 and 2000, respectively, are included in interest expense and other,net.  The year ended December 31, 2001 includeda charge of approximately $4.7 million for the write-off of unamortizeddeferred debt issuance costs, debt discount and a prepayment premium incurredas a result of the early redemption of a portion of our senior subordinatednotes.  The $1.9 million tax benefitrelated to this charge was in the benefit for income taxes in 2001.

 

(f)            Werecorded a tax benefit (provision) at an effective tax rate of 40% and 38% onour income (loss) before income taxes for the years ended December 31, 2003 and2002, respectively, and at an effective tax rate of 40% on our income beforeincome taxes for the period from November 20, 2001, the date of ourreorganization, to December 31, 2001. Because DonJoy, L.L.C. operated as alimited liability company from the date of its recapitalization in June 1999through November 20, 2001, the date on which the reorganization wasconsummated, in accordance with federal, state and local income tax regulationsthat provide that no income taxes are levied on U.S. limited liability companiesas each member of the LLC is individually responsible for reporting themember’s share of net income or loss, we did not provide for income taxes inour historical consolidated financial statements prior to the reorganization.In connection with the reorganization, we recorded a deferred tax benefit of$54.2 million related to the difference between the book and the tax bases ofcertain assets and liabilities of DonJoy at November 20, 2001.

 

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

 

***Overview***

 

We are aglobal medical device company specializing in rehabilitation and regenerationproducts for the non-operative orthopedic and spine markets.  Our broad range of over 600 rehabilitationproducts, including rigid knee braces, soft goods, and pain managementproducts, are used to prevent injury, to treat chronic conditions and to aid inrecovery after surgery or injury. Our regeneration products consist of bonegrowth stimulation devices that are used to treat nonunion fractures and as anadjunct therapy after spinal fusion surgery. We sell our products in the UnitedStates and in more than 30 other countries through networks of agents,distributors and our direct sales force that market our products to orthopedicand spine surgeons, podiatrists, orthopedic and prosthetic centers, third-partydistributors, hospitals, surgery centers, physical therapists, athletictrainers and other healthcare professionals.

 

# ***Acquisitionsand Other Recent Transactions***

 

On November26, 2003, we acquired the bone growth stimulation device business fromOrthoLogic, which we now operate as our Regentek division, for approximately$93.0 million in cash. We financed the purchase with cash on hand of $12.1million and a portion of the proceeds of a $100.0 million term loan received inconnection with a new credit agreement. Proceeds from the term loan were alsoused to repay all of our existing bank debt, amounting to approximately $15.5million. The credit agreement also provides us with available borrowings undera $30.0 million revolving credit facility. The Regentek acquisition wasaccounted for using the purchase method of accounting whereby the totalpurchase price was allocated to tangible and intangible assets acquired andliabilities assumed based on their estimated fair market values as of theacquisition date.

 

We acquiredall of the operating assets of the bone growth stimulation device business,which is located in Tempe, Arizona, and approximately 140 employees of the bonegrowth stimulation device business have become our employees. The bone growthstimulation products we acquired utilize patented combined magnetic fieldtechnology to deliver a highly specific, low-energy signal and include theOL1000 for the non-invasive treatment of an established nonunion fracture andSpinaLogic, a device used as an adjunct therapy after primary lumbar spinalfusion surgery. The bone growth stimulation business represented substantiallyall of the operating assets of OrthoLogic.

 

In December2003, we signed a lease for a 200,000 square foot built-to-suit facility inTijuana, Mexico, where we intend to relocate all of our Mexico-basedmanufacturing operations in late 2004. In October 2003, we commenced direct distribution of our products inFrance through a new wholly-owned subsidiary, dj Orthopedics France S.A.S.

 

In June 2003,we completed the purchase of specified assets and assumed certain liabilitiesof Dura*Kold Corporation for an aggregate purchase price of $3.0 million. Theassets acquired from DuraKold included tangible and intangible assets relatedto a line of proprietary cold wrap products for orthopedic and medicalapplications. We had previously sold the products manufactured by DuraKoldsince July 2001 under a distribution agreement. The DuraKold acquisition wasaccounted for using the purchase method of accounting whereby the totalpurchase price was allocated to tangible and intangible assets acquired andliabilities assumed based on their estimated fair values as of the acquisitiondate.

 

***Performance Improvement Program***

 

In 2002, wecompleted a company-wide performance improvement program with the objective ofincreasing revenues and reducing both costs of goods sold and operatingexpenses as a percentage of net revenues beginning in 2003.  We retained the services of AlixPartners,LLC, a consulting firm specializing in corporate performance enhancement, toassist with the performance improvement program.

 

With theobjective of reducing costs by streamlining our organization structure, ourperformance improvement program included the elimination of several seniormanagement and other positions.  We alsomoved the manufacturing of all our remaining soft goods and certain non-customrigid braces manufactured in the United States to our manufacturing facilitiesin Mexico.  The move of thesemanufacturing operations was completed by the end of 2002 and resulted in theelimination of approximately 165 United States positions.  More than 140 positions were added inMexico. The manufacturing move reduced our manufacturing costs beginning in thefirst quarter of 2003 and is intended to provide ongoing manufacturing costreduction. In connection with the manufacturing move, a portion of our UnitedStates manufacturing facilities was vacated and in 2002 we accrued theestimated future net rent that would be paid for the vacated facilities, inexcess of estimated sublease income. In 2003, we decided to retain the vacantspace for future expansion and discontinued our efforts to sublease the vacantspace.  Accordingly, the remainingaccrual for rent for the vacant space of $0.5 million was reversed and creditedto operating expenses in 2003.

 

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Other focusesof the performance improvement program included: reducing operating expenses;improving the profitability of sales to our third-party payor customers;improving working capital management; and improving our business processes andinformation systems.  We also refocusedour resources on our core rehabilitation business and discontinued themarketing of our surgical products and our knee replacement product in 2002. Inconnection with our decision to discontinue marketing our surgical products,all remaining assets of Alaron Technologies, L.L.C., which we acquired for$500,000 in June 2001, were written off in 2002.  We also divested our 60% interest in our Australian jointventure, dj Orthopaedics Pty Ltd, effective December 31, 2002, with no materialgain or loss.  The minority ownerassumed full ownership of this entity and continues to sell our currentproducts as an independent distributor.

## * *

## ***Critical Accounting Policies and Estimates***

 

Our discussion andanalysis of our financial condition and results of operations is based upon ourconsolidated financial statements, which have been prepared in accordance withaccounting principles generally accepted in the United States.  The preparation of these financialstatements requires us to make estimates and judgments that affect the reportedamounts of assets, liabilities, revenues and expenses, and related disclosureof contingent assets and liabilities. On an on-going basis, we evaluate our estimates including those relatedto contractual allowances, doubtful accounts, inventories, rebates, productreturns, warranty obligations, income taxes, intangibles and investments.  We base our estimates on historicalexperience and on various other assumptions that are believed to be reasonableunder the circumstances, the results of which form the basis for makingjudgments about the carrying values of assets and liabilities that are notreadily apparent from other sources. Actual results may differ from these estimates under differentassumptions or conditions.

 

We believe thefollowing critical accounting policies affect our more significant judgmentsand estimates used in the preparation of our consolidated financial statementsand this discussion and analysis of our financial condition and results of operations:

 

*Provisionfor Contractual Allowances and Doubtful Accounts.*We maintainprovisions for contractual allowances for reimbursement amounts from ourthird-party payor customers based on negotiated contracts and historicalexperience for non-contracted payors. We also maintain provisions for doubtfulaccounts for estimated losses resulting from the inability of our customers tomake required payments. We have contracts with certain third-party payors forour third-party reimbursement billings, which call for specified reductions inreimbursement of billed amounts based upon contractual reimbursement rates.Historically through December 31, 2002, we have reserved for and reduced grossrevenues from third-party payors by between 20% and 28% for allowances relatedto these contractual reductions. For 2003, we recorded contractual allowancesfor our third-party payor revenue of 22% to 33% of gross billed charges tothird-party payors.  Our contractualallowances percentages increased in 2003 following increases in our currentgross price levels.  For our new bonegrowth stimulation business, we record revenue net of actual contractualallowances and discounts from our gross prices, which are determined on aspecific identification basis and amount to approximately 28% to 32% of ourgross prices for bone growth stimulation products.

 

Our reserve fordoubtful accounts is based upon estimated losses from customers who are billeddirectly and the portion of third-party reimbursement billings that ultimatelybecome the financial responsibility of the end user patients. Direct-billedcustomers represent approximately 56% of our net accounts receivable atDecember 31, 2003 and we have historically experienced write-offs of less than2% of these accounts receivable. Our third-party reimbursement customersinclude all of the customers of our OfficeCare business segment, the majorityof our Regentek business segment and certain third-party payor customers of ourDonJoy business segment, including insurance companies, managed care companiesand certain governmental payors such as Medicare. Our third-party payorcustomers represented approximately 19% of our net revenue for the year endedDecember 31, 2003 and 44% of our net accounts receivable at December 31, 2003and we estimate bad debt expense to be approximately 4 - 8% of gross revenuesfrom these third-party reimbursement customers. If the financial condition ofour customers were to deteriorate resulting in an impairment of their abilityto make payments or if third-party payors were to deny claims for late filings,incomplete information or other reasons, additional provisions may be required.

 

Historically, werelied heavily on third-party billing service providers to provide informationabout the accounts receivable of our third-party payor customers, including thedata utilized to determine reserves for contractual allowances and doubtfulaccounts. During 2002, we enhanced the ability of our systems to obtain andanalyze the information processed by these billing service providers. Ourincreased ability to obtain and better analyze information beginning in 2002revealed that, as a result of historical third-party billing problems, we hadexperienced an increase in allowances and bad debts for accounts receivable fromour third-party payor customers and we increased our provisions for contractualallowances and doubtful accounts accordingly in 2002. In March 2003, wecompleted the transition to a new third-party insurance billing serviceprovider. We also continue to enhance our ability to analyze historicalinformation, resolve issues related to our accounts receivable, and reduce ouraging.  Based on information currentlyavailable to us, we believe we have provided adequate reserves for ourthird-party payor accounts receivable. If claims are denied, or amounts areotherwise not paid, in excess of our estimates, the recoverability of our net

 

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accounts receivable couldbe reduced by a material amount. In addition, if the transition to our newthird-party insurance billing service provider is not successful, we may berequired to increase our reserve estimates.

 

# *Reservefor Excess and Obsolete Inventories.* We provide reserves for estimated excess or obsolete inventories equalto the difference between the cost of inventories on hand plus future purchasecommitments and the estimated market value based upon assumptions about futuredemand.  If future demand is lessfavorable than currently projected by management, additional inventorywrite-downs may be required.  Inaddition, reserves for inventories on hand in our OfficeCare locations areprovided based on historical shrinkage rates of approximately 18%.  If actual shrinkage rates differ from ourestimated shrinkage rates, revisions to the reserve may be required.  We also provide reserves for newer productinventories, as appropriate, based on any minimum purchase commitments and thecurrent status of any FDA approval process, if required, and our level of salesof the new products.  In connection withour decision, as part of our performance improvement program, to discontinuemarketing our Alaron surgical products and our knee replacement product, werecorded provisions in 2002 to reserve all remaining net inventories related tothese products.  We based our reservesfor our knee replacement product on inventory amounts in excess of amounts weestimated would be recoverable from our supplier of the knee replacementproduct who agreed to repurchase the inventory.  In 2003, we received approximately $263,000 from the supplier inexcess of our original estimate, which we recorded as a reduction of costs ofgoods sold. If we receive additional amounts from the supplier in the future,additional credits may be taken.  We alsoprovided reserves in 2002 for all remaining net inventories of our OrthoPulseproduct based on the inability of the manufacturer of OrthoPulse to make anymaterial progress in 2002 in achieving FDA approval for the product.  We also increased our estimates of reservesrequired for certain other excess inventories in 2002.  Aggregate inventory reserves recorded in2002 in connection with these decisions were $5.1 million, which is includedwithin costs of goods sold in our consolidated statement of operations for2002.

 

*Rebates.*  We record estimated reductions to revenuefor customer rebate programs based upon historical experience and estimatedrevenue levels.  We offer certain of ourdistributors rebates based on sales volume, sales growth and to reimburse thedistributor for certain discounts.

 

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

 

*Valuation Allowance for Deferred Tax Asset.*As of December 31, 2003, we have approximately $58.8 million of net deferredtax assets on our balance sheet related primarily to tax deductible goodwillarising at the date of our reorganization in 2001 and not recognized for bookpurposes and net losses reported during 2002. Realization of our deferred tax assets is dependent on our ability togenerate approximately $154.0 million of future taxable income over the next 15years.  Our management believes that itis more likely than not that the deferred tax assets will be realized based onforecasted future taxable income. However, there can be no assurance that we will meet our expectations offuture taxable income.  Management willevaluate the realizability of the deferred tax assets on a quarterly basis toassess any need for valuation allowances.

 

*Goodwilland Other Intangibles.* In 2002, Statement of FinancialAccounting Standards No. 142, or SFAS No. 142, “Goodwill and Other IntangibleAssets” became effective and as a result, we ceased amortization ofgoodwill.  In lieu of amortization, weare required to perform an annual review for impairment.  Goodwill is considered to be impaired if wedetermine that the carrying value of the segment or reporting unit exceeds itsfair value.   At October 1, 2003, ourgoodwill was evaluated for impairment and we determined that no impairmentexisted at that date.  With theexception of goodwill related to our Regentek acquisition of $39 million, webelieve that the goodwill acquired through December 31, 2003 benefits theentire enterprise and since our reporting units share the majority of ourassets, we compared the total carrying value of our consolidated net assets(including goodwill) to the fair value of the Company.

 

At December 31,2003 other intangibles were evaluated for impairment as required by SFAS No.144, “Accounting for Impairment or Disposal of Long-Lived Assets.”  The determination of the fair value ofcertain acquired assets and liabilities is subjective in nature and ofteninvolves the use of significant estimates and assumptions.  Determining the fair values and useful livesof intangible assets requires the exercise of judgment.  Upon initially recording certain of ourother intangible assets, including the intangible assets that were acquired inconnection with the Regentek acquisition, we used independent valuation firmsto assist us in determining the appropriate values for these assets.  Subsequently, we have used the samemethodology and updated our assumptions. While there are a number of different generally accepted valuationmethods to estimate the value of intangible assets acquired, we primarily usedthe undiscounted cash flows expected to result from the use of the assets.  This method requires significant managementjudgment to forecast the future operating results used in the analysis.  In addition, other significant estimates arerequired such as residual growth rates and discount factors.  The estimates we have used are consistent

 

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with the plans andestimates that we use to manage our business and are based on availablehistorical information and industry averages.

 

We recorded animpairment charge for certain long-lived assets in 2002 as a result of certainnew products not achieving anticipated revenues and estimated recovery valuesof assets being disposed of being less than anticipated.  The value of our goodwill and otherintangible assets is exposed to future impairments if we experience furtherdeclines in operating results, if additional negative industry or economictrends occur or if our future performance is below our projections orestimates.

 

***Segments***

 

Our reportablesegments, which, except for Regentek, reflect our primary distributionchannels, are as follows:

 

•                  *DonJoy*,our largest sales channel, comprised of the sale of rigid braces, painmanagement products and certain soft goods. Approximately 40 independent sales agents who employ approximately 270independent commissioned sales representatives and a few of our direct salesrepresentatives sell our DonJoy products to orthopedic surgeons, podiatrists,orthopedic and prosthetic centers, hospitals, athletic trainers and otherhealthcare professionals. The representatives are technical specialistsresponsible for educating patients on device usage. After a product order isreceived by a sales representative, we generally ship the product directly tothe orthopedic professional and pay a sales commission to the agent based onsales of such products. These commissions are reflected in sales and marketingexpense in our consolidated financial statements;

 

•                  *ProCare*, in which products are sold by approximately30 direct and independent representatives that manage over 320 dealers focusedon primary and acute facilities. Products are sold primarily to nationalthird-party distributors, other regional medical supply dealers and medicalproduct buying groups, generally at a discount from list prices. The majorityof these products are soft goods products requiring little or no patienteducation. These distributors resell these products to large hospital chains,hospital buying groups, primary care networks and orthopedic physicians for useby the patients;

 

•                  *Regentek,*in which our Regentek productsare sold through a combination of direct sales representatives and certainindependent regional sales agents, with respect to the OL1000 product, and byDePuy Spine under a exclusive sales agreement, with respect to the SpinaLogicproduct.  These products are sold eitherdirectly to the patient or to independent distributors.  We arrange billing to the third party payorsor patients, for products sold directly to the patient;

 

•                  *OfficeCare*,in which we maintain an inventory of product (mostly soft goods) on hand atorthopedic practices for immediate disbursement to the patient. For theseproducts, we arrange billing to the patient or third-party payor after the productis provided to the patient. In March 2003, we began outsourcing the revenuecycle of this program, from billing to collections, to an independentthird-party contractor. The OfficeCare program is also intended to facilitatethe introduction of our products to orthopedic surgeons who had not previouslybeen our customers.  As of December 31,2003, the OfficeCare program was located at over 540 physician officesthroughout the United States.  We havecontracts with over 350 third-party payors for its OfficeCare products; and

 

•                  *International*, in which our products aresold in foreign countries through wholly-owned subsidiaries or independentdistributors.  We sell our products inover 30 foreign countries, primarily in Europe, Australia, Canada and Japan.

 

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Set forth below is revenue, gross profit and operating income (loss)information for our 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 corporate expensesfor all periods presented, (ii) the impairment of long-lived assets andperformance improvement, restructuring, and other costs for 2002, and (iii)certain goodwill amortization for 2001.

 
|                                                  |   | **2003** |   | **2002** |   | **2001** |   |
|-------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| **DonJoy:**                                           |   |     |   |     |   |     |   |
| Net revenues                                          |   | $        | 95,353 |     | $      | 90,799   |   | $ | 83,913 |   |
| Gross profit                                          |   | 53,824   |   | 53,380   |   | 51,306   |   |
| Gross profit margin                                   |   | 56.4     | %      | 58.8     | %      | 61.1     | %      |
| Operating income                                      |   | 22,437   |   | 23,043   |   |     | (1)    |
| Operating income as a percent of net  revenues        |   | 23.5     | %      | 25.4     | %      |     | (1)    |
| **ProCare:**                                          |   |     |   |     |   |     |   |
| Net revenues                                          |   | $        | 47,858 |     | $      | 46,441   |   | $ | 45,440 |   |
| Gross profit                                          |   | 19,805   |   | 11,320   |   | 11,499   |   |
| Gross profit margin                                   |   | 41.4     | %      | 24.4     | %      | 25.3     | %      |
| Operating income                                      |   | 10,224   |   | 2,379    |   |     | (1)    |
| Operating income as a percent of net  revenues        |   | 21.4     | %      | 5.1      | %      |     | (1)    |
| **Regentek (2):**                                     |   |     |   |     |   |     |   |
| Net revenues                                          |   | $        | 3,989  |     | — |     | — |   |
| Gross profit                                          |   | 3,145    |   | —   |   | —   |   |
| Gross profit margin                                   |   | 78.8     | %      | —   |   | —   |   |
| Operating income                                      |   | 537      |   | —   |   | —   |   |
| Operating income as a percent of net  revenues        |   | 13.5     | %      | —   |   | —   |   |
| **OfficeCare:**                                       |   | $        | 25,631 |     | $      | 22,966   |   | $ | 21,654 |   |
| Net revenues                                          |   |     |   |     |   |     |   |
| Gross profit                                          |   | 20,162   |   | 16,829   |   | 16,036   |   |
| Gross profit margin                                   |   | 78.7     | %      | 73.3     | %      | 74.1     | %      |
| Operating income (loss)                               |   | 2,801    |   | (4,591   | )      |     | (1)    |
| Operating income (loss) as a percent of net  revenues |   | 10.9     | %      | (20.0%   | )      |     | (1)    |
| **International:**                                    |   |     |   |     |   |     |   |
| Net revenues                                          |   | $        | 25,108 |     | $      | 22,430   |   | $ | 18,163 |   |
| Gross profit                                          |   | 15,076   |   | 10,325   |   | 7,250    |   |
| Gross profit margin                                   |   | 60.0     | %      | 46.0     | %      | 39.9     | %      |
| Operating income                                      |   | 6,255    |   | 824      |   |     | (1)    |
| Operating income as a percent of net  revenues        |   | 24.9     | %      | 3.7      | %      |     | (1)    |

 

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(1)          Segment operating incomeis not available for periods prior to December 31, 2002.

(2)          Regentek includesoperations for the period subsequent to the Regentek acquisition on November26, 2003 and includes the impact of the Regentek purchase accounting andrelated amortization of acquired intangible assets.

 

# ***DomesticSales***

 

Domesticsales, including all sales of our DonJoy, ProCare, Regentek and OfficeCarechannels, accounted for approximately 87%, 88% and 89% of our net revenues in2003, 2002 and 2001, respectively.

 

# ***International***

 

International sales accounted for approximately 13%, 12% and 11% of ournet revenues, in 2003, 2002 and 2001, respectively. The following table sets forth ourinternational net revenues as a percentage of our total net revenues, bycountry for the years ended December 31:

 
|                      |   | **2003** |   | **2002** |   | **2001** |   |
|---------------------------|--------|----------|--------|----------|--------|----------|--------|
|                      |   |     |   |     |   |     |   |
| Germany                   |   | 5        | %      | 4        | %      | 4        | %      |
| Australia                 |   | 1        | %      | 2        | %      | 1        | %      |
| Canada                    |   | 2        | %      | 2        | %      | 1        | %      |
| Other countries           |   | 5        | %      | 4        | %      | 5        | %      |
| Total international sales |   | 13       | %      | 12       | %      | 11       | %      |

 

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The “Othercountries” category consists primarily of sales in Italy, Belgium, the UnitedKingdom, the Czech Republic, Denmark, France, Japan and Spain.

 

International sales are currently made primarilythrough two distinct channels: independent third-party distributors, and through our wholly-owned foreign subsidiaries in Germany and the UnitedKingdom (in each case since January 1, 2002), in Canada (since May 2002) and inFrance (since October 2003).

 

Commencing January 1, 2002, we began selling productsthrough our subsidiaries in Germany in Euros and the United Kingdom in PoundsSterling. Commencing May 7, 2002, we began selling products through oursubsidiary in Canada in Canadian Dollars and commencing in October 2003,we began selling products through our subsidiary in France in Euros. The U.S.dollar equivalent of international sales denominated in foreign currencies in2003 and 2002 were favorably impacted by foreign currency exchange rate fluctuationswith the weakening of the U.S. dollar against the Euro and the PoundSterling.  The U.S. dollar equivalent ofthe related costs denominated in these foreign currencies were unfavorablyimpacted during the same period.  Inaddition, the costs associated with our Mexico-based manufacturing operationsare incurred in Mexican pesos.  As wecontinue to distribute and manufacture our products in selected foreigncountries, we expect that future sales and costs associated with our activitiesin these markets will continue to be denominated in the applicable foreigncurrencies, which could cause currency fluctuations to materially impact ouroperating results. Occasionally we seek to reduce the potential impact ofcurrency fluctuations on our business through hedging transactions. At December31, 2003, we had no hedging transactions in place.

 

***Results of Operations***

 

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

 

The following table sets forth our operatingresults as a percentage of net revenues:

 
|                                                    |   | **2003** |   | **2002** |   | **200­1** |   |
|---------------------------------------------------------|--------|----------|--------|----------|--------|----------------|--------|
| Net revenues: DonJoy                                    |   | 48.2     | %      | 49.7     | %      | 49.6           | %      |
| ProCare                                                 |   | 24.2     |   | 25.4     |   | 26.9           |   |
| Regentek                                                |   | 2.0      |   | —   |   | —         |   |
| OfficeCare                                              |   | 12.9     |   | 12.6     |   | 12.8           |   |
| International                                           |   | 12.7     |   | 12.3     |   | 10.7           |   |
| Total net revenues                                      |   | 100.0    |   | 100.0    |   | 100.0          |   |
| Costs of goods sold                                     |   | 43.4     |   | 52.5     |   | 49.1           |   |
| Gross profit                                            |   | 56.6     |   | 47.5     |   | 50.9           |   |
| Operating expenses:                                     |   |     |   |     |   |           |   |
| Sales and marketing                                     |   | 27.3     |   | 30.8     |   | 21.4           |   |
| General and administrative                              |   | 11.0     |   | 14.4     |   | 14.8           |   |
| Research and development                                |   | 2.2      |   | 1.6      |   | 1.3            |   |
| Amortization of acquired intangibles                    |   | 0.2      |   | —   |   | —         |   |
| Impairment of long-lived assets                         |   | —   |   | 2.0      |   | —         |   |
| Performance improvement, restructuring and  other costs |   | (0.2     | )      | 5.5      |   | —         |   |
| Total operating expenses                                |   | 40.5     |   | 54.3     |   | 37.5           |   |
| Income (loss) from operations                           |   | 16.1     |   | (6.8     | )      | 13.4           |   |
| Interest expense and other, net                         |   | (6.0     | )      | (6.6     | )      | (13.0          | )      |
| Income (loss) before income taxes                       |   | 10.1     |   | (13.4    | )      | 0.4            |   |
| Benefit (provision) for income taxes                    |   | (4.0     | )      | 5.1      |   | 33.0           |   |
| Net income (loss)                                       |   | 6.1      | %      | (8.3     | )%     | 33.4           | %      |

 

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

 

***Net Revenues.***Netrevenues increased $15.3 million, or 8.4%, to $197.9 million in 2003from $182.6 million in 2002. Net revenues in 2003 for our DonJoy, ProCare,OfficeCare and International segments were $95.4 million, $47.9 million,$25.6 million, and $25.1 million, respectively, compared to prior yearamounts of $90.8 million, $46.4 million, $23.0 million and$22.4 million, respectively.  Wealso had sales in 2003 from our new Regentek segment of $4.0 million whichinclude operations subsequent to the Regentek acquisition on November 26, 2003.Sales in 2003 for the DonJoy segment increased $4.6 million, or 5.0%, ascompared to 2002 primarily due to increased sales of cold therapy,osteoarthritic knee braces, shoulder and elbow bracing products. ProCaresegment net revenues increased $1.4 million, or 3.1%, as compared to 2002,reflecting an increase in sales to

 

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national accounts customers,including through our contract with Broadlane, Inc. Sales in 2003 for theOfficeCare segment increased by $2.7 million, or 11.6%, compared to 2002primarily due to certain price increases in this segment and the addition ofnew OfficeCare locations, offset by reductions due to a change in the Medicarereimbursement code for certain fracture boot products.  Sales in 2003 for the International segmentincreased by $2.7 million, or 11.9%, compared to 2002.  Net revenue in the International segment in2003 included a benefit from favorable changes in foreign exchange rates of$2.0 million compared to the rates in effect in 2002, but was negativelyaffected by a decrease of $3.5 million in sales in Australia, compared to2002, based on the discontinuation of our majority owned subsidiary inAustralia effective December 31, 2002. Without the impact of either thefavorable changes in foreign exchange rates, or sales in Australia,International segment revenues increased 23.3% in 2003 compared to 2002 due toincreased sales through our subsidiaries located in Germany, Canada and the UKand from our independent distributors.

