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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2008
or
o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from to .
Commission file number 333-142188
DJO Finance LLC
(Exact name of Registrant as specified in its charter)
Delaware | | 20-5653965 |
(State or other jurisdiction of | | (I.R.S. Employer |
incorporation or organization) | | Identification Number) |
| | |
1430 Decision Street | | |
Vista, California | | 92081 |
(Address of principal executive offices) | | (Zip Code) |
Registrant’s telephone number, including area code: (800) 336-5690
Securities registered pursuant to Section 12(b) of the Act:
Title of each class | | Name of each exchange on which registered |
None | | None |
Securities registered pursuant to Section 12(g) of the Act:
None
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
Yes o No x
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.
Yes o No x
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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x
Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer”, “accelerated filer”, and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer o | | Accelerated filer o |
| | |
Non-accelerated filer x | (Do not check if a smaller reporting company) | Smaller reporting company o |
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).
Yes o No x
As of March 11, 2009, 100% of the issuer’s membership interests were owned by DJO Holdings LLC.
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FORWARD-LOOKING STATEMENTS
This Annual Report on Form 10-K (“Annual Report”) of DJO Finance LLC (“DJOFL”, or “the Company”) for the year ended December 31, 2008 contains forward-looking statements, principally in the sections entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Business.” These statements can be identified because they use words like “anticipates,” “believes,” “estimates,” “expects,” “forecasts,” “future,” “intends,” “plans,” and similar terms. These statements reflect only our current expectations. Forward-looking statements include statements concerning our plans, objectives, goals, strategies, future events, capital expenditures, future results, our competitive strengths, our business strategy, the trends in our industry and the benefits of our acquisitions.
Although we do not make forward-looking statements unless we believe we have a reasonable basis for doing so, we cannot guarantee their accuracy, and actual results may differ materially from those we anticipated due to a number of uncertainties, many of which are unforeseen, including, among others, the risks we face as described in the paragraph below and elsewhere in this filing. You should not place undue reliance on these forward-looking statements, which apply only as of the date of this Annual Report. These forward-looking statements are within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, and are intended to be covered by the safe harbors created thereby. To the extent that such statements are not recitations of historical fact, such statements constitute forward-looking statements that, by definition, involve risks and uncertainties. In any forward-looking statement, where we express an expectation or belief as to future results or events, such expectation or belief is expressed in good faith and believed to have a reasonable basis, but there can be no assurance that such future results or events expressed by the statement of expectation or belief will be achieved or accomplished.
We believe it is important to communicate our expectations to our security holders. There may be events in the future, however, that we are unable to predict accurately or over which we have no control. The risk factors listed in Item 1A below, as well as any cautionary language in this Annual Report, provide examples of risks, uncertainties and events that may cause our actual results to differ materially from the expectations we describe in our forward-looking statements.
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PART I.
ITEM 1. BUSINESS
Overview
We are a global provider of high-quality, orthopedic devices, with a broad range of products used for rehabilitation, pain management and physical therapy. We also develop, manufacture and distribute a broad range of surgical reconstructive implant products. We are the largest non-surgical orthopedic rehabilitation device company in the United States and among the largest globally, as measured by revenues. Many of our products have leading market positions. We believe that our strong brand names, comprehensive range of products, focus on quality, innovation and customer service, extensive distribution network, and our strong relationships with orthopedic and physical therapy professionals have contributed to our leading market positions. We believe that we are one of only a few orthopedic device companies that offer healthcare professionals and patients a diverse range of orthopedic rehabilitation products addressing the complete spectrum of preventative, pre-operative, post-operative, clinical and home rehabilitation care. Our products are used by orthopedic specialists, spine surgeons, primary care physicians, pain management specialists, physical therapists, podiatrists, chiropractors, athletic trainers and other healthcare professionals to treat patients with musculoskeletal conditions resulting from degenerative diseases, deformities, traumatic events and sports-related injuries. In addition, many of our non-surgical medical devices and related accessories are used by athletes and patients for injury prevention and at-home physical therapy treatment.
Our current business activities are the result of a combination of two companies with broad orthopedic product offerings in the United States and foreign countries. One of those companies, ReAble Therapeutics, Inc. (“ReAble”), was a leading manufacturer and distributor of electrotherapy products for pain therapy and rehabilitation, a broad range of clinical devices for the treatment of patients in physical therapy clinics, and a broad range of knee, hip and shoulder implant products. In 2006, ReAble was acquired by an affiliate of Blackstone Capital Partners V L.P. (“Blackstone”). The other company, DJO Opco Holdings, Inc. (“DJO Opco”), formerly named DJO Incorporated, was a leading manufacturer and distributor of orthopedic rehabilitation products, including rigid knee bracing, orthopedic soft goods, cold therapy systems, vascular systems and bone growth stimulation devices. On November 20, 2007, ReAble acquired DJO Opco through a merger transaction (the “DJO Merger”). ReAble then changed its name to DJO Incorporated (“DJO”) and continues to be owned primarily by affiliates of Blackstone. ReAble Therapeutics Finance LLC was renamed DJO Finance LLC (“DJOFL”) and ReAble Finance Corporation, the co-issuer of both the 10.875% senior notes due 2014 (the “10.875% Notes”) and 11.75% senior subordinated notes due 2014 (the “11.75% Notes”) (see Note 8 in our audited consolidated financial statements in this Annual Report), was renamed DJO Finance Corporation (“Finco”). DJO is a Delaware corporation incorporated on March 21, 1995. DJOFL is a Delaware limited liability company organized on September 27, 2006.
Historical financial results include results of ReAble and its subsidiaries before and after its acquisition by Blackstone and include the results of DJO Opco from the date of the DJO Merger through December 31, 2008.
Except as otherwise indicated, references to “us”, “we”, “our”, “our Company”, or “the Company” in this Annual Report refers to DJO and its consolidated subsidiaries. Each one of the following trademarks, trade names or service marks, which is used in this Annual Report, is either (i) our registered trademark, (ii) a trademark for which we have a pending application, (iii) a trade name or service mark for which we claim common law rights or (iv) a registered trademark or application for registration which we have been licensed by a third party to use: Cefar®, Empi®, Ormed®, Compex®, EmpiCare®, Aircast®, DonJoy®, OfficeCare®, ProCare®, SpinaLogic®, RME™, CMF™, OL1000™, and OL1000 SC™. All other trademarks, trade names or service marks of any other company appearing in this Annual Report belong to their respective owners.
The DJO Merger
On July 15, 2007, we entered into an Agreement and Plan of Merger with DJO Opco providing for the DJO Merger pursuant to which DJO Opco became a wholly owned subsidiary of DJOFL, the entity filing this Annual Report. The total purchase price for the DJO Merger, which was consummated on November 20, 2007, was approximately $1.3 billion and consisted of $1.2 billion paid to former equity holders (or $50.25 in cash for each share of common stock of DJO Opco they then held), $15.2 million related to the fair value of stock options held by DJO Opco management that were exchanged for options to purchase DJO common stock, and $22.8 million in direct acquisition costs. The DJO Merger was financed through a combination of equity contributed by our primary shareholder, Blackstone, borrowings under our senior secured credit facility (the “Senior Secured Credit Facility”) and proceeds from the newly issued 10.875% Notes (see Note 8 in our audited consolidated financial statements in this Annual Report).
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The Prior Transaction
On November 3, 2006, Blackstone acquired all of the outstanding shares of capital stock of ReAble in a merger transaction (the “Prior Transaction”). The total purchase price for the Prior Transaction was approximately $529.2 million and consisted of $482.5 million paid to former holders of shares of common stock, $7.2 million related to the fair value of management options that continued to remain as outstanding options to purchase ReAble common stock after the Prior Transaction, and $39.5 million in direct acquisition costs. The Prior Transaction was financed through a combination of equity contributed by Blackstone, cash on hand of ReAble, borrowings under our previous senior secured credit facility and proceeds from the 11.75% Notes. Upon the closing of the Prior Transaction, shares of ReAble’s common stock ceased to be traded on the NASDAQ Global Market.
Operating Segments
We classify our operations, pursuant to SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information” (“SFAS 131”), into the three operating segments further described below.
Domestic Rehabilitation Segment
We market our Domestic Rehabilitation Segment products through the four main businesses described below.
· Bracing and Supports. Our Bracing and Supports business unit was acquired with the DJO Merger and offers DonJoy, ProCare, and Aircast products, including rigid knee bracing, orthopedic soft goods, cold therapy products, and vascular systems. This division also includes our OfficeCare business, through which we maintain an inventory of soft goods and other products at healthcare facilities, primarily orthopedic practices, for immediate distribution to patients.
· Empi. Our Empi business unit offers products in the category of home electrotherapy, iontophoresis, and home traction. This division also includes our Rehab Med + Equip business (“RME”) and until the end of 2008, included our EmpiCare business. RME sells a wide range of proprietary and third party rehabilitation products to physical therapists and chiropractors through a printed catalog and through an on-line e-commerce site. Our EmpiCare business maintained an inventory of soft goods and other products at healthcare facilities, primarily orthopedic practices, for immediate distribution to patients and was consolidated into the OfficeCare business during the fourth quarter of 2008.
· Regeneration. Our Regeneration business unit consists of our bone growth stimulation products. These products are sold through a combination of DonJoy sales representatives and additional independent and employed sales representatives dedicated to selling these products either directly to patients or independent distributors. We arrange billing to these third party payors or patients for products directly sold to the patients.
· Chattanooga. Our Chattanooga business unit offers products in the clinical rehabilitation market in the category of clinical electrotherapy devices, clinical traction devices, and other clinical products and supplies such as treatment tables, continuous passive motion (“CPM”) devices and dry heat therapy.
International Rehabilitation Segment
Our International Rehabilitation Segment, which generates most of its revenues in Europe, is divided into three main businesses:
· Bracing and Supports. The international sales of our Bracing and Supports business unit, which offers DonJoy, ProCare, and Aircast products.
· Ormed.DJO. Our Ormed.DJO business, which provides bracing, CPM, electrotherapy and other products primarily in Germany.
· Cefar-Compex. Our Cefar-Compex business provides electrotherapy products for medical and consumer markets and other physical therapy and rehabilitation products primarily in Europe.
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Surgical Implant Segment
Our Surgical Implant Segment develops, manufactures and markets a wide variety of knee, hip and shoulder implant products that serve the orthopedic reconstructive joint implant market.
Material Acquisitions
Our growth has been driven both by the introduction of products facilitated by our research and development efforts and by selected acquisitions of businesses or products primarily related to our Domestic Rehabilitation and International Rehabilitation Segments. In addition to the DJO Merger, which more than doubled our size and product range, we completed the following acquisitions in the last three years:
On August 9, 2007, a subsidiary of DJOFL acquired IOMED Inc. (“IOMED”), which develops, manufactures and markets active drug delivery systems used primarily to treat acute local inflammation in the physical and occupational therapy and sports medicine markets. The purchase price was $23.3 million and consisted of $21.1 million in cash payments to former IOMED equity holders at $2.75 per share, $0.8 million related to the fair value of vested stock options that were outstanding at the time of the acquisition, and $1.4 million in direct acquisition costs. The acquisition was primarily financed with borrowings under our then existing revolving credit facility.
On July 2, 2007, a subsidiary of DJOFL completed its purchase of substantially all of the assets of The Saunders Group, Inc. (“Saunders”) for total cash consideration of $40.9 million, including $0.9 million of acquisition costs (“The Saunders Acquisition”). Saunders is a supplier of rehabilitation products to physical therapists, chiropractors, athletes, athletic trainers, physicians and patients, with a specialty in patented traction devices, back supports, and equipment for neck and back disorders. The Saunders Acquisition was financed with funds borrowed under our then existing senior credit facilities.
