DJO Opco (DJO) 10-Q 2006 Q3 Quarterly report

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark one)

xQUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2006

OR

oTRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE TRANSITION PERIOD FROM________TO________.

Commission File Number 001-16757

DJO INCORPORATED

(Exact name of registrant as specified in its charter)

DELAWARE	33-0978270
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification Number)

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

Registrant’s telephone number, including area code: (760) 727-1280

Not Applicable

(Former name, former address and former fiscal year, if changed, since last report)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for 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 x   No o

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

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

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

Yes o   No x

The number of shares of the registrant’s Common Stock outstanding at November 3, 2006 was 23,056,343 shares.

DJO INCORPORATED
FORM 10-Q INDEX

PART I.	FINANCIAL INFORMATION
Item 1.	Financial Statements
	Unaudited Consolidated Balance Sheets as of September 30, 2006 and December 31, 2005
	Unaudited Condensed Consolidated Statements of Income for the three and nine months ended September 30, 2006 and October 1, 2005
	Unaudited Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2006 and October 1, 2005
	Notes to Unaudited Condensed Consolidated Financial Statements
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3.	Quantitative and Qualitative Disclosures About Market Risk
Item 4.	Controls and Procedures
PART II.	OTHER INFORMATION
Item 1.	Legal Proceedings
Item 1A.	Risk Factors
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds
Item 3.	Defaults Upon Senior Securities
Item 4.	Submission of Matters to a Vote of Security Holders
Item 5.	Other Information
Item 6.	Exhibits
SIGNATURES

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PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

DJO INCORPORATED

UNAUDITED CONSOLIDATED BALANCE SHEETS
(In thousands, except share and par value data)

	September 30, 2006		December 31, 2005
Assets
Current assets:
Cash and cash equivalents	$	3,657	$	1,107
Accounts receivable, net of provisions for contractual allowances and doubtful accounts of $35,602 and $26,792 at September 30, 2006 and December 31, 2005, respectively	92,286		62,068
Inventories, net	41,123		24,228
Deferred tax asset, net, current portion	7,678		7,066
Prepaid expenses and other current assets	12,638		4,387
Total current assets	157,382		98,856
Property, plant and equipment, net	39,751		15,396
Goodwill	279,167		101,235
Intangible assets, net	164,988		51,242
Debt issuance costs, net	5,842		2,479
Deferred tax asset, net	14,545		32,437
Other assets	4,611		3,019
Total assets	$	666,286	$	304,664
Liabilities and stockholders’ equity
Current liabilities:
Accounts payable	$	17,289	$	10,270
Accrued compensation	17,631		6,310
Accrued commissions	4,152		3,483
Long-term debt, current portion	3,500		5,000
Accrued interest	4,070		385
Accrued restructuring costs	—		417
Accrued taxes	4,508		550
Other accrued liabilities, current portion	22,625		9,680
Total current liabilities	73,775		36,095
Long-term debt, less current portion	330,750		42,500
Accrued pension	332		—
Other accrued liabilities, long-term	4,439		—
Commitments and contingencies
Stockholders’ equity:
Preferred stock, $0.01 par value; 1,000,000 shares authorized, none issued and outstanding at September 30, 2006 and December 31, 2005	—		—
Common stock, $0.01 par value; 39,000,000 shares authorized, 23,024,694 shares and 22,137,860 shares issued and outstanding at September 30, 2006 and December 31, 2005, respectively	230		221
Additional paid-in-capital	152,612		133,656
Accumulated other comprehensive income	816		492
Retained earnings	103,332		91,700
Total stockholders’ equity	256,990		226,069
Total liabilities and stockholders’ equity	$	666,286	$	304,664

See accompanying Notes.

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DJO INCORPORATED

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(In thousands, except per share data)

	Three Months Ended						Nine Months Ended
	September 30, 2006			October 1, 2005			September 30, 2006			October 1, 2005
Net revenues	$	113,205		$	72,133		$	302,293		$	211,210
Costs of goods sold	45,340			26,501			119,961			77,295
Gross profit	67,865			45,632			182,332			133,915
Operating expenses:
Sales and marketing	33,398			21,286			92,375			64,058
General and administrative	13,075			7,679			35,709			22,179
Research and development	2,580			1,486			6,745			4,749
Amortization of acquired intangibles	4,510			1,255			10,651			3,560
Total operating expenses	53,563			31,706			145,480			94,546
Income from operations	14,302			13,926			36,852			39,369
Interest expense, net of interest income	(6,284		)	(983		)	(15,684		)	(3,445		)
Other income (expense), net	439			(383		)	254			(821		)
Income before income taxes	8,457			12,560			21,422			35,103
Provision for income taxes	(4,098		)	(5,024		)	(9,790		)	(14,041		)
Net income	$	4,359		$	7,536		$	11,632		$	21,062
Net income per share:
Basic	$	0.19		$	0.34		$	0.51		$	0.97
Diluted	$	0.18		$	0.33		$	0.50		$	0.93
Weighted average shares outstanding used to calculate per share information:
Basic	22,968			21,845			22,620			21,722
Diluted	23,598			22,761			23,330			22,613

See accompanying Notes.

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DJO INCORPORATED
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)

	Nine Months Ended
	September 30, 2006			October 1, 2005
Operating activities
Net income	$	11,632		$	21,062
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for contractual allowances and doubtful accounts	30,146			24,712
Provision for excess and obsolete inventories	1,167			285
Depreciation and amortization	18,645			9,865
Step-up to fair value of inventory charged to costs of goods sold	1,498			305
Amortization of debt issuance costs	618			420
Write-off of debt issuance costs	2,347			—
Stock-based compensation	6,836			—
Other	47			189
Changes in operating assets and liabilities, net	(35,927		)	(24,371		)
Net cash provided by operating activities	37,009			32,467
Investing activities
Purchases of property, plant and equipment	(12,485		)	(3,627		)
Purchase of businesses, net of cash acquired	(313,634		)	(12,536		)
Changes in other assets, net	(958		)	(1,308		)
Net cash used in investing activities	(327,077		)	(17,471		)
Financing activities
Proceeds from long-term debt	366,000			8,000
Repayment of long-term debt	(79,250		)	(38,250		)
Debt issuance costs	(6,328		)	(665		)
Net proceeds from issuance of common stock	12,020			4,143
Proceeds from repayment of notes receivable issued in connection with sale of common stock	—			1,749
Net cash provided by (used in) financing activities	292,442			(25,023		)
Effect of exchange rate changes on cash and cash equivalents	176			(78		)
Net increase (decrease) in cash and cash equivalents	2,550			(10,105		)
Cash and cash equivalents at beginning of period	1,107			11,182
Cash and cash equivalents at end of period	$	3,657		$	1,077

See accompanying Notes.

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DJO INCORPORATED
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(In thousands, except share and per share data)

1.  General

Business and Organization

DJO Incorporated, formerly dj Orthopedics, Inc., (the Company) is a global provider of solutions for musculoskeletal and vascular health, specializing in rehabilitation and regeneration products for the non-operative orthopedic, spine and vascular markets.

Basis of Presentation

The accompanying unaudited condensed consolidated financial statements as of September 30, 2006 and for the three and nine months ended September 30, 2006 and October 1, 2005 have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information. Accordingly, they do not include all of the information and disclosures required by accounting principles generally accepted in the United States for complete financial statements. These consolidated financial statements should be read in conjunction with the audited consolidated financial statements of the Company and the notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2005. The accompanying unaudited condensed consolidated financial statements as of September 30, 2006 and for the three and nine months ended September 30, 2006 and October 1, 2005 have been prepared on the same basis as the audited consolidated financial statements and include all adjustments (consisting of normal recurring accruals and the adjustments described in Note 3) which, in the opinion of management, are necessary for a fair presentation of the financial position, operating results and cash flows for the interim date and interim periods presented. Results for the interim periods are not necessarily indicative of the results to be achieved for the entire year or future periods.

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

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

The Company’s fiscal year ends on December 31. Each quarter consists of one five-week and two four-week periods.

Cash Equivalents

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

Financial Instruments

The Company utilizes derivative instruments, specifically an interest rate swap agreement and forward contracts, to manage its exposure to market risks such as interest and foreign currency exchange rate risks.  In accordance with the Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards (SFAS) No. 133, Accounting for Derivative Instruments and

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Hedging Activities, the Company records derivative instruments as assets or liabilities in the consolidated balance sheet, measured at fair value.

Accrued Pension

The Company assumed liabilities related to certain pension plans in connection with the acquisition of Aircast Incorporated in April 2006.  The pension plans cover three international employees of the Company who are entitled to pension benefits as part of the terms of their employment agreements.  The accrued pension costs were $0.3 million as of September 30, 2006.

Per Share Information

Earnings per share are computed in accordance with SFAS No. 128, Earnings Per Share. Basic earnings per share are computed using the weighted average number of common shares outstanding during each period. Diluted earnings per share include the dilutive effect of weighted average common share equivalents potentially issuable upon the exercise of stock options. For purposes of computing diluted earnings per share, weighted average common share equivalents (computed using the treasury stock method) do not include stock options with an exercise price that exceeds the average fair market value of the Company’s common stock during the periods presented. The weighted average shares outstanding used to calculate basic and diluted share information consist of the following (in thousands):

	Three Months Ended		Nine Months Ended
	September 30, 2006	October 1, 2005	September 30, 2006	October 1, 2005
Shares used in computations of basic net income per share—weighted average shares outstanding	22,968	21,845	22,620	21,722
Net effect of dilutive common share equivalents based on treasury stock method	630	916	710	891
Shares used in computations of diluted net income per share	23,598	22,761	23,330	22,613

Stock-Based Compensation

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

As of January 1, 2006, the Company began recording compensation expense associated with stock options and other equity-based compensation in accordance with SFAS No. 123(R), using the modified prospective transition method and therefore has not restated results for prior periods.  Under the modified prospective transition method, stock-based compensation expense for the first quarter of 2006 includes: 1) compensation expense for all stock-based awards granted on or after January 1, 2006 as determined based on the grant date fair value estimated in accordance with the provisions of SFAS No. 123(R) and 2) stock-based compensation awards granted prior to, but not yet vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS No. 123.  The Company recognizes these compensation costs on a straight-line basis over the requisite service period of the award, which is generally four years.  As a result of the adoption of SFAS No. 123(R), the Company’s net income for the three and nine months ended September 30, 2006, has been reduced by stock-based compensation expense, net of taxes, of approximately $2.3 million and $5.3 million, respectively.  See Note 8 for additional information regarding stock-based compensation.

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Recently Issued Accounting Standards

In July 2006, the FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes—an interpretation of SFAS No. 109, (FIN 48), which prescribes a recognition threshold and measurement process for recording in the financial statements uncertain tax positions taken or expected to be taken in a tax return. Additionally, FIN 48 provides guidance on the derecognition, classification, accounting in interim periods and disclosure requirements for uncertain tax positions. FIN 48 is effective for fiscal years beginning after December 15, 2006. The Company is in the process of determining the effect, if any, the adoption of FIN 48 will have on its financial statements.

Foreign Currency Translation

The financial statements of the Company’s international subsidiaries, where the local currency is the functional currency, are translated into U.S. dollars using period-end exchange rates for assets and liabilities and average exchange rates during the period for revenues and expenses. Cumulative translation gains and losses are excluded from results of operations and recorded as a separate component of consolidated stockholders’ equity. Gains and losses resulting from foreign currency transactions (transactions denominated in a currency other than the entity’s local currency) are included in the consolidated statements of income as either a component of costs of goods sold or other income or expense, depending on the nature of the transaction. The Company incurred an aggregate foreign currency transaction gain in both the three and nine months ended September 30, 2006 of approximately $0.4 million.  The aggregate foreign currency transaction loss included in determining net income for the three and nine months ended October 1, 2005 was $0.1 million and $0.5 million, respectively.

2.  Financial Statement Information

Inventories consist of the following (in thousands):

	September 30, 2006			December 31, 2005
Raw materials	$	11,437		$	7,335
Work-in-progress	858			1,010
Finished goods	31,544			18,203
	43,839			26,548
Less reserves, primarily for excess and obsolete inventories	(2,716		)	(2,320		)
Inventories, net	$	41,123		$	24,228

Prepaid expenses and other current assets consist of the following (in thousands):

	September 30, 2006		December 31, 2005
Held-for-sale assets	$	4,221	$	—
Prepaid expenses	4,744		2,992
Other current assets	3,673		1,395
Prepaid expenses and other current assets, net	$	12,638	$	4,387

Held-for-sale assets consists of the former Aircast headquarters building, land and certain furniture which was sold in October 2006 (see Note 10).

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Other accrued liabilities, current portion, consists of the following (in thousands):

	September 30, 2006		December 31, 2005
Deferred rent, current portion	$	424	$	250
Accrued product costs	5,859		3,114
Other accrued liabilities, current portion	16,342		6,316
Other accrued liabilities, current portion, net	$	22,625	$	9,680

Other accrued liabilities, long-term, consists of the following (in thousands):

	September 30, 2006		December 31, 2005
Deferred rent, long-term	$	3,242	$	—
Fair value of interest rate swap	1,197		—
Other accrued liabilities, long-term, net	$	4,439	$	—

Deferred rent relates primarily to the Company’s new headquarters in Vista, California (see Note 9).

3. Acquisitions

Aircast Acquisition

On April 7, 2006, the Company completed the acquisition, under an agreement signed on February 27, 2006, of all the outstanding capital stock of Aircast Incorporated (Aircast) for approximately $291.6 million in cash, funded with the proceeds of a new credit agreement as described in Note 6.  The Company also incurred approximately $4.8 million in transaction costs and other expenses in connection with the acquisition and accrued approximately $9.8 million of estimated costs in connection with the Company’s plan to integrate the acquired business, including severance and relocation expenses. Of this total estimated amount, approximately $8.4 million is related to severance and retention payments that had not been paid out as of September 30, 2006.  This amount is included in accrued compensation in the accompanying unaudited consolidated balance sheet at September 30, 2006. Aircast is a leading designer and manufacturer of ankle and other orthopedic bracing products, cold therapy products and vascular therapy systems.

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The fair values of the assets acquired and the liabilities assumed in connection with the Aircast acquisition were estimated in accordance with SFAS No. 141, Business Combinations and SFAS No. 142, Goodwill and Other Intangible Assets. The Company used a third-party valuation firm to assist management in estimating these fair values. The purchase price was allocated as follows to the fair values of the net tangible and intangible assets acquired, including the cumulative impact of adjustments made to such allocations through September 30, 2006:

Fair value of net tangible assets acquired and liabilities assumed (in thousands):
Cash	$	508
Accounts receivable, net	12,953
Inventories, net	8,251
Prepaid expenses and other current assets	2,730
Fixed assets, net	17,907
Deferred tax asset	2,817
Other assets	33
Accounts payable	(3,134		)
Accrued compensation	(986		)
Deferred tax liability	(10,335		)
Other accrued liabilities	(8,026		)
Accrued pension	(300		)
				22,418
Fair value of identifiable intangible assets acquired:
Patents and existing technology	28,700
Customer contracts and related relationships — GPO	6,900
Customer contracts and related relationships — Other	38,300
Trade names and trademarks	47,400
Favorable leasehold interest in Germany	600
				121,900
Goodwill				161,906
Total purchase price allocation				$	306,224

The identifiable intangible assets are being amortized over their estimated useful lives, which range from seven to fifty years.

The purchase price allocation included values assigned to certain specific identifiable intangible assets aggregating $121.9 million. An aggregate value of $28.7 million was assigned to patents and existing technology, determined primarily by estimating the present value of future royalty costs that will be avoided due to the Company’s ownership of the patents and technology acquired. An aggregate value of $6.9 million was assigned to certain Aircast customer relationships for group purchase organization (GPO) customers and an aggregate value of $38.3 million was assigned to certain Aircast customer relationships for other customers existing on the acquisition date based upon an estimate of the future discounted cash flows that would be derived from those GPO and other customers. A value of $47.4 million was assigned to trade names and trademarks, determined primarily by estimating the present value of future royalty costs that will be avoided due to the Company’s ownership of the trade names and trademarks acquired.  A value of $0.6 million was assigned to favorable leasehold interest in Germany, determined by estimating the present value of future rent expense that will be avoided due to the favorable lease rate on the German property.  A value of $161.9 million, representing the difference between the total purchase price and the aggregate fair values assigned to the net tangible assets acquired and liabilities assumed and the identifiable intangible assets acquired, was assigned to goodwill.

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

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The accompanying consolidated statements of income reflect the operating results of the Aircast business since April 7, 2006.  Assuming the acquisition of Aircast had occurred on January 1, 2006, the pro forma unaudited results of operations would have been as follows (in thousands):

	Nine Months Ended
	September 30, 2006
Net revenues	$	327,215
Net income	$	9,626
Net income per share:
Basic	$	0.43
Diluted	$	0.41
Weighted average shares outstanding used to calculate per share information:
Basic	22,620
Diluted	23,330

The above pro forma unaudited results of operations do not include pro forma adjustments relating to costs of integration or post-integration cost reductions that might have been incurred or realized by the Company in excess of actual amounts incurred or realized through September 30, 2006.