 

***Gross Profit.***Grossprofit increased $25.3 million, or 29.1%, to $112.0 million for 2003from $86.8 million for 2002.  Grossprofit increased to 56.6% of net revenues for 2003 as compared to 47.5% of netrevenues for 2002.  The improvement ingross profit margin is primarily related to the successful move of asubstantial portion of our U.S. manufacturing to Mexico in the fourth quarterof 2002, as well as the completion of other manufacturing cost reductioninitiatives.  Gross profit for 2002 wasalso impacted by inventory charges of $5.1 million taken in connection with ourperformance improvement program.  Grossprofit in 2003 for the DonJoy, ProCare, OfficeCare and International segmentswas 56.4%, 41.4%, 78.7% and 60.0% of net segment revenues, respectively.  Comparatively, gross profit for 2002 forDonJoy, ProCare, OfficeCare and International was 58.8%, 24.4%, 73.3% and 46.0%of net segment revenues, respectively. Although total gross profit was increased by our manufacturing move toMexico, the reduced gross profit in the DonJoy segment is primarily the resultof a reallocation of certain U.S. manufacturing overhead expenses from productsmoved to Mexico to DonJoy custom rigid bracing products, which continue to bemanufactured in the U.S.  The increasein gross profit in the ProCare, OfficeCare and International segments isprimarily related to the manufacturing move to Mexico.  International gross profit in 2002 was alsoaffected by sales of lower gross margin surgical products by our Australiansubsidiary, which was discontinued in December 2002. Gross profit in our newRegentek segment was 78.8% of net revenue in the 2003 period subsequent to theRegentek acquisition on November 26, 2003 and was negatively impacted by acharge to costs of goods sold of $0.2 million related to a step up of certainacquired inventory values.

 

***Sales and MarketingExpenses.***Sales and marketing expenses decreased$2.1 million, or 3.8%, to $54.1 million for 2003 from $56.2 million for 2002.Sales and marketing expenses decreased as a percentage of revenues to 27.3% in2003 from 30.8% in 2002. The decrease was due to lower commissions, which wasthe result of a change in product mix and revised commission programs initiatedfor our third-party payor customers. Also, bad debt expense related to our third-party payor customers wassignificantly less in 2003 compared to 2002. In addition, sales and marketingexpenses related to our new Regentek segment were $1.4 million in 2003.

 

***General andAdministrative Expenses.***General andadministrative expenses decreased $4.6 million, or 17.6%, to $21.8 million for2003 from $26.4 million for 2002. General and administrative expenses decreasedas a percentage of revenues to 11.0% in 2003 from 14.4% in 2002.  The decrease was primarily due to lowerexpenses for legal activities and other professional fees and lower wages andbenefits, which were partially offset by increased insurance costs and billingfees related to our third-party insurance billing service provider.  In addition, general and administrativeexpenses related to our new Regentek segment were $0.6 million in 2003.

 

***Research andDevelopment Expenses.***Research and developmentexpenses increased $1.5 million, or 52.0%, to $4.4 million for 2003from $2.9 million for 2002. Research and development expenses increased asa percentage of revenues to 2.2% in 2003 from 1.6% in 2002. The increase wasprimarily as a result of increased spending in order to accelerate new productintroductions.  In addition, researchand development expenses related to our new Regentek segment were $0.1 millionin 2003.

 

***Amortization of Acquired Intangibles.***Amortization ofacquired intangibles was $0.5 million in 2003 and reflects amortization expensefor intangible assets acquired in the Regentek acquisition on November 26, 2003including $0.1 million related to the amortization of acquired customer orderbacklog.

 

***Impairment ofLong-Lived Assets.***During 2002, we recognized $3.7 million in charges related toimpairment of certain of our long-lived assets. These long-term assets includedintangible assets associated with our DonJoy Vista Rehabilitation Systemproduct line and other product lines, estimated impairment in our investment inan internet marketing company and goodwill associated with our surgical productlines.

 

***Performance Improvement, Restructuring and Other Costs. ***In 2002, we recordedcharges of $10.0 million related to our performance improvement program,including changes for severance pay, consultants, moving costs and accrued rentrelated to manufacturing facilities vacated in the United States. The severancepay related to the elimination of the U.S. manufacturing positions, certainsenior management positions and certain positions within our sales and generaland administrative departments. In connection with the manufacturing move, aportion of our U.S. manufacturing facilities was vacated, we accrued anestimate of

 

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the future netrent that would be paid for the vacated facilities, in excess of estimatedsublease income. In 2003, we decided to retain the vacant space for futureexpansion and discontinued our efforts to sublease the vacant space.Accordingly, the remaining accrual for rent for the vacant space of $0.5million was reversed and credited to operating expenses.

 

***Interest Expense andOther, Net.*** Interest expense and other, net,including interest expense and discontinued acquisition costs, net of interestincome and foreign exchange gains, was $11.7 million in 2003 compared to $12.1million in 2002. In 2003, foreign exchange transaction gains and other expensesamounted to $0.5 million.  Other expensefor 2002 primarily included costs of $0.2 million incurred related to apotential acquisition that did not close. Although the interest expense related to our average outstanding debtbalance decreased in 2003 compared to 2002, amortization expense related todeferred debt issuance costs was higher in 2003 due to a write-off of all suchcosts related to our former bank debt.

 

***Benefit (Provision)for Income Taxes.***Our estimated worldwideeffective tax rate was 39.8% for 2003 as compared to approximately 38.1% for2002.  The tax benefit rate in 2002 wasreduced primarily due to the disallowance by certain states of net operatingloss carryforwards.

 

***Net Income (Loss).***Netincome was $12.1 million for 2003 compared to net loss of $15.2 million for2002 as a result of the changes discussed above.

 

***Year EndedDecember 31, 2002 Compared To Year Ended December 31, 2001***

*** ***

***Net Revenues***.  Net revenues increased $13.4 million,or 8.0%, to $182.6 million in 2002 from $169.2 million in 2001.  Domestic revenues for 2002 increased by$9.2 million, or 6.1%, from 2001 primarily as a result of increased salesin our DonJoy business segment. International revenues, which also represent sales of our Internationalbusiness segment, for 2002 increased by $4.3 million, or 23.5%, from 2001primarily as a result of commencing sales through our new subsidiaries inGermany, the United Kingdom and Canada. Net revenues for the DonJoy segment increased $6.9 million over2001 due to growth in the sales of our ligament and osteoarthritic kneebraces.  ProCare segment sales increasedby $1.0 million over 2001 due to increased sales of wrist splints andshoulder braces.  OfficeCare segmentsales increased by $1.3 million over 2001 due primarily to increased salesof lower extremity fracture boots.

*** ***

***Gross Profit***.  Gross profit increased $0.7 million, or0.8%, to $86.8 million for 2002 from $86.1 million for 2001.  Gross profit margin decreased from 50.9% for2001 to 47.5% for 2002.  The decrease ingross profit margin relates partly to charges related to reserves for excess inventories,including inventories of the OrthoPulse product and provisions for inventoriesassociated with our decision to exit our surgical product lines aggregating$5.1 million.  Gross profit marginwas also reduced by a change in product sales mix, an increase in certain othercosts of sales, such as royalties, and by a decrease in overhead absorption dueto a reduction in the volume of units manufactured, due partly to an effort toreduce inventory levels and partly to the transition from international salesdistribution through stocking distributors to direct distribution, particularlyin Germany.  Gross profit for the DonJoysegment increased $2.1 million, with gross profit margin decreasing to58.8% for 2002 from 61.1% for 2001. Gross profit for the ProCare segment decreased $0.2 million, withgross profit margin decreasing to 24.4% for 2002 from 25.3% for 2001.  Gross profit for the OfficeCare segmentincreased $0.8 million, with gross profit margin decreasing to 73.3% in2002 from 74.1% for 2001.  Gross profitfor the International segment increased $3.1 million, with gross profitmargin increasing to 46.0% for 2002 as compared to 39.9% for 2001.

*** ***

***Sales and Marketing Expenses***.  Sales and marketing expenses increased$20.0 million, or 55.3%, to $56.2 million for 2002 from$36.2 million for 2001.  Thisincrease included an increase of $6.7 million in our estimated reservesfor contractual allowances and bad debts related to our third-party payor customers.  The increase in sales and marketing expensealso reflects increased commissions due to higher sales of domestic products,increases in the provision for doubtful accounts related to our direct billedcustomers and costs related to our foreign subsidiaries that became operationalin March 2001 (Australia), January 2002 (Germany and United Kingdom) andMay 2002 (Canada).  Overall, sales andmarketing expenses increased as a percentage of revenues to 30.8% in 2002 from21.4% in 2001.

*** ***

***General and Administrative Expenses***.  General and administrative expensesincreased $1.4 million, or 5.6%, to $26.4 million for 2002 from$25.0 million for 2001.  Theincrease was primarily due to increased costs of insurance and legalactivities, and expenses associated with our status as a publicly-tradedcompany effective November 2001, offset by a decrease in goodwillamortization as a result of new accounting rules.  Overall, general and administrative expenses decreased as apercentage of revenues to 14.4% for 2002 from 14.8% for 2001.

*** ***

***Research and Development Expenses***.  Research and development expenses increasedby $0.6 million, or 26.1%, from $2.3 million for 2001 to$2.9 million for 2002 primarily due to an increase in certain patent costsand other new product development costs in 2002.

 

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***Impairment of Long-Lived Assets***.  During 2002, we recognized $3.7 millionin charges related to impairment of certain of our long-lived assets.  These long-lived assets primarily includedintangible assets associated with certain product lines that did not achieveexpected sales levels, an investment in an internet marketing company, aninvestment in the manufacturer of OrthoPulse, goodwill related to theacquisition of Alaron and fixed assets abandoned in connection with our manufacturingmove to Mexico.

*** ***

***Performance Improvement, Restructuring andOther Costs*.** Performance improvement and restructuring costs for 2002 amounted to$10.0 million, which consisted of employee severance costs of$3.9 million, lease termination and other exit costs of $1.9 million,consulting fees of $3.5 million and other costs of $0.7 million.

*** ***

***Interest Expense and Other, Net***.  Interest, expense and other, net, includinginterest expense and discontinued acquisition costs, net of interest income,decreased $10.0 million, or 45.2%, to $12.1 million in 2002 from$22.1 million in 2001.  Thedecrease was primarily the result of a $4.7 million charge taken in 2001to write-off deferred debt issuance costs associated with our prepayment of$25.0 million of the senior subordinated notes and lower interest on therelated lower debt balances outstanding in 2002.

*** ***

***Benefit (Provision) for Income Taxes***.  Our income tax benefit was $9.4 millionfor 2002 compared to a tax benefit of $56.0 million for the period fromNovember 20, 2001 through December 31, 2001, including a deferred taxbenefit of $54.2 million.  Inconnection with our reorganization on November 20, 2001, we became acorporation and subject to U.S. federal, state, and foreign income taxes on ourearnings after that date.  We did notrecord a benefit (provision) for income taxes prior to that date.  We recorded a $1.8 million tax benefitfor the period from November 21, 2001 to December 31, 2001, relatedprimarily to a benefit for the write-off of deferred debt issuance costs inconnection with a prepayment of the senior subordinated notes.  In connection with our reorganization, werecorded a deferred tax benefit of $54.2 million related to the differencebetween the book and the tax basis of certain assets and liabilities of DonJoyat November 20, 2001, as the related amortization is deductible for taxpurposes.  The tax basis differencesarose at the time of the recapitalization when, for income tax purposes, weelected to increase the basis of certain assets in an amount equal to the gainrecognized by our former parent.  Ourannual worldwide effective tax benefit rate was 38.1% for 2002.  Our estimated worldwide effective tax ratewas 40% for 2001.  The comparable taxbenefit rate for 2002 was reduced primarily due to the disallowance by certainstates of net operating loss carryforwards.

*** ***

***Net Income (Loss)*.**  Net loss was $15.2 million for 2002compared to net income of $56.5 million for 2001 as a result of thechanges discussed above.  Income in 2001before the effect of our income tax benefit of $56.0 million was$0.5 million.

*** ***

***Liquidity andCapital Resources***

 

Our principal liquidity requirements are to service our debt and meetour working capital and capital expenditure needs.  Total indebtedness at December 31, 2003 was $174.2 million.

 

Net cash provided by (used in)operating activities was $26.5 million, $14.8 million and$(4.1) million in 2003, 2002 and 2001, respectively. The net cash providedby operations in 2003 primarily reflects improved operating results offset byamounts paid in 2003 for costs accrued in 2002 in connection with ourperformance improvement program. The positive cash flow in 2002 primarilyreflects a net decrease in accounts receivable (which was primarily related toa decrease in our OfficeCare accounts receivable levels), and inventories,offset by amounts paid for our performance improvement program and a reductionin accounts payable.  The cash used in 2001 primarily reflectsincreased accounts receivable levels.

 

Cash flows used in investing activities were$105.5 million, $7.3 million and $8.1 million in 2003, 2002, and2001, respectively.  Cash used ininvesting activities in 2003 included $93.9 million for the Regentek acquisition,$3.0 million for the acquisition of certain patent licenses in connection withthe settlement of a patent litigation matter, $2.9 million for the DuraKoldasset purchase and other capital expenditures amounting to $5.3 million. Cash used in 2002 primarily reflected theacquisition of distribution rights in conjunction with a terminateddistribution agreement and maintenance capital expenditures. Cash used in 2001primarily reflected an increase in the capitalization of costs directlyassociated with our acquisition and implementation of an enterprise resourceplanning system that was completed in March 2001, investments inmanufacturing equipment, the purchase of an equity interest in IMD and theAlaron acquisition in July 2001.

 

Cash flows provided by (used in) financingactivities were $65.8 million, $(1.5) million and $34.0 million in 2003,2002 and 2001, respectively.  Cash provided by financingactivities in 2003 reflects the proceeds received from the issuance of the$100.0 million term loan received in connection with our new credit agreement,net of repayment of our previous bank debt totaling approximately $35.8 millionand debt issuance costs of $2.6 million associated with the new creditagreement. Also in 2003, additional proceeds of $4.2 million were received fromthe issuance of common stock through our Employee Stock Purchase Plan, theexercise of stock options and the collection of a note receivable. Cash used in2002 reflects principal payments related to our former bank credit facility andadditional costs paid in 2002 related to our 2001 initial public offering.  The cash provided in 2001 is primarily theresult of the net proceeds of $118.5 million from our initial public offeringin November 2001 and $9.6 million in

 

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net proceeds fromthe issuance of common units in June 2001, net of $21.9 millionrepaid under our former bank credit facility, $25.0 million paid to redeem aportion of our senior subordinated notes and $47.3 million paid to redeem allof the outstanding redeemable preferred units of DonJoy in connection with ourreorganization.

 

*Contractual Obligations and CommercialCommitments*

 

The$75.0 million of outstanding senior subordinated notes, due 2009, bearinterest at 125/8%, payable semi-annually on June 15 andDecember 15. We are permitted to redeem the senior subordinated notes onor after June 15, 2004.  We intend topurchase and/or redeem all of the outstanding senior subordinated notes withthe net proceeds, amounting to $56.7 million, of the sale of shares by us froma stock offering completed in February 2004, plus existing cash.  We may purchase the notes in the openmarket, in privately negotiated transactions, or, on or after June 15, 2004,redeem these notes pursuant to the terms of the indenture governing the notes.In the event we redeem the notes, in addition to the write-off of the callpremium, we will write-off unamortized debt issuance costs and discountsrelated to the notes.  If we redeem allof the notes on June 15, 2004, the call premium will be $4.7 million and theunamortized debt issuance costs and discounts will be approximately $3.0million.  In the event we purchase thenotes on the open market before June 15, 2004, these unamortized debtissuance costs and discounts will be higher. We have received the consents necessary under our new credit agreementto use the proceeds from the sale of shares by us from a stock offering andcash on hand to purchase and/or redeem the senior subordinated notes.

 

We enteredinto a new credit agreement in November 2003 to finance the Regentekacquisition and repay our prior bank debt. Our new credit facility provides a term loan of $100.0 million, allof which was outstanding as of December 31, 2003. We also have available up to$30.0 million under a revolving credit facility, which is available forworking capital and general corporate purposes, including financingacquisitions, investments and strategic alliances. As of December 31, 2003, wedid not have any borrowed amount outstanding under our revolving creditfacility, but we were contingently liable for letters of credit issued underthe facility aggregating $3.0 million. Borrowings under the term loan and onthe revolving credit facility bear interest at variables rates plus anapplicable margin. At December 31, 2003, the effective interest rate on theterm loan was 3.9375%. Outstanding letters of credit under the revolving creditfacility bear interest at variable rates plus a fronting fee of 0.25%.

 

In addition to scheduled principal payments of $1.25 million perquarter, beginning in 2005 we are required to make annual mandatory payments of the term loan inan amount equal to 50% of our excess cash flow (75% if our ratio of total debtto consolidated EBITDA exceeds 3.00 to 1.00). Excesscash flow represents our net income adjusted for extraordinary gains or losses,depreciation, amortization and other non-cash charges, changes in workingcapital, changes in deferredrevenues, payments for capital expenditures, and repayment of certainindebtedness.  In addition, theterm loan is subject to mandatory prepayments in an amount equal to(a) 100% of the net cash proceeds of certain equity (50% for certainqualified equity issuances) and debt issuances by us and (b) 100% of thenet cash proceeds of certain asset sales or other dispositions of property byus, in each case subject to certain exceptions.

 

The credit agreement and the indenturegoverning the senior subordinated notes impose certain restrictions on us,including restrictions on our 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, make acquisitions,engage in mergers or consolidations, change the business conducted by us andour subsidiaries, make capital expenditures, grant liens, sell our assets andengage in certain other activities. Indebtedness under the credit agreement issecured by substantially all of our assets, including our real and personalproperty, inventory, accounts receivable, intellectual property and otherintangibles. The credit agreement requires us to maintain: a ratio of totaldebt to consolidated EBITDA of no more than 4.00 to 1.00 at December 31, 2003and gradually decreasing through the first quarter of 2007 to 2.50 to 1.00 forthe first quarter of 2007 and thereafter; a ratio of senior debt toconsolidated EBITDA of no more than 2.50 to 1.00 at December 31, 2003 graduallydecreasing through the third quarter of 2006 to 1.75 to 1.00 for the thirdquarter of 2006 and thereafter; a ratio of consolidated EBITDA to consolidatedinterest expense of at least 3.00 to 1.00 at December 31, 2003 and increasingto 3.50 to 1.00 for the first quarter 2005 and thereafter; and a ratio ofconsolidated EBITDA to fixed charges of at least 1.50 to 1.00 at December 31,2003 and thereafter. At December 31, 2003, our ratio of total debt toconsolidated EBITDA was approximately 3.28 to 1.00, our ratio of senior debt toconsolidated EBITDA was approximately 1.89 to 1.00, our ratio of consolidatedEBITDA to consolidated interest expense was approximately 4.51 to 1.00 and ourratio of consolidated EBITDA to fixed charges was approximately 3.01 to 1.00.

 

As part of ourstrategy, we may pursue additional acquisitions, investments and strategicalliances.  We may require new sourcesof financing to consummate any such transactions, including additional debt orequity financing.  We cannot assure youthat such additional sources of financing will be available on acceptableterms, if at all.  In addition, we maynot be able to consummate any such transactions due to the operating andfinancial restrictions and covenants in our credit agreement and the indenturegoverning the senior subordinated notes.

 

The followingtable lists our contractual obligations as of December 31, 2003 (in thousands):

 

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|                               |   | **Payments Due by Period** |    |
|------------------------------------|--------|----------------------------|---------|
|                               |   |                       |    | **2004** |   | **2005-2007** |   | **2008-2009** |   | **2010+** |   |
| **Contractual  Obligations**       |   | **Total**                  |    | **Less than 1  Year** |   | **1-3 Years** |   | **4-5 Years** |   | **After 5 years** |   |
| Long-Term Debt (1)                 |   | $                          | 174,156 |   | $ | 5,000 |   | $ | 15,000 |   | $ | 154,156 |   | $ | — |   |
| Operating Leases                   |   | 21,994                     |    | 4,238 |   | 9,830 |   | 2,538 |   | 5,388 |   |
| Total Contractual Cash Obligations |   | $                          | 196,150 |   | $ | 9,238 |   | $ | 24,830 |   | $ | 156,694 |   | $ | 5,388 |   |

 

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(1)          Represents scheduled principal payments for2004 through 2009 under the term loan portion of our credit facility and thesenior subordinated note repayment, net of unamortized discount, in 2009.

 

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

 

We do notcurrently have and have never had any relationships with unconsolidatedentities or financial partnerships, such as entities often referred to asstructured finance or special purpose entities, which would have beenestablished for the purpose of facilitating off-balance sheet arrangements orother contractually narrow or limited purposes.  In addition, we do not engage in trading activities involvingnon-exchange traded contracts.  As such,we are not materially exposed to any financing, liquidity, market or creditrisk that could arise if we had engaged in these relationships.

 

As of December31, 2003, we had available a total of approximately $19.1 million in cash  and cash equivalents and $27.0 millionavailable under the revolving credit facility. In February 2004, we received anadditional $56.7 million in net proceeds from a stock offering.  For 2004, we expect to spend total cash ofapproximately $101.4 million for the following requirements:

 

•                  approximately$13.6 million scheduled principal and interest payments on our credit facilityand the senior subordinated notes through the June 15, 2004 redemption date;

 

•                  approximately$8.1 million for capital expenditures; and

 

•                  approximately$79.7 million for redemption of our senior subordinated notes, including thecall premium.

 

In addition,we expect to make other general corporate payments in 2004.

 

***Seasonality***

 

We generallyrecord our highest net revenues per day in the fourth quarter due to a greaternumber of orthopedic surgeries and injuries resulting from increased sportsactivity, particularly football and skiing. In addition, during the fourthquarter, a patient has a greater likelihood of having satisfied his or herannual insurance deductible than in the first three quarters of the year, andthus there is an increase in the number of elective orthopedic surgeries. Wefollow a manufacturing calendar that has a varied number of shipping days ineach quarter.  Although on a per daybasis revenues may be higher in a certain quarter, total net revenues may behigher or lower based upon the number of shipping days in such quarter.Conversely, we generally have lower net revenues per day during our secondquarter as a result of decreased sports activity.

 

# * **Recent Accounting Pronouncements***

 

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

 

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**Item 7A****. Quantitative and Qualitative Disclosures About MarketRisk**

 

We are exposedto certain market risks as part of our ongoing business operations. Primaryexposure includes changes in interest rates. We are exposed to interest raterisk in connection with the term loan and borrowings under our revolving creditfacility, which bear interest at floating rates based on London Inter-BankOffered Rate (LIBOR) or the prime rate plus an applicable borrowing margin. Forfixed rate debt, interest rate changes affect the fair market value but do notimpact earnings or cash flows. Conversely, for variable rate debt, interestrate changes generally do not affect the fair market value but do impact futureearnings and cash flows, assuming other factors are held constant.

 

As of December31, 2003, we had $75.0 million in principal amount of fixed rate debtrepresented by the senior subordinated notes and$100.0 million of variable rate debt represented by borrowings under ourcredit facility (at an interest rate of 3.9375% at December 31, 2003). Based onthe balance outstanding under the credit facility as of December 31, 2003, animmediate change of one percentage point in the applicable interest rate wouldhave caused an increase or decrease in interest expense of approximately$1.0 million on an annual basis. At December 31, 2003, up to$30.0 million of variable rate borrowings were available under our$30.0 million revolving credit facility. As of December 31, 2003, we didnot have any amount outstanding under the revolving credit facility, but wewere contingently liable for letters of credit issued under the facilityaggregating $3.0 million.  We may usederivative financial instruments, where appropriate, to manage our interestrate risks. However, as a matter of policy, we do not enter into derivative orother financial investments for trading or speculative purposes. At December31, 2003, we had no such derivative financial instruments outstanding.

* *

*CommencingJanuary 1, 2002, we began selling products through our subsidiaries inGermany and the United Kingdom in Euros and Pounds Sterling, respectively,commencing May 7, 2002, we began selling products through our subsidiaryin Canada in Canadian Dollars and commencing in October 2003, we beganselling products through our subsidiary in France in Euros. The U.S. dollar equivalentof international sales denominated in foreign currencies in 2003 and 2002 werefavorably impacted by foreign currency exchange rate fluctuations with theweakening of the U.S. dollar against the Euro and the Pound Sterling.  The U.S. dollar equivalent of the relatedcosts denominated in these foreign currencies were unfavorably impacted duringthe same period.  In addition, the costsassociated with our Mexico-based manufacturing operations are incurred inMexican pesos.  As we continue to distributeand manufacture our products in selected foreign countries, we expect thatfuture sales and costs associated with our activities in these markets willcontinue to be denominated in the applicable foreign currencies, which couldcause currency fluctuations to materially impact our operating results.Occasionally we seek to reduce the potential impact of currency fluctuations onour business through hedging transactions. At December 31, 2003, we had nohedging transactions in place.*

* *

*51*

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

 

The followingdocuments are filed as part of this report:

 
| Report of Ernst & Young LLP,  Independent Auditors                                                                                         |   |
|------------------------------------------------------------------------------------------------------------------------------------------------|--------|
| Consolidated Balance Sheets as of December 31, 2003 and 2002                                                                                   |   |
| Consolidated Statements of Operations for  the years ended December 31, 2003, 2002 and 2001                                                    |   |
| Consolidated Statements of Changes in  Stockholders’/Members’ Equity (Deficit) for the years ended December 31,  2003, 2002 and 2001 |   |
| Consolidated Statements of Cash Flows for  the years ended December 31, 2003, 2002 and 2001                                                    |   |
| Notes to Consolidated Financial Statements                                                                                                     |   |

 

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**REPORTOF ERNST & YOUNG LLP, INDEPENDENT AUDITORS**

 

To the Board ofDirectors and Stockholders

dj Orthopedics, Inc.

 

We have auditedthe accompanying consolidated balance sheets of dj Orthopedics, Inc. as ofDecember 31, 2003 and 2002, and the related consolidated statements ofoperations, equity and cash flows for each of the three years in the periodended December 31, 2003.  Our auditsalso included the financial statement schedule listed in the Index at Item15(a).  These consolidated financialstatements and schedule are the responsibility of the Company’smanagement.  Our responsibility is toexpress an opinion on these financial statements and schedule based on ouraudits.

 

We conducted ouraudits in accordance with auditing standards generally accepted in the UnitedStates.  Those standards require that weplan and perform the audit to obtain reasonable assurance about whether the financialstatements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting theamounts and disclosures in the financial statements.  An audit also includes assessing the accounting principles usedand significant estimates made by management, as well as evaluating the overallfinancial statement presentation.  Webelieve that our audits provide a reasonable basis for our opinion.

 

In our opinion,the financial statements referred to above present fairly, in all material respects,the consolidated financial position of dj Orthopedics, Inc. at December 31,2003 and 2002, and the consolidated results of its operations and its cashflows for each of the three years in the period ended December 31, 2003, inconformity with accounting principles generally accepted in the UnitedStates.  Also, in our opinion, therelated financial statement schedule, when considered in relation to the basicfinancial statements taken as a whole, presents fairly in all material respectsthe information set forth therein.