On November 7, 2006, a subsidiary of DJOFL acquired all of the issued and outstanding shares of Cefar AB (“Cefar”), a provider of electrotherapy and rehabilitation devices in Europe used for chronic pain, for women’s health (labor pain, incontinence, dysmenorrhea), electroacupuncture, and other rehabilitation activities. We have integrated the operations of Cefar with those of Compex SA, the European subsidiary of Compex Technologies, Inc. (“Compex”). Our strategy for the merged company is to develop both the professional/medical and consumer markets for electrostimulation across Europe and internationally, while continuing to sell products under both the Cefar and Compex brands. The purchase price for Cefar of $27.1 million was comprised of $16.3 million in cash, issuance of 573,134 shares of our common stock valued at $9.5 million, and approximately $1.3 million in acquisition costs. In addition, we also assumed Cefar’s existing debt of approximately $3.8 million, which was subsequently paid in the third quarter of 2008.
On February 24, 2006, pursuant to the terms of a merger agreement dated November 11, 2005, we acquired all of the issued and outstanding shares of Compex Technologies, Inc., a Minnesota corporation (“Compex”). Compex manufactured and sold a broad line of transcutaneous electrical nerve stimulation (“TENS”) and neuromuscular electronic nerve stimulation (“NMES”) products used for pain management, rehabilitation, fitness and sports performance enhancement in clinical, home healthcare, sports and occupational medicine settings. We paid a total purchase price of approximately $102.9 million, comprised of approximately 7.3 million shares of our common stock valued at approximately $90.0 million in exchange for all of the outstanding common stock of Compex, options to purchase approximately 900,000 shares of our common stock valued at $9.3 million in exchange for all of the outstanding options to purchase common stock of Compex, and $3.6 million in acquisition costs.
Industry Background
Market Opportunities
We participate globally in the rehabilitation, pain management, bone growth stimulation and reconstruction segments of the orthopedic device market. In the United States, we estimate these segments accounted for approximately $7.9 billion of total industry sales in 2007. We believe that several factors are driving growth in the orthopedic products industry, including the following:
· Favorable demographics. An aging population is driving growth in the orthopedic products market. Many conditions that result in rehabilitation, physical therapy or orthopedic surgery are more likely to affect people in middle age or later in life. According to a 2008 United States Census Bureau — International Data Base projection, the aging baby boomer generation will result in the percentage of the North American
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population aged 65 and over to grow from 13.1% in 2009 to 16.6% in 2020 and to 20.1% by 2030. In Western Europe, the population aged 65 and over is expected to grow from 18.0% in 2009 to 20.9% in 2020 and to 24.8% by 2030. In addition, according to a 2007 United States Census Bureau — International Data Base projection, the average life expectancy in North America increased from 78.0 years in 2005 to 78.5 years in 2009 and is expected to grow to 81.3 years by 2030. In Western Europe, the average life expectancy increased from 79.2 years in 2005 to 79.8 years in 2009 and is expected to grow to 82.0 years by 2030. As life expectancy increases, we believe people will remain active longer, causing the number of injuries requiring orthopedic rehabilitation, bone growth stimulation and reconstructive implants to increase.
· Shift toward non-surgical rehabilitation devices and at-home physical therapy. We believe the growing awareness and clinical acceptance by healthcare professionals of the benefits of non-surgical, non-pharmaceutical treatment and rehabilitation products, combined with the increasing interest by patients in rehabilitation solutions that minimize risk and recuperation time and provide greater convenience, will continue to drive demand for these products. For example, TENS and NMES devices are increasingly being recognized as effective solutions for pain management and rehabilitation therapy, respectively. In addition, we believe that orthopedic surgeons are increasingly utilizing braces that assist in rehabilitation and bone growth stimulation devices that enable in-home treatment as viable alternatives to surgery. Many of our orthopedic rehabilitation products are designed for at-home use, which we believe should allow us to benefit from the market shift toward these treatment alternatives.
· Lower cost alternatives appeal to third party payors. With the cost of healthcare rising in the United States and internationally, third party payors are seeking more cost-effective therapies without reducing quality of care. For example, third party payors seek to reduce clinic visits and accommodate patients’ preference for therapies that can be conveniently administered at home. We believe that many of our orthopedic rehabilitation products offer cost-effective alternatives to surgery, pharmaceutical and other traditional forms of physical therapy and pain management.
· Increased need for rehabilitation due to increased orthopedic surgical volume. The combination of increased prevalence of degenerative joint disease (such as osteoarthritis), an increased number of sports-related injuries, an aging population and improvements in orthopedic surgical technique (such as arthroscopy) has contributed to an increase in the number of orthopedic surgeries. We believe that orthopedic surgical volume will continue to increase, which should result in an increase in the need for our products.
Competitive Strengths
We believe that we have a number of competitive strengths that will enable us to further enhance our position in the orthopedic rehabilitation device market:
· Leading market positions. We derived over 60% of our net sales in 2008 from products for which we estimate we have leading market positions, including soft goods, ankle braces, walking braces, rigid knee braces, clinical electrotherapy, TENS, NMES, iontophoresis, cold therapy, home and clinical traction and CPM devices. We believe our orthopedic and physical therapy rehabilitation products marketed under the DonJoy, Aircast, ProCare, Chattanooga, Empi, Cefar, Compex and Ormed brands have a reputation for quality, durability and reliability among healthcare professionals. We believe the strength of our brands and our focus on customer service have allowed us to establish market leading positions in the highly fragmented and growing orthopedic rehabilitation market.
· Comprehensive range of orthopedic products. We offer a diverse range of orthopedic devices, including orthopedic rehabilitation, pain management and physical therapy products, bone growth stimulation and surgical reconstructive implant products, to orthopedic specialists and patients for hospital, clinical and at-home therapies. Our broad product offering meets many of the needs of orthopedic professionals and patients and enables us to leverage our brand loyalty with our customer and distributor base. Our products are available across various stages of the orthopedic patient’s continuum of care.
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· Extensive and diverse distribution network. We use multiple channels to distribute our products to our customers. We use nearly 14,000 dealers and distributors and a direct sales force of over 500 employed sales representatives and approximately 800 independent sales representatives to supply our products to physical therapy clinics, orthopedic surgeons and practices, orthotic and prosthetic centers, hospitals, surgery centers, athletic trainers, chiropractors, other healthcare professionals and retail outlets. We believe that our distribution network provides us with a significant competitive advantage in selling our existing products and in introducing new products.
· Strong relationships with managed care organizations and rehabilitation healthcare providers. Our leading market positions in many of our orthopedic rehabilitation product lines and the breadth of our product offerings have enabled us to secure important preferred provider and managed care contracts. We have developed a third party billing system. Our database includes approximately 9,000 different insurance companies and other payors, including over 1,500 active payor contracts. Our proprietary third party billing system is designed to reduce our reimbursement cycles, improve relationships with managed care organizations and physicians and track patients to improve quality of care and create subsequent selling opportunities. Further, our OfficeCare business maintains inventory at over 1,300 healthcare facilities, primarily orthopedic practices, which further strengthens our relationships with these healthcare providers.
· National contracts with group purchasing organizations. We enjoy strong relationships with a meaningful number of group purchasing organizations (“GPOs”) due to our significant scale. We believe that our broad range of products is well suited to the goals of these buying groups. Under these national contracts, we provide favorable pricing to the buying group and are designated a preferred purchasing source for the members of the buying group for specified products. As we have made acquisitions and expanded our product range, we have been able to add incremental products to our national contracts. During 2008, we signed or renewed over 30 national contracts.
· Low cost, high quality manufacturing capabilities. We have a major manufacturing facility in Tijuana, Mexico that has been recognized for operational excellence. The Mexico facility and our other manufacturing facilities employ lean manufacturing, Six Sigma concepts and continuous improvement processes to drive manufacturing efficiencies and lower costs.
· Ability to generate significant cash flow. Historically, our strong competitive position, brand awareness and high quality products and service as well as our low cost manufacturing have allowed us to generate attractive operating margins. These operating margins, together with limited capital expenditures and modest working capital requirements, significantly benefit our ability to generate free cash flow.
· Experienced management team. The members of our management team have an average of over 28 years of relevant experience. This team has successfully integrated a number of acquisitions in the last several years.
Our Strategy
Our strategy is to increase our leading position in key products and markets, increase revenues and profitability and enhance cash flow. Our key initiatives to implement this strategy include the following:
· Increase our leading market positions. We believe we are the market leader in many of the markets in which we compete. We intend to continue to increase our market share by leveraging the cross-selling and other opportunities created by the DJO Merger and by implementing the initiatives described below. The DJO Merger has allowed us to offer customers a more comprehensive range of products to better meet their evolving needs. We believe our size, scale, brand recognition, comprehensive and integrated product offerings and leading market positions enables us to capitalize on the growth in the orthopedic product industry.
· Focus sales force on entire range of DJO products. Our products address the full continuum of a patient’s care, from preventative measures to pre-operative steps to post-operative care and rehabilitation. Our strategy is to train and incentivize our sales force, which consists of agents and representatives familiar with a particular set of products, to work cooperatively and collaboratively with all segments of our sales force to introduce their customers to the full range of our products of which the customer is typically using only a portion. We believe that this represents a significant opportunity to expand our business among customers who are already satisfied with the performance of some of our products.
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· Continue to develop and launch new products and product enhancements. We have a history of developing and introducing innovative products into the marketplace, and we expect to continue future product launches by leveraging our internal research and development platforms. We believe our ability to develop new technology and to advance existing technology to create new products will position us to further diversify our revenues and to expand our target markets by providing viable alternatives to surgery or medication. We believe that product innovation through effective and focused research and development, as well as our relationships with a number of widely recognized orthopedic surgeons and professionals who assist us in product research, development and marketing, will provide a significant competitive advantage. During 2008, we launched 27 new products, which generated over $27.2 million in revenues.
· 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 revenue growth. We believe that our existing relationships with national buying groups and our broad range of products position us well not only to pursue additional national contracts, but also to expand the scope of our existing contracts.
· Expand international sales. In recent years, DJO Opco successfully established direct distribution capabilities in several major international markets. We believe that sales to European and other markets outside the United States continue to represent a significant growth opportunity, and we intend to continue to expand our direct and independent distribution capabilities in attractive foreign markets. For example, in February 2009, we acquired Donjoy Orthopaedics Pty. Ltd., an unaffiliated Australian distributor of our products, for approximately $3.0 million as part of our strategy to expand our international sales. The recent DJO Merger and several of the acquisitions we made in 2006 have substantially increased our international revenues and operating infrastructure and have provided us with opportunities to expand our international product offerings.
· Drive operating efficiency. We plan to continue to apply the principles of lean operations to our manufacturing sites as well as in our operating and administrative functions to increase speed and efficiency and reduce waste. We have instilled a culture of continuous improvement throughout the Company and are pursuing a regular schedule of addressing operations and processes in the Company to improve efficiency. In addition to achieving the cost saving targets that were identified in the DJO Merger, we believe these lean principles and continuous improvement efforts will enhance our operating efficiencies and our ability to compete in an increasingly price-sensitive health care industry.
Our Products
Our products are used by orthopedic specialists, spine surgeons, primary care physicians, other specialist physicians, physical therapists, podiatrists, chiropractors, athletic trainers and other healthcare professionals to treat patients with musculoskeletal conditions resulting from degenerative diseases, deformities, traumatic events and sports related injuries. In addition, many of our non-surgical medical devices and related accessories are used by athletes and patients to prevent injuries and for at-home physical therapy treatment.
Domestic Rehabilitation Segment
Our Domestic Rehabilitation Segment generated net sales of $700.1 million, $331.6 million, and $248.4 million for the years ended December 31, 2008, 2007, and 2006 (combined basis), respectively. For the year ended December 31, 2006, we have combined the Predecessor period and the Successor period and presented the unaudited results of operations on a combined basis because we believe it is useful to compare our financial results on an annualized basis. The Successor period reflects the acquisition of ReAble by Blackstone using the purchase method of accounting pursuant to the provision of Statement of Financial Accounting Standards No. 141, “Business Combinations.” Accordingly, the comparability of the results of the Successor for the full year 2007 to the combined results of the Successor and the Predecessor for the full year 2006 is affected by differences in the basis of presentation, which reflects purchase accounting in the Successor periods historical cost in the Predecessor period. In addition, the comparability of the combined results is impacted by changes in our capital structure which occurred on the date the Prior Transaction was completed (See note 11 in our consolidated financial statements in this Annual Report for net sales, gross profit and operating income for each segment).