Axmed Acquisition

On January 2, 2006, the Company completed the acquisition, under an agreement originally signed on December 15, 2005, of the shares of Newmed SAS (Axmed) for cash payments aggregating 13 million Euros (approximately $15.5 million), which included payment of certain debts of Axmed.  Certain sellers may also receive up to an additional 1.1 million Euros (approximately $1.3 million) based on achievement of certain revenue targets for 2006 and profitability targets for the second half of 2006. The Company included approximately 1.0 million Euros of such future earn-out in the allocation of the original purchase price, as shown below, based on the expectation that the 2006 revenue targets will be met.  The Company also incurred $0.4 million in certain transaction costs and other expenses in connection with the acquisition.  Axmed, through wholly owned subsidiaries in France and Spain, operating under the trade name Axmed, is engaged in the design, manufacture and sale of orthopedic rehabilitation devices, including rigid knee braces and soft goods. Axmed also owned 70% of a manufacturing subsidiary in Tunisia, which provides low cost manufacturing capabilities to the Axmed group. In May 2006, the Company purchased the minority stockholders’ proportionate share of the net assets of the Company’s subsidiary in Tunisia for approximately $0.5 million and the Tunisian subsidiary became a wholly owned subsidiary.

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The fair values of the assets acquired and the liabilities assumed in connection with the Axmed acquisition were estimated in accordance with SFAS No. 141, Business Combinations and SFAS No. 142, Goodwill and Other Intangible Assets. The Company used a third-party valuation firm to assist management in estimating these fair values. The total purchase price, including the amount paid to acquire the minority interest, was allocated as follows to the fair values of the net tangible and intangible assets acquired, including the cumulative impact of adjustments made to such allocations through September 30, 2006:

Fair value of net tangible assets acquired and liabilities assumed (in thousands):
Cash	$	103
Accounts receivable, net	1,642
Inventories, net	2,573
Other current assets	312
Fixed assets, net	691
Other assets	47
Accounts payable	(3,436		)
Accrued compensation	(488		)
Deferred tax liability	(1,422		)
Other accrued liabilities	(498		)
				(476		)
Fair value of identifiable intangible assets acquired:
Customer relationships	2,800
Existing technology	1,000
Trade names and trademarks	100
				3,900
Goodwill				14,205
Total purchase price allocation				$	17,629

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

The purchase price allocation included values assigned to certain specific identifiable intangible assets aggregating $3.9 million. An aggregate value of $2.8 million was assigned to certain Axmed customer relationships existing on the acquisition date based upon an estimate of the future discounted cash flows that would be derived from those customers. A value of $1.0 million was assigned to existing technology, determined primarily by estimating the present value of future royalty costs that will be avoided due to the Company’s ownership of the technology acquired. A value of $0.1 million was assigned to trade names and trademarks, determined primarily by estimating the present value of future royalty costs that will be avoided due to the Company’s ownership of the trade names and trademarks acquired.  A value of $14.2 million, representing the difference between the total purchase price, including the amount paid to acquire the remaining minority interest, and the aggregate fair values assigned to the net tangible assets acquired and liabilities assumed and the identifiable intangible assets acquired, was assigned to goodwill.

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

Future amortization expense of the Company’s net intangible assets, including those acquired in the Axmed and Aircast acquisitions, is estimated to be $165.0 million, as follows: remainder of 2006-$5.1 million, 2007-$19.7 million, 2008-$18.8 million, 2009-$17.7 million, 2010-$17.6 million and thereafter-$86.1 million.

Purchase of Rights to Distributor Territories

From time to time the Company purchases rights to certain distributor territories in the U.S. and then sells the distribution rights to another party for similar amounts.  These distribution reorganizations are intended to achieve several objectives, including improvement of sales results within the affected territories.  The Company generally receives promissory notes for the resale amounts, which are recorded as notes receivable and included in other current and long-term assets in the accompanying unaudited consolidated

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balance sheet.  For the nine months ended September 30, 2006, the Company purchased and resold territory rights for amounts aggregating $3.3 million and did not record any material gains or losses from the transfer of these distribution rights. 

4.  Accrued Restructuring Costs

Accrued restructuring costs in the accompanying unaudited consolidated balance sheet at December 31, 2005, consisted of $0.4 million of lease termination and other exit costs remaining from an amount accrued in 2002.  This amount related to vacant land leased by the Company and was netted against other costs accounted for as deferred rent at September 30, 2006 (see Note 9).

5.  Comprehensive Income

Comprehensive income consists of the following components (in thousands):

	Three Months Ended					Nine Months Ended
	September 30, 2006			October 1, 2005		September 30, 2006			October 1, 2005
Net income, as reported	$	4,359		$	7,536	$	11,632		$	21,062
Foreign currency translation adjustment	(53		)	19		1,521			(416		)
Change in fair value of interest rate swap	(2,208		)	—		(1,197		)	—
Comprehensive income	$	2,098		$	7,555	$	11,956		$	20,646

6.  Long-Term Debt

New Credit Agreement and Interest Rate Swap Agreement

On April 7, 2006, the Company entered into a new credit agreement with a syndicate of lenders and with Wachovia Bank, National Association, as administrative agent, to finance the Aircast acquisition described in Note 3 and provide available financing for future Company operations. The new credit agreement provided for total borrowings of $400 million, consisting of a term loan of $350 million, which was fully drawn at closing and up to $50 million available under a revolving credit facility. As of September 30, 2006, the balance outstanding under the term loan was $334.3 million and $47.8 million was available under the revolving credit facility, net of outstanding letters of credit.  The new credit agreement replaced the Company’s previously existing credit agreement and approximately $46.3 million of debt outstanding under the former agreement was paid off by the new agreement.  Under the new credit agreement, up to $25 million of outstanding borrowings may be denominated in British Pounds or Euros.

Borrowings under the new term loan and on the new revolving credit facility bear interest at variable rates (either a LIBOR rate or the lenders’ base rate, as elected by the Company) plus a margin. Under the new agreement, the interest rate for the term loan is LIBOR plus a margin of 1.50%, or the lenders’ base rate plus a margin of 0.50%.  The applicable margin on the revolving credit facility varies based on the Company’s leverage ratio.  The interest rate for the revolving credit facility is LIBOR plus an applicable margin of 1.25% to 2.00%, or the lenders’ base rate plus an applicable margin of 0.25% to 1.00%.  At the Company’s current leverage ratio, the applicable interest rate on the revolving credit facility is either LIBOR plus 1.75% or the lender’s base rate plus 0.75%. In connection with the new credit agreement, the Company entered into an interest rate swap agreement for a notional amount of $250 million of the term loan.

Interest Rate Swap Agreement. On April 11, 2006, the Company entered into an interest rate swap agreement with Wachovia Bank which converts the variable LIBOR rate to a fixed LIBOR rate of 5.29% for a term of five years.  Accordingly, with respect to a notional amount of $250 million of the term loan, the Company’s interest rate is fixed at 6.79% (5.29% plus applicable margin of 1.50%) for the term of the swap.  The notional amount of $250 million is scheduled to amortize to zero over the term of the swap in proportion to expected future cash flows.  As of September 30, 2006, the outstanding notional amount of the interest rate swap was $250 million and the fair market value of the swap reflected a loss of approximately $1.2 million.  The Company’s interest rate swap qualifies as a cash flow hedge under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities.  In accordance with SFAS No. 133, the fair market value of the swap at September 30, 2006 was recorded as a long-term liability, with the change in such fair value accounted for as a reduction of accumulated other comprehensive income (loss) included in stockholders’ equity in the accompanying consolidated balance sheet.  The weighted average interest rate applicable to the Company’s borrowings as of September 30, 2006 was 6.81%.

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Repayment. The Company is required to make quarterly principal payments of $0.875 million on the term loan, beginning in June 2006. The balance of the term loan, if any, is due in full on April 7, 2013.  Any borrowings under the revolving credit facility are due in full on April 7, 2012. The Company is also required to make annual mandatory prepayments on the term loan in an amount equal to 50% of its excess cash flow if the Company’s ratio of total debt to consolidated EBITDA exceeds 2.50 to 1.00. Excess cash flow represents the Company’s net income adjusted for extraordinary gains or losses, depreciation, amortization and other non-cash charges, changes in working capital, changes in deferred revenues, payments for capital expenditures and permitted acquisitions and repayment of certain indebtedness.  In addition, the term loan is subject to mandatory prepayments in an amount equal to (a) 100% of the net cash proceeds of certain debt issuances by the Company; (b) 50% of the net cash proceeds of certain equity issuances by the Company if the Company’s ratio of total debt to consolidated EBITDA exceeds 2.50 to 1.00; (c) 100% of the net cash proceeds of certain insurance, condemnation awards or other compensation in respect to any casualty event; and (d) 100% of the net cash proceeds of certain asset sales or other dispositions of property by the Company, in each case subject to certain exceptions. 

Security; Guarantees. The Company’s obligations under the credit agreement are irrevocably guaranteed, jointly and severally, by the Company, all our current and future U.S. subsidiaries. In addition, the credit agreement and the guarantees thereunder are secured by substantially all of the Company’s U.S. assets, including real and personal property, inventory, accounts receivable, intellectual property and other intangibles.

Covenants. The credit agreement imposes certain restrictions on the Company, including restrictions on the ability to incur indebtedness, incur or guarantee obligations, prepay other indebtedness or amend other debt instruments, pay dividends 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 the Company and its subsidiaries, make capital expenditures, grant liens, sell assets and engage in certain other activities. The credit agreement requires the Company to maintain: a ratio of total debt to consolidated EBITDA of no more than 4.50 to 1.00 and gradually decreasing to 2.50 to 1.00 for the first quarter of 2010 and thereafter; and a ratio of consolidated EBITDA to fixed charges of at least 1.50 to 1.00.  Material violations of these covenants and restrictions, or the payment terms described above, can result in an event of default and acceleration of the entire indebtedness. The Company was in compliance with all covenants as of September 30, 2006.

Debt issuance costs. The Company capitalized debt issuance costs of approximately $6.3 million in association with the new credit agreement, which are being amortized over the term of the agreement.  Remaining debt issuance costs of $5.8 million, net of accumulated amortization, were included in the accompanying balance sheet at September 30, 2006.

Write-off of Debt Issuance Costs

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

7.  Segment and Related Information

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

Through the DonJoy sales channel, the Company sells its rehabilitation products utilizing a few of the Company’s direct sales representatives and a network of approximately 370 independent commissioned sales representatives who are employed by approximately 40 independent sales agents. These sales representatives are primarily dedicated to the sale of the Company’s products to orthopedic surgeons, podiatrists, orthopedic and prosthetic centers, hospitals, surgery centers, physical therapists, athletic trainers and other healthcare professionals.  Because certain of the DonJoy product lines require customer education on the application and use of the product, these sales representatives are technical specialists who receive extensive training both from the Company and the agent and use their expertise to help fit the patient with the product and assist the orthopedic professional in choosing the appropriate product to meet the patient’s needs. After a product order is received by a sales representative, the Company generally ships the product directly to the orthopedic professional and pays a sales commission to the agent. These commissions are reflected in sales and marketing expense in the Company’s consolidated financial statements.

Through the ProCare/Aircast sales channel, which is comprised of approximately 90 direct and independent representatives that manage over 310 dealers focused on primary and acute facilities, the Company sells its rehabilitation

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and vascular systems products to national third-party distributors, other regional medical supply dealers and medical product buying groups, generally at a discount from list prices. The majority of these products are soft goods which require little or no patient education. The distributors and dealers generally resell these products to large hospital chains, hospital buying groups, primary care networks and orthopedic physicians for use by the patients.

Through the OfficeCare sales channel, the Company maintains an inventory of rehabilitation products (mostly soft goods) on hand at orthopedic practices for immediate distribution to the patient. For these products, the Company arranges billing to the patient or third-party payor after the product is provided to the patient.  As of September 30, 2006, the OfficeCare program was located at over 1,000 physician offices throughout the United States.  The Company has contracts with over 700 third-party payors.

·Regeneration consists of the sale of the Company’s bone growth stimulation products in the United States.  The Company’s OL1000 product is sold through a combination of the DonJoy channel direct sales representatives and approximately 124 additional sales representatives dedicated to selling the OL1000 product, of which approximately 54 are employed by the Company. The Company’s SpinaLogic product is sold in the U.S. through a combination of direct sales representatives and sales agents, including DePuy Spine.  The Company’s Regeneration products are sold directly to the patient or to independent distributors.  The Company arranges billing to third-party payors or patients, for products sold directly to the patient.

·International consists of the sale of the Company’s products in foreign countries through wholly owned subsidiaries or independent distributors.  The Company sells its products in over 60 foreign countries, primarily in Europe, Canada, Japan and Australia.

Set forth below is net revenues, gross profit and operating income information for the Company’s reporting segments for the three and nine months ended September 30, 2006 and October 1, 2005 (in thousands).  This information excludes the impact of expenses not allocated to segments, which are comprised primarily of general corporate expenses.

	Three Months Ended						Nine Months Ended
	September 30, 2006			October 1, 2005			September 30, 2006			October 1, 2005
Net revenues:
Domestic rehabilitation	$	74,640		$	50,793		$	196,506		$	145,391
Regeneration	15,767			13,600			47,953			40,712
International	22,798			7,740			57,834			25,107
Consolidated net revenues	113,205			72,133			302,293			211,210
Gross profit:
Domestic rehabilitation	38,915			28,519			102,967			81,257
Regeneration	14,428			12,275			44,213			36,232
International	14,522			4,838			35,152			16,426
Consolidated gross profit	67,865			45,632			182,332			133,915
Income from operations:
Domestic rehabilitation	11,033			11,483			30,310			30,519
Regeneration	3,139			3,616			10,560			10,815
International	4,530			1,715			8,851			6,560
Income from operations of reportable segments	18,702			16,814			49,721			47,894
Expenses not allocated to segments	(4,400		)	(2,888		)	(12,869		)	(8,525		)
Consolidated income from operations	$	14,302		$	13,926		$	36,852		$	39,369
Number of operating days	63			63			191			192

The accounting policies of the reportable segments are the same as the accounting policies of the Company. The Company allocates resources and evaluates the performance of segments based on income from operations and therefore has not disclosed certain other items, such as interest, depreciation and amortization by segment. The Company does not allocate assets to reportable segments because a significant portion of assets are shared by the segments.

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For the three and nine months ended September 30, 2006 and October 1, 2005, the Company had no individual customer or distributor that accounted for 10% or more of total revenues.

Net revenues, attributed to the geographic location of the customer, were as follows (in thousands):

	Three Months Ended				Nine Months Ended
	September 30, 2006		October 1, 2005		September 30, 2006		October 1, 2005
United States	$	90,407	$	64,393	$	244,459	$	186,103
Europe	17,732		4,945		45,784		17,529
Other countries	5,066		2,795		12,050		7,578
Total consolidated net revenues	$	113,205	$	72,133	$	302,293	$	211,210

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

	September 30, 2006		December 31, 2005
United States	$	621,176	$	295,257
International	45,110		9,407
Total consolidated assets	$	666,286	$	304,664

8. Stock-Based Compensation

The Company has three stock option plans which provide for the issuance of options to employees, officers, directors and consultants:  the 2001 Omnibus Plan, the 1999 Option Plan and the 2001 Non-Employee Director’s Stock Option Plan (Stock Option Plans).  Eligible employees can also purchase shares of the Company’s common stock at 85% of its fair market value on either the first day or the last day, whichever reflects the lowest fair market price, of each six-month offering period under the Company’s Employee Stock Purchase Plan (ESPP).  Stock options granted under the Stock Option Plans have terms of up to ten years from the date of grant, and generally vest over a four-year period.  The expense recognized under SFAS No. 123(R) is recognized on a straight-line basis over the vesting period.  As of September 30, 2006, approximately 4.5 million shares were available for grant under the Stock Option Plans and 1.3 million shares were available for issuance under the ESPP.  Effective January 1, 2006, the benefits provided under the Stock Option Plans and the ESPP are considered stock-based compensation, subject to the provisions of SFAS No. 123(R).  For the three and nine months ended September 30, 2006, the application of SFAS No. 123(R) resulted in the following adjustments to amounts that would have been reported under previous accounting standards (in thousands): 

	Three Months Ended September 30, 2006									Nine Months Ended September 30, 2006
	Under Previous Accounting			SFAS No. 123(R) Adjustments			As Reported Under SFAS  No. 123(R)			Under Previous Accounting			SFAS No. 123(R) Adjustments			As Reported Under SFAS No. 123(R)
Costs of goods sold	$	44,462		$	308		$	44,770		$	118,703		$	688		$	119,391
Operating expenses:
Sales and marketing	32,052			1,222			33,274			89,076			3,175			92,251
General and administrative	11,965			1,015			12,980			33,069			2,545			35,614
Research and development	2,377			140			2,517			6,297			385			6,682
Income from operations	17,839			(2,685		)	15,154			44,497			(6,793		)	37,704
Provision for income taxes	(4,457		)	359			(4,098		)	(11,287		)	1,497			(9,790		)
Net income	6,685			(2,326		)	4,359			16,928			(5,296		)	11,632

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

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The fair value of each equity award is estimated on the date of grant using the Black-Scholes valuation model for option pricing using the assumptions noted in the following table.  Expected volatility rates are based on the historical volatility (using daily pricing) of the Company’s stock.  In accordance with SFAS No. 123(R), the Company reduces the calculated Black-Scholes value by applying a forfeiture rate, based upon historical pre-vesting option cancellations.  The expected term of options granted is estimated based on a number of factors, including the vesting term of the award, historical employee exercise behavior for both options that have run their course and outstanding options, the expected volatility of the Company’s stock and an employee’s average length of service.  The risk-free interest rate is determined based upon a constant U.S. Treasury security rate with a contractual life that approximates the expected term of the option award.