 

 
|   | /s/ Ernst  & Young LLP |   |
|--------|----------------------------|--------|

 

 

San Diego, California

January 20, 2004,

except for Note14, as to which the date is

February 24, 2004

 

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

# ***CONSOLIDATED BALANCE SHEETS***

(In thousands, except share and per share data)

 
|                                                                                                                                                                                      |   | **December 31,** |    |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|------------------|---------|
|                                                                                                                                                                                      |   | **2003**         |    | **2002** |   |
| **Assets**                                                                                                                                                                                |   |             |    |   |   |
| Current assets:                                                                                                                                                                           |   |             |    |   |   |
| Cash and cash equivalents                                                                                                                                                                 |   | $                | 19,146  |   | $ | 32,085 |   |
| Accounts receivable, net of provisions for  contractual allowances and doubtful accounts of $20,717 and $10,045 at  December 31,2003 and 2002, respectively                               |   | 43,876           |    | 33,705 |   |
| Inventories, net                                                                                                                                                                          |   | 15,534           |    | 14,583 |   |
| Deferred tax asset, current portion                                                                                                                                                       |   | 11,283           |    | 10,247 |   |
| Other current assets                                                                                                                                                                      |   | 6,342            |    | 4,970 |   |
| Total current assets                                                                                                                                                                      |   | 96,181           |    | 95,590 |   |
| Property, plant and equipment, net                                                                                                                                                        |   | 15,556           |    | 14,082 |   |
| Goodwill                                                                                                                                                                                  |   | 96,552           |    | 55,120 |   |
| Intangible assets, net                                                                                                                                                                    |   | 59,045           |    | 13,335 |   |
| Debt issuance costs, net                                                                                                                                                                  |   | 5,042            |    | 3,787 |   |
| Deferred tax asset                                                                                                                                                                        |   | 47,509           |    | 55,484 |   |
| Other assets                                                                                                                                                                              |   | 619              |    | 326 |   |
| Total assets                                                                                                                                                                              |   | $                | 320,504 |   | $ | 237,724 |   |
|                                                                                                                                                                                      |   |             |    |   |   |
| **Liabilities and stockholders’ equity**                                                                                                                                             |   |             |    |   |   |
| Current liabilities:                                                                                                                                                                      |   |             |    |   |   |
| Accounts payable                                                                                                                                                                          |   | $                | 8,325   |   | $ | 8,490 |   |
| Accrued compensation                                                                                                                                                                      |   | 6,646            |    | 4,952 |   |
| Accrued commissions                                                                                                                                                                       |   | 4,629            |    | 1,634 |   |
| Long-term debt, current portion                                                                                                                                                           |   | 5,000            |    | 1,274 |   |
| Accrued performance improvement and  restructuring costs                                                                                                                                  |   | 766              |    | 5,894 |   |
| Other accrued liabilities                                                                                                                                                                 |   | 8,649            |    | 6,025 |   |
| Total current liabilities                                                                                                                                                                 |   | 34,015           |    | 28,269 |   |
|                                                                                                                                                                                      |   |             |    |   |   |
| 12 5/8% senior subordinated notes, net of  unamortized discount                                                                                                                           |   | 74,156           |    | 74,002 |   |
| Long-term debt, less current portion                                                                                                                                                      |   | 95,000           |    | 34,540 |   |
|                                                                                                                                                                                      |   |             |    |   |   |
| Commitments and contingencies                                                                                                                                                             |   |             |    |   |   |
|                                                                                                                                                                                      |   |             |    |   |   |
| Stockholders’ equity:                                                                                                                                                                |   |             |    |   |   |
| Preferred stock, $0.01 par value; 1,000,000  and 25,000,000 shares authorized, none issued and outstanding at December 31,  2003 and 2002                                                 |   | —           |    | — |   |
| Common stock, $0.01 par value; 39,000,000  and 100,000,000 shares authorized, 18,304,269 shares and 17,872,956 shares  issued and outstanding at December 31, 2003 and 2002, respectively |   | 183              |    | 179 |   |
| Additional paid-in-capital                                                                                                                                                                |   | 69,545           |    | 65,478 |   |
| Notes receivable from stockholders and  officers for stock purchases                                                                                                                      |   | (1,988           | )       | (2,197 | ) |
| Accumulated other comprehensive income                                                                                                                                                    |   | 1,106            |    | 1,037 |   |
| Retained earnings                                                                                                                                                                         |   | 48,487           |    | 36,416 |   |
| Total stockholders’ equity                                                                                                                                                           |   | 117,333          |    | 100,913 |   |
| Total liabilities and stockholders’ equity                                                                                                                                           |   | $                | 320,504 |   | $ | 237,724 |   |

 

See accompanyingNotes.

 

54

----

 

**dj Orthopedics, Inc.**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

(In thousands, except per share data)

 
|                                                                                      |   | **Years ended December 31,** |    |
|-------------------------------------------------------------------------------------------|--------|------------------------------|---------|
|                                                                                      |   | **2003**                     |    | **2002** |   | **2001** |   |
| Net revenues                                                                              |   | $                            | 197,939 |   | $ | 182,636 |   | $ | 169,170 |   |
| Costs of goods sold                                                                       |   | 85,927                       |    | 95,878 |   | 83,079 |   |
| Gross profit                                                                              |   | 112,012                      |    | 86,758 |   | 86,091 |   |
| Operating expenses:                                                                       |   |                         |    |   |   |   |   |
| Sales and marketing                                                                       |   | 54,067                       |    | 56,216 |   | 36,175 |   |
| General and administrative                                                                |   | 21,767                       |    | 26,414 |   | 25,042 |   |
| Research and development                                                                  |   | 4,442                        |    | 2,922 |   | 2,285 |   |
| Amortization of acquired intangibles                                                      |   | 464                          |    | — |   | — |   |
| Impairment of long-lived assets                                                           |   | —                       |    | 3,666 |   | — |   |
| Performance improvement, restructuring and  other costs                                   |   | (497                         | )       | 10,008 |   | — |   |
| Total operating expenses                                                                  |   | 80,243                       |    | 99,226 |   | 63,502 |   |
| Income (loss) from operations                                                             |   | 31,769                       |    | (12,468 | ) | 22,589 |   |
| Other income (expense):                                                                   |   |                         |    |   |   |   |   |
| Interest expense                                                                          |   | (12,582                      | )       | (12,477 | ) | (17,796 | ) |
| Interest income                                                                           |   | 398                          |    | 590 |   | 408 |   |
| Prepayment premium and other costs related  to  Senior Subordinated Note  redemption |   | —                       |    | — |   | (4,669 | ) |
| Other income (expense)                                                                    |   | 466                          |    | (201 | ) | — |   |
| Other income (expense), net                                                               |   | (11,718                      | )       | (12,088 | ) | (22,057 | ) |
| Income (loss) before income taxes                                                         |   | 20,051                       |    | (24,556 | ) | 532 |   |
| Benefit (provision) for income taxes:                                                     |   |                         |    |   |   |   |   |
| Benefit (provision) for income taxes                                                      |   | (7,980                       | )       | 9,361 |   | 1,789 |   |
| Deferred tax benefit                                                                      |   | —                       |    | — |   | 54,169 |   |
| Total benefit (provision) for income taxes                                                |   | (7,980                       | )       | 9,361 |   | 55,958 |   |
| Net income (loss)                                                                         |   | 12,071                       |    | (15,195 | ) | 56,490 |   |
| Less: Preferred unit dividends and  accretion of preferred unit fees                      |   | —                       |    | — |   | (5,667 | ) |
| Net income (loss) available to common  stockholders                                       |   | $                            | 12,071  |   | $ | (15,195 | ) | $ | 50,823 |   |
| Net income (loss) per share available to  common stockholders:                            |   |                         |    |   |   |   |   |
| Basic                                                                                     |   | $                            | 0.67    |   | $ | (0.85 | ) | $ | 4.80 |   |
| Diluted                                                                                   |   | $                            | 0.64    |   | $ | (0.85 | ) | $ | 4.68 |   |
|                                                                                      |   |                         |    |   |   |   |   |
| Weighted average shares outstanding used  tocalculate per share information:              |   |                         |    |   |   |   |   |
| Basic                                                                                     |   | 17,963                       |    | 17,873 |   | 10,593 |   |
| Diluted                                                                                   |   | 18,791                       |    | 17,873 |   | 10,858 |   |

 

For the required information related to thepro forma impact of income taxes on 2001 results, see Note 1.

 

See accompanying Notes.

 

55

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**djOrthopedics, Inc.**

**CONSOLIDATED STATEMENTS OF CHANGES INSTOCKHOLDERS’/MEMBERS’ EQUITY (DEFICIT)**

(In thousands,except unit/share and per unit/share data)

 

 
|                                                                                                                                                             |   |             |   |             |   |       |       |       |   | **Additional  Paid-in  Capital** |   | **Notes  Receivable  from  Stockholders  and Officers for  Stock Purchases** |   | **Accumulated  Other  Comprehensive  Income  (Loss)** |   | **Retained********Earnings** |   | **Total  Stockholders’/  Members’ Equity********(Deficit)** |   | **Comprehensive  Income  (Loss)** |   |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|------------------|--------|------------------|--------|------------|------------|------------|--------|----------------------------------|--------|------------------------------------------------------------------------------|--------|-------------------------------------------------------|--------|------------------------------|--------|-----------------------------------------------------------------------|--------|-----------------------------------|--------|
|                                                                                                                                                             |   |             |   |             |   |       |       |       |   |                             |   |                                                                         |   |                                                  |   |
|                                                                                                                                                             |   |             |   |             |   |       |       |       |   |                             |   |                                                                         |   |                                                  |   |
|                                                                                                                                                             |   |             |   |             |   |       |       |       |   |                             |   |                                                                         |   |                                                  |   |
|                                                                                                                                                             |   | **Common Units** |   | **Common Stock** |   |       |       |       |   |                             |   |
|                                                                                                                                                             |   | **Units**        |   | **Amount**       |   | **Shares** |       | **Amount** |   |                             |   |                                                                         |   |                                                  |   |
| **Balance at December 31, 2000**                                                                                                                                 |   | 793,890          |   | $                | 74,754 |       | —     |       | $      | —                           |   | $                                                                            | — |                                                  | $      | (1,772                       | )      | $                                                                     | — |                              | $      | (136,607 | ) | $ | (63,625 | ) | $ | 4,885 |   |
| Issuance of common units at $10.08 per unit, in exchange for cash and  notes receivable, net of transaction fees of $234.                                        |   | 91,743           |   | 9,763            |   | —     |       | —     |   | —                           |   | (211                                                                         | )      | —                                                |   | —                       |   | 9,552                                                                 |   |                              |   |
| Exchange of 885,633 common units and 44,405 preferred units at the  exchange ratio of 10.812 shares of our common stock in conjunction with the  Reorganization. |   | (885,633         | )      | (84,517          | )      | 10,055,566 |       | 101        |   | 84,416                           |   | —                                                                       |   | —                                                |   | —                       |   | —                                                                |   |                              |   |
| Issuance of common stock at par value in conjunction with  Reorganization at $17.00 per share, net of transaction fees of $13,793.                               |   | —           |   | —           |   | 7,800,000  |       | 78         |   | 118,729                          |   | —                                                                       |   | —                                                |   | —                       |   | 118,807                                                               |   |                              |   |
| Reclassification of accumulated deficit to additional paid-in capital  at Reorganization date                                                                    |   | —           |   | —           |   | —     |       | —     |   | (137,503                         | )      | —                                                                       |   | —                                                |   | 137,503                      |   | —                                                                |   |                              |   |
| Transfer of interest receivable to notes receivable from management                                                                                              |   | —           |   | —           |   | —     |       | —     |   | —                           |   | (99                                                                          | )      | —                                                |   | —                       |   | (99                                                                   | )      |                              |   |
| Stock options granted for services                                                                                                                               |   | —           |   | —           |   | —     |       | —     |   | —                           |   | —                                                                       |   | —                                                |   | 92                           |   | 92                                                                    |   |                              |   |
| Tax distributions to preferred unit holders                                                                                                                      |   | —           |   | —           |   | —     |       | —     |   | —                           |   | —                                                                       |   | —                                                |   | (200                         | )      | (200                                                                  | )      |                              |   |
| Preferred unit dividends and accretion of preferred unit fees                                                                                                    |   | —           |   | —           |   | —     |       | —     |   | —                           |   | —                                                                       |   | —                                                |   | (5,667                       | )      | (5,667                                                                | )      |                              |   |
| Foreign currency translation adjustment                                                                                                                          |   | —           |   | —           |   | —     |       | —     |   | —                           |   | —                                                                       |   | (110                                                  | )      |                         |   | (110                                                                  | )      | (110                              | )      |
| Net income                                                                                                                                                       |   | —           |   | —           |   | —     |       | —     |   | —                           |   | —                                                                       |   | —                                                |   | 56,490                       |   | 56,490                                                                |   | 56,490                            |   |
| **Balance at December 31, 2001**                                                                                                                                 |   | —           |   | —           |   | 17,855,566 |       | 179        |   | 65,642                           |   | (2,082                                                                       | )      | (110                                                  | )      | 51,611                       |   | 115,240                                                               |   | 56,380                            |   |
| Transfer of interest receivable to notes receivable from management                                                                                              |   | —           |   | —           |   | —     |       | —     |   | —                           |   | (115                                                                         | )      | —                                                |   | —                       |   | (115                                                                  | )      |                              |   |
| Stock options granted for services                                                                                                                               |   | —           |   | —           |   | —     |       | —     |   | 32                               |   | —                                                                       |   | —                                                |   | —                       |   | 32                                                                    |   |                              |   |
| Unearned compensation expense                                                                                                                                    |   | —           |   | —           |   | —     |       | —     |   | —                           |   | —                                                                       |   | 14                                                    |   |                         |   | 14                                                                    |   | 14                                |   |
| Additional costs related to initial public offering                                                                                                              |   | —           |   | —           |   | —     |       | —     |   | (317                             | )      | —                                                                       |   | —                                                |   | —                       |   | (317                                                                  | )      |                              |   |
| Net proceeds from issuance of common stock under Employee Stock  Purchase Plan                                                                                   |   | —           |   | —           |   | 17,390     |       | —     |   | 121                              |   | —                                                                       |   | —                                                |   | —                       |   | 121                                                                   |   |                              |   |
| Foreign currency translation adjustment                                                                                                                          |   | —           |   | —           |   | —     |       | —     |   | —                           |   | —                                                                       |   | 1,133                                                 |   |                         |   | 1,133                                                                 |   | 1,133                             |   |
| Net loss                                                                                                                                                         |   | —           |   | —           |   | —     |       | —     |   | —                           |   | —                                                                       |   | —                                                |   | (15,195                      | )      | (15,195                                                               | )      | (15,195                           | )      |
| **Balance at December 31, 2002**                                                                                                                                 |   | —           |   | —           |   | 17,872,956 |       | 179        |   | 65,478                           |   | (2,197                                                                       | )      | 1,037                                                 |   | 36,416                       |   | 100,913                                                               |   | (14,048                           | )      |
| Transfer of interest receivable to notes receivable from management                                                                                              |   | —           |   | —           |   | —     |       | —     |   | —                           |   | (123                                                                         | )      | —                                                |   | —                       |   | (123                                                                  | )      | —                            |   |
| Proceeds from payment of notes receivable                                                                                                                        |   | —           |   | —           |   | —     |       | —     |   | —                           |   | 332                                                                          |   | —                                                |   | —                       |   | 332                                                                   |   | —                            |   |
| Stock options granted for services                                                                                                                               |   | —           |   | —           |   | —     |       | —     |   | 178                              |   | —                                                                       |   | —                                                |   | —                       |   | 178                                                                   |   | —                            |   |
| Net proceeds from issuance of common stock under Employee Stock  Purchase Plan                                                                                   |   | —           |   | —           |   | 73,172     |       | 1          |   | 227                              |   | —                                                                       |   | —                                                |   | —                       |   | 228                                                                   |   | —                            |   |
| Net proceeds from exercise of stock options                                                                                                                      |   | —           |   | —           |   | 358,141    |       | 3          |   | 3,662                            |   | —                                                                       |   | —                                                |   | —                       |   | 3,665                                                                 |   | —                            |   |
| Foreign currency translation adjustment                                                                                                                          |   | —           |   | —           |   | —     |       | —     |   | —                           |   | —                                                                       |   | 69                                                    |   | —                       |   | 69                                                                    |   | 69                                |   |
| Net income                                                                                                                                                       |   | —           |   | —           |   | —     |       | —     |   | —                           |   | —                                                                       |   | —                                                |   | 12,071                       |   | 12,071                                                                |   | 12,071                            |   |
| **Balance at December 31, 2003**                                                                                                                                 |   | —           |   | $                | — |       | 18,304,269 |       | $      | 183                              |   | $                                                                            | 69,545 |                                                  | $      | (1,988                       | )      | $                                                                     | 1,106  |                              | $      | 48,487 |   | $ | 117,333 |   | $ | 12,140 |   |

 

Seeaccompanying Notes.

 

56

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**djOrthopedics, Inc.**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

(In thousands)

 
|                                                                                                          |   | **Years ended December 31,** |   |
|---------------------------------------------------------------------------------------------------------------|--------|------------------------------|--------|
|                                                                                                          |   | **2003**                     |   | **2002** |   | **2001** |   |
| **Operating  activities**                                                                                     |   |                         |   |   |   |   |   |
| Net income (loss)                                                                                             |   | $                            | 12,071 |   | $ | (15,195 | ) | $ | 56,490 |   |
| Adjustments to reconcile net income (loss)  to net cash provided by (used in) operating activities:           |   |                         |   |   |   |   |   |
| Provision for contractual allowances and  doubtful accounts                                                   |   | 22,641                       |   | 22,269 |   | 10,701 |   |
| Provision for excess and obsolete  inventories                                                                |   | 2,087                        |   | 6,124 |   | 604 |   |
| Impairment of long-lived assets                                                                               |   | —                       |   | 3,666 |   | — |   |
| Performance improvement and restructuring  costs                                                              |   | (497                         | )      | 10,008 |   | — |   |
| Depreciation and amortization                                                                                 |   | 8,186                        |   | 7,283 |   | 9,444 |   |
| Amortization of debt issuance costs and  discount on Senior Subordinated Notes                                |   | 1,499                        |   | 935 |   | 2,636 |   |
| Other                                                                                                         |   | 178                          |   | 46 |   | 246 |   |
| Changes in operating assets and  liabilities:                                                                 |   |                         |   |   |   |   |   |
| Accounts receivable                                                                                           |   | (24,708                      | )      | (10,409 | ) | (21,379 | ) |
| Inventories                                                                                                   |   | 58                           |   | 8,248 |   | (7,233 | ) |
| Other current assets                                                                                          |   | (1,991                       | )      | (3,571 | ) | (1,114 | ) |
| Accounts payable                                                                                              |   | (501                         | )      | (1,659 | ) | 843 |   |
| Accrued compensation                                                                                          |   | 1,494                        |   | 2,829 |   | (847 | ) |
| Accrued commissions                                                                                           |   | 2,847                        |   | 416 |   | (226 | ) |
| Deferred income taxes                                                                                         |   | 6,944                        |   | (9,695 | ) | (56,036 | ) |
| Accrued performance improvement and  restructuring costs                                                      |   | (4,631                       | )      | (3,961 | ) | — |   |
| Other accrued liabilities                                                                                     |   | 850                          |   | (2,495 | ) | 1,805 |   |
| Net cash provided by (used in) operating  activities                                                          |   | 26,527                       |   | 14,839 |   | (4,066 | ) |
|                                                                                                          |   |                         |   |   |   |   |   |
| **Investing activities**                                                                                      |   |                         |   |   |   |   |   |
| Purchases of property, plant and equipment                                                                    |   | (5,334                       | )      | (4,131 | ) | (5,964 | ) |
| Proceeds from sale of property, plant and  equipment                                                          |   | —                       |   | 288 |   | — |   |
| Purchase of intangible assets                                                                                 |   | (3,000                       | )      | (2,590 | ) | (1,140 | ) |
| Purchase of Regentek business                                                                                 |   | (93,939                      | )      | — |   | — |   |
| Purchase of DuraKold business                                                                                 |   | (2,899                       | )      | — |   | — |   |
| Change in other assets, net                                                                                   |   | (280                         | )      | (916 | ) | (1,005 | ) |
| Net cash used in investing activities                                                                         |   | (105,452                     | )      | (7,349 | ) | (8,109 | ) |
|                                                                                                          |   |                         |   |   |   |   |   |
| **Financing activities**                                                                                      |   |                         |   |   |   |   |   |
| Repayment of senior subordinated notes                                                                        |   | —                       |   | — |   | (25,000 | ) |
| Proceeds from long-term debt                                                                                  |   | 100,000                      |   | — |   | — |   |
| Repayment of long-term debt                                                                                   |   | (35,815                      | )      | (1,272 | ) | (21,876 | ) |
| Distributions to preferred unit holders                                                                       |   | —                       |   | — |   | (200 | ) |
| Net proceeds from exercise of stock options                                                                   |   | 3,665                        |   | — |   | — |   |
| Net proceeds from issuance of common stock  under Employee Stock Purchase Plan                                |   | 228                          |   | 121 |   | — |   |
| Net proceeds from (costs of) issuance of  common stock and common units                                       |   | —                       |   | (317 | ) | 128,359 |   |
| Debt issuance costs                                                                                           |   | (2,600                       | )      | — |   | — |   |
| Repurchase of preferred units in connection  with Reorganization                                              |   | —                       |   | — |   | (47,290 | ) |
| Proceeds from payment of notes receivable                                                                     |   | 332                          |   | — |   | — |   |
| Net cash (used in) provided by financing  activities                                                          |   | 65,810                       |   | (1,468 | ) | 33,993 |   |
| Effect of exchange rate changes on cash and  cash equivalents                                                 |   | 176                          |   | 249 |   | (110 | ) |
| Net increase in cash and cash equivalents                                                                     |   | (12,939                      | )      | 6,271 |   | 21,708 |   |
| Cash and cash equivalents at beginning of  year                                                               |   | 32,085                       |   | 25,814 |   | 4,106 |   |
| Cash and cash equivalents at end of year                                                                      |   | $                            | 19,146 |   | $ | 32,085 |   | $ | 25,814 |   |
|                                                                                                          |   |                         |   |   |   |   |   |
| **Supplemental disclosure of cash flow  information:**                                                        |   |                         |   |   |   |   |   |
| Interest paid                                                                                                 |   | $                            | 10,513 |   | $ | 11,308 |   | $ | 16,974 |   |
| Income taxes paid (refunded), net                                                                             |   | $                            | (43    | ) | $ | 760 |   | $ | — |   |
| **Supplemental disclosure of non-cash  transactions:**                                                        |   |                         |   |   |   |   |   |
| Dividends and accretion of preferred unit  fee related to redeemable preferred units                          |   | $                            | — |   | $ | — |   | $ | 5,667 |   |
| Common units issued in exchange for notes  receivable and transfer of interest receivable to notes receivable |   | $                            | 123    |   | $ | 115 |   | $ | 310 |   |

 

See accompanyingNotes.

 

57

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**dj Orthopedics, Inc.**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**(In thousands)**

 

**1.             Organization and Summary ofSignificant Accounting Policies**

 

dj Orthopedics, Inc. (dj Orthopedics), through its subsidiarydj Orthopedics, LLC (dj Ortho) and dj Ortho’s subsidiaries (collectively, theCompany) is a global medical device company specializing in rehabilitation andregeneration products for the non-operative orthopedic and spine markets. TheCompany is the successor to DonJoy, Inc. (DonJoy), a business started in 1978in Carlsbad, California. In 1987, DonJoy was acquired by Smith & Nephew,Inc. and on June 30,1999, DonJoy consummated a recapitalization pursuant towhich J.P. Morgan DJ Partners, LLC obtained a controlling interest in DonJoyfrom Smith & Nephew, Inc. Concurrently with the completion of djOrthopedics, Inc.’s initial public offering on November 20, 2001, DonJoy mergedwith and into dj Orthopedics through a series of transactions, referred toherein as the “Reorganization.”  As aresult of the foregoing transactions, dj Ortho became a wholly owned subsidiaryof dj Orthopedics, Inc.

 

dj Orthopedicsand dj Orthopedics Development Corporation (dj Development) guarantee djOrtho’s bank borrowings and the senior subordinated notes (the notes).  DJ Orthopedics Capital Corporation (djCapital) was formed solely to act as a co-issuer (and as a joint and severalobligor) with dj Ortho with respect to the notes.  No separate financial information for dj Capital has beenprovided herein because management believes such information would not bematerial as dj Capital does not hold any assets or other properties or conductany business. Condensed consolidating financial statements showing separateinformation for dj Orthopedics, dj Ortho, dj Development and the Company’snon-guarantor subsidiaries in the aggregate have been provided within Note 12.

 

*2003 Acquisition*

 

On November26, 2003, the Company acquired the bone growth stimulation device business fromOrthoLogic Corp. (OrthoLogic), which now operates as the Copmany’s Regentekdivision, for approximately $93.0 million in cash plus certain assumedliabilities aggregating approximately $0.9 million and transaction costsamounting to approximately $0.9 million at closing. The Company financed thepurchase with cash on hand of $12.1 million and a portion of the proceeds of a$100.0 million term loan received in connection with a new credit agreement.Proceeds from the term loan were also used to repay all of the Company’sexisting bank debt, amounting to approximately $15.5 million. The creditagreement also provides the Company with available borrowings under a $30.0million revolving credit facility. The Regentek acquisition has been accountedfor using the purchase method of accounting whereby the total purchase pricehas been allocated to tangible and intangible assets acquired and liabilitiesassumed based on their estimated fair market values as of the acquisition date.

 

*2001 Reorganization and Initial PublicOffering*

 

In theReorganization, holders of the common and preferred units of DonJoy receivedshares of dj Orthopedics, Inc.’s common stock on the basis of 10.812 shares ofcommon stock for each outstanding unit and, in the case of a preferred unit, anamount in cash equal to approximately $1,082, representing the liquidationpreference of the preferred unit, plus accrued and unpaid distributions thereonbut excluding the date that the Reorganization was effective.  A total of 10,055,566 shares of common stockwere issued in the merger. Prior to the Reorganization, the operating resultsof DonJoy were allocated to the members. At the time of the Reorganization,members’ equity was reclassified into common stock and additional paid-incapital. Deferred income taxes of $54.2 million represent the deferred incometaxes related to the difference in the book and tax basis of the assets ofDonJoy at November 20, 2001 and which were recorded at the time of theReorganization. Immediately following the Reorganization, dj Orthopedics, Inc.sold 7,800,000 shares of common stock in an initial public offering at $17.00per share.

 

All referencesto per unit amounts in the Notes to the consolidated financial statementsregarding per share and stock option information have been restated to theirequivalent shares based on the conversion of the common and preferred units ofDonJoy into shares of dj Orthopedics, Inc.’s common stock at theReorganization.

 

*Basis of Presentation and Principles ofConsolidation*

 

The accompanying consolidated financial statements presentthe historical financial position and results of operations of dj Orthopedicsand include the accounts of dj Ortho, the accounts of dj Ortho’s wholly-ownedsubsidiaries, dj Orthopedics Development Corporation (dj Development) and DJOrthopedics Capital Corporation (dj Capital), the accounts of dj Ortho’s whollyowned Mexican subsidiary that manufactures a majority of dj Ortho’s productsunder Mexico’s maquiladora program,

 

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the accounts of dj Ortho’s wholly-owned subsidiaries inCanada, Germany, France and the United Kingdom, and the accounts of dj Ortho’smajority owned subsidiary in Australia (formed in March 2001 and divested inDecember 2002). All intercompany accounts and transactions have been eliminatedin consolidation.

 

In October2003, the Company commenced direct distribution of its products in Francethrough a new wholly-owned subsidiary, dj Orthopedics France S.A.S. (djFrance). Effective May 2002, the Company commenced direct distribution of itsproducts in Canada through a new wholly-owned subsidiary, dj Ortho, Canada Inc.(dj Canada).  Effective January 2002,the Company commenced direct distribution of its products in Germany and theUnited Kingdom through two new wholly-owned subsidiaries, dj OrthopedicsDeutschland GmbH (dj Germany) and dj Orthopaedics UK Ltd (dj UK).  In each of these countries the Company hadpreviously sold its products through third party distributors.