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The following table summarizes many of our Domestic Rehabilitation Segment product categories:
Product Category | | Description | |
Home Electrotherapy Devices | | Transcutaneous electrical nerve stimulation (TENS) Neuromuscular electrical nerve stimulation (NMES) Interferential electrical nerve stimulation | |
Clinical Electrotherapy | | TENS
NMES
Ultrasound
Laser
Light therapy | |
Patient Care | | Nutritional supplements Patient safety devices Pressure care products Vascular systems products Continuous passive motion devices | |
Rigid Bracing and Soft Goods | | Soft goods Lower extremity fracture boots Dynamic splinting Ligament braces Post-operative braces Osteoarthritic braces Ankle bracing Shoulder, elbow and wrist braces Back braces Neck braces | |
Hot, Cold and Compression Therapy | | Dry heat therapy Hot/cold therapy Paraffin wax therapy Moist heat therapy Cold therapy Compression therapy | |
Physical Therapy Tables and Traction Products | | Treatment tables Traction Cervical traction Lumbar traction | |
Iontophoresis | | Needle-free transdermal drug delivery | |
Regeneration | | Non-union fracture bone growth stimulation devices Spine bone growth stimulation devices | |
International Rehabilitation Segment
Our International Rehabilitation Segment generated net sales of $228.5 million, $113.0 million, and $64.2 million for the years ended December 31, 2008, 2007, and 2006 (combined basis), respectively. The product categories for our International Rehabilitation Segment are similar to the product categories for our Domestic Rehabilitation Segment but certain products are tailored to international market requirements and preferences. In addition, our International Rehabilitation Segment sells a number of product categories, none of which are individually significant, that we do not sell domestically.
Surgical Implant Segment
Our Surgical Implant Segment generated net sales of approximately $73.4 million, $66.6 million, and $59.1 million for the years ended December 31, 2008, 2007 and 2006 (combined basis), respectively.
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The following table summarizes our Surgical Implant Segment product categories:
Product Categories | | Description | |
Knee implant | | Primary total joint replacement Revision total joint replacement Unicondylar joint replacement | |
| | | |
Hip implants | | Primary replacement stems Acetabular cup system Revision joint replacement | |
| | | |
Shoulder implants | | Primary total joint replacement Fracture repair system Revision total joint replacement (including reverse shoulder) | |
Research and Development
Our research and development programs focus on the development of new products, as well as the enhancement of existing products with the latest technology and updated designs. We seek to develop new technologies to improve durability, performance and usability of existing products, and to develop our manufacturing process to improve product performance and reduce manufacturing costs. In addition to our own research and development, we receive new product and invention ideas from orthopedic surgeons and other healthcare professionals. We also seek to obtain rights to ideas we consider promising from a clinical and commercial perspective through entering into either assignment or licensing agreements.
We conduct research and development programs at our facilities in Austin, Texas; Chattanooga, Tennessee; Vista, California; and Ecublens, Switzerland. We invested approximately $26.9 million, $18.0 million, and $13.6 million in 2008, 2007 (excluding approximately $3.0 million of acquired in-process research and development (“IPR&D”), and 2006 (on a combined basis and excluding approximately $29.1 million of acquired IPR&D) into research and development activities, respectively. As of December 31, 2008, we had approximately 45 employees in our research and development departments.
Marketing and Sales
Our products reach our customers, including hospitals or other healthcare facilities, physicians or other healthcare providers and end user patients, through several sales and distribution channels.
Domestic Rehabilitation Segment
We market and sell our Domestic Rehabilitation Segment products in several different ways. The DonJoy sales channel is responsible for selling rigid knee braces, cold therapy products, and certain soft goods. Certain DonJoy sales representatives also sell our Regeneration products. The DonJoy channel consists of approximately 460 independent commissioned sales representatives who are employed by approximately 33 independent sales agents. The DonJoy channel is 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 the DonJoy product lines generally require customer education in the application and use of the product, our 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 sales representative receives a product order, we generally ship and bill the product directly to the orthopedic professional, paying a sales commission to the agent. For certain custom rigid braces and other products, we sell directly to the patient and bill a third party payor, if applicable, on behalf of the patient. We enjoy long-standing relationships with most of our agents and sales representatives. Under the arrangements with the agents, each agent is granted an exclusive geographic territory for sales of our products and is not permitted to market products, or represent competitors who sell or distribute products, that compete with our existing products. The agents receive a commission, which varies based on the type of product being sold. If an agent fails to achieve specified sales quotas, we have the right to terminate our relationship with the agent. In the first half of 2008, we converted the Northern and Southern California and Pacific Northwest regions to a direct sales model for products in the DonJoy channel and Regeneration products. We now cover those regions with employed sales representatives.
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The ProCare/Aircast channel consists of approximately 100 direct and independent sales representatives that manage over 310 distributors focused on primary and acute care facilities. Seven vascular systems specialists are also included in this channel. Products in this channel consist primarily of our soft goods, vascular systems and other products, which are generally sold in non-exclusive territories to third party distributors as well as through our direct sales force. Our distributors include large, national third party distributors such as Owens & Minor Inc., McKesson/HBOC, Allegiance Healthcare and Physician Sales and Service Inc., regional medical and surgical distributors, outpatient surgery centers and medical products buying groups that consist of a number of health care providers who make purchases through the buying group. These distributors and our direct sales force generally sell our products to large hospital chains, primary care networks and orthopedic physicians for use by the patients. In addition, we sell our products through GPOs that are a preferred purchasing source for members of a buying group. Unlike our DonJoy products, our ProCare/Aircast products generally do not require significant customer education for their use. Our vascular systems pumps and related equipment are typically consigned to hospitals, and the hospitals then purchase the cuffs that are applied to each patient.
Our OfficeCare business provides stock and bill arrangements for physician practices. Through OfficeCare, we maintain an inventory of soft goods at over 1,300 orthopedic practices and other healthcare facilities for immediate distribution to patients. We then bill the patient or, if applicable, a third party payor. For certain facilities, we provide on-site technical representatives. The OfficeCare channel is managed by our DonJoy sales force.
Through our Empi channel, we market our prescription home therapy products primarily to physicians and physical therapy clinics, which include hospital physical therapy departments, sports medicine clinics and pain management centers, through our sales force of over 250 direct and independent sales representatives. In connection with these product lines, we currently have more than 630 managed care contracts. Our electrotherapy and orthotics products are generally prescribed to patients by a physician such as an orthopedic surgeon. The physician will typically direct the patient to a physical therapy clinic to meet with a trained physical therapist who provides the patient with the prescribed product from our consigned inventory at the clinic. This sales process is facilitated by our relationships with third party payors, such as managed care organizations, who ultimately pay us for the products prescribed to patients. For these reasons, we view physical therapists, physicians and third party payors as key decision makers in product selection and patient referral. Our home therapy products generally are eligible for third party reimbursement by government payors, such as Medicare and Medicaid, and private payors. In addition, we have an outbound telemarketing sales force of 35 representatives, who sell reimbursed electrotherapy supplies and other products directly to our patients.
Through our Regeneration business, our non-union fracture bone growth stimulator devices (“OL1000”) are sold primarily by approximately 150 employed and independent sales representatives specially trained to sell the product. The spine bone growth stimulator device (“SpinaLogic”) is sold by a few of our direct sales representatives and a network of independent spine products distributors. Most of our bone growth stimulator products are sold directly to the patient and a third party payor is billed, if applicable, on behalf of the patient.
Through our Chattanooga business, we sell our clinical rehabilitation product lines to physical therapy clinics, primarily through a worldwide network of approximately 4,800 independent distributors, which are managed by our internal sales managers, and through catalogue sales. These distributors sell our clinical rehabilitation products to a variety of healthcare professionals, including physical therapists, athletic trainers, chiropractors, and sports medicine physicians. Except for distributors outside of the United States, we do not maintain formal distribution contracts for our clinical rehabilitation products. These distributors purchase products from us at discounts off our published list price. We maintain an internal marketing and sales support program to support our distributor network. This program comprises a group of individuals who provide distributor and end-user training, develop promotional materials, and attend over 30 trade shows each year.
No particular customer or distributor accounted for 10% or more of product sales in the Domestic Rehabilitation Segment for the year ended December 31, 2008. Medicare and Medicaid together accounted for approximately 5.9% of our 2008 net sales.
International Rehabilitation Segment
We sell our rehabilitation products internationally through a network of wholly-owned subsidiaries and independent distributors. In Europe, we use sales forces aggregating approximately 220 direct and independent salespersons and a network of independent distributors who call on healthcare professionals, as well as consumer retail stores, such as sporting equipment providers, and pharmacies, to sell our products. We intend to continue to expand our direct and indirect distribution capabilities in attractive foreign markets. One recent example of our strategy to expand our international sales is our acquisition of DonJoy Orthopaedics Pty., Ltd. in February 2009.
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Surgical Implant Segment
We currently market and sell the products of our Surgical Implant Segment in the United States to hospitals and orthopedic surgeons through a network of over 170 independent commissioned sales representatives who are employed by approximately 50 sales agents. Generally, our independent sales representatives sell a range of reconstructive joint products, including our products. We usually enter into agreements with sales agents for a term of one to five years. Agents are typically paid a sales commission and are eligible for bonuses if sales exceed certain preset objectives. Our independent sales representatives work for these agents. We assign our sales agents to an exclusive sales territory. Substantially all of our sales agents agree not to sell competitive products. Typically we can only terminate our agreements with sales agents prior to the expiration of the agreements for cause, which includes failure to meet specified periodic sales targets. We provide our sales agents with product inventories on consignment for their use in marketing our products and filling customer orders. Outside the United States, our surgical implant products are sold through independent distributors, principally in Japan and select countries in Europe.
To a significant extent, sales of our surgical implant products depend on the preference of orthopedic surgeons. We maintain contractual relationships with orthopedic surgeons who assist us in developing our products and provide consulting services in connection with our products. In addition to providing design and conducive input into our new products, some of these orthopedic surgeons may give demonstrations using our products, speak about our products at medical seminars, train other orthopedic surgeons in the use of our products, and provide us with feedback on the acceptance of our products. We have also established relationships with surgeons who conduct clinical studies on various products, establish protocols for use of the products and participate at various symposia. Surgeons who assist us in developing our products are generally compensated with a royalty payment. Consulting surgeons are paid consulting fees for their services.
Manufacturing
We use both in-house manufacturing capabilities and relationships with third party vendors to supply our products. Generally, we use third party vendors only when they have special manufacturing capabilities or when we believe it is appropriate based on certain factors, including our in-house capacity, lead time control and cost. Although we have certain sole source supply agreements, we believe alternate vendors are available, and we believe that adequate capacity exists at our current vendors to meet our anticipated needs.
Our manufacturing facilities are generally certified by the International Organization for Standardization (“ISO”) and generally comply with the U.S. Food and Drug Administration (“FDA”) current Good Manufacturing Practice (“cGMP”) and Quality System Regulations (“QSR”) requirements, which provide standards for safe and consistent manufacturing of medical devices and appropriate documentation of the manufacturing and distribution process. Many of our products carry the European Community Medical Device Directive (“CE”) certification mark.
Domestic Rehabilitation Segment
Our manufacturing facility in Tijuana, Mexico is our largest manufacturing facility. Our Mexico facility has achieved ISO 9001 and ISO 13485 certification. These certifications are internationally recognized quality standards for manufacturing and assist us in marketing our products in certain foreign markets. Our Vista, California facility has achieved ISO 9001 certification, EN46001 certification and certification to the Canadian Medical Device Regulation (ISO 13485) and the European Medical Device Directive. Products manufactured at the Vista, California facility include our custom rigid knee bracing products, the pump portion of our vascular systems products and our regeneration products. Within both our Vista and Tijuana facilities, we operate vertically integrated manufacturing and cleanroom packaging operations and many subassemblies and components can be produced in-house. These include metal stamped parts, injection molding components and fabric-strapping materials. We also have extensive in-house tool and die fabrication capabilities, which typically provide savings in the development of tools and molds as well as flexibility to respond to and capitalize on market opportunities as they are identified.