	Three Months Ended				Nine Months Ended
	September 30, 2006		October 1, 2005		September 30, 2006		October 1, 2005
Stock Option Plans:
Expected volatility	49.5	%	59.6	%	49.5	%	59.6	%
Risk-free interest rate	4.7	%	3.8	%	4.7	%	3.8	%
Forfeitures	7.5	%	7.5	%	7.5	%	7.5	%
Dividend yield	—		—		—		—
Expected term (in years)	3.7		3.7		3.7		3.7
Employee Stock Purchase Plan:
Expected volatility	31.0	%	61.7	%	38.0	%	61.7	%
Risk-free interest rate	5.2	%	2.5	%	4.9	%	2.5	%
Dividend yield	—		—		—		—
Expected term (in years)	0.5		0.5		0.5		0.5

The following table illustrates the pro forma effect on net income and earnings per share for the three and nine months ended October 1, 2005, under the disclosure only provisions of SFAS No. 123, as if the fair value method had been applied to all outstanding and unvested awards (in thousands, except per share amounts):

	Three Months Ended			Nine Months Ended
	October 1, 2005			October 1, 2005
Net income, as reported	$	7,536		$	21,062
Total stock-based employee compensation expense determined under fair value method for all option plans and stock purchase plan, net of related tax effects	(756		)	(5,198		)
Pro forma net income	$	6,780		$	15,864
Basic net income per share:
As reported	$	0.34		$	0.97
Pro forma	$	0.31		$	0.73
Diluted net income per share:
As reported	$	0.33		$	0.93
Pro forma	$	0.30		$	0.70

The following table summarizes option activity under all plans from December 31, 2005 through September 30, 2006:

	Number of Shares		Price per Share		Weighted Average Exercise Price per Share		Weighted Average Remaining Life in Years
Outstanding at December 31, 2005	3,143,083		$	2.97 - $31.81	$	18.22	7.8
Granted	—		N/A		N/A		N/A
Exercised	(578,986	)	2.97 -26.65		12.63		N/A
Cancelled/Expired/Forfeited	(89,725	)	4.05 -25.30		22.03		N/A
Outstanding at April 1, 2006	2,474,372		2.97 -31.81		19.39		7.8

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Granted	688,400		37.20 -39.40	39.04	9.8
Exercised	(155,540	)	2.97 -26.35	17.09	N/A
Cancelled/Expired/Forfeited	(35,750	)	21.38 -39.40	27.39	N/A
Outstanding at July 1, 2006	2,971,482		2.97 -39.40	23.97	8.1
Granted	37,500		36.57 -38.59	38.04	9.9
Exercised	(115,073	)	2.97 -27.75	10.21	N/A
Cancelled/Expired/Forfeited	(42,875	)	4.05 -39.40	21.80	N/A
Outstanding at September 30, 2006	2,851,034		2.97 -39.40	24.67	7.9
Exercisable at September 30, 2006	813,879		2.97 -28.83	18.35	6.9
Remaining reserved for grant at September 30, 2006	4,465,931

The aggregate intrinsic value of options outstanding at September 30, 2006 was approximately $48.1 million and the aggregate intrinsic value of options exercisable at September 30, 2006 was approximately $18.9 million.  The total intrinsic value of options exercised during the three and nine months ended September 30, 2006 was approximately $3.3 million and $20.4 million, respectively.  The weighted-average fair value per share for options that were not vested at December 31, 2005, not vested at April 1, 2006, vested during the three months ended April 1, 2006 and cancelled/expired/forfeited during the three months ended April 1, 2006, were $11.22, $11.48, $9.62 and $11.69, respectively  The weighted-average fair value per share for options that were not vested at December 31, 2005, not vested at July 1, 2006, vested during the three months ended July 1, 2006 and cancelled/expired/forfeited during the three months ended July 1, 2006, were $11.22, $26.26, $23.28 and $27.39, respectively.  The weighted average fair value per share for options that were not vested at December 31, 2005, not vested at September 30, 2006, vested during the three months ended September 30, 2006 and cancelled/expired/forfeited during the three months ended September 30, 2006, were $11.22, $27.20, $12.49 and $21.80, respectively. At September 30, 2006, there was approximately $23.0 million of compensation expense that has not yet been recognized related to non-vested stock-based awards.  That expense is expected to be recognized over a weighted-average period of 1.4 years.  During the three and nine months ended September 30, 2006, cash received from options exercised was $1.2 million and $11.1 million, respectively.

9.  Commitments and Contingencies

In late 2004, the Company entered into a lease agreement with Professional Real Estate Services, Inc. (PRES) under which PRES undertook to build a new 110,000 square foot corporate headquarters facility for the Company on vacant land in Vista, California.  The Company occupies the facility under a 15-year lease, which commenced in August 2006 upon completion of the facility, with two five-year options to extend the term.  The Company completed vacating its former facilities in Vista in October 2006.  Included in income from operations in the accompanying consolidated statements of income, the Company wrote-off the net book value of approximately $0.9 million of leasehold improvements for the former facilities in the third quarter of 2006. Rent expense for the new facility will be recorded on a straight-line basis over the lease term at approximately $1.9 million per year.

In February 2005, PRES purchased the Company’s former facilities as well as the real property underlying the new lease.  Effective on the purchase date, a lease for the vacant land on which the Company was previously obligated was terminated.  In connection with the new lease, the Company’s leases for its former Vista facilities were terminated early in August 2006.  Those leases would otherwise have continued until February 2008.  In August 2006, the Company made a lump sum rent payment to PRES of approximately $1.5 million, representing 40% of the rent that would have been due under the former facilities leases from the early termination date through the original expiration date. If PRES is able to lease the Company’s former facilities during what would have remained of the term of the Company’s existing leases, a portion of that sum may be refunded to the Company. This lump sum rent payment, net of a remaining $0.4 million accrual related to lease termination costs originally accrued in 2002 (see Note 4), will be accounted for as additional rent expense over the term of the new lease and is included in the annual rent expense amount noted above.

In connection with the new lease, the Company and PRES incurred costs of approximately $7.9 million related to negotiated tenant improvements and other improvements to the new facility.  This amount has been recorded as an addition to property and equipment and will be amortized over the 15 year lease term, in the amount of approximately $0.5 million per year.

The amounts paid by PRES for tenant improvements of approximately $3.9 million, net of the lump sum rent payment made by the Company and other costs aggregating $0.2 million, have been included in deferred rent at September 30, 2006 and are included in other accrued liabilities, current and long-term, in the accompanying consolidated balance sheet (see Note 2).

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From time to time, the Company is involved in lawsuits arising in the ordinary course of business. This includes patent and other intellectual property disputes between its various competitors and the Company, as well as ordinary course business disputes.  With respect to these matters, management believes that it has adequate insurance coverage or has made adequate accruals for related costs, and it may also have effective legal defenses. The Company completed an arbitration proceeding in the second quarter of 2006 involving a license agreement under which the Company produced and sold a brace for patella femoral dysfunction.  The inventors alleged that the Company had committed fraud and had breached the license agreement and the related covenant of good faith and fair dealing.  The arbitrator found that the Company did not commit fraud nor did it breach the covenant of good faith and fair dealing.  The arbitrator did find, however, that the Company had breached its obligation to make certain minimum royalty payments and patent expense payments for approximately three years and awarded damages to the complainants of approximately $0.5 million.  The Company also incurred legal fees related to this arbitration of approximately $0.2 million in the second quarter of 2006. The arbitrator’s decision is final and binding on the parties.

10.  Subsequent Event

In October 2006, the Company sold the former Aircast headquarters building, land and certain furniture for net proceeds of $4.2 million.  These assets were classified as held-for-sale at September 30, 2006 (see Note 2).  No gain or loss resulted from this transaction.

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ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion should be read in conjunction with our historical consolidated financial statements and the related notes thereto and the other financial data included in this Form 10-Q and in our Annual Report on Form 10-K for the year ended December 31, 2005.

Overview

We are a global provider of solutions for musculoskeletal and vascular health, specializing in rehabilitation and regeneration products for the non-operative orthopedic, spine and vascular markets.  Our broad range of over 700 rehabilitation products, including rigid knee braces, soft goods, and pain management products, are used in the prevention of injury, in the treatment of chronic conditions and for recovery after surgery or injury. Our regeneration products consist of bone growth stimulation devices that are used to treat nonunion fractures and as an adjunct therapy after spinal fusion surgery. Our vascular systems products help prevent deep vein thrombosis and pulmonary embolism that can occur after orthopedic and other surgeries. We sell our products in the United States and in more than 60 other countries through networks of agents, distributors and our direct sales force that market our products to orthopedic and spine surgeons, podiatrists, orthopedic and prosthetic centers, third-party distributors, hospitals, surgery centers, physical therapists, athletic trainers and other healthcare professionals. Our rigid knee braces, soft goods, pain management, regeneration and vascular systems products represented 23%, 50%, 8%, 16% and 3%, respectively, of our consolidated net revenues for the first nine months of 2006.

Segments

·Domestic Rehabilitation consists of the sale of our rehabilitation products (rigid knee braces, soft goods, pain management and vascular systems products) in the United States through three sales channels, DonJoy, ProCare/Aircast and OfficeCare.

Through the DonJoy sales channel, we sell our rehabilitation products utilizing a few of our direct sales representatives and a network of approximately 370 independent commissioned sales representatives who are employed by approximately 40 independent sales agents. These sales representatives are primarily dedicated to the sale of our products to orthopedic surgeons, podiatrists, orthopedic and prosthetic centers, hospitals, surgery centers, physical therapists, athletic trainers and other healthcare professionals.  Because certain of the DonJoy product lines require customer education on the application and use of the product, these sales representatives are technical specialists who receive extensive training both from us and the agent and use their expertise to help fit the patient with the product and assist the orthopedic professional in choosing the appropriate product to meet the patient’s needs. After a product order is received by a sales representative, we generally ship the product directly to the orthopedic professional and pay a sales commission to the agent. These commissions are reflected in sales and marketing expense in our consolidated financial statements.

Through the ProCare/Aircast sales channel, which is comprised of approximately 90 direct and independent representatives that manage over 310 dealers focused on primary and acute facilities, we sell our rehabilitation and vascular systems products to national third-party distributors, other regional medical supply dealers and medical product buying groups, generally at a discount from list prices. The majority of these products are soft goods which require little or no patient education. The distributors and dealers generally resell these products to large hospital chains, hospital buying groups, primary care networks and orthopedic physicians for use by the patients.

Through the OfficeCare sales channel, we maintain an inventory of rehabilitation products (mostly soft goods) on hand at orthopedic practices for immediate distribution to the patient. For these products, we arrange billing to the patient or third-party payor after the product is provided to the patient.  As of September 30, 2006, the OfficeCare program was located at over 1,000 physician offices throughout the United States.  We have contracts with over 700 third-party payors.

·Regeneration consists of the sale of our bone growth stimulation products in the United States.  Our OL1000 product is sold through a combination of the DonJoy channel direct sales representatives and approximately 124 additional sales representatives dedicated to selling the OL1000 product, of which approximately 54 are employed by us. The SpinaLogic product is sold in the U.S. through a combination of direct sales representatives and sales agents, including

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DePuy Spine.  These products are sold either directly to the patient or to independent distributors.  We arrange billing to third-party payors or patients, for products sold directly to the patient.

·International consists of the sale of our products in foreign countries through wholly owned subsidiaries or independent distributors.  We sell our products in over 60 foreign countries, primarily in Europe, Canada, Japan and Australia.

Our Strategy

Our strategy is to increase revenue and profitability and enhance cash flow by strengthening our market leadership position.  Our key initiatives to implement this strategy include:

·Increase our Lead in the Domestic Rehabilitation Market Segment. We believe we are the market leader in the Domestic Rehabilitation markets in which we compete. We believe we will be able to continue to grow our Domestic Rehabilitation business segment and increase our market share further by focusing on maintaining a continuous flow of new product introductions and continuing to enhance the productivity of our sales force and optimize our distribution strategy. Our key Domestic Rehabilitation growth strategies include the following:

- Continue to Introduce New Products and Product Enhancements.  We have a history of developing and introducing innovative products into the marketplace, and are committed to continuing that tradition by introducing new products across our product platform.  In the nine months ended September 30, 2006, we launched sixteen new products.  We believe that product innovation through effective and focused research and development will provide a sustainable competitive advantage.  We believe we are currently a technology leader in several product categories and we intend to continue to develop next generation technologies.

- Expand Our OfficeCare Channel.  Our OfficeCare channel currently includes over 1,000 physician offices encompassing over 4,000 physicians.  We believe that our OfficeCare channel serves a growing need among orthopedic practices to have a number of products readily available for immediate distribution to patients. Expanding our OfficeCare channel also permits us to increase our weighted-average selling prices, as the units sold through this channel are billed to insurance companies and other third-party payors at higher prices than most of our other sales channels.  Accordingly, our OfficeCare initiatives represent an opportunity for sales growth based on increases in both unit volume and average selling prices.  We intend to expand our OfficeCare channel into more “high-volume” orthopedic offices, thereby increasing the number of potential customers to whom we sell our products.  In the nine months ended September 30, 2006, we added approximately 126 new offices to our OfficeCare channel, net of account terminations. 

- Maximize Existing and Secure Additional National Accounts.  We plan to capitalize on the growing practice in healthcare in which hospitals and other large healthcare providers seek to consolidate their purchasing activities to national buying groups.  Contracts with these national accounts represent a significant opportunity for sales growth. We believe that our broad range of products is well suited to the goals of these buying groups and intend to aggressively pursue these contracts.  In the nine months ended September 30, 2006, we signed or renewed four significant national contracts; including a new three-year sole source contract with Consorta for all of our bracing and soft goods products, a new private label contract with Amerinet for our pain management and cold therapy products, a renewal of our sole source contract with Broadlane for all of our soft goods, bracing and cold therapy products, and a renewal of our multi-source agreement with Premier for all of our bracing, soft goods, cold therapy and bone stimulation products.  We successfully added Aircast products to each of these national contracts.

·Grow Our Regeneration Business. We have integrated the sales force for our OL1000 bone growth stimulator product into our domestic rehabilitation sales organization.  We have also increased the number of regeneration sales specialists dedicated to selling our OL1000 product.  We believe these specialists will be able to use the established relationships of our DonJoy sales representatives to enhance sales of the OL1000 product.  Our distribution arrangement with DePuy Spine has also become non-exclusive beginning in March 2006, which permits us to sell the SpinaLogic product directly or through other independent sales representatives in all territories where we choose to do so.  We have added additional selling resources in those geographical parts of the country where sales were not meeting our expectations.  We believe

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that our new selling strategies for our Regeneration segment will permit us to maintain or improve our growth in this business.

·Expand International Sales. Since 2002, we have successfully established direct distribution capabilities in several major international markets. We believe that sales to foreign markets continue to represent a significant growth opportunity and we intend to continue to develop direct distribution capabilities in selected additional foreign markets.  We also believe we can increase our international revenues by expanding the number of our products we sell in international markets.  Historically we have only sold a limited range of our products in our international markets.  Beginning in 2005, we began to focus on selling an expanded range of soft goods, our cold therapy products and our bone growth stimulation products in our International segment. In January 2006, we completed the acquisition of Newmed SAS (Axmed), as discussed in Note 3 to the unaudited condensed consolidated financial statements included in Part 1, Item 1, herein, which increased our international revenue in France and other parts of Europe. The Aircast acquisition (discussed below and in Note 3 to the unaudited condensed consolidated financial statements included in Part 1, Item 1, herein) also substantially increased our international revenues. For the three and nine months ended September 30, 2006, international sales increased to 20% and 19% of our revenues, respectively, increasing over historical levels (for the year ended December 31, 2005, international sales represented 12% of our international revenues).

·Pursue Selective Acquisitions. We believe that acquisitions represent an attractive and efficient means to broaden our product lines, expand our geographic reach and increase our revenue and profitability. We intend to pursue acquisition opportunities that enhance sales growth, are accretive to earnings, increase customer penetration and/or provide geographic diversity. Since the beginning of 2005, we have completed four acquisitions that meet this criteria:  our acquisition of substantially all of the assets of Superior Medical Equipment, LLC (SME acquisition) and our OSG acquisition, both of which were completed in 2005, as well as the acquisition of Axmed in January 2006 and the Aircast acquisition in April 2006, as discussed in Note 3 to the unaudited condensed consolidated financial statements included in Part 1, Item 1, herein.