 

*Use of Estimates in the Preparation ofFinancial Statements*

 

The preparation of these financial statements requires thatthe Company make estimates and judgments that affect the reported amounts ofassets, liabilities, revenues and expenses and related disclosure of contingentassets and liabilities. On an ongoing basis, the Company evaluates itsestimates, including those related to contractual allowances, doubtfulaccounts, inventories, rebates, product returns, warranty obligations, incometaxes, intangibles and investments.  TheCompany bases its estimates on historical experience and on various otherassumptions that are believed to be reasonable under the circumstances, theresults of which form the basis for making judgments about the carrying valuesof assets and liabilities that are not readily apparent from other sources.  Actual results may differ from theseestimates.

 

*Cash Equivalents*

 

Cash equivalents are short-term, highlyliquid investments and consist of investments in money market funds andcommercial paper with maturities of three months or less at the time of purchase.

 

*Fair Value of Financial Instruments*

 

In accordance with Financial AccountingStandards Board (FASB) Statement of Financial Accounting Standards (SFAS)No. 107, *Disclosures about Fair Valueof Financial Instruments*, the following methods and assumptions wereused in estimating fair value disclosures:

 

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

 

•                  *Long-Term Debt. *Based on the borrowing rates currently available to theCompany for loans with similar terms and average maturities, management of theCompany believes the fair value of long-term debt approximates its carryingvalue at December 31, 2003.

 

*Discounts and Allowances*

 

Accounts receivable in the accompanying consolidated balancesheets are presented net of reserves for estimated payment discounts,contractual allowances related to third-party payors, and allowances fordoubtful accounts.

 

*Long-Lived Assets*

 

Property,plant and equipment and intangible assets are recorded at cost. The Companyprovides for depreciation of property, plant and equipment (3 to 7 years) andamortization of intangible assets (4 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 or theterms of the related leases.

 

*Computer Software Costs*

 

The Company applies the American Institute ofCertified 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

 

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estimated useful life of the software. During2001, the Company capitalized $1.2 million related to the acquisition andimplementation of its enterprise resource planning system. The Company isamortizing these costs over seven years.

 

*Debt Issuance Costs*

 

In 2003, theCompany capitalized debt issuance costs of $2.6 million in association with itsnew credit agreement. The Company capitalized debt issuance costs of $6.6million associated with the issuance of its senior subordinated notes inconnection with the recapitalization in 1999 and the commencement of its formerbank credit facility. These debt issuance costs are reflected on theaccompanying consolidated balance sheets net of accumulated amortization of$5.0 million and $3.8 million as of December 31, 2003 and 2002,respectively. The Company is amortizing these costs over the life of therelated debt instruments, ranging from six to ten years and classifies theamortization expense with interest expense in the accompanying consolidatedstatements of operations. As of December 31, 2003, all debt issuance costsrelated to the Company’s former bank credit facility have been fully amortized.In December 2001, the Company recorded a charge to interest expense of $1.1million to write-off unamortized debt issuance costs in connection with theredemption of a portion of the senior subordinated notes.

 

*Inventories*

 

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

 

*Revenue Recognition*

 

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

 

The Companyrecognizes revenue pursuant to Staff Accounting Bulletin (SAB) No. 101, *Revenue Recognition in Financial Statements,*as amended by SAB No. 104, *Revenue Recognition in Financial Statements*.Accordingly, revenue is recognized when all four of the following criteria aremet: (i) persuasive evidence that an arrangement exists;(ii) shipment of goods and passage of title; (iii) the selling priceis fixed or determinable; and (iv) collectibility is reasonably assured.Revenues from third-party insurance payers are recorded net of estimatedcontractual allowances, which are accrued as a percent of revenues based onactual historical experience. Revenues are also reduced by allowances forestimated returns and rebates related to sales transacted through distributionagreements that provide the distributors with a right to return excess andobsolete inventory. Estimated returns based on historical actual returns areaccrued in accordance with the provisions of SFAS No. 48, *Revenue Recognition When Right of Return Exists*in the period sales are recognized. Some products have a limited warranty andestimated warranty costs are accrued based on historical experience in theperiod sales are recognized. In addition, rebates are accrued at the time ofsale based upon historical experience and estimated revenue levels inaccordance with agreed upon terms with customers.  Furthermore, the Company includes amounts billed to customers forfreight in revenue.

 

*Shippingand Handling Costs*

 

The shipping andhandling  costs included in costs ofgoods sold were $10.7 million, $9.2 million and $9.3 million for the yearsended December 31, 2003, 2002 and 2001, respectively.

 

*AdvertisingExpense*

 

Advertising expenses areexpensed as incurred.  The Companyincurred $243,000, $88,000 and $209,000 in advertising expenses for the yearsended December 31, 2003, 2002 and 2001, respectively.

 

*Foreign Currency Translation*

 

The financial statements of the Company’s internationaloperations where the local currency is the functional currency are translatedinto U.S. dollars using period-end exchange rates for assets and liabilitiesand average exchange rates during the period for revenues and expenses.Cumulative translation gains and losses are excluded from results of operationsand recorded as a separate component of consolidated stockholders’ equity.  Gains and losses resulting from foreigncurrency transactions

 

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(transactions denominated in a currency other than theentity’s local currency) are included in the consolidated statements ofoperations as either a component of costs of goods sold or other income orexpense.

 

*Concentration of Credit Risk*

 

dj Ortho sells the majority of its productsin the United States to orthopedic professionals, distributors, specialtydealers and buying groups. International sales comprised 13%, 12% and 11% of the Company’s net revenuesfor the years ended December 31, 2003, 2002 and 2001, respectively, andare sold through wholly-owned subsidiaries and independent distributors. Creditis extended based on an evaluation of the customer’s financial condition andgenerally collateral is not required. The Company also provides a reserve forestimated bad debts.  In addition,approximately 41% of the Company’s net receivables at December 31, 2003 arefrom third-party payors.  Managementreviews and revises its estimates for credit losses from time to time and suchcredit losses have been within management’s estimates.

 

During the three years endedDecember 31, 2003, the Company had no individual customer or distributor,which accounted for 10% or more of total annual revenues.

 

*PerShare Information*

 

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

 

 
|                                                                                    |   | **2003** |   | **2002** |   | **2001** |   |
|-----------------------------------------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| Shares used in basic net income (loss) per  share - weighted average shares outstanding |   | 17,963   |   | 17,873   |   | 10,593   |   |
| Net effect of dilutive common share  equivalents based on treasury stock method         |   | 828      |   | —   |   | 265      |   |
| Shares used in computations of diluted net  income (loss) per share                     |   | 18,791   |   | 17,873   |   | 10,858   |   |

 

*Stock-Based Compensation*

 

The Companyaccounts for its employee stock option plans and employee stock purchase planunder recognition and measurement principles of Accounting Principles Board(APB) Opinion No. 25, *Accounting for StockIssued to Employees*and its related interpretations, and has adoptedthe disclosure only provisions of SFAS No. 123, *Accounting for Stock-Based Compensation*and its relatedinterpretations. Accordingly, no compensation cost has been recognized for thefixed stock option plans or stock purchase plan.  In accordance with EITF 96-18, stock options and warrants issuedto consultants and other non-employees as compensation for services provided tothe Company are accounted for based upon the fair value of the servicesprovided or the estimated fair market value of the option or warrant, whichevercan be more clearly determined. The Company recognizes this expense over theperiod the services are provided; however, the amount of expense related tothese types of arrangements has never been significant.

 

Pro formainformation regarding net income is required by SFAS No. 123 and has beendetermined as if the Company had accounted for its employee stock options underthe fair value method of SFAS No. 123. The fair value of these options was estimated at the date of grant usingthe Black-Scholes valuation model for option pricing with the followingassumptions for 2003, 2002 and 2001: a risk-free interest rate of 2.68%, 2.92%and 5.5%, respectively; a dividend yield of zero; expected volatility of themarket price of the Company’s common stock of 74.2%, 90.9% and 70.0%,respectively, and a weighted average life of an option of four years.

 

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For the yearsended December 31, the following table illustrates the effect on net income(loss) and earnings (loss) per share if the Company had applied the fair valuerecognition provisions of SFAS No. 123 to stock-based employee compensation (inthousands, except per share amounts):

 
|                                                                                                                                                                |   | **2003** |   | **2002** |   | **2001** |   |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| Net income (loss) available to common  stockholders, as reported                                                                                                    |   | $        | 12,071 |     | $      | (15,195  | )      | $ | 50,823 |   |
| Total stock-based employee compensation  expense  determined under fair value  method for all option plans and stock purchase plan net of related tax  effects |   | (2,026   | )      | (654     | )      | (1,699   | )      |
| Pro forma net income (loss) available to  common stockholders                                                                                                       |   | $        | 10,045 |     | $      | (15,849  | )      | $ | 49,124 |   |
| Basic net income (loss) per share available  to common stockholders:                                                                                                |   |     |   |     |   |     |   |
| As reported                                                                                                                                                         |   | $        | 0.67   |     | $      | (0.85    | )      | $ | 4.80 |   |
| Pro forma                                                                                                                                                           |   | $        | 0.56   |     | $      | (0.89    | )      | $ | 4.64 |   |
|                                                                                                                                                                |   |     |   |     |   |     |   |
| Diluted net income (loss) per share  available to common stockholders:                                                                                              |   |     |   |     |   |     |   |
| As reported                                                                                                                                                         |   | $        | 0.64   |     | $      | (0.85    | )      | $ | 4.68 |   |
| Pro forma                                                                                                                                                           |   | $        | 0.53   |     | $      | (0.89    | )      | $ | 4.52 |   |

 

The pro formaeffect on net income (loss) above is not necessarily indicative of potentialpro forma effects on results for future years. The weighted average fair value of options granted during 2003, 2002 and2001 was $11.30, $3.20 and $7.02 per share, respectively.

 

# *Pro Forma IncomeTaxes and Pro Forma Per Share Information*

 

Pro forma income tax expense represents estimated tax expensebased on the Company’s operating results for the year ended December 31, 2001as if the Company were a corporation from the beginning of the year, using anestimated combined worldwide effective tax rate of 40.0%. The pro forma basicand diluted per share information shown below is computed based on the weightedaverage number of shares of common stock outstanding for each year.  For comparative purposes, the 7,800,000shares of common stock issued as part of the Company’s initial public offeringhave been included in the weighted averaged number of shares outstanding forthe year ended December 31, 2001, as if the shares were outstanding for theentire period.  The computation of proforma diluted per share information for the year ended December 31, 2001 includesthe dilutive effect of common stock equivalents for outstanding common stockoptions using the treasury stock method.  The following table presents the pro forma income taxes and pro formaper share information for the Company and reconciles the denominators used incomputing basic and diluted earnings per share for the year ended December 31,2001 (in thousands, except per share amounts):

 

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| Income before income taxes                                                                                                             |   | $      | 532    |   |
|----------------------------------------------------------------------------------------------------------------------------------------|--------|--------|--------|--------|
| Pro forma benefit (provision) for income  taxes:                                                                                       |   |   |   |
| Historical benefit for income taxes                                                                                                    |   | 1,789  |   |
| Historical deferred tax benefit                                                                                                        |   | 54,169 |   |
| Pro forma adjustment                                                                                                                   |   | (2,001 | )      |
| Total pro forma benefit for income taxes                                                                                               |   | 53,957 |   |
|                                                                                                                                   |   |   |   |
| Pro forma net income                                                                                                                   |   | 54,489 |   |
| Less: Preferred unit dividends and  accretion of preferred unit fees                                                                   |   | (5,667 | )      |
| Pro forma net income available to common  stockholders/members                                                                         |   | $      | 48,822 |   |
|                                                                                                                                   |   |   |   |
| Pro forma net income per share available to  common stockholders:                                                                      |   |   |   |
| Basic                                                                                                                                  |   | $      | 2.80   |   |
| Diluted                                                                                                                                |   | $      | 2.76   |   |
|                                                                                                                                   |   |   |   |
| Shares used in pro forma basic net income  per share and pro forma income per share – weighted average common shares  outstanding |   | 17,410 |   |
| Net effect of dilutive common share  equivalents based on treasury stock method                                                        |   | 265    |   |
| Shares used in pro forma diluted net income  per share – weighted average                                                         |   | 17,675 |   |

 

# *Income Taxes*

 

The Company recorded atax benefit (provision) at an effective tax rate of 39.8% and 38.1% on income(loss) before income taxes for the years ended December 31, 2003 and 2002,respectively, and at an effective tax rate of 40% on its income before incometaxes for the period from November 20, 2001, the date of its reorganization, toDecember 31, 2001. Because DonJoy, L.L.C. operated as a limited liabilitycompany from the date of its recapitalization in June 1999 through November 20,2001, the date on which the reorganization was consummated, in accordance withfederal, state and local income tax regulations that provide that no incometaxes are levied on U.S. limited liability companies as each member of the LLCis individually responsible for reporting the member’s share of net income orloss, the Company did not provide for income taxes in its historicalconsolidated financial statements prior to the reorganization. In connectionwith the reorganization, the Company recorded a deferred tax benefit of $54.2million related to the difference between the book and the tax bases of certainassets and liabilities of DonJoy at November 20, 2001.

 

*Comprehensive Income (Loss)*

 

The Company has adopted SFAS No. 130, *Reporting Comprehensive Income*, whichrequires that all components of comprehensive income (loss), including netincome (loss), be reported in the financial statements in the period in whichthey are recognized. Comprehensive income (loss) is defined as the change inequity during a period from transactions and other events and circumstancesfrom non-owner sources. Net income (loss) and other comprehensive income(loss), including foreign currency translation adjustments, and unrealizedgains and losses on investments, are reported, net of related tax, to arrive atcomprehensive income (loss).

 

*Recently Issued Accounting Standards*

 

In May 2003,the FASB issued SFAS No. 150, *Accounting forCertain Financial Instruments with Characteristics of both Liabilities andEquity.*SFAS No. 150 affects the issuer’s accounting for three typesof freestanding financial instruments; (a) mandatorily redeemable shares whichthe issuing company is obligated to buy back in exchange for cash or otherassets, (b) put options and forward purchase contracts that do or may requirethe issuer to buy back some of its shares in exchange for cash or other assets,and (c) obligations that can be settled with shares, the monetary value ofwhich is fixed, ties solely or predominantly to a variable such as a marketindex, or varies inversely with the value of the issuer’s shares. SFAS No. 150also requires disclosures about alternative ways of settling the instrumentsand the capital structure of entities. SFAS No. 150 is effective for allfinancial instruments entered into or modified after May 31, 2003 and for allperiods beginning after June 15, 2003. The Company does not anticipate thatadoption of SFAS No. 150 will have a material impact on its consolidatedfinancial statements.

 

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In January2003, the FASB issued FASB Interpretation No. 46 (“FIN 46”), *Consolidation of Variable Interest Entities, aninterpretation of ARB No. 51*. FIN 46 was revised in December, 2003and clarifies the application of ARB 51 to certain entities in which equityinvestors do not have the characteristics of a controlling financial interestor do not have sufficient equity at risk for the entity to finance itsactivities without additional subordinated financial support. The applicationof FIN 46 may require that an entity be subject to consolidation even thoughthe investor does not have a controlling financial interest that, under ARB 51,was usually deemed to exist through ownership of a majority voting interest.FIN 46, as revised, is generally effective for all entities subject to theinterpretation no later than the end of the first reporting period that endsafter March 15, 2004. The Company currently has no investments in entitieswithin the scope of FIN 46 and as a result does not believe its applicationwill have a material effect on the Company’s financial statements.

 

# *Goodwill and Other Intangible Assets*

 

In 2002, SFAS No. 141, *Business Combinations*, replaced prioraccounting standards and eliminates pooling-of-interests accountingprospectively. It also provided guidance on purchase accounting related to therecognition of intangible assets and accounting for negative goodwill. SFAS No.142, *Goodwill and Other Intangible Assets,*changed the accounting for goodwill from an amortization method to animpairment write-off approach. Under SFAS No. 142, goodwill will be testedannually and whenever events or circumstances occur indicating that goodwillmight be impaired.  SFAS No. 141 andSFAS No. 142 are effective for all business combinations completed after June30, 2001. Effective January 1, 2002, amortization of goodwill recorded forbusiness combinations consummated prior to July 1, 2001 ceased, and intangibleassets acquired prior to July 1, 2001 that do not meet the criteria forseparate recognition under SFAS No. 141 have been reclassified togoodwill.  On an ongoing basis, absentany indicators of impairment, the Company expects to perform an annualimpairment evaluation during the fourth quarter, as of October 1steach year.

 

The followingtable presents the impact of SFAS No. 142 on net income had the standard beenin effect for the year ended December 31, 2001 (in thousands):

 
| Reported net income                                                    |   | $      | 56,490 |   |
|------------------------------------------------------------------------|--------|--------|--------|--------|
| Adjustments:                                                           |   |   |   |
| Amortization of goodwill and intangibles                               |   | 3,537  |   |
| Income tax effect                                                      |   | (357   | )      |
| Net adjustments                                                        |   | 3,180  |   |
| Adjusted net income                                                    |   | $      | 59,670 |   |
|                                                                   |   |   |   |
| Reported diluted net income per  shareavailable to common stockholders |   | $      | 4.68   |   |
| Amortization of goodwill and intangibles,  net of taxes                |   | 0.29   |   |
| Adjusted diluted net income per  shareavailable to common stockholders |   | $      | 4.97   |   |

 

Components ofintangible assets acquired in prior purchase business combinations and acquiredas individual assets are as follows (in thousands):

 
|                                            |   |             |       | **December 31, 2003**      |       | **December 31, 2002**    |       |
|-------------------------------------------------|--------|------------------|------------|----------------------------|------------|--------------------------|------------|
|                                            |   | **Useful  Life** |       | **Gross Carrying  Amount** |       | **Net Carrying  Amount** |       | **Gross Carrying  Amount** |   | **Net Carrying  Amount** |   |
|                                            |   | **(years)**      | ** ** |                       | ** ** |                     | ** ** |   | ** ** |   | ** ** |
| Intangible assets subject to amortization:      |   |             |       |                       |       |                     |       |   |   |   |   |
| Patented and existing technology                |   | 5-20             |       | $                          | 51,886     |                     | $          | 39,989 |   | $ | 13,987 |   | $ | 2,986 |   |
| Customer base                                   |   | 15-20            |       | 17,519                     |       | 12,499                   |       | 12,200 |   | 7,843 |   |
| Licensing agreements                            |   | 5                |       | 6,000                      |       | 3,767                    |       | 2,000 |   | 533 |   |
| Other                                           |   | .3-20            |       | 5,254                      |       | 2,790                    |       | 3,404 |   | 1,973 |   |
|                                            |   |             |       | $                          | 80,659     |                     | $          | 59,045 |   | $ | 31,591 |   | $ | 13,335 |   |
| Intangible assets not subject to  amortization: |   |             |       |                       |       |                     |       |   |   |   |   |
| Goodwill                                        |   | N/A              |       | $                          | 110,499    |                     | $          | 96,552 |   | $ | 69,067 |   | $ | 55,120 |   |

 

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The amortizationexpense on intangible assets was $3.4 million, $2.8 million and $5.9 millionfor the years ended December 31, 2003, 2002 and 2001, respectively.

 

Future amortization expense of intangible assets is estimatedto be $59.0 million, as follows: 2004 - $6.8 million, 2005 - $6.7 million, 2006- $6.4 million, 2007 - $6.1 million, 2008 - $5.5 million and thereafter - $27.5million.

 

Except for thegoodwill attributed to the Regentek segment (see Note 3), the Company does notallocate goodwill to individual reporting segments.

 

*Reclassifications*

# * *

Certain amounts in prior periods have been reclassified to conform withcurrent period presentation.

 

**2.             Financial Statement Information**

 

## *Inventories*

 

Inventories consist of the following atDecember 31 (in thousands):

 
|                                                          |   | **2003** |   | **2002** |   |
|---------------------------------------------------------------|--------|----------|--------|----------|--------|
| Raw materials                                                 |   | $        | 7,074  |     | $      | 5,774 |   |
| Work-in-progress                                              |   | 1,565    |   | 1,090    |   |
| Finished goods                                                |   | 13,264   |   | 12,283   |   |
|                                                          |   | 21,903   |   | 19,147   |   |
| Less reserves, primarily for excess and  obsolete inventories |   | (6,369   | )      | (4,564   | )      |
|                                                          |   | $        | 15,534 |     | $      | 14,583 |   |

 

## *Property, Plant and Equipment*

 

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

 
|                                            |   | **2003** |   | **2002** |   |
|-------------------------------------------------|--------|----------|--------|----------|--------|
| Buildings and leasehold improvements            |   | $        | 4,477  |     | $      | 4,265 |   |
| Furniture, fixtures and equipment               |   | 38,849   |   | 32,773   |   |
|                                            |   | 43,326   |   | 37,038   |   |
| Less accumulated depreciation and  amortization |   | (27,770  | )      | (22,956  | )      |
|                                            |   | $        | 15,556 |     | $      | 14,082 |   |

 

# *Other AccruedLiabilities*

 

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

 
|                  |   | **2003** |   | **2002** |   |
|-----------------------|--------|----------|--------|----------|--------|
| Accrued product costs |   | 2,032    |   | 1,719    |   |
| Other accruals        |   | 6,617    |   | 4,306    |   |
|                  |   | $        | 8,649  |     | $      | 6,025 |   |
|                       |        |          |        |          |        |  |  |

 

**3.             Acquisitions**

 

*RegentekAcquisition*

 

On November26, 2003, the Company acquired the Regentek business from OrthoLogic forapproximately $93.0 million in cash plus certain assumed liabilitiesaggregating approximately $0.9 million and transaction costs amounting toapproximately $0.9 million. The Company financed the purchase with cash on handof $12.1 million and a portion of the proceeds of a $100.0 million term loanreceived in connection with a new credit agreement. Proceeds from the term loanwere

 

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also used to repay all of theCompany’s existing bank debt, amounting to approximately $15.5 million. Thecredit agreement also provides the Company with available borrowings under a$30.0 million revolving credit facility.

 

The total purchaseprice was comprised of the following:

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

 

The Regentekacquisition has been accounted for using the purchase method of accountingwhereby the total purchase price has been allocated to tangible and intangibleassets acquired and liabilities assumed based on their estimated fair marketvalues as of the acquisition date.  Thepurchase price has been allocated as follows (in thousands):

 
| Fair value of net tangible assets acquired  and liabilities assumed: |   |   |   |   |   |
|----------------------------------------------------------------------|--------|--------|--------|--------|--------|
| Accounts receivable, net                                             |   | $      | 7,662  |   |   |   |
| Inventories, net                                                     |   | 2,382  |   |   |   |
| Other current assets                                                 |   | 42     |   |   |   |
| Fixed assets, net                                                    |   | 960    |   |   |   |
| Other assets                                                         |   | 14     |   |   |   |
| Accounts payable                                                     |   | (401   | )      |   |   |
| Accrued compensation and commissions                                 |   | (277   | )      |   |   |
| Other accrued liabilities                                            |   | (229   | )      |   |   |
|                                                                 |   |   |   | 10,153 |   |
| Fair value of identifiable intangible  assets acquired:              |   |   |   |   |   |
| Existing technology                                                  |   | 27,800 |   |   |   |
| Patented technology                                                  |   | 10,100 |   |   |   |
| Customer relationships                                               |   | 5,200  |   |   |   |
| Customer contract                                                    |   | 800    |   |   |   |
| Distribution agreement                                               |   | 700    |   |   |   |
| Order backlog                                                        |   | 200    |   |   |   |
|                                                                 |   |   |   | 44,800 |   |
| Goodwill                                                             |   |   |   | 38,986 |   |
| Total purchase price allocation                                      |   |   |   | $      | 93,939 |   |
|                                                                      |        |        |        |        |        |  |  |

 

The net assetsacquired do not include $2.6 million relating to debt issuance costs incurred.The intangibles are being amortized over their estimated useful lives, whichrange from 4 months to 10 years.

 

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The accompanying consolidatedstatements of operations reflect the operating results of the Regentek businesssince November 26, 2003. Assuming the purchase of the Regentek business hadoccurred on January 1 of the respective years, the pro forma unaudited resultsof operations would have been as follows (in thousands):

** **
|                                                                          |   | **Year ended**         |    | **Year ended December 31, 2003** |   |
|-------------------------------------------------------------------------------|--------|------------------------|---------|----------------------------------|--------|
|                                                                          |   | **December 31,  2002** |    | **First  Quarter**               |   | **Second  Quarter** |   | **Third  Quarter** |   | **Fourth  Quarter** |   | **Total  2003** |   |
| Net revenues                                                                  |   | $                      | 221,600 |                             | $      | 57,470 |   | $ | 58,942 |   | $ | 61,303 |   | $ | 62,663 |   | $ | 240,378 |   |
| Costs of goods sold                                                           |   | 102,727                |    | 23,291                           |   | 22,881 |   | 22,726 |   | 23,664 |   | 92,562 |   |
| Gross profit                                                                  |   | 118,873                |    | 34,179                           |   | 36,061 |   | 38,577 |   | 38,999 |   | 147,816 |   |
| Operating expenses:                                                           |   |                   |    |                             |   |   |   |   |   |   |   |   |   |
| Sales, marketing, general and  administrative                                 |   | 104,221                |    | 25,219                           |   | 24,202 |   | 24,349 |   | 25,024 |   | 98,794 |   |
| Research and development                                                      |   | 3,779                  |    | 1,147                            |   | 1,239 |   | 1,412 |   | 1,413 |   | 5,211 |   |
| Amortization of acquired intangibles                                          |   | 4,808                  |    | 1,332                            |   | 1,172 |   | 1,152 |   | 1,152 |   | 4,808 |   |
| Impairment of long-lived assets                                               |   | 3,666                  |    | —                           |   | — |   | — |   | — |   | — |   |
| Performance improvement, restructuring and  other                             |   | 10,008                 |    | —                           |   | — |   | (497 | ) | — |   | (497 | ) |
| Total operating expenses                                                      |   | 126,482                |    | 27,698                           |   | 26,613 |   | 26,416 |   | 27,589 |   | 108,316 |   |
| Income (loss) from operations                                                 |   | (7,609                 | )       | 6,481                            |   | 9,448 |   | 12,161 |   | 11,410 |   | 39,500 |   |
| Interest expense, net of interest income                                      |   | (14,365                | )       | (3,571                           | )      | (3,616 | ) | (3,632 | ) | (3,615 | ) | (14,434 | ) |
| Other income (expense)                                                        |   | (200                   | )       | 149                              |   | 398 |   | (242 | ) | 161 |   | 466 |   |
| Income (loss) before income taxes                                             |   | (22,174                | )       | 3,059                            |   | 6,230 |   | 8,287 |   | 7,956 |   | 25,532 |   |
| Benefit (provision) for income taxes                                          |   | 8,453                  |    | (1,224                           | )      | (2,492 | ) | (3,315 | ) | (3,131 | ) | (10,162 | ) |
| Net income (loss)                                                             |   | $                      | (13,721 | )                                | $      | 1,835 |   | $ | 3,738 |   | $ | 4,972 |   | $ | 4,825 |   | $ | 15,370 |   |
|                                                                          |   |                   |    |                             |   |   |   |   |   |   |   |   |   |
| Net income (loss) per share:                                                  |   |                   |    |                             |   |   |   |   |   |   |   |   |   |
| Basic                                                                         |   | $                      | (0.77   | )                                | $      | 0.10 |   | $ | 0.21 |   | $ | 0.28 |   | $ | 0.27 |   | $ | 0.86 |   |
| Diluted                                                                       |   | $                      | (0.77   | )                                | $      | 0.10 |   | $ | 0.20 |   | $ | 0.26 |   | $ | 0.25 |   | $ | 0.82 |   |
|                                                                          |   |                   |    |                             |   |   |   |   |   |   |   |   |   |
| Weighted average shares outstanding used to  calculate per share information: |   |                   |    |                             |   |   |   |   |   |   |   |   |   |
| Basic                                                                         |   | 17,873                 |    | 17,902                           |   | 17,902 |   | 17,945 |   | 18,097 |   | 17,963 |   |
| Diluted                                                                       |   | 17,873                 |    | 17,941                           |   | 18,336 |   | 18,898 |   | 19,619 |   | 18,791 |   |

* *

*DuraKoldacquisition*

 

In June 2003,the Company completed the purchase of specified assets and assumed certainliabilities of Dura*Kold Corporation (DuraKold) for an aggregate purchase priceof $3.0 million. The assets acquired from DuraKold included tangible andintangible assets related to a line of proprietary cold wrap products fororthopedic and medical applications. The Company has sold the productsmanufactured by DuraKold since July 2001 under a distribution agreement. TheDuraKold acquisition has been accounted for using the purchase method ofaccounting whereby the total purchase price has been allocated to tangible andintangible assets acquired and liabilities assumed based on their estimatedfair values as of the acquisition date, as follows:

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

 

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

 

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

 

*PerformanceImprovement Program*

 

In 2002, theCompany completed a company-wide performance improvement program with theobjective of increasing revenues and reducing both costs of goods sold andoperating expenses as a percentage of net revenues beginning in 2003.  The Company retained the services ofAlixPartners, LLC, a consulting firm specializing in corporate performance enhancement,to assist with its performance improvement program.