We make Chattanooga division products, including electrotherapy devices, patient care products and physical therapy and chiropractic treatment tables and CPM devices, in our manufacturing facilities located in Chattanooga, Tennessee. These facilities use various manufacturing processes, including metal fabrication, coating, electronic assembly, mechanical assembly, woodworking and sewing. Our Chattanooga, Tennessee facility has achieved ISO 13485 certification.
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Our home electrotherapy devices sold in the United States and certain components and related accessories are manufactured at our Clear Lake, South Dakota facility. Manufacturing activities at the Clear Lake facility include electronic and mechanical assembly, electrode fabrication and assembly and fabric sewing processes. Our electrotherapy products comprise a variety of components, including die cast metal parts, injection molded plastic parts, printed circuit boards, electronic components, lead wires, electrodes and other components. Parts for these components are purchased from outside suppliers and are, in some instances, manufactured on a custom basis. Our Clear Lake facility has achieved the ISO 13485:2003 certification. Our home electrotherapy devices which are sold outside the United States are primarily manufactured by outside third party vendors.
Many of the component parts and raw materials we use in our manufacturing and assembly operations are available from more than one supplier and are generally available on the open market. We source some of our finished products from manufacturers in China as well as other third party manufacturers. We also currently purchase certain CPM devices from a single supply source, Medireha Gmbh (“Medireha”), which is 50% owned by us. Our distribution agreement with Medireha grants us exclusive rights to the distribution of products that Medireha manufactures. The distribution agreement, which expires on August 14, 2009, also requires that we purchase a certain amount of product annually and that we seek Medireha’s approval if we choose to manufacture or distribute products that are identical or similar, or otherwise compete with the products that are the subject of the distribution agreement.
International Rehabilitation Segment
Many of the products for our International Rehabilitation Segment are manufactured in the same facilities as our Domestic Rehabilitation Segment. We operate a manufacturing facility in Tunisia that provides bracing products for the French and other European markets. In addition, our Ormed and Cefar-Compex businesses source most of the products they sell from third party suppliers. Cefar-Compex currently utilizes a single vendor for many of its home electrotherapy devices.
Surgical Implant Segment
In our Surgical Implant Segment, we manufacture our products in our Austin, Texas facility. This manufacturing facility includes computer controlled machine tools, belting, polishing, cleaning, packaging and quality control. We initially obtained ISO qualification and CE certification for this facility in 1996 and updated our ISO qualification to the ISO 13485:2003 standard in 2005. The primary raw materials used in the manufacture of our surgical implant products are cobalt chromium alloy, stainless steel alloys, titanium alloy and ultra high molecular weight polyethylene. All Surgical Implant Segment products go through in-house quality control, cleaning and packaging operations.
Intellectual Property
We own or have licensing rights to U.S. and foreign patents covering a wide range of our products and have filed applications for additional patents. We have numerous trademarks registered in the United States, a number of which are also registered in countries around the world. We also assert ownership of numerous unregistered trademarks, some of which have been submitted for registration in the United States and foreign countries. In the future, we will continue to apply for such additional patents and trademarks as we deem appropriate. Additionally, we seek to protect our non-patented know-how, trade secrets, processes and other proprietary confidential information, through a variety of methods, including having our vendors, employees and consultants sign invention assignment agreements, proprietary information agreements and confidentiality agreements and having our independent sales agents and distributors sign confidentiality agreements. Because many of our products are regulated, proprietary information created during our development of a new or improved product may have to be disclosed to the FDA or another U.S. or foreign regulatory agency in order for us to have the lawful right to market such product. We have distribution rights for certain products that are manufactured by others and hold both exclusive and nonexclusive licenses under third party patents and trade secrets that cover some of our existing products and products under development.
The validity of any of the patents or other intellectual property owned by or licensed to us may not be upheld if challenged by others in litigation. Due to these and other risks described in this Annual Report, we do not rely solely on our patents and other intellectual property to maintain our competitive position. We believe that the development and marketing of new products and improvement of existing ones is, and will continue to be, more important to our competitive position than relying solely on existing products and intellectual property.
Competition
The orthopedic devices market is highly competitive and fragmented. Some of our competitors, either alone or in conjunction with their respective parent corporate groups, have greater research and development, sales, marketing and manufacturing capabilities than we do, and thus may have a competitive advantage over us. Although we believe that the design and quality of our products compare favorably with those of our competitors, if we are unable to offer products with the latest technological advances at competitive prices, our ability to compete successfully could be materially and adversely affected.
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Given our sales history, our history of product development and the experience of our management team, we believe we are capable of effectively competing in the orthopedic devices market in the future. Further, we believe the comprehensive range of products we offer enables us to reach a diverse customer base and to use multiple distribution channels in an attempt to increase our growth across the orthopedic devices market. In addition, we believe the acquisition of the various companies and product lines which primarily now comprise our Domestic Rehabilitation Segment continues to improve the name recognition of our company and our products.
Among other things, our ability to compete is affected by our ability to:
· develop new products and innovative technologies;
· obtain regulatory clearance and compliance for our products;
· manufacture and sell our products cost-effectively;
· meet all relevant quality standards for our products and their markets;
· respond to competitive pressures specific to each of our geographic markets, including our ability to enforce non-compete agreements;
· protect the proprietary technology of our products and manufacturing processes;
· market our products;
· attract and retain skilled employees and sales representatives; and
· maintain and establish distribution relationships.
Domestic Rehabilitation Segment
Our Domestic Rehabilitation Segment competes with large, diversified corporations and companies that are part of corporate groups that have significantly greater financial, marketing and other resources than we do, as well as numerous smaller niche companies. The primary competitors of Empi and Chattanooga are Dynatronics Corporation, Mettler Electronics Corporation, Rich-Mar, Patterson Medical, Enraf-Nonius, Gymna-Uniphy, Acorn Engineering, International Rehabilitation Sciences, Inc. (d/b/a RS Medical) and Care Rehab. The physical therapy products market is highly competitive and fragmented. Our competitors in the CPM devices market include several multi-product companies with significant market share and numerous smaller niche competitors. Competition in these markets is based primarily on the quality and technical features of products, product pricing and contractual arrangements with third party payors and national accounts.
Our primary competitors in the rigid knee bracing market include companies such as Össur hf., Orthofix International, N.V., Bledsoe Brace Systems and Townsend Industries Inc. In the soft goods products market, our competitors include Biomet, Inc., DeRoyal Industries, Össur hf. and Zimmer Holdings, Inc. In the cold therapy products market, our competitors include Orthofix and Stryker Corporation. Our primary competitor in the dynamic splinting market is Dynasplint Systems, Inc. Several competitors have initiated stock and bill programs similar to our OfficeCare and EmpiCare programs, and there are numerous regional stock and bill competitors. Competition in the rigid knee brace market is primarily based on product technology, quality and reputation, relationships with customers, service and price. Competition in the soft goods and pain management markets is less dependent on innovation and technology and is primarily based on product range, quality, service and price.
Our competitors for regeneration products are large, diversified orthopedic companies. In the nonunion bone growth stimulation market, our competitors include Orthofix International, N.V., Biomet, Inc. and Smith & Nephew, and in the spinal fusion market, we compete with Biomet, Inc. and Orthofix International, N.V. Competition in bone growth stimulation devices is limited as higher regulatory thresholds provide a barrier to market entry.
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International Rehabilitation Segment
Competition for our International Rehabilitation products arises from many of the companies and types of companies that compete with our Domestic Rehabilitation Segment and from foreign manufacturers whose costs may be lower due to their ability to manufacture products within their respective countries. Competition is based primarily on quality, innovative design and technical capability, breadth of product line, availability of and qualification for reimbursement, and price.
Surgical Implant Segment
The market for orthopedic products similar to those produced by our Surgical Implant Segment is dominated by a number of large companies, including Biomet, Inc., DePuy, Inc. (a Johnson & Johnson company), Smith & Nephew plc, Stryker Corporation and Zimmer Holdings, Inc., which are much larger and have significantly greater financial resources than we do. Our Surgical Implant Segment also faces competition from U.S.-based companies similar in size to ours, such as Wright Medical Group, Inc. and Exactech, Inc. Competition in the market in which our Surgical Implant Segment participates is based primarily on price, quality, innovative design and technical capability, breadth of product line, scale of operations and distribution capabilities. Our current and future competitors may have greater resources, more widely accepted and innovative products, less-invasive therapies, greater technical capabilities, and stronger name recognition than we do.
Government Regulation
FDA and Similar Foreign Government Regulations
Our products are subject to rigorous government agency regulation in the United States and in other countries. In the United States, the FDA regulates the development, testing, labeling, manufacturing, storage, recordkeeping, premarket clearance or approval, promotion, distribution and marketing of medical devices to ensure that medical products distributed in the United States are safe and effective for their intended uses. The FDA also regulates the export of medical devices manufactured in the United States to international markets. Our medical devices are subject to such FDA regulation.
Under the Food, Drug and Cosmetic Act, as amended, medical devices are classified into one of three classes depending on the degree of risk to patients using the device. Class I devices are those for which safety and effectiveness can be assured by adherence to General Controls, which include compliance with FDA QSRs, facility and device registrations and listings, reporting of adverse medical events, and appropriate truthful and non-misleading labeling, advertising and promotional materials. Some Class I devices also require pre-market review and clearance by the FDA through the Pre-market Notification 510(k) process described below. Class II devices are subject to General Controls, as well as pre-market demonstration of adherence to certain performance standards or other special controls as specified by the FDA. Pre-market review and clearance by the FDA is accomplished through the Pre-market Notification 510(k) procedure. In the 510(k) procedure, the manufacturer submits certain required information to the FDA in order to establish that the device is “substantially equivalent” to a device that was legally marketed prior to May 28, 1976, the date upon which the Medical Device Amendments of 1976 were enacted or to another similar commercially available device subsequently cleared through the 510(k) process. Upon establishment of such substantial equivalence, the FDA may grant clearance to commercially market the device. If the FDA determines that the device, or its intended use, is not “substantially equivalent,” the FDA will automatically place the device into Class III.
A Class III device is a product that has a new intended use or is based on technology that is not substantially equivalent to a use or technology with respect to a legally marketed device for which the safety and effectiveness of the device cannot be assured solely by the General Controls, performance standards and special controls applied to Class I and II devices. These devices generally require clinical trials involving human subjects to assess their safety and effectiveness. A Pre-Market Approval (“PMA”) from the FDA is required before the manufacturer of a Class III product can proceed in marketing the product. The PMA process is much more extensive than the 510(k) process. In order to obtain a PMA, Class III devices, or a particular intended use of any such device, must generally undergo clinical trials pursuant to an application submitted by the manufacturer for an Investigational Device Exemption (“IDE”). An IDE allows the investigational device to be used in a clinical study in order to collect safety and effectiveness data required to support a PMA application or a 510(k) submission to the FDA. The PMA process generally takes significantly longer than the 510(k) process and can take up to several years. In approving a PMA application, the FDA may require additional clinical data and may also require some form of post-market surveillance whereby the manufacturer follows certain patient groups for a number of years, making periodic reports to the FDA on the clinical status of those patients.
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Our products include both pre-amendment and post-amendment Class I, II and III medical devices. All our currently marketed devices are either exempt from the FDA clearance and approval process (based on our interpretation of those regulations) or we have obtained the requisite clearances or approvals (including all modifications, amendments and changes), or pre-market clearances or approvals, as appropriate, required under federal medical device law. The FDA may disagree with our conclusion that clearances or approvals were not required for specific products and may require clearances or approval for such products. In these circumstances, we may be required to cease distribution of the modified product, the devices may be subject to seizure by the FDA or to a voluntary or mandatory recall, and we also could be subject to significant fines and penalties.