Critical Accounting Policies and Estimates

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

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

Provisions for Contractual Allowances and Doubtful Accounts. We maintain provisions for contractual allowances for reimbursement amounts from our third-party payor customers based on negotiated contracts and historical experience for non-contracted payors. We also maintain provisions for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. We have contracts with certain third-party payors for our third-party reimbursement billings, which call for specified reductions in reimbursement of billed amounts based upon contractual reimbursement rates. For 2005 and for the first nine months of 2006, we reserved for and reduced gross revenues from third-party payors by between 30% and 38% for allowances related to these contractual reductions.  For our Regeneration business, we record revenue net of actual contractual allowances and discounts from our gross prices, which are determined on a specific identification basis and amount to approximately 31% to 38% of our gross prices for bone growth stimulation products. 

Our reserve for doubtful accounts is based upon estimated losses from customers who are billed directly and the portion of third-party reimbursement billings that ultimately become the financial responsibility of the end user patients. Direct-billed customers represented approximately 56% and 51% of our net accounts receivable at September 30, 2006 and December 31, 2005, respectively, and we have historically experienced write-offs of less than 2% of these accounts receivable. Our third-party reimbursement

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customers include all of the customers of our OfficeCare business segment, the majority of our Regeneration business segment and certain third-party payor customers of our DonJoy business segment, including insurance companies, managed care companies and certain governmental payors such as Medicare. Our third-party payor customers represented approximately 24% and 32% of our net revenues for the three months ended September 30, 2006 and October 1, 2005, respectively, approximately 27% and 32% of our net revenues for the nine months ended September 30, 2006 and October 1, 2005, respectively, and approximately 44% and 49% of our net accounts receivable at September 30, 2006 and December 31, 2005, respectively. We estimate bad debt expense to be approximately 4% to 10% of gross amounts billed to these third-party reimbursement customers. If the financial condition of our customers were to deteriorate resulting in an impairment of their ability to make payments or if third-party payors were to deny claims for late filings, incomplete information or other reasons, additional provisions may be required.

We rely on a third-party billing and collections service provider to provide information about the accounts receivable of certain of our third-party payor customers, including the data utilized to determine reserves for contractual allowances and doubtful accounts.  Based on information currently available to us, we believe we have provided adequate reserves for our third-party payor accounts receivable. If claims are denied, or amounts are otherwise not paid, in excess of our estimates, the recoverability of our net accounts receivable could be reduced by a material amount. In addition, if our third-party insurance billing and collections service provider does not perform to our expectations we may be required to increase our reserve estimates.

Reserves for Excess and Obsolete Inventories and Inventory Shrinkage.  We provide reserves for estimated excess or obsolete inventories equal to the difference between the cost of inventories on hand plus future purchase commitments and the estimated market value based upon assumptions about future demand.  If future demand is less favorable than currently projected by management, additional inventory write-downs may be required.  We also provide reserves for newer product inventories, as appropriate, based on any minimum purchase commitments and our level of sales of the new products. In addition, reserves for inventories on hand in our OfficeCare locations are provided based on historical shrinkage rates of approximately 16%.  If actual shrinkage rates differ from our estimated shrinkage rates, revisions to the reserve may be required.

Reserves for Rebates.  We offer rebates to certain of our distributors based on sales volume, sales growth and to reimburse the distributor for certain discounts. We record estimated reductions to revenue for customer rebate programs based upon historical experience and estimated revenue levels. 

Reserves for Returns and Warranties.  We provide reserves for the estimated costs of returns and product warranties at the time revenue is recognized based on historical trends.  While we engage in extensive product quality programs and processes, including actively monitoring and evaluating the quality of our suppliers, our actual returns and warranty costs could differ from our estimates.  If actual product returns, failure rates, material usage or service costs differ from our estimates, revisions to the estimated returns and/or warranty liabilities may be required.

Valuation Allowance for Deferred Tax Asset. As of September 30, 2006, we have approximately $22.2 million of net deferred tax assets on our balance sheet related primarily to tax deductible goodwill arising at the date of our reorganization in 2001 and not recognized for book purposes and net loss carryforwards, offset by approximately $10.5 million in deferred tax liabilities related to non-tax deductible intangible assets acquired in connection with the Aircast and Axmed stock acquisitions during 2006.  Realization of our net deferred tax assets is dependent on our ability to generate future taxable income prior to the expiration of our net operating loss carryforwards.  Our management believes that it is more likely than not that the deferred tax assets will be realized based on forecasted future taxable income.  However, there can be no assurance that we will meet our expectations of future taxable income.  Management will evaluate the realizability of the deferred tax assets on a quarterly basis to assess any need for valuation allowances. 

Goodwill and Other Intangibles. In 2002, Statement of Financial Accounting Standards No. 142, or SFAS No. 142, Goodwill and Other Intangible Assets became effective and as a result, we ceased amortization of goodwill.  In lieu of amortization, we are required to perform an annual review for impairment. Goodwill is considered to be impaired if we determine that the carrying value of the segment or reporting unit exceeds its fair value. At October 1, 2005, our goodwill was evaluated for impairment and we determined that no impairment existed at that date.  We believe that the goodwill acquired prior to our 2003 Regeneration acquisition benefits the entire enterprise and since our reporting units share the majority of our assets, we compared the total carrying value of our consolidated net assets (including goodwill) to our market capitalization. With respect to goodwill related to our acquisitions since the November 2003 Regeneration acquisition, we compare the carrying value of the goodwill related to each acquisition to the fair value of the acquired assets.

At December 31, 2005, 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 of certain acquired assets and liabilities is

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subjective in nature and often involves the use of significant estimates and assumptions.  Determining the fair values and useful lives of intangible assets requires the exercise of judgment.  Upon initially recording certain of our other intangible assets, including the intangible assets that were acquired in connection with the Regeneration, Axmed and Aircast acquisitions, we used independent valuation firms to assist us in determining the appropriate values for these assets.  Subsequently, we have used the same methodology and updated our assumptions.  While there are a number of different generally accepted valuation methods to estimate the value of intangible assets acquired, we primarily used the undiscounted cash flows expected to result from the use of the assets.  This method requires significant management judgment to forecast the future operating results used in the analysis.  In addition, other significant estimates are required such as residual growth rates and discount factors.  The estimates we have used are consistent with the plans and estimates that we use to manage our business and are based on available historical information and industry averages. 

The value of our goodwill and other intangible assets is exposed to future impairments if we experience future declines in operating results, if negative industry or economic trends occur or if our future performance is below our projections or estimates.

Stock-Based Compensation. As of January 1, 2006, we began recording compensation expense associated with stock options and other equity-based compensation in accordance with SFAS No. 123 (revised 2004), Share-Based Payment (SFAS No. 123(R)).   We adopted SFAS No. 123(R) using the modified prospective transition method and therefore we have not restated results for prior periods.  Under the modified prospective transition method, stock-based compensation expense for the first quarter of 2006 includes: 1) compensation expense for all stock-based awards granted on or after January 1, 2006 as determined based on the grant date fair value estimated in accordance with the provisions of SFAS No. 123(R) and 2) stock-based compensation awards granted prior to, but not yet vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS No. 123.  We recognize this compensation expense on a straight-line basis over the requisite service period of the award, which is generally four years.  As a result of the adoption of SFAS No. 123(R), our net income for the three and nine months ended September 30, 2006, has been reduced by compensation expense, net of taxes, of approximately $2.3 million and $5.3 million, respectively. 

Results of Operations

We operate our business on a manufacturing calendar, with our fiscal year always ending on December 31.  Each quarter is 13 weeks, consisting of one five-week and two four-week periods.  Our first and fourth quarters may have more or less operating days from year to year based on the days of the week on which holidays and December 31 fall.  The quarters ended September 30, 2006 and October 1, 2005 each included 63 days.  The nine months ended September 30, 2006 and October 1, 2005 included 191 days and 192 days, respectively.

Three Months Ended September 30, 2006 Compared To Three Months Ended October 1, 2005

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

	Three Months Ended
	September 30, 2006		% of Net Revenues	October 1, 2005		% of Net Revenues	Increase		% Increase
Domestic Rehabilitation	$	74,640	65.9	$	50,793	70.4	$	23,847	46.9
Regeneration	15,767		13.9	13,600		18.9	2,167		15.9
International	22,798		20.2	7,740		10.7	15,058		194.5
Consolidated net revenues	$	113,205	100.0	$	72,133	100.0	$	41,072	56.9

Net revenues in our Domestic Rehabilitation and Regeneration segments decreased as a percentage of total net revenues due to a proportionately higher increase in our International segment revenues related to the acquisitions of Aircast in April 2006 and Axmed in January 2006.  Net revenues in our Domestic Rehabilitation segment increased due to normal market growth in existing product lines, sales of new products, sales attributed to the Aircast acquisition, sales attributed to the OSG acquisition in August 2005, an increase in the number of units billed to third-party payors, which are sold at higher average selling prices, and growth in sales related to national contracts in our ProCare sales channel.  We have also gained incremental revenue from the addition of approximately 149 net new OfficeCare locations since October 1, 2005.  In addition, Domestic Rehabilitation net revenues for the three months ended September 30, 2006 included approximately $1.6 million related to a change in shipping terms for certain Aircast products from FOB destination to FOB shipping point and the shipment of certain products that were on backorder at the end of the second quarter of 2006 due to issues related to the integration of Aircast.  Net revenues in our Regeneration segment increased due to normal market growth, selling resources added for our SpinaLogic products in territories that became non-exclusive in 2006 and also

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increased due to an increased number of sales specialists selling our OL1000 product.  International net revenues increased in the third quarter of 2006 compared to the third quarter of 2005, due to the Aircast acquisition, the Axmed acquisition, increased sales volume due to market growth and the impact of favorable changes in foreign exchange rates.  In addition, International revenues for the three months ended September 30, 2006 included approximately $0.3 million related to the shipment of certain products that were on backorder at the end of the second quarter of 2006 due to issues related to the integration of Aircast. 

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

	Three Months Ended
	September 30, 2006		% of Net Revenues	October 1, 2005		% of Net Revenues	Increase		%  Increase
Domestic Rehabilitation	$	38,915	52.1	$	28,519	56.1	$	10,396	36.5
Regeneration	14,428		91.5	12,275		90.3	2,153		17.5
International	14,522		63.7	4,838		62.5	9,684		200.2
Consolidated gross profit	$	67,865	59.9	$	45,632	63.3	$	22,233	48.7

The increase in gross profit for the third quarter of 2006 compared to the third quarter of 2005 is due to incremental gross profit from an increase in revenues, offset by an increase in cost of goods sold due partly to $0.3 million of stock-based compensation expense associated with the adoption of SFAS No. 123(R) as of January 1, 2006 and approximately $1.7 million of certain other charges and expenses related to our recent acquisitions and the related integrations.  In addition, we incurred approximately $0.8 million of expenses related to our move to our new corporate headquarters in the three months ended September 30, 2006.  The decrease in consolidated gross profit as a percentage of net revenues is primarily due to these increased costs of goods sold.  The decrease in consolidated gross profit as a percentage of net revenues is also due to a change in product mix to include more lower gross profit margin soft goods due to the OSG, Axmed and Aircast acquisitions and increased costs related to freight and certain materials. Gross profit decreased as a percentage of net revenues in the Domestic Rehabilitation segment primarily due to a change in product mix to include more lower gross profit soft goods due to the OSG and Aircast acquisitions and increased freight costs.  The Regeneration segment gross profit increased as a percentage of revenues due to reduced costs of goods sold for these products and a higher mix of insurance sales, which have higher average selling prices and therefore generate higher gross profit margins than sales to wholesale customers.  The increase in the International segment gross profit as a percentage of net revenues is primarily related to a change in product mix.

Operating Expenses.  Set forth below is operating expense information (in thousands):

	Three Months Ended
	September 30, 2006		% of Net Revenues	October 1, 2005		% of Net Revenues	Increase		% Increase
Sales and marketing	$	33,398	29.5	$	21,286	29.5	$	12,112	56.9
General and administrative	13,075		11.5	7,679		10.6	5,396		70.3
Research and development	2,580		2.3	1,486		2.1	1,094		73.6
Amortization of acquired intangibles	4,510		4.0	1,255		1.7	3,255		259.4
Consolidated operating expenses	$	53,563	47.3	$	31,706	43.9	$	21,857	68.9

Sales and Marketing Expenses.  The increase in sales and marketing expenses is primarily due to $1.2 million of stock-based compensation expense associated with the adoption of SFAS No. 123(R) as of January 1, 2006 and the addition of expenses related to Axmed and Aircast which were acquired subsequent to October 1, 2005. The expenses related to Axmed and Aircast include approximately $0.4 million of expenses that are not deemed to be reflective of ongoing operations.  In addition, we incurred approximately $0.3 million of sales and marketing expenses related to our move to our new corporate headquarters in the three months ended September 30, 2006. Current period expenses also include increased commissions, bad debt and sales incentives on increased sales and costs associated with increased headcount.

General and Administrative Expenses. The increase in general and administrative expenses is primarily due to $1.0 million of stock-based compensation expense associated with the adoption of SFAS No. 123(R) as of January 1, 2006, the addition of expenses related to Axmed and Aircast which were acquired subsequent to October 1, 2005, as well as certain increased personnel costs. The expenses related to Axmed and Aircast include approximately $0.3 million of expenses that are not deemed to be reflective of ongoing

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operations.  In addition, we incurred approximately $0.2 million of general and administrative expenses related to our move to our new corporate headquarters in the three months ended September 30, 2006.

Research and Development Expenses. The increase in research and development expense is due to $0.1 million of stock-based compensation expense associated with the adoption of SFAS No. 123(R) as of January 1, 2006, the addition of expenses related to Axmed and Aircast and certain increased personnel costs.  In addition, we incurred approximately $0.2 million of research and development expenses related to our move to our new corporate headquarters in the three months ended September 30, 2006.

Amortization of Acquired Intangibles.  Amortization of acquired intangibles includes amortization expense related to intangible assets acquired in connection with the Regeneration acquisition, which are being amortized over lives ranging from four months to ten years, intangible assets acquired in connection with the Axmed acquisition, which are being amortized over lives ranging from one to nine years, and intangible assets acquired in connection with the Aircast acquisition which are being amortized over lives ranging from seven to 50 years.  The increase in amortization of acquired intangibles is due to amortization expense related to the January 2006 acquisition of Axmed and the April 2006 acquisition of Aircast.

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

	Three Months Ended
	September 30, 2006			% of Net Revenues		October 1, 2005			% of Net Revenues		Increase (Decrease)			% Increase (Decrease)
Domestic Rehabilitation	$	11,033		14.8		$	11,483		22.6		$	(450	)	(3.9	)
Regeneration	3,139			19.9		3,616			26.6		(477		)	(13.2	)
International	4,530			19.9		1,715			22.2		2,815			164.1
Income from operations of reportable segments	18,702			16.5		16,814			23.3		1,888			11.2
Expenses not allocated to segments	(4,400		)	(3.9	)	(2,888		)	(4.0	)	(1,512		)	52.4
Consolidated income from operations	$	14,302		12.6		$	13,926		19.3		$	376		2.7

The increase in income from operations for our Domestic Rehabilitation and International segments is due to increased net revenues and gross profit, partially reduced by increased operating expenses, including stock-based compensation expense associated with the adoption of SFAS No. 123(R) as of January 1, 2006 for each respective segment, purchase accounting adjustments to write up acquired inventories to fair value and certain other costs and expenses incurred in connection with our recent acquisitions.  The decrease in income from operations for our Regeneration segment is due to stock-based compensation expense associated with the adoption of SFAS No. 123(R) as of January 1, 2006.

Interest Expense, Net of Interest Income. Interest expense, net of interest income, was $6.3 million in the third quarter of 2006 compared to $1.0 million in the third quarter of 2005.  Interest expense, net of interest income, increased in the third quarter of 2006 compared to the third quarter of 2005 due to an increase in outstanding debt balances related to the financing of the Aircast acquisition.

Other Expense. Other expense for the third quarter of 2006 reflects net foreign exchange transaction gains.  Other expense for the third quarter of 2005 reflects write-off of costs related to potential acquisitions that were abandoned in third quarter 2005 and net foreign exchange transaction losses.

Provision for Income Taxes. Our estimated worldwide effective tax rate was 48.5% for the third quarter of 2006 compared to 40.0% for the third quarter of 2005.  Our worldwide effective tax rate increased in connection with our adoption of SFAS No. 123(R) as of January 1, 2006.  The stock-based compensation expense recorded in accordance with SFAS No. 123(R) results in a related tax benefit rate of only 13.4% for the third quarter of 2006 due to the mix of our outstanding and unvested incentive stock options and non-qualified stock options.

Net Income. Net income was $4.4 million for the third quarter of 2006 compared to net income of $7.5 million for the third quarter of 2005 as a result of the changes discussed above.