* *

*67*

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* *

*With theobjective of reducing costs by streamlining its organization structure, theCompany’s performance improvement program included the elimination of severalsenior management and other positions. The Company also moved the manufacturing of all its remaining soft goodsand certain non-custom rigid braces manufactured in the United States to itsmanufacturing facilities in Mexico.  Themove of these manufacturing operations was completed by the end of 2002 andresulted in the elimination of approximately 165 United States positions.  More than 140 positions were added inMexico. The manufacturing move reduced the Company’s manufacturing costsbeginning in the first quarter of 2003 and is intended to provide ongoingmanufacturing cost reduction. In connection with the manufacturing move, aportion of the Company’s United States manufacturing facilities was vacated andin 2002 the Company accrued the estimated future net rent that would be paidfor the vacated facilities, in excess of estimated sublease income. In 2003,the Company decided to retain the vacant space for future expansion anddiscontinued its efforts to sublease the vacant space.  Accordingly, the remaining accrual for rentfor the vacant space of $0.5 million was reversed in 2003 and credited tooperating expenses.*

* *

*Otherfocuses of the performance improvement program included: reducing operatingexpenses; improving the profitability of sales to the Company’s third-partypayors; improving working capital management; and improving the Company’sbusiness processes and information systems. The Company also refocused its resources on its core rehabilitationbusiness and discontinued the marketing of its surgical products and its kneereplacement product in 2002. In connection with the Company’s decision todiscontinue marketing its surgical products, all remaining assets of AlaronTechnologies, L.L.C., which had been acquired for $500,000 in June 2001, werewritten off in 2002.  The Company alsodivested its 60% interest in its Australian joint venture, dj Orthopaedics PtyLtd, effective December 31, 2002, with no material gain or loss.  The minority owner assumed full ownership ofthis entity and continues to sell the Company’s current products as anindependent distributor.*

* *

The resultsfor 2002 include charges totaling $10.0 million ($6.4 million net of tax)related to the Company’s performance improvement program, including charges forseverance pay, consultants, moving costs and accrued rent related tomanufacturing facilities vacated by the Company in the United States.

* *

*ContractualAllowances and Doubtful Accounts*

 

Historically,the Company relied heavily on third-party billing service providers to provideinformation about the accounts receivable of its third-party payor customers,including the data utilized to determine reserves for contractual allowancesand doubtful accounts.  During 2002, theCompany enhanced the ability of its systems to obtain and analyze the informationprocessed by these billing service providers. The Company’s increased ability to obtain and better analyze informationbeginning in 2002 revealed that, as a result of historical third-party billingproblems, the Company had experienced an increase in allowances and bad debtsfor accounts receivable for accounts receivable from the Company’s third-partypayor customers and the Company increased its provisions for contractualallowances and doubtful accounts by an aggregate of $6.7 million ($4.3 millionnet of tax) for the year ended December 31, 2002, which is included in salesand marketing expenses in the accompanying consolidated statements ofoperations for 2002. In March 2003, the Company completed the transition to anew third party insurance billing service provider. The Company also continuesto enhance its ability to analyze historical information and resolve issuesrelated to its accounts receivable aged over one year. Based on informationcurrently available, the Company believes it has provided adequate reserves forits third-party payor accounts receivable. If claims are denied, or amounts are otherwise not paid, in excess ofthe Company’s estimates, the recoverability of the net accounts receivablecould be reduced by a material amount. In addition, if the transition to the Company’s new third-partyinsurance billing service provider is not successful, the Company may berequired to increase its reserves estimates.

 

*Excessand Obsolete Inventories*

 

In connectionwith its performance improvement program, the Company refocused its resourceson its core business within the rehabilitation segment of the orthopedicmarket.  As a result, the Company ceasedactive commercialization of its surgical product lines and discontinuedmarketing its knee replacement product. In 2002, the Company recorded provisions for inventories related todiscontinued surgical and knee replacement product lines in the aggregateamount of $2.8 million ($1.8 million net of tax).

 

Additionally, the Company provided incrementalprovisions for estimated excess inventories in the amount of $2.3 million ($1.5million net of tax) in 2002.  Theincrease in the Company’s accounting estimate for these reserves was primarilyrelated to inventories on hand for certain new product areas which had notachieved anticipated market share, including the Company’s OrthoPulseTM bonegrowth stimulator product.  Themanufacturer of OrthoPulse, I.M.D., b.v. (IMD), was unable to

 

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make any material progress in 2002 inachieving FDA approval for the product. As a result, the Company recorded charges aggregating $1.8 million in2002 to fully reserve its inventories of this product.

 

*Impairment of Long-Lived Assets*

 

As a result ofcertain new products not achieving anticipated revenues or estimated recoveryvalues of assets being disposed of being less than anticipated, the Company’scash flows from such new products or assets have been lower than originallyestimated. In accordance with SFAS No. 144, the Company recognized charges of$3.7 million related to impairment of certain long-lived assets during2002.  These long-lived assets primarilyinclude intangible assets associated with the Company’s DonJoy VistaTMRehabilitation System product line, estimated impairment related to an investmentin an internet marketing company, which was sold during 2002, an investment inthe manufacturer of OrthoPulseTM, goodwill related to the acquisition of Alaron,and fixed assets abandoned in connection with the Company’s manufacturing moveto Mexico.

* *

*Totalperformance improvement, restructuring and other charges accrued in 2002 andreflected in the accompanying consolidated balance sheet at December 31, 2003are as follows (in thousands):*

 
|                                                                                       |   | **Total  costs** |   | **Cash  payments** |   | **Non-cash  charges** |   | **Reversalsaffecting  operating results** |    | **Accrual at  December 31, 2003** |   |
|--------------------------------------------------------------------------------------------|--------|------------------|--------|--------------------|--------|-----------------------|--------|-------------------------------------------|---------|-----------------------------------|--------|
| Costs of goods sold:                                                                       |   |             |   |               |   |                  |   |                                      |    |                              |   |
| Reserves for inventories                                                                   |   | $                | 5,082  |               | $      | —                |   | $                                         | (5,082  | )                                 | $      | — |   | $ | — |   |
| Sales and marketing expenses:                                                              |   |             |   |               |   |                  |   |                                      |    |                              |   |
| Increase in estimated contractual  allowances and bad debts for third-party payorcustomers |   | 6,747            |   | —             |   | (6,747                | )      | —                                    |    | —                            |   |
|                                                                                       |   |             |   |               |   |                  |   |                                      |    |                              |   |
| Impairment of long-lived assets                                                            |   | 3,666            |   | —             |   | (3,666                | )      | —                                    |    | —                            |   |
|                                                                                       |   |             |   |               |   |                  |   |                                      |    |                              |   |
| Performance improvement and restructuring  costs:                                          |   |             |   |               |   |                  |   |                                      |    |                              |   |
| Employee severance costs                                                                   |   | 3,936            |   | (3,888             | )      | —                |   | —                                    |    | 48                                |   |
| Consulting fees                                                                            |   | 3,460            |   | (3,460             | )      | —                |   | —                                    |    | —                            |   |
| Lease termination and other exit costs                                                     |   | 1,926            |   | (711               | )      | —                |   | (497                                      | )       | 718                               |   |
| Other                                                                                      |   | 686              |   | (686               | )      | —                |   | —                                    |    |                              |   |
| Subtotal                                                                                   |   | 10,008           |   | (8,745             | )      | —                |   | (497                                      | )       | 766                               |   |
| Total                                                                                      |   | $                | 25,503 |               | $      | (8,745                | )      | $                                         | (15,495 | )                                 | $      | (497 | ) | $ | 766 |   |

* *

**5.             Long-Term Debt**

 

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

 
|                                                                                                                                   |   | **2003** |   | **2002** |   |
|----------------------------------------------------------------------------------------------------------------------------------------|--------|----------|--------|----------|--------|
| 12 5/8% senior subordinated notes due 2009,  net of unamortized discount of $844 and $998 at December 31, 2003 and 2002,  respectively |   | $        | 74,156 |     | $      | 74,002 |   |
| Bank term loans bearing interest at 4.19%  at December 31, 2002                                                                        |   | $        | — |     | $      | 37,086 |   |
| Term loan due in installments through  December 31, 2008 bearing  interest at  LIBOR plus 2.75% (3.9375% at December 31, 2003)    |   | 100,000  |   |     |   |
| Less current portion                                                                                                                   |   | (5,000)  |   | (1,274)  |   |
| Long-term portion of bank term loans                                                                                                   |   | $        | 95,000 |     | $      | 35,812 |   |

 

12 5/8*% senior subordinated notes Due 2009*

 

On June 30, 1999, dj Ortho issued $100.0 million of 125/8% senior subordinated notes due 2009 (the notes) to various investors in connectionwith the financing of the Recapitalization. The notes were issued at a discount of $2.0 million, which is beingamortized to interest expense over the life of the notes and accreted to thenotes balance. The notes are general

 

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unsecuredobligations of dj Ortho, subordinated in right of payment to all existing andfuture senior indebtedness of dj Ortho, pari passu in right of payment to anysenior subordinated indebtedness of dj Ortho and senior in right of payment toany subordinated indebtedness.  Intereston the notes is payable in cash semi-annually on each June 15 and December15.  The aggregate principal amount ofthe notes matures on June 15, 2009.

 

*Covenants*.  The notes contain covenants restricting theability of dj Ortho and its subsidiaries to (i) incur additional indebtedness;(ii) prepay, redeem or repurchase debt; (iii) make loans and investments; (iv)incur liens and engage in sale lease-back transactions; (v) enter intotransactions with affiliates; (vi) engage in mergers, acquisitions and assetsales; (vii) make optional payments on or modify the terms of the subordinateddebt; (viii) restrict preferred and capital stock of subsidiaries; (ix) declaredividends or redeem or repurchase capital stock; and (x) engage in other linesof businesses.

* *

*Guarantees; Co-Issuers*.  The botes are guaranteed by dj Orthopedics,Inc. and dj Development and co-issued by dj Ortho and DJ Capital, but are notguaranteed by any of dj Ortho’s foreign subsidiaries.

 

*Optional Redemption*.  Before June 15, 2002, up to 35% of theaggregate principal amount of the notes could be redeemed with the proceedsfrom sales of common equity at a redemption price of 112.625% of theirprincipal amount, plus any accrued and unpaid interest.  Pursuant to such provision, following itsinitial public offering in 2001, the Company redeemed $25 million principalamount of the notes for an aggregate price, including the prepayment premium andaccrued interest, of $28.3 million.

 

On or after June 15, 2004, the notes may be redeemed, inwhole or in part, at the following redemption prices (expressed as percentagesof principal amount), plus accrued and unpaid interest, if any, to theredemption date if redeemed during the 12-month period commencing on June 15 ofthe years set forth below:

 
| **Year**            |   | **Redemption  Price** |   |
|---------------------|--------|-----------------------|--------|
| 2004                |   | 106.313               | %      |
| 2005                |   | 104.208               | %      |
| 2006                |   | 102.104               | %      |
| 2007 and thereafter |   | 100.000               | %      |

 

The Companyintends to purchase and/or redeem all of the outstanding senior subordinated noteswith the net proceeds, amounting to $56.7 million, of the sale of shares from astock offering completed February 2004, plus existing cash.  The Company may purchase the notes in theopen market, in privately negotiated transactions, or, on or after June 15,2004, redeem these notes pursuant to the terms of the indenture governing thenotes. In the event the Company redeems the notes, in addition to the write-offof the call premium, the Company will write-off unamortized debt issuance costsand discounts related to the notes.  Ifthe Company redeems all of the notes on June 15, 2004, the call premium will be$4.7 million and the unamortized debt issuance costs and discounts will beapproximately $3.0 million.  In theevent the Company purchases the notes on the open market before June 15,2004, these unamortized debt issuance costs and discounts will be higher.  The Company has received the consentsnecessary under its new credit agreement to use the proceeds from the sale ofshares from its stock offering and cash on hand to purchase and/or redeem thesenior subordinated notes.

 

# *Credit Agreement*

 

In connectionwith the Regentek acquisition, the Company entered into a new credit agreement,which is comprised of a $100.0 million term loan and also provides the Companywith available borrowings under a $30.0 million revolving credit facility.Proceeds from the term loan were also used to repay the Company’s existing bankdebt, amounting to approximately $15.5 million. The term loan bears interest atLIBOR plus 2.75% (3.9375% at December 31, 2003). The revolving credit facilitypermits the Company to enter into revolving loans of up to $30.0 million, enterinto swing line loans and obtain letters of credit. The Company currently hasno borrowed amounts drawn under the revolving credit facility, but iscontingently liable for outstanding letters of credit aggregating $3.0 million.Borrowings under the Revolver, if any, will bear interest at variable ratesplus an applicable margin. The maturity date of the revolving credit facilityis November 26, 2008. The Company incurred debt issuance costs in connectionwith the credit agreement of approximately $2.6 million, which have beencapitalized and will be amortized as interest expense over the term of thecredit agreement.

 

*Repayment*.  Principal repayment is scheduled inquarterly installments of $1.25 million through December 31, 2008, with theremaining principal due in two equal installments on March 31, 2009 and May 15,2009.  If more than $15.0 million

 

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of the Company’s senior subordinated notes, due June 15, 2009, remainsoutstanding on January 2, 2009, the term loan will be due and payable onJanuary 2, 2009.

 

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

 

*Covenants*. The credit facility contains a number of covenants that, among otherthings, restrict the ability of dj Ortho and its subsidiaries to (i) incuradditional indebtedness; (ii) incur or guarantee obligations; (iii) prepaysubordinated indebtedness or amend other debt instruments; (iv) pay dividendsor make other distributions (except for certain tax distributions); (v) redeemor repurchase equity, make investments, loans or advances, make acquisitions;(vi) engage in mergers or consolidations; (vii) change the business conductedby dj Ortho and its subsidiaries; (viii) grant liens, sell its assets; (ix) orengage in certain other activities.  Inaddition, the credit agreement requires dj Ortho and its subsidiaries to maintainspecified financial ratios, including maximum total and senior leverage ratios,a minimum consolidated interest coverage ratio and a minimum consolidated fixedcharge coverage ratio.  The creditagreement also contains provisions that prohibit any modifications of the notesin any manner adverse to the lenders under the credit agreement and that limitdj Ortho’s ability to refinance or otherwise prepay the notes without theconsent of such lenders. The Company was in compliance with all covenants as ofDecember 31, 2003.

 

*Former Bank Credit Facility*

 

In connection with the Recapitalization, dj Ortho entered into a bankcredit facility as amended with Wachovia Bank, National Association, JP MorganChase Bank and other lenders. During 2003, the Company repaid approximately$20.0 million of the term loans and retired the remainder (approximately $15.5million) with a portion of the proceeds from the new $100.0 million term loanreceived in conjunction with the Regentek acquisition.

 

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

 

dj Ortho paid affiliates of JPMDJ Partners $250,000 in each of 2001 and2002 for providing financial advisory services in connection with financingsand acquisitions, including providing the services of Charles T. Orsatti, theCompany’s former Chairman. This arrangement terminated in 2002.

 

On June 30, 1999, DonJoy consummated a recapitalization pursuant towhich JPMDJ Partners obtained a controlling interest in DonJoy.  On June 28, 2000, JPMDJ Partners and certainmembers of management repurchased the remaining common units held by DonJoy’sformer parent, Smith & Nephew.  Inconnection with an equity investment in June 2001, JPMDJ Partners and certainmembers of management purchased additional common units in DonJoy.  In connection with these equitytransactions, certain members of management financed their common unitpurchases with full recourse promissory notes (see Note 7).

 

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

 

The Company issued 7,800,000 shares of common stock in its initialpublic offering in November 2001 for proceeds of $118.8 million, net of $13.8million in related costs.  At December31, 2003, the Company had a total of 18,304,269 shares of common stockoutstanding.

 

In connection with the Reorganization in 2001, the outstanding 885,633common units of DonJoy were converted to common stock at an exchange ratio of10.812 shares for each unit, for a total of 9,575,459 shares of common stockand the outstanding 44,405 redeemable preferred units of dj Ortho wereexchanged for $47.3 million in cash (representing the liquidation value of theunits plus accrued and unpaid distributions as of the Reorganization date) and480,107 shares of common stock based on an exchange ratio of 10.812 shares foreach unit.  Prior to the Reorganization,the redeemable preferred units accrued a cumulative quarterly preferreddividend at a fixed rate of 14.0% per annum. Total dividends accrued for theyear ended December 31, 2001 were $5.7 million, respectively.

 

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In May 2003, the Company’s shareholders approved a reduction in thetotal authorized number of shares of capital stock from 125,000,000 to40,000,000; a reduction in the authorized number of shares of common stock from100,000,000 to 39,000,000; and a reduction in the authorized number of sharesof preferred stock from 25,000,000 to 1,000,000.

 

# *Other Equity Transactions*

 

InJune 2001, DonJoy sold 89,186 common units to JPMDJ Partners for grossproceeds of $9.7 million and 2,557 common units to certain members ofmanagement for gross proceeds of $0.3 million (for which $0.2 millionwas paid through the issuance of full recourse promissory notes to DonJoy).

 

In 2000, in connection with the acquisition of the bracing and softgoods business of DePuy Orthopaedic Technology, Inc., a subsidiary of Johnsonand Johnson, 73,775 common units were sold to JPMDJ Partners for gross proceedsof $8.0 million and 2,115 common units were sold to certain members ofmanagement for gross proceeds of $231,000 (for which $174,000 was paid throughthe issuance of full recourse promissory notes by the management members).  In addition, 4,221 redeemable preferredunits were sold to existing redeemable preferred unit holders for net proceedsof $3.4 million (after preferred unit fees).

 

In connection with a unit purchase agreement dated as of June 28, 2000,Smith & Nephew sold its remaining interest in DonJoy to JPMDJ Partners andcertain members of management for $5.9 million.  JPMDJ Partners purchased 52,495 common units for a total considerationof $5.7 million and the members of management purchased 1,505 units for a totalconsideration of $0.2 million, substantially all of which was financed by djOrthopedics and evidenced by full recourse promissory notes.  dj Orthopedics agreed to amend and restatethe promissory notes originally received from certain members of management inconnection with the Recapitalization. The principal amount of each amended andrestated note was equal to the sum of outstanding principal on the originalnotes and any accrued and unpaid interest on the notes. In addition, theamended and restated notes permit the members of management to increase theprincipal amount due under the note by the amount of a scheduled interestpayment (the “PIK Option”).  If a memberof management elects the PIK Option, the principal amount of his note isincreased by the amount of the scheduled interest payment and interest thenaccrues on the principal amount of the note as so increased.  The amended and restated notes mature in 2007.

 

Total promissory notes due from current and former managementstockholders amount to $2.0 million and $2.2 million at December 31, 2003 and2002, respectively.  A former managementstockholder repaid the entire balance of his promissory note owed to theCompany in 2003, amounting to $0.3 million. The notes are secured by all of the shares of common stock of djOrthopedics owned by each noteholder.

 

#### *Stock Options*

 

*2001 Omnibus Plan*

 

The 2001 Omnibus plan provides for awards of stock options, stockappreciation rights, performance awards, restricted stock, restricted stockunits, stock bonuses, stock unit awards and cash bonuses to key personnel,including consultants and advisors. Except as hereafter described and subject to equitable adjustments toreflect certain corporate events, the maximum number of shares of the Company’scommon stock with respect to which awards may be granted under the Omnibus Planis 4,336,189 at December 31, 2003.  Oneach January 1, commencing with January 1, 2003, the number of shares of commonstock available for issuance under the Omnibus Plan is automatically increasedby a number of shares equal to 3% of the number of shares of common stockoutstanding on the previous December 31. In addition, shares of common stock reserved for but not subject tooptions granted under the 1999 Option Plan or subject to awards that areforfeited, terminated, canceled or settled without the delivery of common stockunder the Omnibus Plan and the 1999 Option Plan will increase the number ofshares available for awards under the Omnibus Plan.  Also, shares tendered to dj Orthopedics, Inc. in satisfaction orpartial satisfaction of the exercise price of any award under the Omnibus Planor the 1999 Option Plan will increase the number of shares available for awardsunder the Omnibus Plan to the extent permitted by Rule 16b-3 under theSecurities Exchange Act of 1934, as amended. The Omnibus Plan is administered by the Company’s CompensationCommittee, which has the sole and complete authority to grant awards under theOmnibus Plan to eligible employees and officers of, and consultants andadvisors to, dj Orthopedics, Inc. and its subsidiaries. At December 31, 2003and 2002, options to purchase 2,559,550 and 1,116,650 shares had been grantedand 270,971 and 5,000 shares were exercisable, respectively.  On December 31, 2003, 2,713,991 shares wereavailable for future grant under the Omnibus Plan. On January 1, 2004, theshares available for future grant were increased by 549,128 shares to 3,263,119shares.

## * *

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## *1999 Option Plan*

 

Under the Company’s Fifth Amended and Restated 1999 Option Plan (the1999 Option Plan), 1,933,174 common shares have been reserved for issuance uponexercise of options granted under the plan. The 1999 Option Plan is administeredby the Compensation Committee of the Board of Directors. The plan will expireon August 19, 2015 unless the Company terminates it before that date. The 1999Option Plan provides for the grant of nonqualified options to officers,directors and employees of, and consultants and advisors to, dj Orthopedics,Inc.

 

The Company has granted options to purchase an aggregate of 637,681shares of common stock under the 1999 Option Plan of which approximately 71%are time-vesting options and approximately 29% are event-vesting options.  As of December 31, 2003, options to purchase524,331 shares issued under the 1999 Option Plan were exercisable.  No future options will be granted under the1999 Option Plan, and all shares of common stock, which would otherwise havebeen available for issuance under the 1999 Option Plan will be available forissuance under the 2001 Omnibus Plan. In connection with the initial public offering, all of the Tier IIoptions vested in accordance with their terms and all Tier III optionspreviously outstanding were cancelled.

 

*2001 Non-Employee Director’s Stock Option Plan*

 

The Companyhas adopted the dj Orthopedics, Inc. 2001 Non-Employee Directors’ StockOption Plan. In May 2003, the Company’s shareholders approved the followingamendments to this plan: (1) individuals elected to the Board more than 12months after the company’s 2001 initial public offering of common stock wouldreceive an automatic grant of 30,000 options instead of 15,000 options at anexercise price equal to 100% of the fair market value of the common stock as ofsuch date; (2) options granted after the effective date of the amendment wouldvest entirely on the first anniversary of the grant date; and (3) individualselected to the Board who are representing J.P. Morgan DJ Partners, LLC, wouldnot be eligible for grants under the plan. A total of 1,500,000 shares of the Company’s common stock have beenreserved for issuance under the plan.  Atotal of 135,000 and 60,000 options had been granted under the Plan at December31, 2003 and 2002, respectively.  Nooptions were granted under this plan prior to 2002.

 

The following table summarizes option activity under all plans throughDecember 31, 2003:

 
|                                |   | **Number of  Shares** |   | **Price per  Share** |   | **Weighted  Average Exercise  Price per Share** |   |
|-------------------------------------|--------|-----------------------|--------|----------------------|--------|-------------------------------------------------|--------|
| Outstanding as of December 31, 2000 |   | 1,596,239             |   | $9.25-$10.08         |   | $                                               | 9.32   |   |
| Granted                             |   | 607,142               |   | $9.25-$17.00         |   | 14.34                                           |   |
| Cancelled                           |   | (193,492              | )      | $9.25-$10.08         |   | 9.39                                            |   |
| Outstanding as of December 31, 2001 |   | 2,009,889             |   | $9.25-$17.00         |   | 12.36                                           |   |
| Granted                             |   | 1,111,350             |   | $2.97-$12.80         |   | 4.85                                            |   |
| Cancelled                           |   | (913,839              | )      | $3.52-$17.00         |   | 10.54                                           |   |
| Outstanding at December 31, 2002    |   | 2,207,400             |   | $2.97-$17.00         |   | 8.03                                            |   |
| Granted                             |   | 1,715,500             |   | $3.91-$25.92         |   | 19.82                                           |   |
| Exercised                           |   | (358,141              | )      | $2.97-$17.00         |   | 10.22                                           |   |
| Cancelled                           |   | (232,528              | )      | $3.52-$17.00         |   | 9.16                                            |   |
| Outstanding at December 31, 2003    |   | 3,332,231             |   | $2.97-$25.92         |   | $                                               | 13.78  |   |

 

The following table summarizes information concerning currentlyoutstanding and exercisable options:

 
|                                 |   | **Options  Outstanding**                          |   | **Options  Exercisable**                        |   |
|--------------------------------------|--------|---------------------------------------------------|--------|-------------------------------------------------|--------|
| **Range of  Exercise Prices**        |   | **Options  Outstanding as of  December 31, 2003** |   | **Weighted  Average  Remaining Life in  Years** |   | **Weighted  Average Exercise  Price** |   | **Options  Exercisable  as of December 31,  2003** |   | **Weighted  Average  Exercise Price** |   |
| $  2.97 -  $4.10 |   | 967,000                                           |   | 8.9                                             |   | $ | 3.86 |   | 211,421 |   | $ | 3.88 |   |
| $  7.24 -$10.80            |   | 912,899                                           |   | 7.5                                             |   | 8.78 |   | 461,487 |   | 9.31 |   |
| $12.25 -$17.00                       |   | 271,332                                           |   | 7.8                                             |   | 14.85 |   | 140,388 |   | 15.18 |   |
| $25.30 -$25.92                       |   | 1,181,000                                         |   | 9.9                                             |   | 25.51 |   | 2,000 |   | 25.92 |   |
| $ 2.97 - $25.92                 |   | 3,332,231                                         |   | 8.8                                             |   | $ | 13.78 |   | 815,296 |   | $ | 8.96 |   |

 

73

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*Employee StockPurchase Plan*

 

The EmployeeStock Purchase Plan provides for the issuance of up to 1,178,729 shares of theCompany’s common stock.  During eachpurchase period eligible employees may designate between 1% and 15% of theircash compensation, subject to certain limitations, to be deducted from theircash compensation for the purchase of common stock under the plan.  The purchase price of the shares under theplan is equal to 85% of the lesser of the fair market value per share on thefirst day of each twenty-four month offering period or the last day of eachsix-month purchase period during the offering period.  On January 1 of each year, commencing with January 1, 2003, theaggregate number of shares reserved for issuance under this plan will increaseautomatically by a number of shares equal to 1.0% of the Company’s outstandingshares on December 31 of the preceding year. The Company’s Board of Directors or the Compensation Committee mayreduce the amount of the increase in any particular year.  The aggregate number of shares reserved forissuance under the Employee Stock Purchase Plan may not exceed 5,000,000shares.  During 2003, the number ofshares reserved for issuance under the Employee Stock Purchase Plan wasincreased by 178,729 shares and on January 1, 2004 an additional 183,042 shareswere reserved for issuance and the total shares reserved for issuance were1,271,209.