Our manufacturing processes are also required to comply with cGMP and QSR requirements that cover the methods and documentation of the design, testing, production processes, control, quality assurance, labeling, packaging and shipping of our products. Furthermore, our facilities, records and manufacturing processes are subject to periodic unscheduled inspections by the FDA and other agencies. Failure to comply with applicable QSR or other U.S. medical device regulatory requirements could result in, among other things, warning letters, fines, injunctions, civil penalties, repairs, replacements, refunds, recalls or seizures of products, total or partial suspensions of production, refusal of the FDA to grant future pre-market clearances or PMA approvals, withdrawals or suspensions of current clearances or approvals, and criminal prosecution. We are also required to report to the FDA if our products cause or contribute to death or serious injury or malfunction in a way that would likely cause or contribute to death or serious injury were the malfunction to recur; the FDA or other agencies may require the recall of products in the event of material defects or deficiencies in design or manufacturing. The FDA can also withdraw or limit our product approvals or clearances in the event of serious unanticipated health or safety concerns.
In January 2007, we received a warning letter from the FDA to the effect that they believed that certain discrete processes related to our Surgical Implant Segment did not conform with cGMP. During 2007, we worked with the FDA to resolve all outstanding issues they had identified in the past as a result of their audits regarding QSR and cGMP compliance. During the first quarter of 2008, the FDA officially concluded their investigation and all areas of concern were resolved satisfactorily. Also, in the first quarter of 2008, we received an FDA Form 483 “Inspectional Observations” in connection with an FDA audit of the Chattanooga division of our Domestic Rehabilitation Segment, stating that we failed to report certain customer complaints claiming that our muscle stimulator devices malfunctioned, and that we did not adequately implement corrective and preventive action to prevent recurrence of potential product failures relating to our muscle stimulator devices. The FDA issued a warning letter in the second quarter of 2008 related to the issues at our Chattanooga operation. We believe we have corrected these issues and are implementing a recall of certain devices. We do not believe that this warning letter and recall will have a material adverse effect on our financial condition or results of operations. However, we cannot assure you that the FDA will not take further action in the future.
Even if regulatory approval or clearance of a medical device is granted, the FDA may impose limitations or restrictions on the use and indications for which the device may be labeled or promoted. Medical devices may be marketed only for the uses and indications for which they are cleared or approved. FDA regulations prohibit a manufacturer from promotion for an unapproved or off-label use.
The FDA has broad regulatory and enforcement powers. If the FDA determines we have failed to comply with applicable regulatory requirements, it can impose a variety of enforcement actions, from warning letters, fines, injunctions, consent decrees, and civil penalties, to suspension or delayed issuance of applications, seizure or recall of our products, total or partial shutdowns, withdrawals of approvals or clearances already granted, and criminal prosecution. The FDA can also require us to repair or replace or refund the costs of devices we manufactured or distributed.
We must obtain export certificates from the FDA before we can export certain of our products. We are also subject to extensive regulations that are similar to those of the FDA in many of the foreign countries in which we sell our products, including those in Europe, our largest foreign market. These include product standards, packaging requirements, labeling requirements, import restrictions, tariff regulations, duties and tax requirements. The regulation of our products in Europe falls primarily within the European Economic Area, which consists of the twenty-seven member states of the European Union, as well as Iceland, Liechtenstein and Norway. Only medical devices that comply with certain conformity requirements are allowed to be marketed within the European Economic Area. In addition, the national health or social security organizations of certain countries other than in Europe require our products to be qualified before they can be marketed in those countries.
We have also implemented policies and procedures allowing us to position ourselves for the changing international regulatory environment. Our Surgical Implant Segment has received an ISO 13485:2003 certification for its facilities and an EC Certificate for its many products. Receiving ISO 13485:2003 certification assists us in meeting international regulatory requirements to allow for export of products to Japan, countries in Europe, Australia and Canada. Our Surgical Implant Segment has also met the requisites for the Canadian Medical Device Requirements. Our Domestic Rehabilitation Segment has received ISO 9001 certification, EN46001 certification and certification to the Canadian Medical Device Regulation (ISO 13485) and the European Medical Device Directive.
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Third Party Reimbursement
Our home therapy products, rigid knee braces, regeneration products, and certain of our soft goods are generally prescribed by physicians and are eligible for third party reimbursement by government payors, such as Medicare and Medicaid, and private payors. Customer selection of our products depends, in part, on coverage of our products and whether third party payment amounts will be adequate. We believe that Medicare and other third party payors will continue to focus on measures to contain or reduce their costs through managed care and other methods. Medicare policies are important to our business because private payors often model their policies after the Medicare program’s coverage and reimbursement policies. In December 2008, Medicare issued a notice to its contractors responsible for reimbursement of orthotics, among other products, to the effect that elastic braces that are not rigid or semi-rigid are not considered “braces” for Medicare coverage purposes and will no longer be reimbursed, effective January 1, 2009. We are seeking a redetermination by Medicare of the application of this notice to several braces we sell that, while not composed of rigid material, operate to support and correct physical issues, particularly relating to the knee cap, and should be continued to be classified as braces for coverage purposes. This decision by Medicare is likely to eventually be adopted by private third-party payers and, subject to our success in seeking the redetermination, could adversely impact our sales in the bracing and soft goods product line of our Domestic Rehabilitation Segment.
Healthcare reform legislation in the Medicare area has focused on containing healthcare spending in recent years. The Medicare Prescription Drug, Improvement, and Modernization Act of 2003 (the “Medicare Modernization Act”) provides for revisions to payment methodologies and other standards for durable medical equipment and orthotic devices under the Medicare program. The Medicare Modernization Act mandated a new competitive bidding program for durable medical equipment, orthotics, prosthetics, and supplies. In April 2007, the Centers for Medicare & Medicaid Services (“CMS”), the agency responsible for administering the Medicare program, issued final regulations in connection with the competitive bidding program. Under competitive bidding, Medicare will no longer reimburse for certain products and services based on the Medicare fee schedule amount in designated competitive bidding areas. Instead, CMS will provide reimbursement for these items and services based on a competitive bidding process. Only those suppliers selected through the competitive bidding process within each designated region will be eligible to have their products reimbursed by Medicare. Bidding was conducted in 2007 for the first phase of competitive bidding in ten metropolitan statistical areas for ten product categories, and bid prices briefly went into effect on effect July 2, 2008. The program was scheduled to be expanded to an additional 70 areas in 2009, and additional areas thereafter. Due to widespread concerns about implementation of the program, however, on July 15, 2008, the U.S. Congress enacted the Medicare Improvements for Patients and Providers Act of 2008 (“MIPPA”), which terminated round one contracts and requires CMS to rebid those areas in 2009. The legislation also delays round two bidding until 2011 and makes a series of changes to program requirements. The delay in bidding is financed by nationwide reductions in Medicare DMEPOS fee schedule payments for items that were subject to the first round of bidding. While none of our product categories is included in the first round of competitive bidding, off-the-shelf orthotics could eventually be subject to the bidding process. The competitive bidding process may reduce the number of suppliers providing certain items and services to Medicare beneficiaries and the amounts paid for such items and services within a given geographic area. In addition, CMS may use payment information from regions subject to competitive bidding to reduce Medicare reimbursement in regions not subject to competitive bidding. CMS also has proposed revising the way Medicare sets payment amounts for all new durable medical equipment, orthotics, prosthetics, and supplies, under which reimbursement could be based in part or in whole on functional assessments, price comparisons, and medical benefits assessments, although that methodology has not yet been finalized. While the program is currently delayed, once it is back in effect, we expect it will be expanded to additional areas and additional product categories may be selected.
In addition, as mandated by the Medicare Modernization Act, in August 2006, CMS issued quality standards for suppliers, which are being applied by independent accreditation organizations. Suppliers must be accredited as meeting supplier standards as a condition of participation in competitive bidding, but all Medicare suppliers eventually must be accredited to participate in Medicare, with different deadlines based on when the supplier applies for enrollment. Those portions of our business that act as Medicare suppliers have been accredited. Moreover, the Medicare Modernization Act requires that new clinical conditions for payment of durable medical equipment be established. CMS issued a proposed rule to implement this provision in August 2004, but the agency to date only has finalized such standards for power mobility devices. Some of our products could be impacted by this requirement in the future. At this time, we cannot predict what clinical conditions will be adopted, the timing of such adoption, or the impact that the new quality standards or any new clinical conditions that are adopted may have on our business.
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CMS also published a rule on January 2, 2009 requiring most Medicare suppliers of durable medical equipment, prosthetics, orthotics and supplies to post a $50,000 surety bond from an authorized surety, with higher amounts required for certain “high-risk” suppliers. The rule provides an exception from the surety bond requirement for the provision of orthotics, prosthetics, and supplies by (1) state-licensed orthotic and prosthetic personnel and (2) state-licensed physical and occupational therapists providing such items to their own patients. This exception applies only to personnel and therapists operating in private practice; medical supply companies employing such personnel or therapists do not qualify for this exception. The rule is effective March 3, 2009. Existing suppliers must comply with the surety bond requirement by October 2, 2009), while new enrolling suppliers or suppliers seeking to change ownership after the effective date must meet this requirement by May 4, 2009.
Our international sales also depend in part upon the eligibility of our products for reimbursement through third party payors, the amount of reimbursement and the allocation of payments between the patient 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 reimbursement standards. For example, in Germany, our largest foreign market, new regulations generally require adult patients to pay a portion of the cost of each medical technical device prescribed. This may adversely affect our sales and profitability by making it more difficult for patients in Germany to pay for our products. Any developments in our foreign markets that eliminate, reduce or materially modify coverage of, and reimbursement rates for, our products could have an adverse effect on our ability to sell our products.
Fraud and Abuse
We are subject to various federal and state laws and regulations pertaining to healthcare fraud and abuse. Violations of these laws are punishable by criminal and civil sanctions, including, in some instances, exclusion from participation in federal and state healthcare programs, including Medicare, Medicaid, Veterans Administration health programs and TRICARE (the health care program for active duty military, retirees and their families managed by the Department of Defense). We have no reason to believe that our operations are not in material compliance with such laws. However, because these laws and regulations are broad in scope and may change, we may be required to alter one or more of our practices to be in compliance with these laws. In addition, the occurrence of one or more violations of these laws or regulations, a challenge to our operations by a governmental authority under these laws or regulations or a change in the laws or regulations may have a material adverse effect on our financial condition and results of operations.
Anti-Kickback and Other-Fraud Laws
Our operations are subject to federal and state anti-kickback laws. Certain provisions of the Social Security Act, commonly referred to as the Anti-Kickback Statute, prohibit persons from knowingly and willfully soliciting, receiving, offering or providing remuneration directly or indirectly to induce either the referral of an individual, or the furnishing, recommending, or arranging for a good or service, for which payment may be made under a federal healthcare program such as Medicare and Medicaid. The definition of “remuneration” has been broadly interpreted to include anything of value, including such items as gifts, discounts, waiver of payments, and providing anything at less than its fair market value. The U.S. Department of Health and Human Services (“HHS”) has issued regulations, commonly known as safe harbors, that set forth certain conditions which, if fully met, will assure healthcare providers and other parties that they will not be prosecuted under the Anti-Kickback Statute. Although full compliance with these provisions ensures against prosecution under the Anti-Kickback Statute, the failure of a transaction or arrangement to fit within a specific safe harbor does not necessarily mean that the transaction or arrangement is illegal or that prosecution under the Anti-Kickback Statute will be pursued. The penalties for violating the Anti-Kickback Statute include imprisonment for up to five years, fines of up to $25,000 per violation and possible exclusion from federal healthcare programs such as Medicare and Medicaid. Many states have adopted prohibitions similar to the Anti-Kickback Statute, some of which apply to the referral of patients for healthcare services reimbursed by any source, not only by the Medicare and Medicaid programs.