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Nine Months Ended September 30, 2006 Compared To Nine Months Ended October 1, 2005

Net Revenues. Set forth below are net revenues, in total and on a per day basis, for our reporting segments (in thousands):

Net revenues:

	Nine Months Ended
	September 30, 2006		% of Net Revenues	October 1, 2005		% of Net Revenues	Increase		% Increase
Domestic Rehabilitation	$	196,506	65.0	$	145,391	68.8	$	51,115	35.2
Regeneration	47,953		15.9	40,712		19.3	7,241		17.8
International	57,834		19.1	25,107		11.9	32,727		130.4
Consolidated net revenues	$	302,293	100.0	$	211,210	100.0	$	91,083	43.1

Average revenues per day:

	Nine Months Ended
	September 30, 2006		October 1, 2005		Increase		%  Increase
Domestic Rehabilitation	$	1,028.8	$	757.3	$	271.5	35.9
Regeneration	251.1		212.0		39.1		18.4
International	302.8		130.8		172.0		131.5
Consolidated average net revenues per day	$	1,582.7	$	1,100.1	$	482.6	43.9
Number of operating days	191		192

The nine months ended September 30, 2006 included one less operating day than the nine months ended October 1, 2005.  Net revenues in our Domestic Rehabilitation and Regeneration segments decreased as a percentage of total net revenues due to a proportionately higher increase in our International segment revenues related to the acquisition of Axmed in January 2006 and Aircast in April 2006.  Net revenues in our Domestic Rehabilitation segment increased due to normal market growth in existing product lines, sales of new products, sales attributed to our recent acquisitions, an increase in the number of units billed to third-party payors, which are sold at higher average selling prices, and growth in sales related to national contracts in our ProCare sales channel.  We have also gained incremental revenue from the addition of approximately 149 net new OfficeCare locations since October 1, 2005.  In addition, Domestic Rehabilitation net revenues for the third quarter of 2006 included approximately $1.6 million related to a change in shipping terms for certain Aircast products from FOB destination to FOB shipping point and the shipment of certain products that were on backorder at the end of the second quarter of 2006 due to issues related to the integration of Aircast. Net revenues in our Regeneration segment increased due to selling resources added for our SpinaLogic products in territories that became non-exclusive in 2006 and also increased due to an increased number of sales specialists selling our OL1000 product.  International net revenues increased in the first nine months of 2006 compared to the first nine months of 2005, due to our recent acquisitions, increased sales volume due to market growth and the impact of favorable changes in foreign exchange rates.  In addition, International net revenues for the third quarter of 2006 included approximately $0.3 million related to the shipment of certain products that were on backorder at the end of the second quarter 2006 due to issues related to the integration of Aircast.

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

	Nine Months Ended
	September 30, 2006		% of Net Revenues	October 1, 2005		% of Net Revenues	Increase		%  Increase
Domestic Rehabilitation	$	102,967	52.4	$	81,257	55.9	$	21,710	26.7
Regeneration	44,213		92.2	36,232		89.0	7,981		22.0
International	35,152		60.8	16,426		65.4	18,726		114.0
Consolidated gross profit	$	182,332	60.3	$	133,915	63.4	$	48,417	36.2

The increase in gross profit for the first nine months of 2006 compared to the first nine months of 2005 is due to incremental gross profit from an increase in revenues, partially offset by an increase in cost of goods sold due to $0.7 million of stock-based compensation expense associated with the adoption of SFAS No. 123(R) as of January 1, 2006, approximately $1.5 million of purchase accounting adjustments to write up acquired inventories to fair value and approximately $3.3 million of certain other charges and expenses related to our recent acquisitions and related integrations.  In addition, we incurred approximately $0.8 million of

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expenses related to our move to our new corporate headquarters in the third quarter of 2006.  The decrease in consolidated gross profit as a percentage of net revenues is primarily due to these increased costs of goods sold. The decrease in consolidated gross profit as a percentage of net revenues is also due to a change in product mix to include more lower gross profit margin soft goods due to our recent acquisitions and increased costs related to freight and certain materials. Gross profit decreased as a percentage of net revenues in the Domestic Rehabilitation segment primarily due to a change in product mix to include more lower gross profit soft goods due to our recent acquisitions and increased freight costs.  The Regeneration segment gross profit increased as a percentage of revenues due to reduced costs of goods sold for these products and a higher mix of insurance sales, which have higher average selling prices and therefore generate higher gross profit margins than sales to wholesale customers.  The decrease in the International segment gross profit as a percentage of net revenues is primarily related to a change in product mix to include more lower gross profit margin soft goods due to our recent acquisitions.

Operating Expenses.  Set forth below is operating expense information (in thousands):

	Nine Months Ended
	September 30, 2006		% of Net Revenues	October 1, 2005		% of Net Revenues	Increase		% Increase
Sales and marketing	$	92,375	30.6	$	64,058	30.3	$	28,317	44.2
General and administrative	35,709		11.8	22,179		10.5	13,530		61.0
Research and development	6,745		2.2	4,749		2.2	1,996		42.0
Amortization of acquired intangibles	10,651		3.5	3,560		1.7	7,091		199.2
Consolidated operating expenses	$	145,480	48.1	$	94,546	44.7	$	50,934	53.9

Sales and Marketing Expenses.  The increase in sales and marketing expenses is primarily due to $3.2 million of stock-based compensation expense associated with the adoption of SFAS No. 123(R) as of January 1, 2006 and the addition of expenses related to our recent acquisitions.  The expenses related to our recent acquisitions include approximately $0.9 million of expenses that are not deemed to be reflective of ongoing operations. In addition, we incurred approximately $0.3 million of selling and marketing expenses related to our move to our new corporate headquarters in the third quarter of 2006.  The increase in sales and marketing expenses is also partly due to costs associated with increased commissions, bad debt and sales incentives on increased sales and increased headcount, partially offset by decreased costs due to the nine months ended September 30, 2006 including one less operating day than the nine months ended October 1, 2005.

General and Administrative Expenses. The increase in general and administrative expenses is primarily due to $2.5 million of stock-based compensation expense associated with the adoption of SFAS No. 123(R) as of January 1, 2006 and the addition of expenses related to our recent acquisitions.  The expenses related to our recent acquisitions include approximately $0.7 million of expenses that are not deemed to be reflective of ongoing operations. The increase in general and administrative expenses is also partly due to certain increased personnel costs, partially offset by decreased costs due to the nine months ended September 30, 2006 including one less operating day than the nine months ended October 1, 2005.  General and administrative expenses for the nine months ended September 30, 2006 also include $0.7 million related to an arbitration concluded during the second quarter of 2006 and  approximately $0.2 million of general and administrative expenses related to our move to our new corporate headquarters in the third quarter of 2006.

Research and Development Expenses. The increase in research and development expense is due to the addition of expenses related to our recent acquisitions, $0.4 million of stock-based compensation expense associated with the adoption of SFAS No. 123(R) as of January 1, 2006, and certain increased personnel costs, partially offset by decreased costs due to the nine months ended September 30, 2006 including one less operating day than the nine months ended October 1, 2005. In addition, we incurred approximately $0.2 million of research and development expenses related to our move to our new corporate headquarters in the third quarter of 2006.

Amortization of Acquired Intangibles.  Amortization of acquired intangibles includes amortization expense related to intangible assets acquired in connection with the Regeneration acquisition, which are being amortized over lives ranging from four months to ten years, intangible assets acquired in connection with the Axmed acquisition, which are being amortized over lives ranging from one to nine years, and intangible assets acquired in connection with the Aircast acquisition which are being amortized over lives ranging from seven to 50 years.  The increase in amortization of acquired intangibles is due to amortization expense related to the January 2006 acquisition of Axmed and the April 2006 acquisition of Aircast.

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

	Nine Months Ended
	September 30, 2006			% of Net Revenue		October 1, 2005			% of Net Revenue		Increase (Decrease)			% Increase (Decrease)
Domestic Rehabilitation	$	30,310		15.4		$	30,519		21.0		$	(209	)	(0.7	)
Regeneration	10,560			22.0		10,815			26.6		(255		)	(2.4	)
International	8,851			15.3		6,560			26.1		2,291			34.9
Income from operations of reportable segments	49,721			16.5		47,894			22.6		1,827			3.8
Expenses not allocated to segments	(12,869		)	(4.3	)	(8,525		)	(4.0	)	(4,344		)	51.0
Consolidated income from operations	$	36,852		12.2		$	39,369		18.6		$	(2,517	)	(6.4	)

The increase in income from operations for our Domestic Rehabilitation and International segments is due to increased net revenues and gross profit, which offset increased operating expenses including stock-based compensation expense associated with the adoption of SFAS No. 123(R) as of January 1, 2006 for each respective segment, purchase accounting adjustments to write up acquired inventories to fair value and certain other costs and expenses incurred in connection with our recent acquisitions.  The decrease in income from operations for our Regeneration segment is primarily due to stock-based compensation expense associated with the adoption of SFAS No. 123(R) as of January 1, 2006.

Interest Expense, Net of Interest Income. Interest expense, net of interest income, was $15.7 million in the first nine months of 2006 compared to $3.4 million in first nine months of 2005.  Interest expense, net of interest income, increased in the first nine months of 2006 compared to the first nine months of 2005 due to an increase in outstanding debt balances due to the financing of the Aircast acquisition. Interest expense, net, for the nine months ended September 30, 2006 also included $2.3 million related to a write-off of net deferred debt issuance costs in connection with the repayment of our former credit facility.

Other Expense. Other expense for the first nine months of 2006 reflects a write-off of costs related to a potential acquisition that was abandoned in the first quarter of 2006, offset by net foreign exchange transaction gains. Other expense for the first nine months of 2005 reflects write-off of costs related to potential acquisitions that were abandoned in third quarter of 2005 and net foreign exchange transaction losses.

Provision for Income Taxes. Our estimated worldwide effective tax rate was 45.7% for the first nine months of 2006 compared to 40.0% for the first nine months of 2005.  Our worldwide effective tax rate increased in connection with our adoption of SFAS No. 123(R) as of January 1, 2006.  The stock-based compensation expense recorded in accordance with SFAS No. 123(R) results in a related tax benefit rate of only 22.0% for the first nine months of 2005 due to the mix of our outstanding and unvested incentive stock options and non-qualified stock options.

Net Income. Net income was $11.6 million for the first nine months of 2006 compared to net income of $21.1 million for the first nine months of 2005 as a result of the changes discussed above.

Liquidity and Capital Resources

Our principal liquidity requirements are to service our debt and meet our working capital and capital expenditure needs.  Total indebtedness at September 30, 2006 was $334.3 million.  Total cash and cash equivalents were $3.7 million at September 30, 2006.

Net cash provided by operating activities was $37.0 million and $32.5 million for the nine months ended September 30, 2006 and October 1, 2005, respectively. The net cash provided by operations in the first nine months of 2006 primarily reflected positive operating results offset by an increase in net accounts receivable and net inventories and payments made in connection with the integration of our recently acquired businesses. The net cash provided by operations in the first nine months of 2005 primarily reflected positive operating results partially offset by an increase in net accounts receivable and by cash of approximately $1.9 million paid in the first nine months of 2005 for restructuring costs accrued in 2004.

Cash flows used in investing activities were $327.1 million and $17.5 million for the nine months ended September 30, 2006 and October 1, 2005, respectively.  Cash used in investing activities for the first nine months of 2006 included $16.3 million used for the acquisition of Axmed, $297.3 million used for the acquisition of Aircast, and $12.5 million used for capital expenditures. Capital expenditures for the nine months ended September 30, 2006 included $7.7 million related to tenant improvements and equipment for our

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new corporate headquarters and the expansion of our Indianapolis distribution center. Cash used in investing activities for the first nine months of 2005 included $3.1 million used for the acquisition of SME, $9.5 million used for the acquisition of OSG and $3.6 million used for capital expenditures.

Cash flows provided by (used in) financing activities were $292.4 million and ($25.0) million for the nine months ended September 30, 2006 and October 1, 2005, respectively.  In the first nine months of 2006, the cash provided by financing activities included $286.8 million of net proceeds from long-term debt, $11.1 million of net proceeds received from the exercise of stock options and $0.9 million from the issuance of stock under our Employee Stock Purchase Plan.  In the first nine months of 2005, the cash used in financing activities included $3.6 million of net proceeds received from the exercise of stock options, $0.5 million from the issuance of stock under our Employee Stock Purchase Plan and approximately $1.8 million received from the collection of a note receivable, offset by approximately $38.3 million used to pay down long-term debt and $0.7 million paid for debt issuance costs incurred in connection with the amendment to our credit agreement in May 2005.

Contractual Obligations and Commercial Commitments

New Credit Agreement

On April 7, 2006, we entered into a new credit agreement with a syndicate of lenders and with Wachovia Bank, National Association, as administrative agent to finance the Aircast acquisition. The new credit agreement provided for total borrowings of $400 million, consisting of a term loan of $350 million, which was fully drawn at closing and up to $50 million available under a revolving credit facility.  As of September 30, 2006, the balance outstanding under the term of the loan was $334.3 million and $47.8 million was available under the revolving credit facility, net of outstanding letters of credit.  The new credit agreement replaced our previously existing credit agreement and approximately $46.3 million of debt outstanding under the former agreement was paid off by the new agreement.  Under the new credit agreement, up to $25 million of outstanding borrowings may be denominated in British Pounds or Euros.

Borrowings under the new term loan and on the new revolving credit facility bear interest at variable rates (either a LIBOR rate or the lenders’ base rate, as elected by us) plus a margin. Under the new agreement, the interest rate for the term loan is LIBOR plus a margin of 1.50%, or the lenders’ base rate plus a margin of 0.50%.  The applicable margin on the revolving credit facility varies based on our leverage ratio.  The interest rate for the revolving credit facility is LIBOR plus an applicable margin of 1.25% to 2.00%, or the lenders’ base rate plus an applicable margin of 0.25% to 1.00%.  At our current leverage ratio, the applicable interest rate on the revolving credit facility is either LIBOR plus 1.75% or the lender’s base rate plus 0.75%.

Interest Rate Swap Agreement. In connection with the new credit agreement, on April 11, 2006 we entered into an interest rate swap agreement with Wachovia Bank for a notional amount of $250 million of the term loan.  The interest rate swap agreement converts the variable LIBOR rate to a fixed LIBOR rate of 5.29% for a term of five years.  Accordingly, with respect to a notional amount of $250 million of the term loan, our interest rate is fixed at 6.79% (5.29% plus applicable margin of 1.50%) for the term of the swap.  The notional amount of $250 million is scheduled to amortize to zero over the term of the swap in proportion to expected future cash flows.  As of September 30, 2006, the outstanding notional amount of the interest rate swap was $250 million and the fair market value of the swap reflected a loss of approximately $1.2 million.  Our interest rate swap qualifies as a cash flow hedge under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities.  In accordance with SFAS No. 133, the fair market value of the swap at September 30, 2006 was recorded as a long-term liability, with the change in such fair value accounted for as a reduction of accumulated other comprehensive income (loss) included in the stockholders’ equity in the accompanying consolidated balance sheet.  The weighted average interest rate applicable to our borrowings as of September 30, 2006 was 6.81%.

Repayment. We are required to make quarterly principal payments of $0.875 million on the term loan, beginning in June 2006. The balance of the term loan, if any, is due in full on April 7, 2013.  Any borrowings under the revolving credit facility are due in full on April 7, 2012. We are also required to make annual mandatory prepayments on the term loan in an amount equal to 50% of our excess cash flow if our ratio of total debt to consolidated EBITDA exceeds 2.50 to 1.00. Excess cash flow represents our net income adjusted for extraordinary gains or losses, depreciation, amortization and other non-cash charges, changes in working capital, changes in deferred revenues, payments for capital expenditures and permitted acquisitions and repayment of certain indebtedness.  In addition, the term loan is subject to mandatory prepayments in an amount equal to (a) 100% of the net cash proceeds of certain debt issuances by us; (b) 50% of the net cash proceeds of certain equity issuances by us if our ratio of total debt to consolidated EBITDA exceeds 2.50 to 1.00; (c) 100% of the net cash proceeds of certain insurance, condemnation awards or other compensation in respect to any casualty

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event; and (d) 100% of the net cash proceeds of certain asset sales or other dispositions of property by us, in each case subject to certain exceptions.

Security; Guarantees.  Our obligations under the credit agreement are irrevocably guaranteed, jointly and severally, by us, and all of our current and future U.S. subsidiaries.  In addition, the credit agreement and the guarantees thereunder are secured by substantially all of our U.S. assets, including real and personal property, inventory, accounts receivable, intellectual property and other intangibles.

Covenants. The credit agreement imposes certain restrictions on us, including restrictions on the ability to incur indebtedness, incur or guarantee obligations, prepay other indebtedness or amend other debt instruments, pay dividends 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 and our subsidiaries, make capital expenditures, grant liens, sell assets and engage in certain other activities. The credit agreement requires us to maintain: a ratio of total debt to consolidated EBITDA of no more than 4.50 to 1.00 and gradually decreasing to 2.50 to 1.00 for the first quarter of 2010 and thereafter; and a ratio of consolidated EBITDA to fixed charges of at least 1.50 to 1.00.  Material violations of these covenants and restrictions, or the payment terms described above, can result in an event of default and acceleration of the entire indebtedness. We were in compliance with all covenants as of September 30, 2006.

Debt issuance costs. We capitalized debt issuance costs of approximately $6.3 million in association with the new credit agreement, which will be amortized over the term of the agreement.  Remaining debt issuance cost of $5.8 million, net of accumulated amortization, were included in the accompanying balance sheet at September 30, 2006.  We wrote off approximately $2.3 million in April 2006, representing the net carrying value of debt issuance costs capitalized in connection with our previous credit agreement.