 

**8.****                                      IncomeTaxes**

 

In connection with the Reorganization on November 20, 2001, the Companybecame a corporation and subject to U.S. federal, state, and foreign incometaxes on its earnings after that date. For 2001, the Company incurred a loss before income taxes of $4.5million attributable to operations for the period following the Reorganization,including expenses related to an early extinguishment of debt of $4.7million.  A deferred tax benefit of$54.2 million was recorded in 2001 related to future tax benefits for thedifference in the book and tax basis of the assets of the Company at the timeof the Reorganization.

 

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

 
|                                 |   | **2003** |       | **2002** |       | **2001** |       |
|--------------------------------------|--------|----------|------------|----------|------------|----------|------------|
| Current                              |   |     | ** ** |     | ** ** |     | ** ** |
| Federal                              |   | $        | (15        | )        | $          | —   |       | $ | — |   |
| State                                |   | (380     | )          | (150     | )          | —   |       |
| Foreign                              |   | (647     | )          | (183     | )          | —   |       |
|                                 |   | (1,042   | )          | (333     | )          | —   |       |
| Deferred                             |   |     |       |     |       |     |       |
| Federal                              |   | (5,064   | )          | 9,279    |       | 1,522    |       |
| State                                |   | (1,874   | )          | 415      |       | 267      |       |
| Foreign                              |   | —   |       | —   |       | —   |       |
|                                 |   | (6,938   | )          | 9,694    |       | 1,789    |       |
|                                 |   |     |       |     |       |     |       |
| Benefit (provision) for income taxes |   | $        | (7,980     | )        | $          | 9,361    |       | $ | 1,789 |   |

 

Significantcomponents of the Company’s deferred tax assets and liabilities as of December31 are as follows (in thousands):

 
|                                           |   | **2003** |   | **2002** |   |
|------------------------------------------------|--------|----------|--------|----------|--------|
| Deferred tax assets/(liabilities):             |   |     |   |     |   |
| Goodwill for tax purposes                      |   | $        | 39,657 |     | $      | 44,024 |   |
| Accrued expenses                               |   | 2,234    |   | 4,381    |   |
| Allowance for bad debts                        |   | 5,987    |   | 2,780    |   |
| Provision for excess and obsolete  inventories |   | 3,062    |   | 3,086    |   |
| Net operating loss carryforwards               |   | 10,623   |   | 10,323   |   |
| Fixed assets depreciation                      |   | (1,061   | )      | 1,038    |   |
| Other, net                                     |   | 159      |   | 99       |   |
| Total deferred taxes                           |   | 60,661   |   | 65,731   |   |
| Valuation allowance                            |   | (1,869   | )      | —   |   |
| Net deferred tax assets                        |   | $        | 58,792 |     | $      | 65,731 |   |

 

Realization ofthe Company’s deferred tax assets is dependent on the Company’s ability togenerate approximately $154 million of future taxable income over the next 15years.  A valuation allowance has beenestablished against that portion of net operating loss carryforwards thatmanagement does not believe it is more likely than not that this asset will berealized.

 

74

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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, 2003.

 

                                                Thereconciliation of income tax attributable to income before benefit for incometaxes at the United States federal statutory rate to income tax benefit in theaccompanying statements of operations for the years ended December 31 is asfollows (in thousands):

 
|                                    |   | **2003** |   | **2002** |   | **2001** |   |
|-----------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| Federal tax at statutory rate           |   | 35.0     | %      | 34.0     | %      | 34.0     | %      |
| State income tax net of federal benefit |   | 7.3      | %      | 1.0      | %      | 6.0      | %      |
| Other                                   |   | (2.5     | )%     | 3.1      | %      | —   |   |
|                                    |   | 39.8     | %      | 38.1     | %      | 40.0     | %      |

 

As of December 31, 2003, the Company has United States federal netoperating loss carryforwards of $28.0 million, which begin to expire in2021.  The Company also has $15.9million of various state net operating loss carryforwards, which begin toexpire in 2006 and $0.4 million of various foreign net operating losscarryforwards, which begin to expire in 2008.

 

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

 

The Company’sreportable segments, which, except for Regentek, reflect its primary distributionchannels, are as follows:

 

•                  *DonJoy*,is the Company’s largest sales channel, comprised of the sale of rigid braces,pain management products and certain soft goods.  Approximately 40 independent sales agents who employapproximately 270 independent commissioned sales representatives and a fewdirect sales representatives sell the Company’s DonJoy products to orthopedicsurgeons, podiatrists, orthopedic and prosthetic centers, hospitals, athletictrainers and other healthcare professionals. The representatives are technicalspecialists responsible for educating patients on device usage. After a productorder is received by a sales representative, the Company generally ships theproduct directly to the orthopedic professional and pays a sales commission tothe agent based on sales of such products. These commissions are reflected insales and marketing expense in the Company’s consolidated financial statements;

 

•                  *ProCare*,in which products are sold by approximately 30 direct and independent representativesthat manage over 320 dealers focused primary and acute facilities. Products aresold primarily 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 and specialtyproducts requiring little or no patient education. These distributors resellthese products to large hospital chains, hospital buying groups, primary carenetworks and orthopedic physicians for use by the patients;

 

•                  *Regentek,*inwhich the Company’s Regentek products are sold through a combination of directsales representatives and certain independent regional sales agents, withrespect to the OL1000, and by DePuy Spine under a exclusive sales agreement,with respect to the SpinaLogic.  Theseproducts are sold either directly to the patient or to independentdistributors.  The Company arrangesbilling to the third-party payers or patients, for products sold directly tothe patient;

 

•                  *OfficeCare*,in which the Company maintains an inventory of product (mostly soft goods) onhand at orthopedic practices for immediate distribution to the patient. Forthese products, the Company arranges billing to the patient or third-partypayor after the product is provided to the patient. In March 2003, the Companybegan outsourcing the revenue cycle of this program, from billing tocollections, to an independent third-party contractor.  The OfficeCare program is also intended tofacilitate the introduction of the Company’s products to orthopedic surgeonswho had not previously been the Company’s customers.  As of December 31, 2003, the OfficeCare program was located atover 540 physician offices throughout the United States.  The Company has contracts with over 350third-party payors for its OfficeCare products; and

 

•                  *International*,in which the Company’s products are sold in foreign countries throughwholly-owned subsidiaries or independent distributors.  The Company sells its products in over 30foreign countries, primarily in Europe, Australia, Canada and Japan.

 

Set forth below is revenue, gross profit andoperating income (loss) information for the Company’s reporting segments forthe years ended December 31 (in thousands). This information excludes theimpact of other expenses not allocated to segments, which are comprised of (i)general corporate expenses for all periods presented, (ii) the impairment oflong-lived assets and performance improvement, restructuring, and other costsfor 2002, and (iii) certain goodwill amortization for 2001.

 

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|                                          |   | **2003** |   | **2002** |   | **2001** |   |
|-----------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| **Net Revenues:**                             |   |     |   |     |   |     |   |
| DonJoy                                        |   | $        | 95,353 |     | $      | 90,796   |   | $ | 83,913 |   |
| ProCare                                       |   | 47,858   |   | 46,444   |   | 45,440   |   |
| Regentek (2)                                  |   | 3,989    |   | —   |   | —   |   |
| OfficeCare                                    |   | 25,631   |   | 22,966   |   | 21,654   |   |
| International                                 |   | 25,108   |   | 22,430   |   | 18,163   |   |
| Consolidated net revenues                     |   | 197,939  |   | 182,636  |   | 169,170  |   |
|                                          |   |     |   |     |   |     |   |
| **Gross Profit:**                             |   |     |   |     |   |     |   |
| DonJoy                                        |   | 53,824   |   | 53,377   |   | 51,306   |   |
| ProCare                                       |   | 19,805   |   | 11,323   |   | 11,499   |   |
| Regentek (2)                                  |   | 3,145    |   | —   |   | —   |   |
| OfficeCare                                    |   | 20,162   |   | 16,829   |   | 16,036   |   |
| International                                 |   | 15,076   |   | 10,325   |   | 7,250    |   |
| Gross profit of reportable segments           |   | 112,012  |   | 91,854   |   | 86,091   |   |
| Expenses not allocated to segments            |   | —   |   | (5,096   | )      | —   |   |
| Consolidated gross profit                     |   | 112,012  |   | 86,758   |   | 86,091   |   |
|                                          |   |     |   |     |   |     |   |
| **Income (loss) from  operations (1):**       |   |     |   |     |   |     |   |
| DonJoy                                        |   | 22,437   |   | 23,040   |   | —   |   |
| ProCare                                       |   | 10,224   |   | 2,382    |   | —   |   |
| Regentek (2)                                  |   | 537      |   | —   |   | —   |   |
| OfficeCare                                    |   | 2,801    |   | (4,591   | )      | —   |   |
| International                                 |   | 6,255    |   | 824      |   | —   |   |
| Income from operations of reportable segments |   | 42,254   |   | 21,655   |   | —   |   |
| Expenses not allocated to segments            |   | (10,485  | )      | (34,123  | )      | —   |   |
| Consolidated income (loss) from operations    |   | $        | 31,769 |     | $      | (12,468  | )      | — |   |
|                                               |        |          |        |          |        |          |        |  |  |  |

 

----

(1)          Segment income (loss) from operations is notavailable for periods prior to December 31, 2002.

(2)          Regentek includesoperations for the period subsequent to the Regentek acquisition on November26, 2003 and includes the impact of the Regentek purchase accounting andrelated amortization of acquired intangible assets.

 

For the yearsended December 31, 2003, 2002 and 2001, the Company had no individual customeror distributor that accounted for 10% or more of total annual revenues.

 

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

 

Net revenues,attributed to countries based on the location of the customer, for the yearsended December 31, were as follows (in thousands):

 
|                            |   | **2003** |    | **2002** |   | **2001** |   |
|---------------------------------|--------|----------|---------|----------|--------|----------|--------|
|                            |   |     |    |     |   |     |   |
| United States                   |   | $        | 172,831 |     | $      | 160,206  |   | $ | 151,007 |   |
| Europe                          |   | 16,265   |    | 13,073   |   | 12,564   |   |
| Other countries                 |   | 8,843    |    | 9,357    |   | 5,599    |   |
| Total consolidated net revenues |   | $        | 197,939 |     | $      | 182,636  |   | $ | 169,170 |   |

 

76

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

 
|                      |   | **2003** |       | **2002** |       |
|---------------------------|--------|----------|------------|----------|------------|
|                      |   |     | ** ** |     | ** ** |
| United States             |   | $        | 313,857    |     | $          | 232,772 |   |
| International             |   | 6,647    |       | 4,952    |       |
| Total consolidated assets |   | $        | 320,504    |     | $          | 237,724 |   |

 

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

 

The Company isobligated under various noncancellable operating leases for land, buildings,equipment and vehicles through August 2014. Certain of the leases provide that the Company pay all or a portion of taxes,maintenance, insurance and other operating expenses, and certain of the rentsare subject to adjustment for changes as determined by certain consumer priceindices and exchange rates.  The Companyis headquartered in Vista, California and operates manufacturing locations inVista, California; Tijuana, Mexico; and Tempe, Arizona. In connection with theRecapitalization, the Company entered into a subleasing agreement with Smith& Nephew for its Vista facility. The manufacturing facilities located in Tijuana,Mexico are currently conducted in three buildings in a campus environment andare within 100 miles of Vista. In December 2003, the Company signed a lease fora 200,000 square foot built-to-suit facility in Tijuana, Mexico where theCompany intends to relocate all of its Mexico-based manufacturing operations inlate 2004.  In connection with theRegentek acquisition, the Company entered into a sublease for a facility inTempe, Arizona.  In December 2003, theCompany established a pilot east coast distribution center in Lansing,Michigan. The Company also leases warehouse and office space in Germany,Canada, France and the United Kingdom. All of the Company’s facilities are leased, none are owned.

 

Minimum annuallease commitments for noncancellable operating leases as of December 31, 2003are as follows (in thousands):

 
| 2004                |   | $     | 4,238  |   |
|---------------------|--------|-------|--------|--------|
| 2005                |   | 3,445 |   |
| 2006                |   | 3,297 |   |
| 2007                |   | 3,088 |   |
| 2008                |   | 1,424 |   |
| 2009 and thereafter |   | 6,502 |   |
|                |   | $     | 21,994 |   |

 

Aggregate rentexpense was approximately $3.4 million, $3.9 million and $3.6 million for theyears ended December 31, 2003, 2002 and 2001, respectively.

 

*Contingencies*

 

Several classaction complaints were filed in the United States District Courts for theSouthern District of New York and for the Southern District of California onbehalf of purchasers of the Company’s common stock alleging violations of thefederal securities laws in connection with its initial public offering inNovember 2001.  These actions werelater consolidated into a single action, In re DJ Orthopedics, Inc. SecuritiesLitigation, Case No. 01-CV-2238-K (RBB) (S.D. Cal.).  The Company is named as a defendant along with Leslie H. Cross,its President and Chief Executive Officer, Cyril Talbot III, its former SeniorVice President, Finance, Chief Financial Officer, and Secretary, Charles T.Orsatti, former Chairman of its Board of Directors, its outside directorsMitchell J. Blutt, M.D. and Kirby L. Cramer and its former director Damion E.Wicker, M.D and the underwriters of its initial public offering. The complaintseeks unspecified damages and following the filing of a motion to dismiss thateliminated all but one alleged omission, continues to assert that defendantsviolated Sections 11, 12, and 15 of the Securities Act of 1933 by failing todisclose allegedly material intra-quarterly sales data in the registrationstatement and prospectus. On July 22, 2003, the Court appointed LouisianaSchool Employees’ Retirement System as substitute lead plaintiff following thewithdrawal of Oracle Partners L.P. who was the original lead plaintiff, and onNovember 17, 2003, the Court certified the class. The parties have reached atentative settlement of the case and entered into a Memorandum of Understandingconfirming the settlement and the terms thereof.  The amount of the settlement is within the coverage limits of theCompany’s directors’ and officers’ liability insurance policies.  The settlement will become final upon courtapproval, provided that, if class members who purchased more than a specifiednumber of shares exclude themselves from the class, the defendants mayterminate the settlement.

 

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From time totime, the Company has been involved in lawsuits arising in the ordinary courseof business. This includes patent and other intellectual property disputesbetween its various competitors and the Company.  With respect to these matters, management believes that it hasadequate legal defense, insurance and/or have provided adequate accruals forrelated costs. The Company is not aware of any pending lawsuits not mentionedabove that could have a material adverse effect on its business, financialcondition and results of operations.

** **

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

 

djOrthopedics, Inc. has a qualified 401(k) profit-sharing plan coveringsubstantially all of its U.S. employees. The Company matches 100% of the first$500 contributed annually by each employee and 30 percent of additionalemployee contributions up to 6 percent of total compensation.  The Company’s matching contributions relatedto this plan were $0.3 million, $0.4 million and $0.5 million for the yearsended December 31, 2003, 2002 and 2001, respectively. The plan also providesfor discretionary Company contributions as approved by the Board of Directors.There were no discretionary contributions for the years ended December 31,2003, 2002 or 2001.

 

**12.****                               CondensedConsolidating Financial Information**

 

dj Orthopedicsand dj Development guarantee dj Ortho’s bank borrowings and its obligationsunder the 12 5/8% senior subordinated notes (the notes). dj Capital was formedsolely to act as a co-issuer (and as a joint and several obligor) with dj Orthowith respect to the notes. dj Development was formed to conduct the Company’sresearch and development activities and its principal assets consist of theCompany’s intellectual property.

 

dj Orthorepresents substantially all of the revenues, operating results and operatingassets of dj Orthopedics. The guarantees of the notes by dj Orthopedics and djDevelopment and any guarantee of the notes by a future parent or wholly ownedsubsidiary guarantor are full and unconditional. dj Ortho, dj Capital and djDevelopment comprise all the direct and indirect subsidiary guarantors of djOrthopedics. dj Ortho’s foreign subsidiaries are not guarantors of the notes.The indenture governing the notes (Indenture) and the Company’s creditfacility, as amended, contain certain covenants restricting the ability of djOrtho and dj Capital to, among other things, pay dividends or make otherdistributions (other than certain tax distributions) or loans or advances to djOrthopedics unless certain financial tests are satisfied in the case of theIndenture or the consent of the lenders is obtained in the case of the creditfacility, as amended. The Indenture and the credit facility, as amended, permitdj Ortho to make distributions to dj Orthopedics in amounts required by djOrthopedics to pay federal, state and local income taxes to the extent suchincome taxes are attributable to the income of dj Ortho and its subsidiaries.

 

The followingsupplemental condensed consolidating financial information presents the balancesheets as of December 31, 2003 and 2002 and the statements of operations andcash flows for each of two years in the period ended December 31, 2003. Sincethe Company did not establish dj Development until the second quarter of 2002and the non-guarantor foreign subsidiaries were previously not material,supplemental condensed consolidating statements of operations and cash flowsfor the year ended December 31, 2001 are not required under the SecuritiesExchange Act of 1934. During 2002, the Company established new operatingsubsidiaries in Germany, the United Kingdom and Canada. Therefore, in theaggregate, the non-guarantor subsidiaries are no longer minor. For purposes ofthe financial information below, “DJO, Inc.” represents dj Orthopedics, “DJO,LLC” represents dj Ortho, “DJODC” represents dj Development (subsidiaryguarantor), “Non-Guarantors” represents the Company’s subsidiaries in Mexico,Germany, the United Kingdom, Canada, France (established September 2003) andAustralia (divested in December 2002) (non-guarantor subsidiaries) and “Elims”represents the consolidating elimination entries recorded by the Company. No separatefinancial information has been provided herein for dj Capital becausemanagement believes such information would not be meaningful, as dj Capital hasno financial or other data to report in response to the requirements of Form10-K. The accompanying condensed consolidating financial statements have beenprepared in accordance with accounting principles generally accepted in theUnited States and include all adjustments (consisting of normal recurringaccruals and the adjustments discussed in Note 4) which, in the opinion ofmanagement, are necessary for a fair presentation of the financial position,operating results and cash flows for the date and periods presented.

 

78

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**CondensedConsolidating Balance Sheet**

**December31, 2003**

(In thousands)

 
|                                               |   | **DJO, Inc.** |    | **DJO, LLC** |   | **DJODC** |   | **Non-  Guarantors** |   | **Elims** |   | **Consolidated** |   |
|----------------------------------------------------|--------|---------------|---------|--------------|--------|-----------|--------|----------------------|--------|-----------|--------|------------------|--------|
| **Assets:**                                        |   |          |    |         |   |      |   |                 |   |      |   |             |   |
| Current assets:                                    |   |          |    |         |   |      |   |                 |   |      |   |             |   |
| Cash and cash equivalents                          |   | $             | —  |         | $      | 18,221    |   | $                    | — |      | $      | 925              |   | $ | — |   | $ | 19,146 |   |
| Accounts receivable, net                           |   | —        |    | 41,792       |   | —    |   | 2,084                |   | —    |   | 43,876           |   |
| Inventories, net                                   |   | —        |    | 13,895       |   | —    |   | 3,692                |   | (2,053    | )      | 15,534           |   |
| Deferred tax asset, current portion                |   | 11,283        |    | —       |   | —    |   | —               |   | —    |   | 11,283           |   |
| Intercompany, net                                  |   | 50,160        |    | (23,907      | )      | (24,250   | )      | (2,003               | )      | —    |   | —           |   |
| Other current assets                               |   | 56            |    | 5,621        |   | —    |   | 665                  |   | —    |   | 6,342            |   |
| Total current assets                               |   | 61,499        |    | 55,622       |   | (24,250   | )      | 5,363                |   | (2,053    | )      | 96,181           |   |
| Property, plant and equipment, net                 |   | —        |    | 14,318       |   | 5         |   | 1,233                |   | —    |   | 15,556           |   |
| Goodwill, intangible assets and other assets,  net |   | —        |    | 121,168      |   | 39,989    |   | 101                  |   | —    |   | 161,258          |   |
| Intercompany loans                                 |   | —        |    | 1,803        |   | —    |   | (1,803               | )      | —    |   | —           |   |
| Investment in subsidiaries                         |   | 8,454         |    | 16,793       |   | —    |   | —               |   | (25,247   | )      | —           |   |
| Deferred tax asset                                 |   | 47,509        |    | —       |   | —    |   | —               |   | —    |   | 47,509           |   |
| Total assets                                       |   | $             | 117,462 |         | $      | 209,704   |   | $                    | 15,744 |      | $      | 4,894            |   | $ | (27,300 | ) | $ | 320,504 |   |
| **Liabilities and stockholders’ equity:**     |   |          |    |         |   |      |   |                 |   |      |   |             |   |
| Current liabilities:                               |   |          |    |         |   |      |   |                 |   |      |   |             |   |
| Accounts payable and other accrued  liabilities    |   | $             | 129     |         | $      | 27,093    |   | $                    | 1      |      | $      | 1,792            |   | $ | — |   | $ | 29,015 |   |
| Long-term debt, current portion                    |   | —        |    | 5,000        |   | —    |   | —               |   | —    |   | 5,000            |   |
| Total current liabilities                          |   | 129           |    | 32,093       |   | 1         |   | 1,792                |   | —    |   | 34,015           |   |
| Long-term debt, less current portion               |   | —        |    | 169,156      |   | —    |   | —               |   | —    |   | 169,156          |   |
| Total stockholders’ equity                    |   | 117,333       |    | 8,455        |   | 15,743    |   | 3,102                |   | (27,300   | )      | 117,333          |   |
| Total liabilities and stockholders’ equity    |   | $             | 117,462 |         | $      | 209,704   |   | $                    | 15,744 |      | $      | 4,894            |   | $ | (27,300 | ) | $ | 320,504 |   |

 

**CondensedConsolidating Balance Sheet**

**December31, 2002**

(In thousands)

 
|                                               |   | **DJO, Inc.** |    | **DJO, LLC** |   | **DJODC** |   | **Non-  Guarantors** |   | **Elims** |   | **Consolidated** |   |
|----------------------------------------------------|--------|---------------|---------|--------------|--------|-----------|--------|----------------------|--------|-----------|--------|------------------|--------|
| **Assets:**                                        |   |          |    |         |   |      |   |                 |   |      |   |             |   |
| Current assets:                                    |   |          |    |         |   |      |   |                 |   |      |   |             |   |
| Cash and cash equivalents                          |   | $             | 25,211  |         | $      | 5,424     |   | $                    | — |      | $      | 1,450            |   | $ | — |   | $ | 32,085 |   |
| Accounts receivable, net                           |   | —        |    | 31,860       |   | —    |   | 1,845                |   | —    |   | 33,705           |   |
| Inventories, net                                   |   | —        |    | 13,074       |   | —    |   | 4,070                |   | (2,561    | )      | 14,583           |   |
| Deferred tax asset, current portion                |   | 10,247        |    | —       |   | —    |   | —               |   | —    |   | 10,247           |   |
| Intercompany, net                                  |   | 18,563        |    | (20,315      | )      | 5,885     |   | (3,869               | )      | (264      | )      | —           |   |
| Other current assets                               |   | 591           |    | 4,056        |   | —    |   | 2                    |   | 321       |   | 4,970            |   |
| Total current assets                               |   | 54,612        |    | 34,099       |   | 5,885     |   | 3,498                |   | (2,504    | )      | 95,590           |   |
| Property, plant and equipment, net                 |   | —        |    | 12,912       |   | 10        |   | 1,160                |   | —    |   | 14,082           |   |
| Goodwill, intangible assets and other  assets, net |   | —        |    | 73,998       |   | 2,986     |   | (1,903               | )      | (2,513    | )      | 72,568           |   |
| Investment in subsidiaries                         |   | (9,183        | )       | 10,810       |   | —    |   | —               |   | (1,627    | )      | —           |   |
| Deferred tax asset                                 |   | 55,484        |    | —       |   | —    |   | —               |   | —    |   | 55,484           |   |
| Total assets                                       |   | $             | 100,913 |         | $      | 131,819   |   | $                    | 8,881  |      | $      | 2,755            |   | $ | (6,644 | ) | $ | 237,724 |   |
| **Liabilities and stockholders’ equity:**     |   |          |    |         |   |      |   |                 |   |      |   |             |   |
| Current liabilities:                               |   |          |    |         |   |      |   |                 |   |      |   |             |   |
| Accounts payable and other accrued  liabilities    |   | $             | —  |         | $      | 26,169    |   | $                    | 20     |      | $      | 806              |   | $ | — |   | $ | 26,995 |   |
| Long-term debt, current portion                    |   | —        |    | 1,274        |   | —    |   | —               |   | —    |   | 1,274            |   |
| Total current liabilities                          |   | —        |    | 27,443       |   | 20        |   | 806                  |   | —    |   | 28,269           |   |
| Long-term debt, less current portion               |   | —        |    | 108,542      |   | —    |   | —               |   | —    |   | 108,542          |   |
| Total stockholders’ equity                    |   | 100,913       |    | (4,166       | )      | 8,861     |   | 1,949                |   | (6,644    | )      | 100,913          |   |
| Total liabilities and stockholders’ equity    |   | $             | 100,913 |         | $      | 131,819   |   | $                    | 8,881  |      | $      | 2,755            |   | $ | (6,644 | ) | $ | 237,724 |   |

 

79

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**CondensedConsolidating Statement of Operations**

**Forthe Year Ended December 31, 2003**

(In thousands)

 
|                                             |   | **DJO, Inc.** |   | **DJO, LLC** |   | **DJODC** |   | **Non-  Guarantors** |   | **Elims** |   | **Consolidated** |   |
|--------------------------------------------------|--------|---------------|--------|--------------|--------|-----------|--------|----------------------|--------|-----------|--------|------------------|--------|
|                                             |   |          |   |         |   |      |   |                 |   |      |   |             |   |
| Net revenues                                     |   | $             | — |         | $      | 190,192   |   | $                    | 10,188 |      | $      | 25,397           |   | $ | (27,838 | ) | $ | 197,939 |   |
| Costs of goods sold                              |   | —        |   | 95,484       |   | —    |   | 17,796               |   | (27,353   | )      | 85,927           |   |
| Gross profit                                     |   | —        |   | 94,708       |   | 10,188    |   | 7,601                |   | (485      | )      | 112,012          |   |
| Operating expenses:                              |   |          |   |         |   |      |   |                 |   |      |   |             |   |
| Sales and marketing                              |   | —        |   | 47,275       |   | 131       |   | 6,661                |   | —    |   | 54,067           |   |
| General and administrative                       |   | —        |   | 21,758       |   | 1,002     |   | —               |   | (993      | )      | 21,767           |   |
| Research and development                         |   | —        |   | 2,946        |   | 1,496     |   | —               |   | —    |   | 4,442            |   |
| Other purchased intangibles amortization         |   | —        |   | 148          |   | 316       |   | 464                  |   |      |   |             |   |
| Impairment of long-lived assets                  |   | —        |   | —       |   | —    |   | —               |   | —    |   | —           |   |
| Performance improvement and restructuring  costs |   | —        |   | (497         | )      | —    |   | —               |   | —    |   | (497             | )      |
| Total operating expenses                         |   | —        |   | 71,630       |   | 2,945     |   | 6,661                |   | (993      | )      | 80,243           |   |
| Income from operations                           |   | —        |   | 23,078       |   | 7,243     |   | 940                  |   | 508       |   | 31,769           |   |
| Income from subsidiaries                         |   | 19,930        |   | 9,048        |   | —    |   | —               |   | (28,978   | )      | —           |   |
| Interest income (expense) and other, net         |   | 121           |   | (12,196      | )      | —    |   | 357                  |   | —    |   | (11,718          | )      |
| Income (loss) before income taxes                |   | 20,051        |   | 19,930       |   | 7,243     |   | 1,297                |   | (28,470   | )      | 20,051           |   |
| Benefit (provision) for income taxes             |   | (7,980        | )      | (646         | )      | —    |   | (646                 | )      | 1,292     |   | (7,980           | )      |
| Net income                                       |   | $             | 12,071 |         | $      | 19,284    |   | $                    | 7,243  |      | $      | 651              |   | $ | (27,178 | ) | $ | 12,071 |   |