Recently, certain manufacturers of implant products entered into monetary settlement agreements, corporate integrity agreements and deferred prosecution agreements with the U.S. Department of Justice (“DOJ”) based upon allegations that, among other things, they entered into a variety of consulting and other agreements with physicians as improper inducements to those physicians to use the manufacturers’ products in violation of federal anti-kickback laws. We believe that remuneration paid to surgeons with which we have agreements represents fair market value for legitimate designing, consulting and advisory services rendered on our behalf.
Our OfficeCare program is a stock and bill arrangement through which we make products and services available in the offices of physicians or other providers. In conjunction with the OfficeCare program, we may pay participating physicians a fee for rental space and support services provided by such physicians to us. In a February 2000 Special Fraud Alert, the Office of Inspector General (“OIG”) indicated that it may scrutinize stock and bill programs involving excessive rental payments or rental space for possible violation of the Anti-Kickback Statute, but noted that legitimate arrangements, including fair market value rental arrangements, will not be considered violations of the statute. We believe that we have structured our OfficeCare program to comply with the Anti-Kickback Statute.
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The Health Insurance Portability and Accountability Act of 1995 (“HIPAA”) created two new federal crimes effective as of August 21, 1996, relating to healthcare fraud and false statements regarding healthcare matters. The healthcare fraud statute prohibits knowingly and willfully executing or attempting to execute a scheme or artifice to defraud any healthcare benefit program, including private payors. The false statements statute prohibits knowingly and willfully falsifying, concealing or covering up a material fact or making any materially false, fictitious or fraudulent statement or representation in connection with the delivery of or payment for healthcare benefits, items or services. HIPAA applies to any healthcare benefit plan, not just Medicare and Medicaid. Additionally, HIPAA granted expanded enforcement authority to HHS and the DOJ and provided enhanced resources to support the activities and responsibilities of the HHS, OIG and DOJ by authorizing large increases in funding for investigating fraud and abuse violations relating to healthcare delivery and payment. In addition, HIPAA mandates the adoption of standards for the electronic exchange of health information, as described below in greater detail under “Federal Privacy and Transaction Law and Regulations.”
Physician Self-Referral Laws
We may also be subject to federal and state physician self-referral laws. Federal physician self-referral legislation, commonly known as the Stark Law, prohibits, subject to certain exceptions, physician referrals of Medicare and Medicaid patients to an entity providing certain “designated health services” if the physician or an immediate family member of the physician or a physician organization in which the physician participates has any financial relationship with the entity. Durable medical equipment and orthotics are included as designated health services. The Stark Law also prohibits the entity receiving the referral from billing any good or service furnished pursuant to an unlawful referral, and any person collecting any amounts in connection with an unlawful referral is obligated to refund such amounts. A person who engages in a scheme to circumvent the Stark Law’s referral prohibition may be fined up to $100,000 for each such arrangement or scheme. The penalties for violating the Stark Law also include civil monetary penalties of up to $15,000 per referral and possible exclusion from federal healthcare programs such as Medicare and Medicaid. Various states have corollary laws to the Stark Law, including laws that require physicians to disclose any financial interest they may have with a healthcare provider to their patients when referring patients to that provider. Both the scope and exceptions for such laws vary from state to state.
False Claims Laws
Under multiple state and federal statutes, submissions of claims for payment that are “not provided as claimed” may lead to civil money penalties, criminal fines and imprisonment and/or exclusion from participation in Medicare, Medicaid and other federally funded state health programs. These false claims statutes include the federal False Claims Act, which prohibits the knowing filing of a false claim or the knowing use of false statements to obtain payment from the federal government. When an entity is determined to have violated the False Claims Act, it must pay three times the actual damages sustained by the government, plus mandatory civil penalties of between $5,500 and $11,000 for each separate false claim. Suits filed under the False Claims Act, known as “qui tam” actions, can be brought by any individual on behalf of the government and such individuals, commonly known as whistleblowers, may share in any amounts paid by the entity to the government in fines or settlement. In addition, certain states have enacted laws modeled after the federal False Claims Act. Qui tam actions have increased significantly in recent years, causing greater numbers of healthcare companies to have to defend a false claim action, pay fines or be excluded from Medicare, Medicaid or other federal or state healthcare programs as a result of an investigation arising out of such action. A number of manufacturers have entered settlements, following allegations that they “aided and abetted” in the submission of false claims, related to pricing, off-label promotion, and other issues. Under the Deficit Reduction Act of 2006, additional requirements related to the establishment and dissemination of written policies regarding the False Claims Act were placed on certain providers of Medicare services.
Governmental Audits
Because we participate in governmental programs as a supplier of medical devices, our operations are subject to periodic surveys and audits by governmental entities or contractors to assure compliance with Medicare and Medicaid standards and requirements. To maintain our billing privileges, we are required to comply with certain supplier standards, including licensure and documentation requirements for our claims submissions. From time to time in the ordinary course of business, we, like other healthcare companies, are audited by, or receive claims documentation requests from, governmental entities, which may identify certain deficiencies based on our alleged failure to comply with applicable supplier standards or other requirements. Medicare contractors and Medicaid agencies periodically conduct pre- and post-payment reviews and other audits of claims and are under increasing pressure to more closely scrutinize healthcare claims and supporting documentation. We have
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historically been subject to pre and post-payment reviews as well as audits of claims and may experience such reviews and audits of claims in the future. We review and assess such audits or reports and attempt to take appropriate corrective action. We are also subject to surveys of our facilities for compliance with the supplier standards. In November 2008, we were advised that the Medicare Administrative Contractor in the Western Region for our type of products, CIGNA Governmental Services (“CIGNA”), had conducted an audit of our operations. As a result of that audit, CIGNA has asserted that we have been overpaid in the amount of approximately $6.0 million from January 1, 2006 to April 9, 2007. The reason asserted by CIGNA that Medicare was not obligated to provide reimbursement on these claims is that we failed to maintain a California Home Medical Device Retail Exemptee License during such 15 month period. We believe that this licensing program does not apply to our business and have appealed the assessment of the overpayment. During the pendency of the appeal, we are not required to pay the assessed $6.0 million overpayment, but interest at the rate of 11.375% per annum will run on the amount, if any, eventually determined to be due. The $6.0 million is accrued in our consolidated balance sheet as of December 31, 2008.
We have also been subject to periodic audits of our compliance with other federal requirements for our facilities and related quality and manufacturing processes. Our Surgical Implant facility in Austin, Texas resolved in 2008 an FDA warning letter received in 2007 and our facility in Chattanooga received a warning letter following an FDA audit in early 2008. Both of these warning letters are described above in the section “FDA and Similar Foreign Government Regulations”.
Federal Privacy and Transaction Law and Regulations
HIPAA impacts the transmission, maintenance, use and disclosure of certain individually identifiable health information (referred to as “protected health information” or “PHI”). Since HIPAA was enacted in 1996, numerous implementing regulations have been issued, including, but not limited to: (1) standards for the privacy of individually identifiable health information (the “Privacy Rule”), (2) security standards (the “Security Rule”), (3) standards for electronic transactions (the “Transactions Rule”), and (4) standard unique national provider identifier (“NPI Rule”). We refer to these rules as the Administrative Simplification Rules. CMS has also issued regulations governing the enforcement of the Administrative Simplification Rules. Sanctions for violation of HIPAA and /or the Administrative Simplification Rules include criminal and civil penalties.
HIPAA applies to “covered entities,” which includes certain health care providers who conduct certain transactions electronically. As such, HIPAA and the Administrative Simplification Rules apply to certain aspects of our business. The effective date for all of the Administrative Simplification Rules outlined above has passed, and, as such, all of the Administrative Simplification Rules are in effect. To the extent applicable to our operations, we are currently in compliance with HIPAA and the applicable Administrative Simplification Rules.
On February 17, 2009, President Obama signed into law the American Recovery and Reinvestment Act (the “ARRA”). This economic stimulus package includes many health care policy provisions, including strengthened federal privacy and security provisions to protect personally-identifiable health information, including notification requirements for health data security breaches. Many of the details of the new requirements will be implemented through future regulations. We are reviewing the new law to assess the potential impact on our operations.
Employees
As of December 31, 2008, we had approximately 4,690 employees. Of these, approximately 3,100 were engaged in production and production support, 45 in research and development, approximately 1,120 in sales and support, and approximately 425 in various administrative capacities including third party billing. Of these employees, approximately 2,200 were located in the United States, approximately 1,860 were located in Mexico and approximately 630 were located in various other countries, primarily in Europe. Our workforce in the United States is not unionized; however, portions of our workforce in Europe are unionized. We have not experienced any strikes or work stoppages, and our management considers our relationship with our employees to be good.
Segment and Geographic Information
Information about our segments and geographic areas can be found in Note 11 “Segment and Geographic Information” under notes to our audited consolidated financial statements in this Annual Report.
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Available Information
We have made available free of charge through our website, www.DJOglobal.com, our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, other Exchange Act reports and all amendments to those reports as soon as reasonably practicable after such material is electronically filed with the Securities and Exchange Commission (“SEC”). This information can be found under the “Investors-SEC Reports” page of our website. DJO uses its website as a channel of distribution of material Company information. Financial and other material information regarding the Company is routinely posted and accessible on our website. Our SEC reports are also available free of charge on the SEC website at, www.sec.gov. Our Code of Business Conduct and Ethics is available free of charge on our website. It may be found under the “Corporate Governance” page of our website.
ITEM 1A. RISK FACTORS
Our ability to achieve our operating and financial goals is subject to a number of risks, including risks arising from the current economic downturn and 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 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 the Economic Downturn
The current US and global economic downturn and related credit and financial market problems may pose additional risks and exacerbate existing risks to our business.
The serious slowdown in the US and global economy, as well as the dramatic problems in the current credit and financial markets, could have a negative effect on demand for our products, availability and reliability of vendors and third party contract manufacturers, our ability to timely collect our accounts receivable and the availability of financing for acquisitions and working capital requirements.
The slowing of economic activity and lack of available financing could impact our business in a variety of ways, including the following:
· Loss of jobs and lack of health insurance as a result of the economic slowdown could depress demand for health care services and demand for our products.
· Weakened demand for health care services, reduction in the number of insureds and lack of available credit could result in the inability of private insurers to satisfy their reimbursement obligations, lead to delays in payment or cause the insurers to increase their scrutiny of our claims.
· Shortage of available credit for working capital could lead customers who buy capital goods from us to curtail their purchases or have difficulty meeting payment obligations.
· Tightening of credit and disruption in the financial markets could disrupt or delay performance by our third party vendors and contractors and adversely affect our business.
· Problems in the credit and financial markets could limit the availability and size of alternative or additional financing for our working capital or other corporate needs and could make it more difficult and expensive to obtain waivers under or make changes to our existing credit arrangements.
Any of these risks, among others, could adversely affect our business and operating results, and the risks could become more pronounced if the problems in the US and global economies and the credit and financial markets continue or become worse.
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Risks Related To Our Indebtedness
Our substantial leverage could adversely affect our ability to raise additional capital to fund our operations, limit our ability to react to changes in the economy or our industry, expose us to interest rate risk to the extent of our variable rate debt and prevent us from meeting our obligations under our indebtedness.
Due to the DJO Merger, we are highly leveraged. As of December 31, 2008, our total indebtedness was $1,843.6 million. We have an additional $100.0 million available for borrowing under our new revolving credit facility, of which $24.0 million was outstanding as of December 31, 2008.
Our high degree of leverage could have important consequences, including:
· making it difficult for us to make payments on our 10.875% Notes and our 11.75% Notes (collectively, the “Notes”) and other debt;
· increasing our vulnerability to general economic and industry conditions;
· requiring a substantial portion of cash flow from operations to be dedicated to the payment of principal and interest on our indebtedness, therefore reducing our ability to use our cash flow to fund our operations, capital expenditures and future business opportunities;
· exposing us to the risk of increased interest rates as certain of our borrowings, including certain borrowings under our Senior Secured Credit Facility, will be subject to variable rates of interest;
· limiting our ability to make strategic acquisitions or causing us to make non-strategic divestitures;
· limiting our ability to obtain additional financing for working capital, capital expenditures, product development, debt service requirements, acquisitions and general corporate or other purposes; and
· limiting our ability to adjust to changing market conditions and placing us at a competitive disadvantage compared to our competitors who are less highly leveraged.