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

The following table lists our contractual obligations as of September 30, 2006 (in thousands):

	Payments Due by Period
			2006		2007-2009		2010-2011		2012+
Contractual Obligations	Total		Remaining		1-3 Years		4-5 Years		After 5 years
Long-Term Debt	$	334,250	$	875	$	10,500	$	7,000	$	315,875
Operating Leases	51,510		2,874		12,486		7,810		28,340
Total Contractual Cash Obligations	$	385,760	$	3,749	$	22,986	$	14,810	$	344,215

In late 2004, we entered into a lease agreement with Professional Real Estate Services, Inc. (PRES) under which PRES undertook to build a new 110,000 square foot corporate headquarters facility for us on vacant land in Vista, California.  We occupy the facility under a 15-year lease, which commenced in August 2006 upon completion of the facility, with two five-year options to extend the term. We have vacated our existing facilities in Vista.  Rent expense for the new facility will be recorded on a straight-line basis over the lease term at approximately $1.9 million per year.

In February 2005, PRES purchased our former facilities as well as the real property underlying the new lease.  Effective on the purchase date, our lease for the vacant land was terminated. In connection with our new lease, our leases for our former Vista facilities were terminated early in August 2006.  Those leases would otherwise have continued until February 2008.  In August 2006, we made a lump sum rent payment to PRES of approximately $1.5 million, representing 40% of the rent that would have been due under the former facilities leases from the early termination date through the original expiration date. If PRES is able to lease our former facilities during what would have remained of the term of our existing leases, a portion of that sum may be refunded to us.  This lump sum rent payment, net of a remaining $0.4 million accrual related to lease termination costs originally accrued in 2002 (see Note 4 to the consolidated financial statements included in Part 1, Item 1 herein), will be accounted for as additional rent expense over the term of the new lease and is included in the annual rent expense amount noted above. The contractual obligations table above includes the rent for our new facility beginning in August 2006.

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Our ability to pay principal and interest on our indebtedness, fund working capital requirements and make anticipated capital expenditures will depend on our future performance, which is subject to general economic, financial and other factors, some of which are beyond our control.  We believe that based on current levels of operations and anticipated growth, cash flow from operations, together with other available sources of funds including the availability of borrowings under our revolving credit facility, will be adequate for at least the next twelve months to make required payments of principal and interest on our indebtedness, to fund anticipated capital expenditures and for working capital requirements.  There can be no assurance, however, that our business will generate sufficient cash flow from operations or that future borrowings will be available under the revolving credit facility in an amount sufficient to enable us to service our indebtedness or to fund our other liquidity needs.  In such event, we may need to raise additional funds through public or private equity or debt financings.  We cannot assure you that any such funds will be available to us on favorable terms or at all.

We do not currently have and have never had any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.  In addition, we do not engage in trading activities involving non-exchange traded contracts.  As such, we are not materially exposed to any financing, liquidity, market or credit risk that could arise if we had engaged in these relationships.

In connection with the Axmed acquisition, as discussed in Note 3 to the consolidated financial statements included in Part 1, Item 1 herein, we may be required to pay certain sellers up to an additional 1.1 million Euros (approximately $1.3 million) based on achievement of certain revenue targets for 2006 and operating income targets for the second half of 2006.

As of September 30, 2006, we had available liquidity of approximately $3.7 million in cash and cash equivalents and $47.8 million available under our new revolving credit facility, net of $2.2 million of outstanding letters of credit. For the remainder of 2006, we expect to spend total cash of approximately $20.9 million for the following requirements:

·up to approximately $6.8 million for scheduled principal and estimated interest payments on our new credit facility;

·approximately $2.9 million scheduled payments for noncancellable operating leases;

·up to approximately $4.7 million in severance and relocation payments to certain Aircast employees as part of the Aircast integration plan as discussed in Note 3 to the unaudited condensed consolidated financial statements included in Part 1, Item 1, herein; and

·up to approximately $6.5 million for capital expenditures.

In addition, we expect to make other general corporate payments in 2006.  We also expect to continue to make payments related to integrating the acquired Aircast business.

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Seasonality

We generally record our highest net revenues per day in the fourth quarter due to a greater number of orthopedic surgeries and injuries resulting from increased sports activity, particularly football and skiing. In addition, during the fourth quarter, a patient has a greater likelihood of having satisfied his or her annual insurance deductible than in the first three quarters of the year, and thus there is an increase in the number of elective orthopedic surgeries. We follow a manufacturing calendar that has a varied number of operating days in each quarter.  Although on a per day basis revenues may be higher in a certain quarter, total net revenues may be higher or lower based upon the number of operating days in such quarter. Conversely, we generally have lower net revenues per day during our second quarter as a result of decreased sports activity, with the end of both football and skiing seasons. For 2006 and 2005, our number of operating days per quarter is as follows:

	2006	2005
First quarter	64	65
Second quarter	64	64
Third quarter	63	63
Fourth quarter	61	61
Total operating days	252	253

Forward-Looking Statements

This quarterly report on Form 10-Q contains, in addition to historical information, statements by us with respect to our expectations regarding financial results and other aspects of our business that involve risks and uncertainties and may constitute forward-looking statements within the meaning of Section 27A of the Securities Act and Section 21E of the Exchange Act.  These statements reflect our current views and are based on certain assumptions.  Actual results could differ materially from those currently anticipated as a result of a number of factors, including, the risks discussed under Item 1A “Risk Factors” in this Form 10-Q. If the expectations or assumptions underlying our forward-looking statements prove inaccurate or if risks or uncertainties arise, actual results could differ materially from those predicted in any forward-looking statement.

ITEM 3.      QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We are exposed to certain market risks as part of our ongoing business operations. Our primary exposures include changes in interest rates and foreign exchange rates.

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

As of September 30, 2006 we had $84.3 million of variable rate debt represented by borrowings under our new credit facility (at a weighted-average interest rate of 6.88% at September 30, 2006) which are not covered by the interest rate swap agreement entered into in connection with the new credit agreement. Based on the balance outstanding under the credit facility as of September 30, 2006, an immediate change of one percentage point in the applicable interest rate would have caused an increase or decrease in interest expense of approximately $0.8 million on an annual basis. At September 30, 2006, up to $47.8 million of variable rate borrowings were available under our new $50.0 million revolving credit facility.  We may use derivative financial instruments, where appropriate, to manage our interest rate risks. However, as a matter of policy, we do not enter into derivative or other financial investments for trading or speculative purposes. On April 11, 2006, in connection with our new credit agreement, we entered into an interest rate swap agreement for a notional amount of $250 million of the term loan.  The interest rate swap agreement converts the variable LIBOR rate to a fixed LIBOR rate of 5.29% for a term of five years.  Accordingly, with respect to the notional amount of $250 million, our interest rate is fixed at 6.79% (5.29% plus applicable margin of 1.50%) for the term of the swap.  The notional amount of $250 million is scheduled to amortize to zero over the term of the swap in proportion to expected cash flows.  As of September 30, 2006, the outstanding notional amount of the interest rate swap was $250 million. At September 30, 2006, the fair market value reflected a loss of $1.2 million and was recorded as a long-term liability, with the change in such fair value accounted for as a reduction of accumulated other comprehensive income (loss) included in stockholders’ equity in the accompanying consolidated balance sheet.

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Through our wholly owned international subsidiaries, we sell products in several foreign currencies, primarily Euros, Pounds Sterling and Canadian Dollars. The U.S. dollar equivalent of our international sales denominated in foreign currencies in the first nine months of both 2006 and 2005 were favorably impacted by foreign currency exchange rate fluctuations with the weakening of the U.S. dollar against the foreign currencies of our subsidiaries.  The U.S. dollar equivalent of the related costs denominated in these foreign currencies were unfavorably impacted during the same period.  In addition, the costs associated with our Mexico-based manufacturing operations are incurred in Mexican pesos.  As we continue to distribute and manufacture our products in selected foreign countries, we expect that future sales and costs associated with our activities in these markets will continue to be denominated in the applicable foreign currencies, which could cause currency fluctuations to materially impact our operating results. Occasionally we seek to reduce the potential impact of currency fluctuations on our business through hedging transactions.

ITEM 4.      CONTROLS AND PROCEDURES

Disclosure Controls and Procedures

We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

Under the supervision and with the participation of our management, including our Chief Executive Officer and our Chief Financial Officer, we carried out an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures (as such term is defined in SEC Rules 13a — 15(e) and 15d — 15(e)) as of the end of the quarter covered by this report.  Based on the foregoing, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective at the reasonable assurance level.

Changes in Internal Control over Financial Reporting

Other than as set forth below with respect to our recent acquisitions, there has been no change to our internal control over financial reporting during our most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

We completed the acquisitions of Aircast in April 2006 and Axmed in January 2006, as more fully described in Note 3 to the unaudited condensed consolidated financial statements included in Part 1, Item 1, herein. As part of our ongoing integration activities, we are in the process of incorporating the operations of Axmed and Aircast into our controls and procedures and we expect to complete the process by no later than January 2, 2007 for Axmed and April 7, 2007 for Aircast.  Management has excluded from its assessment of the effectiveness of the Company’s internal control over financial reporting as of September 30, 2006 certain elements of the internal control over financial reporting of Axmed and Aircast.

PART II. OTHER INFORMATION

ITEM 1.      LEGAL PROCEEDINGS

From time to time, we are involved in lawsuits arising in the ordinary course of business. This includes patent and other intellectual property disputes between our various competitors and us, as well as ordinary course business disputes.  With respect to these matters, management believes that it has adequate insurance coverage or has made adequate accruals for related costs, and it may also have effective legal defenses.

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ITEM 1A.RISK FACTORS

Our ability to achieve our operating and financial goals is subject to a number of risks, including risks relating to our business operations, our debt level and government regulations.  If any of the following risks actually occur, our business, operating results, prospects or financial condition could be materially and adversely affected.  The risk factors described below reflect any material changes from the risk factors previously disclosed in our Annual Report on Form 10-K for the year ended December 31, 2005.  The risks described below are not the only ones that we face. Additional risks not presently known to us or that we currently deem immaterial may also affect our business operations.

Risks Related to Our Business

We may have difficulty integrating the operations and growing the business of Aircast Incorporated.

In April 2006, we acquired Aircast Incorporated, a New Jersey based orthopedics company that manufactures and markets ankle and other orthopedic bracing products, cold therapy products and vascular therapy systems.  We are in the process of integrating all of the manufacturing operations of Aircast into our existing facility in Tijuana, Mexico, and to absorbing or relocating the U.S. general and administrative, product development and marketing functions of Aircast to our facilities in Indianapolis, Indiana and Vista, California.  The sales and distribution resources of Aircast are being integrated into our sales and distribution network, and we are combining Aircast operations in several European countries with existing operations of ours in those countries.  Our ability to complete these integration steps on a timely basis and to realize the synergies we expect from the transaction are subject to numerous risks and uncertainties, including the following:

·we may experience delay and difficulty in moving the production of Aircast products to our Mexico facility and training our work force in these new products;

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

·our existing resources in customer support, product development, quality and billing and collections will have to be trained to address the Aircast business and new or relocated employees will have to be trained and integrated into our systems and processes;

·we may experience delay and difficulty in integrating the Aircast business into our existing information technology systems;

·we may have difficulty retaining the sales and distribution resources of Aircast and combining them effectively into our sales and distribution organization in order to retain and grow the Aircast business;

·we may experience delay and difficulty in integrating our operations with those of Aircast in several countries in Europe; and

·we may not be able to retain the loyalty and business of Aircast customers or realize selling synergies between the two companies.

Our ability to integrate the Aircast business on a timely and effective basis and to avoid the risk factors listed above and others will determine our success in realizing the cost savings and other synergies we expect from the acquisition.  Our failure to realize those synergies, or to grow the Aircast business along with our business in the manner that we expect, will adversely impact our operating results for the current fiscal year and possibly for subsequent periods.

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

Our growth strategy will continue to include the pursuit of acquisitions, both domestically and, in particular, internationally.  We may not be able to identify acceptable opportunities or complete acceptable acquisitions of targets identified in a timely manner.  Acquisitions involve a number of risks, including the following:

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·our management’s attention will be diverted from our existing business while evaluating acquisitions and thereafter while integrating the operations and personnel of the new business into our business;

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

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

·we may experience higher than anticipated costs of integration and unforeseen operating difficulties and expenditures;

·an acquisition may be in a market or geographical area in which we have little experience;

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

·we may use a substantial amount of our cash and other financial resources to consummate an acquisition.

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

Prior to the Regeneration acquisition, we did not have experience operating in the regeneration segment of the non-operative orthopedic and spine markets.

Historically, our principal focus has been the market for orthopedic rehabilitation products.  Accordingly, prior to our acquisition of the bone growth stimulation device business from OrthoLogic in November 2003, we did not have any experience operating in the regeneration segment of the non-operative orthopedic and spine markets.  The regeneration segment of the non-operative orthopedic and spine markets has different competitive characteristics from those we have experienced in the market for our rehabilitation products and the third-party payor coverage and reimbursement issues are more complex than in our traditional rehabilitation markets.  In addition, the products we acquired from OrthoLogic are subject to Class III Food and Drug Administration, or FDA, review.  This level of review is more stringent than that required for our rehabilitation products.

In addition, we have made significant changes and additions to the sales force for the bone growth stimulation (BGS) products as compared to the sales force in place at the time of the Regeneration acquisition.  With respect to the OL1000, we have hired and trained a significant number of new sales specialists and introduced the product to our DonJoy direct distribution sales force.  At the time of the Regeneration acquisition, DePuy Spine was acting as the exclusive distributor of the SpinaLogic device in significant portions of the U.S.  The agreement with DePuy Spine was amended in 2005 to make certain territories non-exclusive and commencing early in 2006, it became a non-exclusive arrangement for the U.S.  We have begun developing alternative selling resources for SpinaLogic and will continue that effort, but prior to the Regeneration acquisition, we did not have any relationships with spine surgeons or with independent distributors who specialize in spine products.  The different nature of the Regeneration business from our traditional rehabilitation business and the significant changes we have made and will be required to make to the Regeneration sales force could involve risks to our business such as the following:

·we may have difficulty training and retaining the number of product specialists we will need to grow the OL1000 and SpinaLogic business. To date, we have experienced, and may continue to experience, relatively high turnover among our Regeneration sales specialists and sales managers, which can lead to disruption of customer relations and increased training time and costs;

·in those areas of the country where we will need to supplement the DePuy Spine distributors, we may not be able to develop a network of distributors who can effectively market and sell the SpinaLogic product to spine surgeons;

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·our existing customers may not have a need for bone growth stimulation products or may have existing relationships with our competitors for similar products;

·our prior experience in billing Medicare is limited, and we may encounter difficulties in processing the higher level of Medicare claims in the Regeneration business as compared to our other businesses; and

·competitive products or technologies in fracture repair or spinal fusion surgery may undermine our sales and profitability goals.

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

Changes in the regulatory status of our BGS products could adversely affect the operations and financial results of our Regeneration business.

In February 2005, a petition was filed with the US Food and Drug Administration (“FDA”) seeking to reclassify non-invasive bone growth stimulator devices from Class III to Class II.  Although our BGS products that utilize combined magnetic field technology were subsequently excluded from the petition, if the petition were to succeed, new market entrants could seek clearance of a BGS device using other technologies through the 510(k) process (as opposed to the PMA process). This would likely increase competition from new products in the electrical bone growth stimulation device business which could result in downward price pressures on our products and business.  The FDA referred the petition to the Orthopaedic and Rehabilitation Devices Advisory Panel (the Panel), which consists of medical professionals with recognized expertise in BGS technology, and requested the Panel’s recommendation regarding whether the FDA should deny or approve the petition.  On June 2, 2006, the Panel held a public meeting regarding the petition.  At the close of the meeting, the Panel, by a vote of 4 to 2, recommended that the FDA deny the petition, meaning that the Panel believes that BGS devices should remain in Class III and should continue to be subject to the PMA process.  While the FDA typically follows the recommendations of Advisory Panels, it is not legally bound to do so.  We therefore continue to actively oppose the reclassification of BGS products until the FDA renders a final decision on the petition. In addition, the medical committee responsible for providing advice on coverage matters to Medicare held a meeting during 2005 for the purpose of, among other things, considering the effectiveness of products such as our BGS products on healing nonunion fractures among the Medicare patient population.  We have provided information to the Medicare advisory committee on the clinical data on effectiveness of our BGS products.  Although it has not sought to do so, CMS, which is responsible for Medicare coverage determinations, may decide to re-evaluate current coverage policies in a way that restrict payment for our BGS products. We cannot be certain of the outcome of either regulatory matter, and an adverse outcome on either such matter could impact our ability to grow sales and realize profits in our Regeneration business.  Furthermore, we cannot be sure that other regulatory changes will not be proposed or implemented that adversely impact our Regeneration business.  See additional risk factors under the heading “Risks Relating to Government Regulation” below.

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

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

We have outsourced certain administrative functions relating to our OfficeCare and insurance billing channels to a third-party contractor and this arrangement may not prove successful.