 

**CondensedConsolidating Statement of Operations**

**Forthe Year Ended December 31, 2002**

(In thousands)

 
|                                             |   | **DJO, Inc.** |    | **DJO, LLC** |   | **DJODC** |   | **Non-  Guarantors** |   | **Elims** |   | **Consolidated** |   |
|--------------------------------------------------|--------|---------------|---------|--------------|--------|-----------|--------|----------------------|--------|-----------|--------|------------------|--------|
|                                             |   |          |    |         |   |      |   |                 |   |      |   |             |   |
| Net revenues                                     |   | $             | —  |         | $      | 170,130   |   | $                    | 7,046  |      | $      | 15,794           |   | $ | (10,334 | ) | $ | 182,636 |   |
| Costs of goods sold                              |   | —        |    | 94,629       |   | —    |   | 8,923                |   | (7,674    | )      | 95,878           |   |
| Gross profit                                     |   | —        |    | 75,501       |   | 7,046     |   | 6,871                |   | (2,660    | )      | 86,758           |   |
| Operating expenses:                              |   |          |    |         |   |      |   |                 |   |      |   |             |   |
| Sales and marketing                              |   | —        |    | 51,148       |   | 51        |   | 5,017                |   | —    |   | 56,216           |   |
| General and administrative                       |   | 47            |    | 22,558       |   | 1,315     |   | 2,494                |   | —    |   | 26,414           |   |
| Research and development                         |   | —        |    | 2,523        |   | 399       |   | —               |   | —    |   | 2,922            |   |
| Impairment of long-lived assets                  |   | —        |    | 3,666        |   | —    |   | —               |   | —    |   | 3,666            |   |
| Performance improvement and restructuring  costs |   | —        |    | 10,008       |   | —    |   | —               |   | —    |   | 10,008           |   |
| Total operating expenses                         |   | 47            |    | 89,903       |   | 1,765     |   | 7,511                |   | —    |   | 99,226           |   |
| Income (loss) from operations                    |   | (47           | )       | (14,402      | )      | 5,281     |   | (640                 | )      | (2,660    | )      | (12,468          | )      |
| Income (loss) from subsidiaries                  |   | (24,426       | )       | 3,652        |   | —    |   | —               |   | 20,774    |   | —           |   |
| Interest income (expense) and other, net         |   | (83           | )       | (13,676      | )      | —    |   | (101                 | )      | 1,772     |   | (12,088          | )      |
| Income (loss) before income taxes                |   | (24,556       | )       | (24,426      | )      | 5,281     |   | (741                 | )      | 19,886    |   | (24,556          | )      |
| Benefit (provision) for income taxes             |   | 9,361         |    | (183         | )      | —    |   | (183                 | )      | 366       |   | 9,361            |   |
| Net income (loss)                                |   | $             | (15,195 | )            | $      | (24,609   | )      | $                    | 5,281  |      | $      | (924             | )      | $ | 20,252 |   | $ | (15,195 | ) |

 

80

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**CondensedConsolidating Statement of Cash Flows**

**Forthe Year Ended December 31, 2003**

(In thousands)

 
|                                                                           |   | **DJO, Inc.** |   | **DJO, LLC** |   | **DJODC** |   | **Non-  Guarantors** |   | **Consolidated** |   |
|--------------------------------------------------------------------------------|--------|---------------|--------|--------------|--------|-----------|--------|----------------------|--------|------------------|--------|
| **Operating activities**                                                       |   |          |   |         |   |      |   |                 |   |             |   |
| Net cash provided by operating activities                                      |   | $             | 19,723 |         | $      | 5,242     |   | $                    | 982    |             | $      | 580 |   | $ | 26,527 |   |
| **Investing activities**                                                       |   |          |   |         |   |      |   |                 |   |             |   |
| Purchases of property, plant and equipment                                     |   | —        |   | (4,841       | )      | —    |   | (493                 | )      | (5,334           | )      |
| Disposal (purchase) of intangible assets                                       |   | —        |   | (3,000       | )      | —    |   | —               |   | (3,000           | )      |
| Purchase of Regentek business                                                  |   | —        |   | (56,039      | )      | (37,900   | )      | (93,939              | )      |             |   |
| Purchase of DuraKold business                                                  |   | —        |   | (2,802       | )      | (97       | )      | (2,899               | )      |             |   |
| Other assets, net                                                              |   | (5            | )      | (253         | )      | —    |   | (22                  | )      | (280             | )      |
| Net cash used in investing activities                                          |   | (5            | )      | (66,935      | )      | (37,997   | )      | (515                 | )      | (105,452         | )      |
| **Financing activities**                                                       |   |          |   |         |   |      |   |                 |   |             |   |
| Proceeds  from long-term debt                                                  |   | —        |   | 100,000      |   | —    |   | 100,000              |   |             |   |
| Repayment of long-term debt                                                    |   | —        |   | (35,815      | )      | —    |   | —               |   | (35,815          | )      |
| Net proceeds from issuance of common stock  under Employee Stock Purchase Plan |   | 228           |   | —       |   | —    |   | —               |   | 228              |   |
| Net proceeds from exercise of stock options                                    |   | 3,665         |   | —       |   | —    |   | —               |   | 3,665            |   |
| Debt issuance costs                                                            |   | —        |   | (2,600       | )      | (2,600    | )      |                 |   |             |   |
| Proceeds from payment on notes receivable                                      |   | 332           |   | —       |   | —    |   | —               |   | 332              |   |
| Intercompany obligations                                                       |   | (49,154       | )      | 12,905       |   | 37,015    |   | (766                 | )      | —           |   |
| Net cash (used in) provided by financing  activities                           |   | (44,929       | )      | 74,490       |   | 37,015    |   | (766                 | )      | 65,810           |   |
| Effect of exchange rate changes on cash                                        |   | —        |   | —       |   | —    |   | 176                  |   | 176              |   |
| Net increase (decrease) in cash and cash  equivalents                          |   | (25,211       | )      | 12,797       |   | —    |   | (525                 | )      | (12,939          | )      |
| Cash and cash equivalents at beginning of  year                                |   | 25,211        |   | 5,424        |   | —    |   | 1,450                |   | 32,085           |   |
| Cash and cash equivalents at end of year                                       |   | $             | — |         | $      | 18,221    |   | $                    | — |             | $      | 925 |   | $ | 19,146 |   |

 

81

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**CondensedConsolidating Statement of Cash Flows**

**Forthe Year Ended December 31, 2002**

(In thousands)

 
|                                                                           |   | **DJO, Inc.** |   | **DJO, LLC** |   | **DJODC** |   | **Non-  Guarantors** |   | **Consolidated** |   |
|--------------------------------------------------------------------------------|--------|---------------|--------|--------------|--------|-----------|--------|----------------------|--------|------------------|--------|
| **Operating activities**                                                       |   |          |   |         |   |      |   |                 |   |             |   |
| Net cash provided by (used in) operating  activities                           |   | $             | (3,478 | )            | $      | 10,287    |   | $                    | 5,706  |             | $      | 2,324 |   | $ | 14,839 |   |
| **Investing activities**                                                       |   |          |   |         |   |      |   |                 |   |             |   |
| Purchases of property, plant and equipment                                     |   | —        |   | (3,019       | )      | (14       | )      | (1,098               | )      | (4,131           | )      |
| Proceeds from the sale of property, plant  and equipment                       |   | —        |   | —       |   | —    |   | 288                  |   | 288              |   |
| Disposal (purchase) of intangible assets                                       |   | —        |   | 797          |   | (3,387    | )      | —               |   | (2,590           | )      |
| Other assets, net                                                              |   | —        |   | (2,747       | )      | —    |   | 1,831                |   | (916             | )      |
| Net cash provided by (used in) investing  activities                           |   | —        |   | (4,969       | )      | (3,401    | )      | 1,021                |   | (7,349           | )      |
| **Financing activities**                                                       |   |          |   |         |   |      |   |                 |   |             |   |
| Repayment of long-term debt                                                    |   | —        |   | (1,272       | )      | —    |   | —               |   | (1,272           | )      |
| Net proceeds from (costs of) issuance of  equity securities                    |   | —        |   | (2,621       | )      | 3,580     |   | (959                 | )      | —           |   |
| Additional costs related to initial public  offering                           |   | (317          | )      | —       |   | —    |   | —               |   | (317             | )      |
| Net proceeds from issuance of common stock  under Employee Stock Purchase Plan |   | 121           |   | —       |   | —    |   | —               |   | 121              |   |
| Intercompany obligations                                                       |   | 3,311         |   | 3,180        |   | (5,885    | )      | (606                 | )      | —           |   |
| Net cash (used in) provided by financing  activities                           |   | 3,115         |   | (713         | )      | (2,305    | )      | (1,565               | )      | (1,468           | )      |
| Effect of exchange rate changes on cash                                        |   | —        |   | —       |   | —    |   | 249                  |   | 249              |   |
| Net increase (decrease) in cash and cash  equivalents                          |   | (363          | )      | 4,605        |   | —    |   | 2,029                |   | 6,271            |   |
| Cash and cash equivalents at beginning of  year                                |   | 25,572        |   | —       |   | —    |   | 242                  |   | 25,814           |   |
| Cash and cash equivalents at end of year                                       |   | $             | 25,209 |         | $      | 4,605     |   | $                    | — |             | $      | 2,271 |   | $ | 32,085 |   |

 

82

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**13.****                               QuarterlyResults (unaudited)**

 

The following table summarizes certain of the Company’s operatingresults by quarter for 2003 and 2002:

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

 
|                                                                            |   | **Year Ended  December 31, 2002**          |   |
|---------------------------------------------------------------------------------|--------|--------------------------------------------|--------|
|                                                                            |   | **First  Quarter**                         |   | **Second  Quarter** |   | **Third  Quarter** |   | **Fourth  Quarter** |   | **Total  Year** |   |
|                                                                            |   | **(In  thousands, except per share data)** |   |
| Net revenues                                                                    |   | $                                          | 44,439 |   | $ | 45,709 |   | $ | 45,828 |   | $ | 46,660 |   | $ | 182,636 |   |
| Gross profit                                                                    |   | 23,833                                     |   | 21,259 |   | 20,356 |   | 21,310 |   | 86,758 |   |
| Income (loss) from operations                                                   |   | 5,515                                      |   | (4,715 | ) | (6,171 | ) | (7,097 | ) | (12,468 | ) |
| Net income (loss) (1)                                                           |   | $                                          | 1,450  |   | $ | (4,859 | ) | $ | (5,814 | ) | $ | (5,972 | ) | $ | (15,195 | ) |
| Basic and diluted net income (loss) per  share available to common stockholders |   | $                                          | 0.08   |   | $ | (0.27 | ) | $ | (0.33 | ) | $ | (0.33 | ) | $ | (0.85 | ) |
|                                                                            |   |                                       |   |   |   |   |   |   |   |   |   |
| Number of operating days                                                        |   | 63                                         |   | 64 |   | 63 |   | 63 |   | 253 |   |
|                                                                                 |        |                                            |        |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

----

(1)          Includes performance improvement,restructuring and other charges of $7.6 million, $9.4 million and $8.5 millionin the second, third and fourth quarters of 2002, respectively.

 

**14.****                               SubsequentEvent**

 

On February 24, 2004, the Company completed an offering of 8,625,000shares 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 of $56.7 million and 5,462,500 shares sold bycertain of the Company’s stockholders The Company intends to purchase and/or redeem all of the outstandingsenior subordinated notes with the net proceeds from the sale of the shares bythe Company plus existing cash.  TheCompany may purchase the notes in the open market, in privately negotiatedtransactions, or, on or after June 15, 2004, redeem these notes pursuant to theterms of the indenture governing the notes. In the event the Company redeemsthe notes, in addition to the write-off of the call premium, the Company willwrite-off unamortized debt issuance costs and discounts related to thenotes.  If the Company redeems all ofthe notes on June 15, 2004, the call premium will be $4.7 million and theunamortized debt issuance costs and discounts will be approximately $3.0million.  In the event the Companypurchases the notes on the open market before June 15, 2004, theseunamortized debt issuance costs and discounts will be higher.  The Company has received the consentsnecessary under its new credit agreement to use the proceeds from the sale ofshares by the Company and cash on hand to purchase and/or redeem the seniorsubordinated notes.

 

83

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**Item 9. Changes in and Disagreements withAccountants on Accounting and Financial Disclosure**

 

Not applicable.

 

**Item9A. Controls and Procedures**

 

We maintain disclosure controls and procedures that are designed toensure that information required to be disclosed in our Exchange Act reports isrecorded, processed, summarized and reported within the time periods specifiedin the Securities and Exchange Commission’s rules and forms and that suchinformation is accumulated and communicated to the Company’s management,including its Chief Executive Officer and Chief Financial Officer, asappropriate, to allow for timely decisions regarding required disclosure.  In designing and evaluating the disclosurecontrols and procedures, management recognizes that any controls andprocedures, no matter how well designed and operated, can provide onlyreasonable assurance of achieving the desired control objectives, andmanagement is required to apply its judgment in evaluating the cost-benefitrelationship of possible controls and procedures.

 

As required by SEC Rule 13a-15(b), we carried out an evaluation, underthe supervision and with the participation of our management, including ourChief Executive Officer and our Chief Financial Officer, of the effectivenessof the design and operation of our disclosure controls and procedures as of theend of the quarter covered by this report.  Based on the foregoing, ourChief Executive Officer and Chief Financial Officer concluded that ourdisclosure controls and procedures were effective at the reasonable assurancelevel.

 

There has been no change in our internal controls over financialreporting during our most recent fiscal quarter that has materially affected,or is reasonably likely to materially affect, our internal controls overfinancial reporting.

 

84

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**PART III**

 

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

 

The Companyhas adopted a Code of Business Conduct and Ethics and a set of CorporateGovernance Guidelines.  These documentscan be accessed on the Company’s website under the investor relations page, andare available in print to stockholders who submit a written request to theSecretary of the Company at the address of the Company’s principal executiveoffices.  In addition, the Audit,Compensation and Nominating and Corporate Governance Committees are eachadopting a charter governing the activities of such committee.  In accordance with New York Stock Exchangerules, these documents will similarly be available either on the website or bywritten request no later than the date of the Company’s 2004 AnnualStockholders Meeting.  The otherinformation under Item 10 is hereby incorporated by reference from djOrthopedics, Inc.’s Definitive Proxy Statement to be filed with the Securitiesand Exchange Commission on or prior to April 30, 2004.  See also Item 4A.of this Form 10-K.

 

**Item 11. Executive Compensation**

 

Item 11 ishereby incorporated by reference from dj Orthopedics, Inc.’s Definitive ProxyStatement to be filed with the Securities and Exchange Commission on or priorto April 30, 2004.

 

##### **Item 12. Security Ownership of Certain BeneficialOwners and Management and Related Stockholder Matters**

 

Item 12 ishereby incorporated by reference from dj Orthopedics, Inc.’s Definitive ProxyStatement to be filed with the Securities and Exchange Commission on or priorto April 30, 2004.

 

**Item 13. Certain Relationships and RelatedTransactions**

 

Item 13 ishereby incorporated by reference from dj Orthopedics, Inc.’s Definitive ProxyStatement to be filed with the Securities and Exchange Commission on or priorto April 30, 2004.

 

**Item 14. Principal Accountant Fees andServices**

 

Item 14 is hereby incorporated by reference from dj Orthopedics, Inc.’sDefinitive Proxy Statement to be filed with the Securities and ExchangeCommission on or prior to April 30, 2004.

 

85

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**PART IV**

 

**Item 15. Exhibits, Financial StatementSchedules and Reports on Form 8-K**

 

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

 

 

 

1.          The following consolidated financialstatements of dj Orthopedics, Inc., including the report thereon of Ernst &Young LLP, are filed as part of this report under Item 8- Financial Statementsand Supplementary Data:

 
| Report of Ernst & Young LLP,  Independent Auditors                                                                                         |   |
|------------------------------------------------------------------------------------------------------------------------------------------------|--------|
| Consolidated Balance Sheets as of December 31, 2003 and 2002                                                                                   |   |
| Consolidated Statements of Operations for  the years ended December 31, 2003, 2002 and 2001                                                    |   |
| Consolidated Statements of Changes in  Stockholders’/Member’s Equity (Deficit) for the years ended December 31,  2003, 2002 and 2001 |   |
| Consolidated Statements of Cash Flows for  the years ended December 31, 2003, 2002 and 2001                                                    |   |
| Notes to Consolidated Financial Statements                                                                                                     |   |

 

2.          Financial Statement Schedules:

 

Schedule II – Valuation and QualifyingAccounts

 

All other financial statement schedules are not required under therelated instructions or are inapplicable and therefore have been omitted.

 

3.          Exhibits:

 
| **Exhibit  Number** |   | **Description**                                                                                                                                                                                                                                                                                                        |
|---------------------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1                 |   | Amended and Restated Certificate of Incorporation of dj Orthopedics,  Inc. (Incorporated by reference to Exhibit 4.1 to the Registration Statement  of dj Orthopedics, Inc. on Form S-8 (Reg. No. 333-73966))                                                                                                          |
| 3.2                 |   | Amended and Restated By-laws of dj Orthopedics, Inc. (Incorporated by  reference to Exhibit 4.2 to the Registration Statement of dj Orthopedics,  Inc. on Form S-8 (Reg. No. 333-73966))                                                                                                                               |
| 3.3                 |   | Amended and Restated Operating Agreement of dj Orthopedics, LLC  (Incorporated by reference to Exhibit 3.1 to the Registration Statement on  Form S-4 (Reg. No. 333-86835))                                                                                                                                            |
| 3.4                 |   | By-laws of dj Orthopedics, LLC (Incorporated by reference to Exhibit  3.4 to the Registration Statement on Form S-4 (Reg. No. 333-86835))                                                                                                                                                                              |
| 3.5                 |   | Certificate of Incorporation of DJ Orthopedics Capital Corporation  (Incorporated by reference to Exhibit 3.3 to the Registration Statement on  Form S-4 (Reg. No. 333-86835))                                                                                                                                         |
| 3.6                 |   | By-laws of DJ Orthopedics Capital Corporation (Incorporated by  reference to Exhibit 3.6 to the Registration Statement on Form S-4 (Reg. No.  333-86835))                                                                                                                                                              |
| 4.1                 |   | Indenture dated as of June 30, 1999 among dj Orthopedics, Inc., as  successor to DonJoy, L.L.C., dj Orthopedics, LLC and DJ Orthopedics Capital  Corporation and The Bank of New York, as Trustee (Incorporated by reference  to Exhibit 4.1 to the Registration Statement on Form S-4 (Reg. No.  333-86835))          |
| 4.2                 |   | Form of 12 5/8% Senior Subordinated Note due 2009 (included as  Exhibit B to Exhibit 4.1)                                                                                                                                                                                                                              |
| 10.1                |   | Distribution Agreement dated as of June 30, 1999 between dj  Orthopedics, Inc., as successor to DonJoy, L.L.C., Smith & Nephew and the  affiliates of Smith & Nephew listed on Schedule I thereto (Incorporated  by reference to Exhibit 10.5 to the Registration Statement on Form S-4 (Reg.  No. 333-86835)) |
| 10.2                |   | Subleases dated as of June 30, 1999 between dj Orthopedics, LLC and  Smith & Nephew (Incorporated by reference to Exhibit 10.7 to the  Registration Statement on Form S-4 (Reg. No. 333-86835))                                                                                                                    |
| 10.3                |   | Guaranties dated as of June 30, 1999 of dj Orthopedics, Inc., as  successor to DonJoy, L.L.C. (Incorporated by reference to Exhibit 10.8 to the  Registration Statement on Form S-4 (Reg. No. 333-86835))                                                                                                              |
| 10.4                |   | Leasehold Deed of Trust, Security Agreement and Assignment of Leases  and Rents dated as of June 30, 1999 by dj Orthopedics, LLC, as grantor, to  First American Title Insurance Company, as trustee (Incorporated by reference  to Exhibit 10.17 to the Registration Statement on Form S-4 (Reg. No.  333-86835))     |

 

86

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| **Exhibit  Number** |   | **Description**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
|---------------------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.5                |   | Fifth Amended and Restated 1999 Option Plan of dj Orthopedics, Inc.  dated October 25, 2001 (Incorporated by reference to Exhibit 4.3 to the  Registration Statement on Form S-8 of dj Orthopedics, Inc. (Reg. No.  333-73966))                                                                                                                                                                                                                                                                                                                                                              |
| 10.6                |   | Secured Promissory Note dated as of July 7, 2000 between Leslie H.  Cross and dj Orthopedics, Inc., as successor to DonJoy, L.L.C. (Incorporated  by reference to Exhibit 4.3 to DonJoy, L.L.C.’s report on Form 8-K dated July  21, 2000)                                                                                                                                                                                                                                                                                                                                              |
| 10.7                |   | Secured Promissory Note dated as of July 7, 2000 between Michael R.  McBrayer and dj Orthopedics, Inc., as successor to DonJoy, L.L.C.  (Incorporated by reference to Exhibit 4.5 to DonJoy, L.L.C.’s report on Form  8-K dated July 21, 2000)                                                                                                                                                                                                                                                                                                                                          |
| 10.8                |   | Third Amended and Restated Pledge Agreement dated as of June 11,  2001, among Leslie H. Cross, Leslie H. Cross & Deborah L. Cross Family  Trust, and dj Orthopedics, Inc., as successor to DonJoy, L.L.C. (Incorporated  by reference to Exhibit 10.7 to DonJoy, L.L.C.’s quarterly report on Form  10-Q for the quarter ended June 30, 2001)                                                                                                                                                                                                                                       |
| 10.9                |   | Third Amended and Restated Pledge Agreement dated as of June 11,  2001, between Michael R. McBrayer and dj Orthopedics, Inc., as successor to  DonJoy, L.L.C. (Incorporated by reference to Exhibit 10.9 to DonJoy, L.L.C.’s  quarterly report on Form 10-Q for the quarter ended June 30, 2001)                                                                                                                                                                                                                                                                                        |
| 10.10               |   | Amended and Restated Secured Promissory Note dated as of June 28,  2000 between Michael R. McBrayer and dj Orthopedics, Inc., as successor to  DonJoy, L.L.C. (Incorporated by reference to Exhibit 4.10 to DonJoy, L.L.C.’s  report on Form 8-K dated July 21, 2000)                                                                                                                                                                                                                                                                                                                   |
| 10.11               |   | Amended and Restated Secured Promissory Note dated as of June 28,  2000 among Leslie H. Cross & Deborah L. Cross Family Trust, Leslie H.  Cross and dj Orthopedics, Inc., as successor to DonJoy, L.L.C. (Incorporated  by reference to Exhibit 4.11 to DonJoy, L.L.C.’s report on Form 8-K dated  July 21, 2000)                                                                                                                                                                                                                                                                   |
| 10.12               |   | Secured Promissory Note dated as of June 28, 2000 among Leslie H.  Cross & Deborah L. Cross Family Trust, Leslie H. Cross and dj Orthopedics,  Inc., as successor to DonJoy, L.L.C. (Incorporated by reference to Exhibit  4.13 to DonJoy’s report on Form 8-K dated July 21, 2000)                                                                                                                                                                                                                                                                                                 |
| 10.13               |   | Secured Promissory Note dated as of June 28, 2000 between Michael R.  McBrayer and dj Orthopedics, Inc., as successor to DonJoy, L.L.C.  (Incorporated by reference to Exhibit 4.15 to DonJoy’s report on Form 8-K  dated July 21, 2000)                                                                                                                                                                                                                                                                                                                                                |
| 10.14               |   | Secured Promissory Note dated as of June 11, 2001 among Leslie H.  Cross & Deborah L. Cross Family Trust, Leslie H. Cross and dj  Orthopedics, Inc., as successor to DonJoy, L.L.C. (Incorporated by reference  to Exhibit 10.4 to DonJoy, L.L.C.’s quarterly report on Form 10-Q for the  quarter ended June 30, 2001)                                                                                                                                                                                                                                                             |
| 10.15               |   | Secured Promissory Note dated as of June 11, 2001 between Michael R.  McBrayer and dj Orthopedics, Inc., as successor to DonJoy, L.L.C.  (Incorporated by reference to Exhibit 10.6 to DonJoy, L.L.C.’s quarterly  report on Form 10-Q for the quarter ended June 30, 2001)                                                                                                                                                                                                                                                                                                             |
| 10.16               |   | dj Orthopedics, Inc. 2001 Omnibus Plan (Incorporated by reference to  Exhibit 4.6 to the Registration Statement on Form S-8 of dj Orthopedics, Inc.  (Reg. No. 333-73966))                                                                                                                                                                                                                                                                                                                                                                                                                   |
| 10.17               |   | dj Orthopedics, Inc. 2001 Non-Employee Director Plan (Incorporated by  reference to Exhibit 4.5 to the Registration Statement on Form S-8 of dj  Orthopedics, Inc. (Reg. No. 333-73966))                                                                                                                                                                                                                                                                                                                                                                                                     |
| 10.18               |   | dj Orthopedics, Inc. 2001 Employee Stock Purchase Plan (Incorporated  by reference to Exhibit 4.4 to the Registration Statement on Form S-8 of dj  Orthopedics, Inc. (Reg. No. 333-73966))                                                                                                                                                                                                                                                                                                                                                                                                   |
| 10.19               |   | Registration Rights Agreement dated November 20, 2001 by and among dj  Orthopedics, Inc., J.P. Morgan DJ Partners, L.L.C., Leslie H. Cross &  Deborah L. Cross Family Trust, Michael R. McBrayer, Cyril Talbot III, J.P.  Morgan Partners (23A SBIC), LLC, First Union Capital Partners, LLC, DJ  Investment, LLC, DJC, Inc., TCW/ Crescent Mezzanine Trust II, TCW Leveraged  Income Trust II, L.P., TCW Investment Management Company and Crescent Mach I  Partners, L.P. (Incorporated by reference to Exhibit 10.53 to the Registration  Statement on Form S-1 (Reg. No. 333-74998)) |
| 10.20               |   | Letter Agreement dated November 20, 2001 between dj Orthopedics, Inc.  and the Leslie H. Cross and Deborah L. Cross Family Trust (Incorporated by  reference to Exhibit 10.54 to the Registration Statement on Form S-1 (Reg.  No. 333-74998))                                                                                                                                                                                                                                                                                                                                               |
| 10.21               |   | Letter Agreement dated November 20, 2001 between dj Orthopedics, Inc.  and Michael R. McBrayer (Incorporated by reference to Exhibit 10.56 to the  Registration Statement on Form S-1 (Reg. No. 333-74998))                                                                                                                                                                                                                                                                                                                                                                                  |
| 10.22               |   | Assignment and Assumption Agreement dated November 20, 2001 among  DonJoy, L.L.C., dj Orthopedics, Inc., First Union National Bank and The Chase  Manhattan Bank (Incorporated by reference to Exhibit 10.58 to the  Registration Statement on Form S-1 (Reg. No. 333-74998))                                                                                                                                                                                                                                                                                                                |