We may not be able to incur substantial additional indebtedness in the future. Although our Senior Secured Credit Facility and each of the indentures governing the Notes, which we refer to as the 10.875% Indenture and the 11.75% Indenture (or collectively, the “Indentures”), contain restrictions on the incurrence of additional indebtedness, these restrictions are subject to a number of significant qualifications and exceptions, and under certain circumstances, the amount of indebtedness that could be incurred in compliance with these restrictions could be substantial. If new indebtedness is added to our current debt levels, the related risks that we now face could intensify. In addition, the Indentures will not prevent us from incurring obligations that do not constitute indebtedness under the Indentures.
Our cash paid for interest for the Successor years ended December 31, 2008 and 2007 was $158.8 million and $70.2 million, respectively. As of December 31, 2008, we had $1,079.3 million of debt subject to floating interest rates, including $1,078.3 million under the Senior Secured Credit Facility. Although we currently have interest rate swaps in place to hedge against rising interest rates (see Note 8 to our audited consolidated financial statements in this Annual Report), any additional borrowings we make under the Senior Secured Credit Facility will also be subject to floating interest rates.
Our debt agreements contain restrictions that limit our flexibility in operating our business.
Our Senior Secured Credit Facility and the Indentures governing the Notes contain various covenants that limit our ability to engage in specified types of transactions. These covenants limit our and our restricted subsidiaries’ ability to, among other things:
· incur additional indebtedness or issue certain preferred shares;
· pay dividends on, repurchase or make distributions in respect of our capital stock or make other restricted payments;
· make certain investments;
· sell certain assets;
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· create liens;
· consolidate, merge, sell or otherwise dispose of all or substantially all of our assets; and
· enter into certain transactions with our affiliates.
In addition, we are required to satisfy and maintain a specified senior secured leverage ratio, which becomes more restrictive over time. This covenant could materially and adversely affect our ability to finance our future operations or capital needs. Furthermore, it may restrict our ability to conduct and expand our business and pursue our business strategies. Our ability to meet this senior secured leverage ratio can be affected by events beyond our control, including changes in general economic and business conditions, and we cannot assure you that we will meet the senior secured leverage ratio in the future or at all.
A breach of any of these covenants could result in a default under one or more of these agreements, including as a result of cross default provisions. Upon the occurrence of an event of default under the Senior Secured Credit Facility, the lenders could elect to declare all amounts outstanding under the Senior Secured Credit Facility to be immediately due and payable and terminate all commitments to extend further credit. Such actions by those lenders could cause cross defaults under our other indebtedness. If we were unable to repay those amounts, the lenders under the Senior Secured Credit Facility could proceed against the collateral granted to them to secure that indebtedness. We have pledged a significant portion of our assets as collateral under the Senior Secured Credit Facility. If the lenders under the Senior Secured Credit Facility accelerate the repayment of borrowings, we cannot assure you that we will have sufficient assets to repay the amounts borrowed under the Senior Secured Credit Facility, as well as our unsecured indebtedness.
We may not be able to generate sufficient cash to service all of our indebtedness, and may be forced to take other actions to satisfy our obligations under our indebtedness, which may not be successful.
Our ability to make scheduled payments on or to refinance our debt obligations depends on our financial condition and operating performance, which is subject to prevailing economic and competitive conditions and to certain financial, business and other factors beyond our control. We cannot assure you that we will maintain a level of cash flows from operating activities sufficient to permit us to pay the principal, premium, if any, and interest on our indebtedness.
If our cash flows and capital resources are insufficient to fund our debt service obligations, we may be forced to reduce or delay investments and capital expenditures, or to sell assets, seek additional capital or restructure or refinance our indebtedness. These alternative measures could affect the operation and growth of our business and may not be successful and may not permit us to meet our scheduled debt service obligations. If our operating results and available cash are insufficient to meet our debt service obligations, we could face substantial liquidity problems and might be required to dispose of material assets or operations to meet our debt service and other obligations. In that case, we may not be able to consummate those dispositions or to obtain the proceeds that we could realize from them, and the proceeds from those dispositions may not be adequate to meet any debt service obligations then due. Additionally, our Senior Secured Credit Facility and the Indentures governing the Notes limit the use of the proceeds from dispositions of assets; as a result, we may not be permitted, under our Senior Secured Credit Facility and the Indentures governing the Notes, to use the proceeds from such dispositions to satisfy all current debt service obligations.
We may not be able to repurchase the Notes upon a change of control.
Upon the occurrence of specific kinds of change of control events, we will be required to offer to repurchase all outstanding Notes at 101% of their principal amount plus accrued and unpaid interest. The source of funds for any such purchase of the Notes will be our available cash or cash generated from our subsidiaries’ operations or other sources, including borrowings, sales of assets or sales of equity. We may not be able to repurchase the Notes upon a change of control because we may not have sufficient financial resources to purchase all of the Notes that are tendered upon a change of control. Further, we will be contractually restricted under the terms of our Senior Secured Credit Facility from repurchasing all of the Notes tendered by holders upon a change of control. Accordingly, we may not be able to satisfy our obligations to purchase the Notes unless we are able to refinance or obtain waivers under our Senior Secured Credit Facility. Our failure to repurchase the notes upon a change of control would cause a default under the Indentures governing the Notes and a cross-default under the Senior Secured Credit Facility. Our Senior Secured Credit Facility also provides that a change of control will be a default that permits lenders to accelerate the maturity of borrowings thereunder. Any of our future debt agreements may contain similar provisions.
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The lenders under the Senior Secured Credit Facility will have the discretion to release the guarantors under the senior secured credit agreement in a variety of circumstances, which will cause those guarantors to be released from their guarantees of the Notes.
While any obligations under the Senior Secured Credit Facility remain outstanding, any guarantee of the Notes may be released without action by, or consent of, any holder of the Notes or the trustee under the Indentures governing the Notes, at the discretion of lenders under the Senior Secured Credit Facility, if the related guarantor is no longer a guarantor of obligations under the Senior Secured Credit Facility. The lenders under the Senior Secured Credit Facility will have the discretion to release the guarantees under the Senior Secured Credit Facility in a variety of circumstances. You will not have a claim as a creditor against any subsidiary that is no longer a guarantor of the Notes, and the indebtedness and other liabilities, including trade payables, whether secured or unsecured, of those subsidiaries will effectively be senior to claims of noteholders.
Transfer of the Notes may be limited by the absence of an active trading market, and there is no assurance that any active trading market will develop for the Notes.
The 10.875% Notes and the 11.75% Notes were registered with the SEC in July 2008 and May 2007, respectively, and are publicly traded.
We do not intend to apply for a listing of the Notes on a securities exchange or on any automated dealer quotation system. We cannot make assurances as to the liquidity of markets for the Notes, the ability to sell the Notes or the price at which a holder may be able to sell the Notes. If such markets were to exist, the Notes could trade at prices that may be lower than their principal amount or purchase price depending on many factors, including prevailing interest rates, the market for similar notes, our financial and operating performance and other factors. Historically, the market for non-investment grade debt has been subject to disruptions that have caused substantial volatility in the prices of securities similar to the Notes. The market, if any, for the Notes may experience similar disruptions and any such disruptions may adversely affect the prices at which you may sell your Notes.
Risks Related To Our Business
Recent changes in coverage and reimbursement policies for our products by Medicare or reductions in reimbursement rates for our products could adversely affect our business and results of operations.
The Medicare Modernization Act mandates a number of changes in the Medicare payment methodology and conditions for coverage of orthotic devices and durable medical equipment, including many of our products. These changes include a temporary freeze in annual increases in payments for durable medical equipment from 2004 through 2008, competitive bidding requirements, new clinical conditions for payment and quality standards. Although these changes affect our products generally, specific products may be affected by some, but not all, of the Medicare Modernization Act’s provisions.
Prefabricated orthotic devices and certain durable medical equipment, including many of our products, may be subject to a competitive bidding process established under the Medicare Modernization Act. In April 2007, CMS issued final regulations in connection with the competitive bidding program. Under competitive bidding, Medicare will no longer reimburse for certain products and services based on the Medicare fee schedule amount in designated competitive bidding areas. Instead, CMS will provide reimbursement for these items and services based on a competitive bidding process. Only those suppliers selected through a competitive bidding process within each designated region will be eligible to have their products reimbursed by Medicare. Bidding was conducted in 2007 for the first phase of competitive bidding in ten metropolitan statistical areas for ten product categories, and bid prices briefly went into effect on July 1, 2008. The program was scheduled to be expanded to 70 additional areas in 2009, and additional areas thereafter. On July 15, 2008, the U.S. Congress enacted the Medicare Improvements for Patients and Providers Act of 2008 (MIPPA), which terminated round one contracts and requires CMS to rebid those areas in 2009. The legislation also delays round two bidding until 2011 and makes a series of changes to program requirements. The delay in bidding is financed by nationwide reductions in Medicare DMEPOS fee schedule payments for items that were subject to the first round of bidding. When it is eventually implemented, the competitive bidding process may reduce the number of suppliers providing certain items and services to Medicare beneficiaries and the amounts paid for such items and services within a given geographic area. None of our products is included in the initial round of items subject to bidding; however, there is no assurance they will not be included in the future. Inclusion of any of our products in Medicare competitive bidding or other Medicare reimbursement or coverage reductions could result in such products being sold in lesser quantities or for a lower price, or coverage for such products being discontinued altogether. Any of these developments could have a material adverse effect on our results of operations. In addition, if we are not selected to participate in the competitive bidding program in a particular region, it could have a material adverse effect on our sales and profitability.
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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, if we fail to pass a Quality System Regulation inspection or to comply with these and other applicable regulatory requirements, we may receive a warning letter or could otherwise be required to take corrective action and, in severe cases, we could suffer a disruption of our operations and manufacturing delays. If we fail to take adequate corrective actions, we could be subject to certain enforcement actions, including, among other things, significant fines, suspension of approvals, seizures or recalls of products, operating restrictions and criminal prosecutions. 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.
We have received FDA warning letters in the past. Our Surgical Implant business received a warning letter in January 2007 in which the FDA investigator concluded that we had failed to establish and maintain adequate procedures for handling and investigating complaints, failed to establish and maintain procedures for changes to specifications and processes, including verification or validation of such changes, and found that these failures caused certain products to be misbranded. In the warning letter, the FDA informed us that we would not receive premarket approval for Class III devices to which these issues are reasonably related until the issues have been corrected. During 2007, we submitted a response and met with FDA representatives, and instituted the necessary changes and improvements in our policies and procedures to correct these issues. During the first quarter of 2008, the FDA concluded their follow-up investigation concerning the January 2007 warning letter. We received no observations and all areas of concern were addressed satisfactorily. Also, in the first quarter of 2008, we received FDA Form 483 “Inspectional Observations” in connection with an FDA audit of the Chattanooga division of our Domestic Rehabilitation Segment, stating that we failed to report certain customer complaints claiming that our muscle stimulator devices malfunctioned, and that we did not adequately implement corrective and preventive action to prevent recurrence of potential product failures relating to our muscle stimulator devices. The auditor also recommended that we recall a series of ultrasound devices that had experienced operating issues in 2005, and we are implementing such a recall. We received a warning letter from the FDA in June 2008 relating to reporting issues on the muscle stimulator device complaints and requesting software verification and validation plans and reports regarding the correction of problems associated with the ultrasound product. We believe that we are in a position to address these areas of concern adequately. However, we cannot assure you that the FDA will not take further action along these lines in the future.