Our OfficeCare sales channel maintains an inventory of products (mostly soft goods) on hand at orthopedic practices for immediate distribution to patients.  In our insurance billing channel, we provide products, principally custom-made rigid knee braces, directly to patients.  In both situations, we arrange billing to a patient or third-party payor after the product is provided to the patient.  We outsource the revenue cycle of this program, from billing to collections, to an independent third-party contractor. This provider may not remain successful in achieving or maintaining our billing and collections goals and there can be no assurance that we will not have to resume these administrative functions in the future.

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

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

The U.S. patent for our “Four Points of Leverage” system expired in January 2005. Revenues generated from the sale of products in the U.S. using our “Four Points of Leverage” system represented approximately 14%, 15% and 22% of our historical net revenues for 2005, 2004 and 2003, respectively. The majority of our anterior cruciate ligament, or ACL, braces, including Defiance, Legend and 4TITUDE, and certain of our osteoarthritic braces use this system. We believe a number of our competitors may introduce ligament braces that incorporate aspects of our “Four Points of Leverage” system now that the patent has expired.  In such event, our competitors may be able to sell products that are similar to ours at lower prices than we currently sell our products, which could adversely affect our revenue and profitability.

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

·knee ligament bracing product lines, including components and features such as frame construction and shape, strap attachment systems, anti-migration padding systems and extreme sport features;

·custom contour measuring system, which serves as an integral part of the measurement process for patients ordering our customized ligament and osteoarthritic braces;

·series of hinges for our rigid braces, including the FourcePoint™ hinge;

·pneumatic pad design and production technologies which utilize air inflatable cushions that allow the patient to vary the location and degree of support provided by braces such as the Defiance knee ligament brace;

·osteoarthritic bracing concepts;

·ankle bracing, both rigid and soft;

·rigid shoulder bracing; and

·combined magnetic field technology, which is used in our bone growth stimulation products.

However, we cannot assure you that:

·our existing or future patents, if any, will afford us adequate protection;

·our patent applications will result in issued patents; or

·our patents will not be circumvented or invalidated.

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

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

Our future success and the ability to grow our revenues and earnings require the continued development, licensing or acquisition of new products and the enhancement of our existing products. We may not be able to:

·continue to develop or license successful new products and enhance existing products;

·obtain required regulatory clearances and approvals for such products;

·market such products in a commercially viable manner; or

·gain market acceptance for such products.

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

We rely heavily on our relationships with orthopedic professionals who prescribe and dispense our products and our failure to maintain these relationships could adversely affect our business.

The sales of our products depend significantly on the prescription or recommendation of such products by orthopedic and spine surgeons and other healthcare professionals.  We have developed and maintain close relationships with a number of widely recognized orthopedic surgeons and specialists who support and recommend our products.  Failure of our products to retain the support of these surgeons and specialists, or the failure of our products to secure and retain similar support from leading surgeons and specialists, could have an adverse effect on our business.

The majority of our sales force consists of independent agents and distributors who maintain close relationships with our hospital and physician customers.

Our success also depends largely upon arrangements with independent agents and distributors and their relationships with our hospital and physician customers in the marketplace. These agents and distributors are not our employees, and our ability to influence their actions and performance is limited.  Our inability to effectively manage these agents and distributors or our failure generally to maintain relationships with these independent agents and distributors could have an adverse effect on our business.

We operate in a very competitive business environment.

The non-operative orthopedic and spine markets are highly competitive and fragmented.  Our competitors include several large, diversified general orthopedic products companies and numerous smaller niche companies. Some of our competitors are part of corporate groups that have significantly greater financial, marketing and other resources than we have.  Accordingly, we may be at a competitive disadvantage with respect to these competitors.

In the rehabilitation market, our primary competitors in the rigid knee bracing product line include Orthofix International, N.V., Bledsoe Brace Systems, Ossur hf. and Townsend Industries Inc.  Our competitors in the soft goods products market include Biomet, Inc., DeRoyal Industries, Ossur hf. and Zimmer Holdings, Inc.  Our primary competitors in the pain management products market include I-Flow Corp., Orthofix and Stryker Corporation.

In the regeneration market, our primary competitors selling bone growth stimulation products approved by the FDA for the treatment of nonunion fractures are Orthofix, Biomet, Inc. and Smith & Nephew.  Biomet and Orthofix also sell bone growth stimulation products for use by spinal fusion patients.  We estimate that Biomet has dominant shares of the U.S. markets for bone growth stimulation products used both to treat nonunion fractures and as adjunct therapy after spinal fusion surgery.

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Our quarterly operating results are subject to substantial fluctuations and you should not rely on them as an indication of our future results.

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

·the number of business days in each quarter;

·demand for our products, which historically has been higher in the fourth quarter when scholastic sports and ski injuries are more frequent;

·our ability to meet the demand for our products;

·the direct distribution of our products in foreign countries;

·the number, timing and significance of new products and product introductions and enhancements by us and our competitors, including delays in obtaining government review and clearance of medical devices;

·our ability to develop, introduce and market new and enhanced versions of our products on a timely basis;

·the impact of any acquisitions that occur in a quarter;

·the impact of any changes in generally accepted accounting principles;

·changes in pricing policies by us and our competitors and reimbursement rates by third-party payors, including government healthcare agencies and private insurers;

·the loss of any of our distributors;

·changes in the treatment practices of orthopedic and spine surgeons and their allied healthcare professionals; and

·the timing of significant orders and shipments.

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

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

We believe that various demographics and industry specific trends will help drive growth in the rehabilitation and regeneration markets, including:

·a growing elderly population with broad medical coverage, increased disposable income and longer life expectancy;

·a growing emphasis on physical fitness, leisure sports and conditioning, which has led to increased injuries, especially among women; and

·the increasing awareness and use of non-invasive devices for prevention, treatment and rehabilitation purposes.

These demographics and trends are beyond our control.  The projected demand for our products could materially differ from actual demand if our assumptions regarding these factors prove to be incorrect or do not materialize or if alternative treatments to those offered by our products gain widespread acceptance.

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Our business, operating results and financial condition could be adversely affected if we become involved in litigation regarding our patents or other intellectual property rights.

The orthopedic products industry has experienced extensive litigation regarding patents and other intellectual property rights. We or our products may become subject to patent infringement claims or litigation or interference proceedings declared by the U.S. Patent and Trademark Office, or USPTO, or the foreign equivalents thereto to determine the priority of inventions. The defense and prosecution of intellectual property suits, USPTO interference proceedings or the foreign equivalents thereto and related legal and administrative proceedings are both costly and time consuming. An adverse determination in litigation or interference proceedings to which we may become a party could:

·subject us to significant liabilities to third-parties;

·require disputed rights to be licensed from a third-party for royalties that may be substantial; or

·require us to cease using such technology.

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

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

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

Some of our important suppliers are in China and other parts of Asia and provide us predominately finished soft goods products.  In fiscal year 2005, we obtained approximately 10% of our total purchased materials from suppliers in China and other parts of Asia. Political and economic instability and changes in government regulations in these areas could affect our ability to continue to receive materials from our suppliers there. The loss of our suppliers in China and other parts of Asia, any other interruption or delay in the supply of our required materials or our inability to obtain these materials at acceptable prices and within a reasonable amount of time could impair our ability to meet scheduled product deliveries to our customers and could hurt our reputation and cause customers to cancel orders.

In addition, we purchase the microprocessor used in the OL1000â and SpinaLogic devices from a single manufacturer. Although there are feasible alternate microprocessors that might be used immediately, all are produced by a single supplier.  In addition, there are single suppliers for other components used in the OL1000 and SpinaLogic devices and only two suppliers for the magnetic field sensor employed in them.  Establishment of additional or replacement suppliers for these components cannot be accomplished quickly.

Our international sales and profitability may be adversely affected by foreign currency exchange fluctuations and other risks.

We sell products in foreign currency through our foreign subsidiaries.  The U.S. dollar equivalent of international sales denominated in foreign currencies in fiscal years 2005, 2004 and 2003 were favorably impacted by foreign currency exchange rate fluctuations with the weakening of the U.S. dollar against the foreign currencies of our subsidiaries.  The U.S. dollar equivalent of the related costs denominated in these foreign currencies was unfavorably impacted during the same periods.  In addition, the costs associated with our Mexico-based manufacturing operations are incurred in Mexican pesos.  As we continue to distribute and manufacture our products in selected foreign countries, we expect that future sales and costs associated with our activities in these markets will continue to be denominated in the applicable foreign currencies, which could cause currency fluctuations to materially impact our operating results.

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We are also subject to other risks inherent in international operations such as political and economic conditions, foreign regulatory requirements, exposure to different legal requirements and standards, exposure to different approaches to treating injuries, potential difficulties in protecting intellectual property, import and export restrictions, increased costs of transportation or shipping, currency fluctuations, difficulties in staffing and managing international operations, labor disputes, difficulties in collecting accounts receivable and longer collection periods and potentially adverse tax consequences.  For example, in Germany, our largest foreign market, orthopedic professionals began re-using our bracing devices on multiple patients during 2004, which adversely impacted our sales of these devices in this market in 2004.  As we continue to expand our international business, our success will be dependent, in part, on our ability to anticipate and effectively manage these and other risks.  If we are unable to do so, these and other factors may have an adverse effect on our international operations.

The direct distribution of our products in selected foreign countries involves financial and operational risks.

Since 2005, we have been implementing a strategy to selectively replace our third-party international distributors with wholly owned distributorships.  Our foreign activities require additional financial and operational controls beyond those we have in the U.S.  We cannot assure you that we will be able to successfully maintain organizational controls in our foreign operations or that our international strategy will result in increased revenues or profitability.

Our concentration of manufacturing operations in Mexico raises business and competitive risks.

Other than a relatively small manufacturing operation in Tunisia acquired in the recent Axmed acquisition and other than the manufacturing of our BGS products and our custom rigid knee braces that is conducted in Vista, California, all of our manufacturing activities are carried out in our facility in Tijuana, Mexico.  These operations are subject to risks of political and economic instability inherent in activities conducted in foreign countries.  In addition, as a result of this concentration of manufacturing activities, our sales in foreign markets may be at a competitive disadvantage to products manufactured locally due to freight costs, custom and import duties and favorable tax rates for local businesses.  In order to reduce the risk involved in the concentration of most of our manufacturing activities in one foreign jurisdiction and to compete successfully with foreign manufacturers, we may be required to open or expand manufacturing operations abroad, which would be costly to implement and may not effectively reduce the risk of doing business in foreign countries.  We may not be able to successfully operate additional offshore manufacturing operations.

Product liability claims may harm our business if our insurance proves inadequate or the number of claims increases significantly.

We face an inherent business risk of exposure to product liability claims in the event that the use of our technology or products is alleged to have resulted in adverse effects. We have, from time to time, been subject to product liability claims.  In addition, we have operated a Knee Guarantee program since 2001 in relation to our Defiance knee brace.  The Knee Guarantee program will, in specified instances, cover a patient’s insurance deductible up to $1,000, or give uninsured patients $1,000, towards surgery should an ACL re-injury occur while wearing the brace.  In 2003, the Technology You Can Trust program was introduced in connection with our BGS products. If a patient has a nonunion fracture that fails to heal while using a BGS product, the Technology You Can Trust program will, if the patient meets the specified requirements of the program, refund the costs for treatment using the BGS product. If there is a significant increase in claims under these programs, our business could be adversely affected.

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

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

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

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

Our facilities and operations are subject to federal, state and local environmental and occupational health and safety requirements of the United States and foreign countries, including those relating to discharges of substances to the air, water, and land, the handling, storage and disposal of wastes and the cleanup of properties affected by pollutants.  In the future, federal, state, local or foreign governments could enact new or more stringent laws or issue new or more stringent regulations concerning environmental and worker health and safety matters that could affect our operations.  Also, contamination may be found to exist at our current, former or future facilities, including the facility in Tempe, Arizona that we occupied following the Regeneration acquisition, or off-site locations where we have sent wastes.  We could be held liable for such contamination, which could have a material adverse effect on our business or financial condition.  In addition, changes in environmental and worker health and safety requirements or liabilities from newly discovered contamination could have a material effect on our business or financial condition.

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

Nearly all of our rehabilitation products are manufactured in our new facility in Tijuana, Mexico, with a number of products for the European market manufactured in our recently-acquired Tunisian facility.  The products that are still manufactured in Vista, California consist of our custom rigid bracing products, which remain in the U.S. to facilitate quick turn-around on custom orders and the Regeneration product line. These facilities and the manufacturing equipment we use to produce our products would be difficult to repair or replace.  Our facilities may be affected by natural or man-made disasters.  If one of our facilities were affected by a disaster, we would be forced to rely on third-party manufacturers or shift production to another manufacturing facility.  In addition, our insurance may not be sufficient to cover all of our potential losses and may not continue to be available to us on acceptable terms, or at all.

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

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

·authorizing the issuance of “blank check” preferred stock by our board of directors to increase the number of outstanding shares and thwart a takeover attempt;

·a classified board of directors with staggered, three-year terms, which may lengthen the time required to gain control of the board of directors;

·prohibiting cumulative voting in the election of directors, which would otherwise allow less than a majority of stockholders to elect director candidates;

·requiring supermajority voting to effect particular amendments to our certificate of incorporation and bylaws;

·limitations on who may call special meetings of stockholders;

·prohibiting stockholder action by written consent, thereby requiring all actions to be taken at a meeting of the stockholders; and

·establishing advance notice requirements for the nomination of candidates for election to the board of directors or for proposing matters that can be acted upon by stockholders at stockholder meetings.

In addition, Section 203 of the Delaware General Corporation Law prohibits a publicly held Delaware corporation from engaging in a business combination with an interested stockholder, generally defined as a person that together with its affiliates owns or within the last three years has owned 15% of the corporation’s voting stock, for a period of three years after the date of the transaction in which the person became an interested stockholder, unless the business combination is approved in a prescribed manner. Accordingly, Section 203 may discourage, delay or prevent a change in control of our company.

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

Risks Related to Government Regulation

Our failure to comply with regulatory requirements or receive regulatory clearance or approval for our products or operations in the United States or abroad would adversely affect our revenues and potential for future growth.

Our products are medical devices that are subject to extensive regulation in the United States by the Food and Drug Administration, or FDA, and by respective authorities in foreign countries where we do business.  The FDA regulates virtually all aspects of a medical device’s design and testing, manufacture, safety, labeling, storage, recordkeeping, reporting, clearance and approval, promotion and distribution.  The FDA also regulates the export of medical devices to foreign countries.  Failure to comply with the regulatory requirements of the FDA and other applicable U.S. regulatory requirements may subject a company to administrative or judicially imposed sanctions ranging from warning letters to criminal penalties or product withdrawal. Unless an exemption applies, a medical device must receive either clearance or premarket approval from the FDA before it can be marketed in the United States.  The FDA’s 510(k) clearance process for Class II devices usually takes from three to twelve months, but may take significantly longer.  The premarket approval process for Class III devices generally takes from one to three years from the time the application is filed with the FDA, but also can be significantly longer.  Premarket approval typically requires extensive clinical data and can be significantly longer, more expensive and more uncertain than the 510(k) clearance process.  Despite the time, effort and expense expended, there can be no assurance that a particular device will be approved or cleared by the FDA through either the 510(k) clearance process or the premarket approval process.

Medical devices may only be marketed for the indications for which they are approved or cleared.  We may be required to obtain additional new premarket approvals, premarket approval supplements or 510(k) clearances to market additional products or for new indications for or modifications to our existing products.  We cannot be certain that we would obtain additional premarket approvals or 510(k) clearances in a timely manner or at all.  We have modified various aspects of our devices in the past and we determined that new approvals, supplements or clearances either were not required.  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 premarket approvals, supplement approvals or 510(k) clearances for any modification to a previously cleared or approved device, we may be required to cease manufacturing and marketing the modified device or to recall such modified device until we obtain FDA clearance or approval and we may be subject to significant regulatory fines or penalties.  In addition, there can be no assurance that the FDA will clear or approve such submissions in a timely manner, if at all.

Our failure to obtain FDA clearance or approvals of new products, new indications or product modifications that we develop in the future, any limitations imposed by the FDA on such products’ development or use, or the costs of obtaining FDA clearance or approvals could have a material adverse effect on our business.

In many of the foreign countries in which we market our products, we are subject to extensive regulations essentially the same as those of the FDA, including those in Germany, our largest foreign market.  The regulation of our products in Europe falls primarily within the European Economic Area, which consists of the fifteen member states of the European Union, as well as Iceland, Liechtenstein and Norway.  The Council of the European Union (formerly the Council of the European Communities) and the Council of the European Parliament have adopted three directives in order to harmonize national provisions regulating the design, manufacture, clinical trials, labeling and adverse event reporting for medical devices to ensure that medical devices marketed are safe and effective for their intended uses.  The member states of the European Economic Area have implemented the directives into their respective national law.  Medical devices that comply with the conformity requirements of the national provisions and the directives will be entitled to bear a CE marking.  Unless an exemption applies, only medical devices which bear a CE marking may be marketed within the European Economic Area.  Switzerland also allows the marketing of medical devices that bear a CE marking.  Due to the movement towards harmonization of standards in the European Union and the expansion of the European Union, we expect a changing regulatory environment in Europe characterized by a shift from a country-by-country regulatory system to a European Union-wide single regulatory system. Failure to receive, or delays in the receipt of, relevant foreign qualifications, such as the CE marking, could have a material adverse effect on our international operations.