 

87

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| **Exhibit  Number** |   | **Description**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
|---------------------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.23               |   | Supplemental Indenture dated as of April 4,  2002 among dj Orthopedics Development Corporation, dj Orthopedics Capital  Corporation, dj Orthopedics, Inc. and The Bank of New York (Incorporated by  reference to Exhibit 10.62 to dj Orthopedics, Inc.’s Report of Form 10-Q for  the quarter ended June 29, 2002)                                                                                                                                                                                                                    |
| 10.24               |   | Amended and Restated  Employment Agreement dated as of July 11, 2002 among dj Orthopedics, LLC, dj  Orthopedics, Inc. and Cyril Talbot III (Incorporated by reference to Exhibit  10.64 of Post-Effective Amendment #1 to dj Orthopedics, Inc.’s Registration  Statement on Form S-1 (Reg. No. #333-74998))                                                                                                                                                                                                                            |
| 10.25               |   | Amendment No. 2 to Credit Agreement, dated as of October 29, 2002  among dj Orthopedics, Inc., dj Orthopedics, LLC, Wachovia Bank, National  Association, and JPMorgan Chase Bank (Incorporated by reference to dj  Orthopedics, Inc.’s Report of Form 10-Q for the quarter ended September 28,  2002)                                                                                                                                                                                                                                 |
| 10.26               |   | Outsourcing Agreement, dated as of December 30, 2002 by and between  Creditek MediFinancial, Inc. and dj Orthopedics, LLC (Incorporated by  reference to dj Orthopedics, Inc.’s Report of Form 10-K for the year ended  December 31, 2002)                                                                                                                                                                                                                                                                                             |
| 10.27               |   | Amendment No. 3 to Credit Agreement, dated as of February 14, 2003  among dj Orthopedics, Inc., dj Orthopedics, LLC, Wachovia Bank, National  Association, and JPMorgan Chase Bank (Incorporated by reference to dj  Orthopedics, Inc.’s Report of Form 10-K for the year ended December 31, 2002)                                                                                                                                                                                                                                     |
| 10.28               |   | The Asset Purchase Agreement, dated June 18, 2003, by and between  Dura*Kold Corporation and the Company (Incorporated by reference to dj  Orthopedics, Inc.’s Report of Form 10-Q for the quarter ended June 28, 2003)                                                                                                                                                                                                                                                                                                                |
| 10.29               |   | Amendment Number One to the DJ Orthopedics, Inc. 2001 Non-Employee  Director Stock Option Plan, dated May 29, 2003 (Incorporated by reference to  dj Orthopedics, Inc.’s Report of Form 10-Q for the quarter ended June 28,  2003)                                                                                                                                                                                                                                                                                                     |
| 10.30               |   | Non-exclusive License and Settlement Agreement by and between  Generation II Orthopedics Inc. and Generation II USA Inc. and the Company  entered into on May 29, 2003. (Incorporated by reference to dj Orthopedics,  Inc.’s Report of Form 10-Q for the quarter ended June 28, 2003)                                                                                                                                                                                                                                                 |
| 10.31               |   | Asset Purchase Agreement, dated October 8, 2003, by and between  OrthoLogic Corp. and the Company (Incorporated by reference to dj  Orthopedics, Inc.’s Report of Form 10-Q for the quarter ended September 27,  2003)                                                                                                                                                                                                                                                                                                                 |
| 10.32               |   | Credit Agreement among dj Orthopedics, LLC, as borrower, dj  Orthopedics, Inc., the lenders named thereto, Wachovia Bank, National  Association, as Administrative Agent, Wells Fargo Bank, National Association,  as  Syndication Agent, and Bank of America, N.A., Bank of the West and  Union Bank of California, N.A., as Documentation Agents for $130,000,000  Senior Secured Credit Facilities, dated as of November 26, 2003 (Incorporated  by reference to dj Orthopedics, Inc.’s Report of Form 8-K dated December 3,  2003) |
| 10.33*              |   | Amendment Number One to Outsourcing Agreement, dated December 12,  2003 by and between Creditek MediFinancial, Inc. and dj Orthopedics, LLC.                                                                                                                                                                                                                                                                                                                                                                                                |
| 10.34*+             |   | Sales Representative Agreement, dated August 18, 2000, between dj  Orthopedics LLC (successor to OrthoLogic Corp. with respect to this  agreement) and DePuy Spine, Inc. (formally known as DePuy AcroMed, Inc.).                                                                                                                                                                                                                                                                                                                           |
| 10.35*+             |   | Amendment to Sales Representative Agreement, dated March 1, 2002,  between dj Orthopedics LLC (successor to OrthoLogic Corp. with respect to  this agreement) and DePuy Spine, Inc. (formally known as DePuy AcroMed,  Inc.).                                                                                                                                                                                                                                                                                                               |
| 10.36*+             |   | Amendment No. 3 to Sales Representative Agreement, dated September  15, 2003, between dj Orthopedics LLC (successor to OrthoLogic Corp. with  respect to this agreement) and DePuy Spine, Inc. (formally known as DePuy  AcroMed, Inc.).                                                                                                                                                                                                                                                                                                    |
| 12.1*               |   | Statement re: Computation of Ratio of Earnings to Fixed Charges                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| 21.1*               |   | Subsidiaries of the Registrant                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 23.1*               |   | Consent of Ernst & Young LLP, Independent Auditors                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
| 31.1*               |   | Certification of Chief Executive Officer pursuant to Rule 13a-14(a)  and Rule 15d-14(a) of the Securities Exchange Act, as amended.                                                                                                                                                                                                                                                                                                                                                                                                         |
| 31.2*               |   | Certification of Chief Financial Officer pursuant to Rule 13a-14(a)  and Rule 15d-14(a) of the Securities Exchange Act, as amended.                                                                                                                                                                                                                                                                                                                                                                                                         |
| 32.0*               |   | Certification of Chief Executive Officer and Chief Financial Officer  Pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                                                                                                                                    |

 

----

* Filed herewith

+ Confidential treatment has been requested with respect to portions ofthis exhibit.

 

88

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(b)                                 Reports on Form 8-K filed in the fourth quarter of 2003:

 

# *(1) Form8-K dated October 9, 2003 including “Item 5. Other Events” - Furnishingpress release to announce the signing of a definitive agreement to purchase thebone growth stimulation business from OrthoLogic Corp., for $93 million incash, subject to the approval of OrthoLogic’s stockholders and customarygovernmental approvals and closing conditions.*

 

(2) Form 8-K dated October 28, 2003 including “Item 12. Results ofOperations and Financial Condition” – Furnishing the press release announcingour financial results for the fiscal quarter ended September 27, 2003.

 

(3) Form 8-K dated December 3, 2003 including “Item 2 Acquisition ofDisposition of Assets, Item 7. Financial Statements and Exhibits and Item 12.  Results of Operations and Financial Condition” – Furnishinginformation regarding the press release, financial statements and pro formafinancial statements relating to the acquisition of bone growth stimulationdevice business from OrthoLogic Corp..

 

89

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**DJORTHOPEDICS, INC.**

**SCHEDULEII — Valuation and Qualifying Accounts**

**Forthe Three Years Ended December 31, 2003**

** **
|                                |   | **Allowance  for  Doubtful  Accounts and  Sales Returns** |   | **Reserve  for  Excess and  Obsolete  Inventory** |   |
|-------------------------------------|--------|-----------------------------------------------------------|--------|---------------------------------------------------|--------|
|                                |   |                                                      |   |                                              |   |
| Balance at December 31, 2000        |   | $4,278,000                                                |   | $3,774,000                                        |   |
| Provision                           |   | 10,701,000                                                |   | 604,000                                           |   |
| Write-offs and recoveries, net      |   | (6,238,000                                                | )      | (1,378,000                                        | )      |
| Balance at December 31, 2001        |   | 8,741,000                                                 |   | 3,000,000                                         |   |
| Provision                           |   | 22,269,000                                                |   | 6,124,000                                         |   |
| Write-offs and recoveries, net      |   | (20,965,000                                               | )      | (4,560,000                                        | )      |
| Balance at December 31, 2002        |   | 10,045,000                                                |   | 4,564,000                                         |   |
| Provision                           |   | 22,641,000                                                |   | 2,087,000                                         |   |
| Write-offs and recoveries, net      |   | (14,601,000                                               | )      | (1,449,000                                        | )      |
| Additions from Regentek acquisition |   | 2,632,000                                                 |   | 1,167,000                                         |   |
| Balance at December 31, 2003        |   | $20,717,000                                               |   | $6,369,000                                        |   |

 

90

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**SIGNATURES**

 

Pursuant to the requirements of Section 13 or 15(d) of the SecuritiesExchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the undersigned, thereunto duly authorized.

 
| Date: March 12, 2004 | **DJ ORTHOPEDICS,  INC.**                |
|----------------------|------------------------------------------|
|                 | By:                                      | /s/ Leslie H. Cross |   |
|                 |                                     | Leslie H. Cross |   |
|                 | *President and  Chief Executive Officer* |

 

Pursuant to the requirements of the Securities Exchange Act of 1934,this Report has been signed below by the following persons on behalf of theregistrant and in the capacities and on the dates indicated.

 
| **Signature**           |   | **Title**                                                                                                           |   | **Date**       |
|-------------------------|--------|---------------------------------------------------------------------------------------------------------------------|--------|----------------|
|                    |   |                                                                                                                |   |           |
| /s/ Leslie H. Cross     |   | President, Chief Executive Officer and Director                                                                     |   | March 12, 2004 |
| Leslie H. Cross         |   | (Principal Executive Officer)                                                                                       |   |           |
|                    |   |                                                                                                                |   |           |
| /s/ Vickie L. Capps     |   | Senior Vice President, Finance, Chief Financial Officer and Treasurer  (Principal Financial and Accounting Officer) |   | March 12, 2004 |
| Vickie L. Capps         |   |                                                                                                                |   |
|                    |   |                                                                                                                |   |           |
| /s/ Jack R. Blair       |   | Chairman of the Board of Directors                                                                                  |   | March 12, 2004 |
| Jack R. Blair           |   |                                                                                                                |   |           |
|                    |   |                                                                                                                |   |           |
| /s/ Mitchell J. Blutt   |   | Director                                                                                                            |   | March 12, 2004 |
| Mitchell J. Blutt, M.D. |   |                                                                                                                |   |           |
|                    |   |                                                                                                                |   |           |
| /s/ Benjamin Edmands    |   | Director                                                                                                            |   | March 12, 2004 |
| Benjamin Edmands        |   |                                                                                                                |   |           |
|                    |   |                                                                                                                |   |           |
| /s/ Lewis Parker        |   | Director                                                                                                            |   | March 12, 2004 |
| Lewis Parker            |   |                                                                                                                |   |           |
|                    |   |                                                                                                                |   |           |
| /s/ Charles T. Orsatti  |   | Director                                                                                                            |   | March 12, 2004 |
| Charles T. Orsatti      |   |                                                                                                                |   |           |
|                    |   |                                                                                                                |   |           |
| /s/ Lesley H. Howe      |   | Director                                                                                                            |   | March 12, 2004 |
| Lesley H. Howe          |   |                                                                                                                |   |           |
|                    |   |                                                                                                                |   |           |
| /s/ Kirby L. Cramer     |   | Director                                                                                                            |   | March 12, 2004 |
| Kirby L. Cramer         |   |                                                                                                                |   |           |

 

91

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**INDEXTO EXHIBITS**

** **
| **Exhibit  Number** |   | **Description**                                                                                                                                                                                                                                                                                                                                        |
|---------------------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1                 |   | Amended and Restated Certificate of Incorporation of dj Orthopedics,  Inc. (Incorporated by reference to Exhibit 4.1 to the Registration Statement  of dj Orthopedics, Inc. on Form S-8 (Reg. No. 333-73966))                                                                                                                                          |
| 3.2                 |   | Amended and Restated By-laws of dj Orthopedics, Inc. (Incorporated by  reference to Exhibit 4.2 to the Registration Statement of dj Orthopedics,  Inc. on Form S-8 (Reg. No. 333-73966))                                                                                                                                                               |
| 3.3                 |   | Amended and Restated Operating Agreement of dj Orthopedics, LLC  (Incorporated by reference to Exhibit 3.1 to the Registration Statement on  Form S-4 (Reg. No. 333-86835))                                                                                                                                                                            |
| 3.4                 |   | By-laws of dj Orthopedics, LLC (Incorporated by reference to Exhibit  3.4 to the Registration Statement on Form S-4 (Reg. No. 333-86835))                                                                                                                                                                                                              |
| 3.5                 |   | Certificate of Incorporation of DJ Orthopedics Capital Corporation  (Incorporated by reference to Exhibit 3.3 to the Registration Statement on  Form S-4 (Reg. No. 333-86835))                                                                                                                                                                         |
| 3.6                 |   | By-laws of DJ Orthopedics Capital Corporation (Incorporated by  reference to Exhibit 3.6 to the Registration Statement on Form S-4 (Reg. No.  333-86835))                                                                                                                                                                                              |
| 4.1                 |   | Indenture dated as of June 30, 1999 among dj Orthopedics, Inc., as  successor to DonJoy, L.L.C., dj Orthopedics, LLC and DJ Orthopedics Capital  Corporation and The Bank of New York, as Trustee (Incorporated by reference  to Exhibit 4.1 to the Registration Statement on Form S-4 (Reg. No.  333-86835))                                          |
| 4.2                 |   | Form of 12 5/8% Senior Subordinated Note due 2009 (included as  Exhibit B to Exhibit 4.1)                                                                                                                                                                                                                                                              |
| 10.1                |   | Distribution Agreement dated as of June 30, 1999 between dj  Orthopedics, Inc., as successor to DonJoy, L.L.C., Smith & Nephew and the  affiliates of Smith & Nephew listed on Schedule I thereto (Incorporated  by reference to Exhibit 10.5 to the Registration Statement on Form S-4 (Reg.  No. 333-86835))                                 |
| 10.2                |   | Subleases dated as of June 30, 1999 between dj Orthopedics, LLC and  Smith & Nephew (Incorporated by reference to Exhibit 10.7 to the  Registration Statement on Form S-4 (Reg. No. 333-86835))                                                                                                                                                    |
| 10.3                |   | Guaranties dated as of June 30, 1999 of dj Orthopedics, Inc., as  successor to DonJoy, L.L.C. (Incorporated by reference to Exhibit 10.8 to the  Registration Statement on Form S-4 (Reg. No. 333-86835))                                                                                                                                              |
| 10.4                |   | Leasehold Deed of Trust, Security Agreement and Assignment of Leases  and Rents dated as of June 30, 1999 by dj Orthopedics, LLC, as grantor, to  First American Title Insurance Company, as trustee (Incorporated by reference  to Exhibit 10.17 to the Registration Statement on Form S-4 (Reg. No.  333-86835))                                     |
| 10.5                |   | Fifth Amended and Restated 1999 Option Plan of dj Orthopedics, Inc.  dated October 25, 2001 (Incorporated by reference to Exhibit 4.3 to the  Registration Statement on Form S-8 of dj Orthopedics, Inc. (Reg. No.  333-73966))                                                                                                                        |
| 10.6                |   | Secured Promissory Note dated as of July 7, 2000 between Leslie H.  Cross and dj Orthopedics, Inc., as successor to DonJoy, L.L.C. (Incorporated  by reference to Exhibit 4.3 to DonJoy, L.L.C.’s report on Form 8-K dated July  21, 2000)                                                                                                        |
| 10.7                |   | Secured Promissory Note dated as of July 7, 2000 between Michael R.  McBrayer and dj Orthopedics, Inc., as successor to DonJoy, L.L.C.  (Incorporated by reference to Exhibit 4.5 to DonJoy, L.L.C.’s report on Form  8-K dated July 21, 2000)                                                                                                    |
| 10.8                |   | Third Amended and Restated Pledge Agreement dated as of June 11,  2001, among Leslie H. Cross, Leslie H. Cross & Deborah L. Cross Family  Trust, and dj Orthopedics, Inc., as successor to DonJoy, L.L.C. (Incorporated  by reference to Exhibit 10.7 to DonJoy, L.L.C.’s quarterly report on Form  10-Q for the quarter ended June 30, 2001) |
| 10.9                |   | Third Amended and Restated Pledge Agreement dated as of June 11,  2001, between Michael R. McBrayer and dj Orthopedics, Inc., as successor to  DonJoy, L.L.C. (Incorporated by reference to Exhibit 10.9 to DonJoy, L.L.C.’s  quarterly report on Form 10-Q for the quarter ended June 30, 2001)                                                  |
| 10.10               |   | Amended and Restated Secured Promissory Note dated as of June 28, 2000  between Michael R. McBrayer and dj Orthopedics, Inc., as successor to DonJoy,  L.L.C. (Incorporated by reference to Exhibit 4.10 to DonJoy, L.L.C.’s report  on Form 8-K dated July 21, 2000)                                                                             |
| 10.11               |   | Amended and Restated Secured Promissory Note dated as of June 28,  2000 among Leslie H. Cross & Deborah L. Cross Family Trust, Leslie H.  Cross and dj Orthopedics, Inc., as successor to DonJoy, L.L.C. (Incorporated  by reference to Exhibit 4.11 to DonJoy, L.L.C.’s report on Form 8-K dated  July 21, 2000)                             |
| 10.12               |   | Secured Promissory Note dated as of June 28, 2000 among Leslie H.  Cross & Deborah L. Cross Family Trust, Leslie H. Cross and dj  Orthopedics, Inc., as successor to DonJoy, L.L.C. (Incorporated by reference  to Exhibit 4.13 to DonJoy’s report on Form 8-K dated July 21, 2000)                                                           |

 

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| **Exhibit  Number** |   | **Description**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
|---------------------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.13               |   | Secured Promissory Note dated as of June 28, 2000 between Michael R.  McBrayer and dj Orthopedics, Inc., as successor to DonJoy, L.L.C.  (Incorporated by reference to Exhibit 4.15 to DonJoy’s report on Form 8-K  dated July 21, 2000)                                                                                                                                                                                                                                                                                                                                                |
| 10.14               |   | Secured Promissory Note dated as of June 11, 2001 among Leslie H.  Cross & Deborah L. Cross Family Trust, Leslie H. Cross and dj  Orthopedics, Inc., as successor to DonJoy, L.L.C. (Incorporated by reference  to Exhibit 10.4 to DonJoy, L.L.C.’s quarterly report on Form 10-Q for the  quarter ended June 30, 2001)                                                                                                                                                                                                                                                             |
| 10.15               |   | Secured Promissory Note dated as of June 11, 2001 between Michael R.  McBrayer and dj Orthopedics, Inc., as successor to DonJoy, L.L.C.  (Incorporated by reference to Exhibit 10.6 to DonJoy, L.L.C.’s quarterly  report on Form 10-Q for the quarter ended June 30, 2001)                                                                                                                                                                                                                                                                                                             |
| 10.16               |   | dj Orthopedics, Inc. 2001 Omnibus Plan (Incorporated by reference to  Exhibit 4.6 to the Registration Statement on Form S-8 of dj Orthopedics, Inc.  (Reg. No. 333-73966))                                                                                                                                                                                                                                                                                                                                                                                                                   |
| 10.17               |   | dj Orthopedics, Inc. 2001 Non-Employee Director Plan (Incorporated by  reference to Exhibit 4.5 to the Registration Statement on Form S-8 of dj  Orthopedics, Inc. (Reg. No. 333-73966))                                                                                                                                                                                                                                                                                                                                                                                                     |
| 10.18               |   | dj Orthopedics, Inc. 2001 Employee Stock Purchase Plan (Incorporated  by reference to Exhibit 4.4 to the Registration Statement on Form S-8 of dj  Orthopedics, Inc. (Reg. No. 333-73966))                                                                                                                                                                                                                                                                                                                                                                                                   |
| 10.19               |   | Registration Rights Agreement dated November 20, 2001 by and among dj  Orthopedics, Inc., J.P. Morgan DJ Partners, L.L.C., Leslie H. Cross &  Deborah L. Cross Family Trust, Michael R. McBrayer, Cyril Talbot III, J.P.  Morgan Partners (23A SBIC), LLC, First Union Capital Partners, LLC, DJ Investment,  LLC, DJC, Inc., TCW/ Crescent Mezzanine Trust II, TCW Leveraged Income Trust  II, L.P., TCW Investment Management Company and Crescent Mach I Partners,  L.P. (Incorporated by reference to Exhibit 10.53 to the Registration  Statement on Form S-1 (Reg. No. 333-74998)) |
| 10.20               |   | Letter Agreement dated November 20, 2001 between dj Orthopedics, Inc.  and the Leslie H. Cross and Deborah L. Cross Family Trust (Incorporated by  reference to Exhibit 10.54 to the Registration Statement on Form S-1 (Reg.  No. 333-74998))                                                                                                                                                                                                                                                                                                                                               |
| 10.21               |   | Letter Agreement dated November 20, 2001 between dj Orthopedics, Inc.  and Michael R. McBrayer (Incorporated by reference to Exhibit 10.56 to the  Registration Statement on Form S-1 (Reg. No. 333-74998))                                                                                                                                                                                                                                                                                                                                                                                  |
| 10.22               |   | Assignment and Assumption Agreement dated November 20, 2001 among  DonJoy, L.L.C., dj Orthopedics, Inc., First Union National Bank and The Chase  Manhattan Bank (Incorporated by reference to Exhibit 10.58 to the  Registration Statement on Form S-1 (Reg. No. 333-74998))                                                                                                                                                                                                                                                                                                                |
| 10.23               |   | Supplemental Indenture dated as of April 4,  2002 among dj Orthopedics Development Corporation, dj Orthopedics Capital  Corporation, dj Orthopedics, Inc. and The Bank of New York (Incorporated by  reference to Exhibit 10.62 to dj Orthopedics, Inc.’s Report of Form 10-Q for  the quarter ended June 29, 2002)                                                                                                                                                                                                                                                                     |
| 10.24               |   | Amended and Restated  Employment Agreement dated as of July 11, 2002 among dj Orthopedics, LLC, dj  Orthopedics, Inc. and Cyril Talbot III (Incorporated by reference to Exhibit  10.64 of Post-Effective Amendment #1 to dj Orthopedics, Inc.’s Registration  Statement on Form S-1 (Reg. No. #333-74998))                                                                                                                                                                                                                                                                             |
| 10.25               |   | Amendment No. 2 to Credit Agreement, dated as of October 29, 2002  among dj Orthopedics, Inc., dj Orthopedics, LLC, Wachovia Bank, National  Association, and JPMorgan Chase Bank (Incorporated by reference to dj  Orthopedics, Inc.’s Report of Form 10-Q for the quarter ended September 28,  2002)                                                                                                                                                                                                                                                                                  |
| 10.26               |   | Outsourcing Agreement, dated as of December 30, 2002 by and between  Creditek MediFinancial, Inc. and dj Orthopedics, LLC (Incorporated by  reference to dj Orthopedics, Inc.’s Report of Form 10-K for the year ended  December 31, 2002)                                                                                                                                                                                                                                                                                                                                              |
| 10.27               |   | Amendment No. 3 to Credit Agreement, dated as of February 14, 2003  among dj Orthopedics, Inc., dj Orthopedics, LLC, Wachovia Bank, National  Association, and JPMorgan Chase Bank (Incorporated by reference to dj  Orthopedics, Inc.’s Report of Form 10-K for the year ended December 31, 2002)                                                                                                                                                                                                                                                                                      |
| 10.28               |   | The Asset Purchase Agreement, dated June 18, 2003, by and between  Dura*Kold Corporation and the Company (Incorporated by reference to dj  Orthopedics, Inc.’s Report of Form 10-Q for the quarter ended June 28, 2003)                                                                                                                                                                                                                                                                                                                                                                 |
| 10.29               |   | Amendment Number One to the DJ Orthopedics, Inc. 2001 Non-Employee  Director Stock Option Plan, dated May 29, 2003 (Incorporated by reference to  dj Orthopedics, Inc.’s Report of Form 10-Q for the quarter ended June 28,  2003)                                                                                                                                                                                                                                                                                                                                                      |
| 10.30               |   | Non-exclusive License and Settlement Agreement by and between  Generation II Orthopedics Inc. and Generation II USA Inc. and the Company  entered into on May 29, 2003 (Incorporated by reference to dj Orthopedics,  Inc.’s Report of Form 10-Q for the quarter ended June 28, 2003)                                                                                                                                                                                                                                                                                                   |

 

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| **Exhibit  Number** |   | **Description**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
|---------------------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.31               |   | Asset Purchase Agreement, dated October 8, 2003, by and between  OrthoLogic Corp. and the Company (Incorporated by reference to dj  Orthopedics, Inc.’s Report of Form 10-Q for the quarter ended September 27,  2003)                                                                                                                                                                                                                                                                                                                 |
| 10.32               |   | Credit Agreement among dj Orthopedics, LLC, as borrower, dj  Orthopedics, Inc., the lenders named thereto, Wachovia Bank, National  Association, as Administrative Agent, Wells Fargo Bank, National Association,  as  Syndication Agent, and Bank of America, N.A., Bank of the West and  Union Bank of California, N.A., as Documentation Agents for $130,000,000  Senior Secured Credit Facilities, dated as of November 26, 2003 (Incorporated  by reference to dj Orthopedics, Inc.’s Report of Form 8-K dated December 3,  2003) |
| 10.33*              |   | Amendment Number One to Outsourcing Agreement, dated December 12,  2003 by and between Creditek MediFinancial, Inc. and dj Orthopedics, LLC.                                                                                                                                                                                                                                                                                                                                                                                                |
| 10.34*+             |   | Sales Representative Agreement, dated August 18, 2000, between dj  Orthopedics LLC (successor to OrthoLogic Corp. with respect to this  agreement) and DePuy Spine, Inc. (formally known as DePuy AcroMed, Inc.).                                                                                                                                                                                                                                                                                                                           |
| 10.35*+             |   | Amendment to Sales Representative Agreement, dated March 1, 2002,  between dj Orthopedics LLC (successor to OrthoLogic Corp. with respect to  this agreement) and DePuy Spine, Inc. (formally known as DePuy AcroMed,  Inc.).                                                                                                                                                                                                                                                                                                               |
| 10.36*+             |   | Amendment No. 3 to Sales Representative Agreement, dated September  15, 2003, between dj Orthopedics LLC (successor to OrthoLogic Corp. with  respect to this agreement) and DePuy Spine, Inc. (formally known as DePuy  AcroMed, Inc.).                                                                                                                                                                                                                                                                                                    |
| 12.1*               |   | Statement re: Computation of Ratio of Earnings to Fixed Charges                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| 21.1*               |   | Subsidiaries of the Registrant                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 23.1*               |   | Consent of Ernst & Young LLP, Independent Auditors                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
| 31.1*               |   | Certification of Chief Executive Officer pursuant to Rule 13a-14(a)  and Rule 15d-14(a) of the Securities Exchange Act, as amended.                                                                                                                                                                                                                                                                                                                                                                                                         |
| 31.2*               |   | Certification of Chief Financial Officer pursuant to Rule 13a-14(a)  and Rule 15d-14(a) of the Securities Exchange Act, as amended.                                                                                                                                                                                                                                                                                                                                                                                                         |
| 32.0*               |   | Certification of Chief Executive Officer and Chief Financial Officer  Pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                                                                                                                                    |

 

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* Filed herewith

+ Confidential treatment hasbeen requested with respect to portions of this exhibit.

 

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