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

We are subject to medical device reporting, or MDR, regulations that require us to report to the FDA or governmental authorities in other countries if our products cause or contribute to a death or serious injury or malfunction in a way that would be reasonably likely to contribute to death or serious injury if the malfunction were to recur.  The FDA and similar governmental authorities in other countries have the authority to require the recall of our products in the event of material deficiencies or defects in design or manufacturing, and we have been subject to product recalls in the past.  A government mandated, or voluntary, 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 and financial resources and could harm our reputation with customers.  There can be no assurance that there will not be product recalls in the future or that such recalls would not have a material adverse effect on our business.

If we fail to comply with the FDA’s Quality System Regulation, our manufacturing could be delayed, and our product sales and profitability could suffer.

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

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

Our products are sold to healthcare providers and physicians who may receive reimbursement for the cost of our products from private third-party payors and, to a lesser extent, from Medicare, Medicaid and other governmental programs.  In certain circumstances, such as for our Regeneration products and the products sold through our OfficeCare program, we submit claims to third-party payors for reimbursement. Our ability to sell our products successfully will depend in part on the purchasing and practice patterns of healthcare providers and physicians, who are influenced by cost containment measures taken by third-party payors.  Limitations or reductions in third-party reimbursement for our products can have a material adverse effect on our sales and profitability.

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

With the passage of the Medicare Prescription Drug, Improvement, and Modernization Act of 2003, or Modernization Act, a number of changes have been mandated to the Medicare payment methodology and conditions for coverage for our orthotic devices and durable medical equipment, including our bone growth stimulators.  These changes include a freeze in reimbursement levels for certain medical devices from 2004 through 2008, competitive bidding requirements, and 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 the Modernization Act’s provisions.  Our Class III bone growth stimulator devices, for example, are not affected by the reimbursement level freeze and are not subject to competitive bidding.  Off-the-shelf orthotic devices are subject to competitive bidding. Under competitive bidding, which is scheduled to be phased in beginning in 2007, Medicare will change its approach to reimbursing certain items and services covered by Medicare from the current fee schedule amount to an amount established through a bidding process

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between the government and suppliers.  Competitive bidding may reduce the number of suppliers providing certain items and services to Medicare beneficiaries and the amounts paid for such items and services.  Also, Medicare payments in regions not subject to competitive bidding may be reduced using payment information from regions subject to competitive bidding.  Any payment reductions or the inclusion of certain of our orthotic devices in competitive bidding, in addition to the other changes to Medicare reimbursement and standards contained in the Modernization Act, could have a material adverse effect on our results of operations.

CMS issued proposed regulations regarding the implementation of competitive bidding on April 24, 2006.  The proposed regulations include, among other things, proposals regarding how CMS will determine in which metropolitan statistical areas it will initiate the program and which products will be subject to competitive bidding.  The proposed regulations also describe how CMS plans to award contracts and how it will evaluate bids and set payment rates.  CMS also proposed to revise the methodology it would use to price new products not included in competitive bidding.  In addition, the proposed regulations define off-the-shelf orthotics as orthotics that “require minimal self-adjustment for appropriate use and do not require expertise in trimming, bending, molding, assembling, or customizing to fit the individual.” CMS further proposes that “minimal self-adjustment” would mean “adjustments that the beneficiary, caretaker for the beneficiary, or supplier of the device can perform without the assistance of a certified orthotist.” This is not a final regulation and, until the proposed regulations are finalized, significant uncertainty remains as to how the competitive bidding program will be implemented.  The proposed regulations do not provide us with sufficient details to assess the impact that competitive bidding and other elements of the rule would have on our business.

In addition, on February 11, 2003, CMS made effective an interim final regulation implementing “inherent reasonableness” authority, which allows adjustments to payment amounts for certain items and services covered by Medicare when the existing payment amount is determined to be grossly excessive or grossly deficient.  The regulation lists factors that may be used to determine whether an existing reimbursement rate is grossly excessive or grossly deficient and to determine what is a realistic and equitable payment amount.  Also, under the regulation, a payment amount will not be considered grossly excessive or grossly deficient if an overall payment adjustment of less than fifteen percent would be necessary to produce a realistic and equitable payment amount.  The Modernization Act clarified that the use of inherent reasonableness authority is precluded for devices provided under competitive bidding.  CMS finalized the inherent reasonableness regulation in December 2005, with an effective date of February 10, 2006, essentially keeping in place the policies in the interim final regulation.  When using the inherent reasonableness authority, CMS may reduce reimbursement levels for certain items and services, which could have a material adverse effect on our results of operations.

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

Changes in international regulations regarding reimbursement for our products could adversely affect our business and results of operations.

Similar to our domestic business, our success in international markets also depends upon the eligibility of our products for reimbursement through government sponsored healthcare payment systems and third-party payors, the portion of cost subject to reimbursement, and the cost allocation between the patient and government sponsored healthcare payment systems and third-party payors.  Reimbursement practices vary significantly by country, with certain countries requiring products to undergo a lengthy regulatory review in order to be eligible for third-party reimbursement.  In addition, healthcare cost containment efforts similar to those we face in the United States are prevalent in many of the foreign countries in which our products are sold, and these efforts are expected to continue in the future, possibly resulting in the adoption of more stringent standards. Any developments in our foreign markets that eliminate or reduce reimbursement rates for our products could have an adverse effect on our ability to sell our products or cause our orthopedic professional customers to use less expensive products in these markets.

Medicare laws mandating new supplier quality standards and conditions for coverage could adversely impact our business.

Medicare regulations require entities or individuals submitting claims and receiving payment to obtain a supplier number, which in turn is predicated on compliance with a number of supplier standards.  Under the Modernization Act, any entity or individual that bills Medicare for durable medical equipment, such as bone growth stimulators, and orthotics and that has a supplier number for submission of such bills will be subject to new quality standards as a condition of receiving payment from the Medicare program.  On August 14, 2006, CMS finalized supplier quality standards.  The standards consist of business-related standards, such as financial and human resources management standards, which would be applicable to all durable medical equipment, orthotics and prosthetics suppliers, and product-specific standards, such as those for customized orthotics products, which focus on product specialization and

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service standards for such items. The Modernization Act also authorizes CMS to establish clinical conditions for payment for durable medical equipment, including establishing types or classes of covered items that require a prescription and a face-to-face examination of the individual by a physician or practitioner.  CMS has proposed to expand the face-to-face visit requirement for clinical conditions of coverage to prosthetics, orthotics and supplies (POS) because they believe items of POS require the same level of medical intervention and skill as durable medical equipment.  These new supplier quality standards and clinical conditions for payment could affect our ability to bill Medicare, limit or reduce the number of individuals who can fit, sell or provide our products and could restrict coverage for our products.

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

The development of managed care programs in which the providers contract to provide comprehensive healthcare to a patient population at a fixed cost per person (referred to as capitation) has put pressure on, and is expected to continue to cause, healthcare providers to lower costs.  One result has been, and is expected to continue to be, a shift toward lower 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-bracing segment, we and many of our competitors are offering lower priced, off-the-shelf products in response to managed care customers.

A further result of managed care and the related pressure on costs has been the advent of buying groups in the United States.  Such buying groups enter into preferred supplier arrangements with one or more manufacturers of orthopedic or other medical products in return for price discounts.  The extent to which such buying groups are able to obtain compliance by their members with such preferred supplier agreements varies considerably depending on the particular buying groups.  In response to the organization of new buying groups, we have entered into national contracts with selected groups and believe that the high levels of product sales to such groups and the opportunity for increased market share have the potential to offset the financial impact of discounting.  We believe that our ability to maintain our existing arrangements will be important to our future success and the growth of our revenues.  In addition, we may not be able to obtain new preferred supplier commitments for major buying groups, in which case we could lose significant potential sales, to the extent these groups are able to command a high level of compliance by their members.  On the other hand, if we receive preferred supplier commitments from particular groups which do not deliver high levels of compliance, we may not be able to offset the negative impact of lower per unit prices or lower margins with any increases in unit sales or in market share.

In international markets, we have experienced downward pressure on product pricing and other effects of healthcare reform similar to that which we have experienced in the United States.  We expect healthcare reform and managed care to continue to develop in our primary international markets, which we expect will result in further downward pressure in product pricing.  The timing and effects on us of healthcare reform and the development of managed care in international markets cannot currently be predicted.

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

In response to pressure from mostly orthopedic practitioners, Congress and state legislatures have from time to time considered proposals that limit the types of orthopedic professionals who can fit or sell our orthotic device products or who can seek reimbursement for them.  Several states have adopted legislation which imposes certification or licensing requirements on the measuring, fitting and adjusting of certain orthotic devices.  Some of these laws have exemptions for manufacturers’ representatives.  Other laws apply to the activities of such representatives.  Other states may be considering similar legislation.  Such laws could limit our potential customers in those jurisdictions in which such legislation or regulations are enacted by limiting the measuring and fitting of these devices to certain licensed individuals.  We may not be successful in opposing their adoption and, therefore, such laws could have a material adverse effect on our business. In addition, efforts have been made to establish such requirements at the federal level for the Medicare program.  For example, in 2000 Congress passed the Medicare, Medicaid, and SCHIP Benefits Improvement and Protection Act of 2000 (BIPA).  BIPA contained a provision requiring as a condition for payment by the Medicare program that certain certification or licensing requirements be met for individuals and suppliers furnishing certain, but not all, custom-fabricated orthotic devices.  CMS has not implemented this requirement.  We cannot predict the effect of implementation of BIPA or implementation of other such laws will have on our business.

We may need to change our business practices to comply with healthcare fraud and abuse laws and regulations.

We are subject to various 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 by criminal and civil sanctions, including, in some instances, imprisonment and exclusion from participation in federal and state healthcare programs, including Medicare, Medicaid, Veterans

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Administration health programs and TRICARE.  Because of the far-reaching nature of these laws, we may be required to alter one or more of our practices.  Healthcare fraud and abuse regulations are complex and even minor, inadvertent irregularities in submissions can potentially give rise to claims that a fraud and abuse law or regulation has been violated.  Any violations of these laws 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 judicial interpretations, we may have to change our business practices or our existing business practices could be challenged as unlawful.

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

As part of our business structure, we submit claims directly to and receive payments directly from the Medicare and Medicaid programs.  Therefore, we are subject to extensive government regulation, including requirements for maintaining certain documentation to support our claims.  Medicare contractors and Medicaid agencies periodically conduct pre- and post-payment review and other audits of claims, and are under increasing pressure to scrutinize more closely healthcare claims and supporting documentation generally.  We periodically receive requests for documentation during the governmental audits of individual claims either on a pre-payment or post-payment basis.  We cannot assure you that review and/or other audits of our claims will not result in material delays in payment, as well as material recoupments or denials, which could reduce our revenue or profits.

Risks Related to our Debt

We substantially increased our indebtedness in connection with the Aircast acquisition.

In order to finance the purchase price of the outstanding stock of Aircast Incorporated and to cover related acquisition costs as well as repay our existing bank debt, we entered into a new credit facility on April 7, 2006, consisting of a term loan of $350 million which was fully drawn at closing and up to $50 million available under a revolving credit facility, under which no amounts were borrowed and of which $45.8 million was available at closing, net of outstanding letters of credit.  As a result, our total long-term debt was increased to approximately $350 million following the acquisition from approximately $46 million just prior to the acquisition.  Following the transaction, we are a much more highly leveraged company, and our flexibility in conducting business operations and continuing to invest in growth opportunities could be reduced as a result of this increased indebtedness. As of September 30, 2006, the balance outstanding under the term loan was $334.3 million and $47.8 million was available under the revolving credit facility, net of outstanding letters of credit.

Our debt agreements contain operating and financial restrictions, which restrict our business and financing activities.

The operating and financial restrictions and covenants in our credit agreement and any future financing agreements may adversely affect our ability to finance future operations, meet our capital needs or engage in our business activities. Currently, our existing credit agreement restricts our ability to:

·incur additional indebtedness;

·issue redeemable equity interests and preferred equity interests;

·pay dividends or make distributions, repurchase equity interests or make other restricted payments;

·redeem subordinated indebtedness;

·create liens;

·enter into certain transactions with affiliates;

·make investments;

·sell assets; or

·enter into mergers or consolidations.

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With respect to mergers or acquisitions, our credit agreement limits our ability to finance acquisitions through additional borrowings.  In addition, our credit agreement prohibits us from acquiring assets or the equity of another company unless:

·we are not in default under the credit agreement;

·after giving pro forma effect to the transaction, we remain in compliance with the financial covenants contained in the credit agreement;

·if the acquisition price is greater than $15 million, the company we are acquiring has positive EBITDA;

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

·if the acquisition involves assets outside the United States, the acquisition price is less than $40 million in the aggregate with all other permitted acquisitions consummated outside the United States during the term of the agreement.

Restrictions contained in our credit agreement could:

·limit our ability to plan for or react to market conditions or meet capital needs or otherwise restrict our activities or business plans; and

·adversely affect our ability to finance our operations, acquisitions, investments or strategic alliances or other capital needs or to engage in other business activities that would be in our interest.

A breach of any of these covenants, ratios, tests or other restrictions could result in an event of default under the credit agreement. Upon the occurrence of an event of default under the credit agreement, the lenders could elect to declare all amounts outstanding under the credit agreement, together with accrued interest, to be immediately due and payable. If we were unable to repay those amounts, the lenders could proceed against the collateral granted to them to secure such indebtedness. If the lenders under the credit agreement accelerate the payment of the indebtedness, there can be no assurance that our assets would be sufficient to repay in full such indebtedness and our other indebtedness.

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

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

·our future financial and operating performance, which will be affected by prevailing economic conditions and financial, business, regulatory and other factors, many of which are beyond our control; and

·the future availability of borrowings under our revolving credit facility or any successor facility, the availability of which depends or may depend on, among other things, our complying with covenants in the credit agreement.

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

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ITEM 2.          UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

None.

ITEM 3.       DEFAULTS UPON SENIOR SECURITIES

None.

ITEM 4.       SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

      None.

ITEM 5.       OTHER INFORMATION

None.

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ITEM 6.       EXHIBITS

(a)  Exhibits

3.1		Amended and Restated Certificate of Incorporation of DJO Incorporated (Incorporated by reference to Exhibit 4.1 to the Registration Statement of DJO Incorporated on Form S-8 (Reg. No. 333-73966))
3.2		Certificate of Amendment of Amended and Restated Certificate of Incorporation of DJO Incorporated (Incorporated by reference to the Registration Statement of DJO Incorporated on Form S-3 (Reg. No. 333-111465))
3.3		Amended and Restated By-laws of DJO Incorporated (Incorporated by reference to Exhibit 4.2 to the Registration Statement of DJO Incorporated on Form S-8 (Reg. No. 333-73966))
3.4		Certificate of Ownership and Merger of DJO Merger Sub, Inc. with and into dj Orthopedics, Inc. dated May 26, 2006 (Incorporated by reference to DJO Incorporated’s Report on Form 8-K dated May 26, 2006)
31.1		Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2		Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
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

* This certification is being furnished solely to accompany this quarterly report pursuant to 18 U.S.C. § 1350, and is not being filed for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, and is not to be incorporated by reference into any filing of DJO Incorporated, whether made before or after the date hereof, regardless of any general incorporation language in such filing.

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

	DJO INCORPORATED
	(Registrant)
Date: November 8, 2006	BY:	/s/ Leslie H. Cross
	Leslie H. Cross
	President and Chief Executive Officer
	(Principal Executive Officer)
Date: November 8, 2006	BY:	/s/ Vickie L. Capps
	Vickie L. Capps
	Executive Vice President, Chief
	Financial Officer and Treasurer
	(Principal Financial and Accounting Officer)

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INDEX TO EXHIBITS

3.1		Amended and Restated Certificate of Incorporation of DJO Incorporated (Incorporated by reference to Exhibit 4.1 to the Registration Statement of DJO Incorporated on Form S-8 (Reg. No. 333-73966))
3.2		Certificate of Amendment of Amended and Restated Certificate of Incorporation of DJO Incorporated (Incorporated by reference to the Registration Statement of DJO Incorporated on Form S-3 (Reg. No. 333-111465))
3.3		Amended and Restated By-laws of DJO Incorporated (Incorporated by reference to Exhibit 4.2 to the Registration Statement of DJO Incorporated on Form S-8 (Reg. No. 333-73966))
3.4		Certificate of Ownership and Merger of DJO Merger Sub, Inc. with and into dj Orthopedics, Inc. dated May 26, 2006 (Incorporated by reference to DJO Incorporated’s Report on Form 8-K dated May 26, 2006)
31.1		Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2		Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
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

* This certification is being furnished solely to accompany this quarterly report pursuant to 18 U.S.C. § 1350, and is not being filed for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, and is not to be incorporated by reference into any filing of DJO Incorporated, whether made before or after the date hereof, regardless of any general incorporation language in such filing.

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