We may not be able to successfully integrate businesses that we have recently acquired, or businesses we may acquire in the future, and we may not be able to realize the anticipated cost savings, revenue enhancements or other synergies from such acquisitions.
Our ability to successfully implement our business plan and achieve targeted financial results is highly dependent on our ability to successfully integrate businesses that we have recently acquired and other businesses we acquire in the future. The process of integrating such acquired businesses involves risks. These risks include, but are not limited to:
· demands on management related to the significant increase in the size of our business;
· diversion of management’s attention from the management of daily operations to the integration of newly acquired operations;
· difficulties in the assimilation of different corporate cultures, practices and sales and distribution methodologies;
· difficulties in conforming the acquired company’s accounting policies to ours;
· increased exposure to risks relating to business operations outside the United States;
· retaining the loyalty and business of the customers of acquired businesses;
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· retaining employees who may be vital to the integration of the acquired business or to the future prospects of the combined businesses;
· difficulties and unanticipated expenses related to the integration of departments, information technology systems, including accounting systems, technologies, books and records and procedures, and maintaining uniform standards, such as internal accounting controls, procedures and policies; and
· costs and expenses associated with any undisclosed or potential liabilities.
Failure to successfully integrate the operations of ReAble with the operations of DJO Opco or any other acquired businesses may result in reduced levels of revenue, earnings or operating efficiency than we have achieved or might have achieved if we had not acquired such businesses, and loss of customers of the acquired businesses.
In addition, an important part of our strategy is to generate revenue growth by cross selling products through the expanded distribution network achieved following the acquisition of businesses. Our ability to successfully cross sell our products to the extent we anticipate or at all is subject to considerable uncertainty. To the extent we are not successful in our cross selling efforts, our revenues and income will be adversely affected.
Furthermore, even if we are able to integrate successfully the operations of DJO Opco with the operations of ReAble, as well as other businesses we have recently acquired, or any other acquired business, we may not be able to realize the potential cost savings, synergies and revenue enhancements that were anticipated from the acquisitions, either in the amount or within the time frame that we expect, and the costs of achieving these benefits may be higher than, and the timing may differ from, what we expect. Our ability to realize anticipated cost savings, synergies and revenue enhancements may be affected by a number of factors, including, but not limited to, the following:
· the use of more cash or other financial resources on integration and implementation activities than we expect;
· increases in other expenses unrelated to the acquisitions, which may offset the cost savings and other synergies from the acquisitions;
· our ability to eliminate effectively duplicative back office overhead and overlapping and redundant selling, general and administrative functions, rationalize manufacturing capacity and shift production to more economical facilities; and
· our ability to avoid labor disruptions in connection with any integration, particularly in connection with any headcount reduction.
Specifically, the DJO Merger created significant opportunities to reduce our manufacturing and other costs. We took steps to achieve cost savings by leveraging newly acquired low-cost manufacturing capabilities, rationalizing our combined manufacturing and distribution footprints, increasing procurement savings and eliminating duplicative overhead functions. We also expect to receive cost savings from initiatives we have undertaken in connection with a number of our previously completed acquisitions. However, while we anticipate cost savings based on estimates and assumptions made by our management as to the benefits and associated expenses with respect to our cost savings initiatives, it is possible that these estimates and assumptions may not ultimately reflect actual results. In addition, these estimated cost savings are only estimates and may not actually be achieved in the timeframe anticipated or at all.
If we fail to realize anticipated cost savings, synergies or revenue enhancements, our financial results will be adversely affected, and we may not generate the cash flow from operations that we anticipated, or that is sufficient to repay our indebtedness.
We may experience substantial fluctuations in our quarterly operating results 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:
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· demand for many of 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 that have seasonal variations;
· 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 significant distributors;
· changes in the treatment practices of orthopedic and spine surgeons, primary care physicians, and pain-management specialists, 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.
We operate in a highly competitive business environment, and our inability to compete effectively could adversely affect our business prospects and results of operations.
We operate in highly competitive and fragmented markets. Our Domestic Rehabilitation Segment and International Rehabilitation Segment compete with both large and small companies, including several large, diversified companies with significant market share and numerous smaller niche companies, particularly in the physical therapy products market. Our Surgical Implant Segment competes with a small number of very large companies that dominate the market, as well as other companies similar to our size. We may not be able to offer products similar to, or more desirable than, those of our competitors or at a price comparable to that of our competitors. Compared to us, many of our competitors have:
· greater financial, marketing and other resources;
· more widely accepted products;
· a larger number of endorsements from healthcare professionals;
· a larger product portfolio;
· superior ability to maintain new product flow;
· greater research and development and technical capabilities;
· patent portfolios that may present an obstacle to the conduct of our business;
· stronger name recognition;
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· larger sales and distribution networks; and/or
· international manufacturing facilities that enable them to avoid the transportation costs and foreign import duties associated with shipping our products manufactured in the United States to international customers.
Accordingly, we may be at a competitive disadvantage with respect to our competitors. These factors may materially impair our ability to develop and sell our products.
If we are unable to develop or license new products or product enhancements or find new applications for our existing products, we will not remain competitive.
The markets for our products are characterized by continued new product development and the obsolescence of existing products. Our future success and our ability to increase revenues and make payments on our indebtedness will depend, in part, on our ability to develop, license, acquire and distribute new and innovative products, enhance our existing products with new technology and find new applications for our existing products. However, we may not be successful in developing, licensing or introducing new products, enhancing existing products or finding new applications for our existing products. We also may not be successful in manufacturing, marketing and distributing products in a cost-effective manner, establishing relationships with marketing partners, obtaining coverage of and satisfactory reimbursement for our future products or product enhancements or obtaining required regulatory clearances and approvals in a timely fashion or at all. If we fail to keep pace with continued new product innovation or enhancement or fail to successfully commercialize our new or enhanced products, our competitive position, financial condition and results of operations could be materially and adversely affected.
In addition, if any of our new or enhanced products contain undetected errors or design defects, especially when first introduced, or if new applications that we develop for existing products do not work as planned, our ability to market these and other products could be substantially delayed, and we could ultimately become subject to product liability litigation, resulting in lost revenues, potential damage to our reputation and/or delays in regulatory clearance. In addition, approval of our products or obtaining acceptance of our products by physicians, physical therapists and other healthcare professionals that recommend and prescribe our products could be adversely affected.
The success of our surgical implant products depends on our relationships with leading surgeons who assist with the development and testing of our products.
A key aspect of the development and sale of our surgical implant products is the use of designing and consulting arrangements with orthopedic surgeons who are well recognized in the healthcare community. These surgeons assist in the development and clinical testing of new surgical implant products. They also participate in symposia and seminars introducing new surgical implant products and assist in the training of healthcare professionals in using our new products. We may not be successful in maintaining or renewing our current designing and consulting arrangements with these surgeons or in developing similar arrangements with new surgeons. In that event, our ability to develop, test and market new surgical implant products could be adversely affected. In addition, federal legislation has been proposed that would increase disclosure requirements regarding financial arrangements between manufacturers and physicians, including physicians who serve as consultants. We cannot determine at this time the impact, if any, of such requirements on our relationships with surgeons, but there can be no assurances that such requirements would not impose additional costs on us and/or adversely impact our consulting and other arrangements with surgeons.
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 certain groups (mostly orthotists), the United States Congress and state legislatures have periodically 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. Although some of these state laws exempt manufacturers’ representatives, other states’ laws subject the activities of such representatives to certification or licensing requirements. Additional states may be considering similar legislation. Such laws could reduce the number of potential customers by restricting the activities of our sales representatives in those jurisdictions where such legislation or regulations are enacted. Furthermore, because the sales of orthotic devices are driven in part by the number of professionals who fit and sell them, laws that limit these activities could reduce demand for these products. We may not be successful in opposing the adoption of such legislation or regulations and, therefore, such laws could have a material adverse effect on our business.
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In addition, efforts have been made to establish similar 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. Although CMS has not implemented this requirement, Medicare follows state requirements in those states that require the use of an orthotist or prosthetist for furnishing of orthotics or prosthetics. We cannot predict the effect of implementation of BIPA or implementation of other such laws will have on our business.
If we fail to establish new sales and distribution relationships or maintain our existing relationships, or if our third party distributors and independent sales representatives fail to commit sufficient time and effort or are otherwise ineffective in selling our products, our results of operations and future growth could be adversely impacted.
The sales and distribution of certain of our orthopedic products, regeneration products and our surgical implant products depend, in part, on our relationships with a network of third party distributors and independent commissioned sales representatives. These third party distributors and independent sales representatives maintain the customer relationships with the hospitals, orthopedic surgeons, physical therapists and other healthcare professionals that purchase, use and recommend the use of our products. Although our internal sales staff trains and manages these third party distributors and independent sales representatives, we do not directly monitor the efforts that they make to sell our products. In addition, some of the independent sales representatives that we use to sell our surgical implant products also sell products that directly compete with our core product offerings. These sales representatives may not dedicate the necessary effort to market and sell our products. If we fail to attract and maintain relationships with third party distributors and skilled independent sales representatives or fail to adequately train and monitor the efforts of the third party distributors and sales representatives that market and sell our products, or if our existing third party distributors and independent sales representatives choose not to carry our products, our results of operations and future growth could be adversely affected.
We rely on our own direct sales force for certain of our products, which may result in higher fixed costs than our competitors and may slow our ability to reduce costs in the face of a sudden decline in demand for our products.
We rely on our own direct sales force of over 400 representatives in the United States and approximately 220 representatives in Europe to market and sell certain of the orthopedic rehabilitation products which are intended for use in the home and in rehabilitation clinics. Some of our competitors rely predominantly on independent sales agents and third party distributors. A direct sales force may subject us to higher fixed costs than those of companies that market competing products through independent third parties, due to the costs that we will bear associated with employee benefits, training and managing sales personnel. As a result, we could be at a competitive disadvantage. Additionally, these fixed costs may slow our ability to reduce costs in the face of a sudden decline in demand for our products, which could have a material adverse effect on our results of operations.
The success of all of our products depends heavily on acceptance by healthcare professionals who prescribe and recommend our products, and our failure to maintain a high level of confidence by key healthcare professionals in our products could adversely affect our business.
We have maintained customer relationships with numerous orthopedic surgeons, primary care physicians, other specialist physicians, physical therapists, athletic trainers, chiropractors and other healthcare professionals. We believe that sales of our products depend significantly on their confidence in, and recommendations of, our products. Acceptance of our products depends on educating the healthcare community as to the distinctive characteristics, perceived benefits, clinical efficacy and cost-effectiveness of our products compared to the products offered by our competitors and on training healthcare professionals in the proper use and application of our products. Failure to maintain these customer relationships and develop similar relationships with other leading healthcare professionals could result in a less frequent recommendation of our products, which may adversely affect our sales and profitability.
Our international operations expose us to risks related to conducting business in multiple jurisdictions outside the United States.
The international scope of our operations exposes us to economic, regulatory and other risks in the countries in which we operate. We generated 26.0% of our net revenues from customers outside the United States for the year ended December 31, 2008. Doing business in foreign countries exposes us to a number of risks, including the following:
· fluctuations in currency exchange rates;
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· imposition of investment, currency repatriation and other restrictions by foreign governments;
· potential adverse tax consequences, including the imposition or increase of withholding and other taxes on remittances and other payments by foreign subsidiaries, which, among other things, may preclude payments or dividends from foreign subsidiaries from being used for our debt service, and exposure to adverse tax regimes;
· difficulty in collecting accounts receivable and longer collection periods;
· the imposition of additional foreign governmental controls or regulations on the sale of our products;
· intellectual property protection difficulties;
· changes in political and economic conditions;
· difficulties in attracting high-quality management, sales and marketing personnel to staff our foreign operations;
· labor disputes;
· import and export restrictions and controls, tariffs and other trade barriers;
· increased costs of transportation or shipping;
· exposure to different approaches to treating injuries;
· exposure to different legal, regulatory and political standards; and
· difficulties of local governments in responding to severe weather emergencies, natural disasters or other such similar events.
In addition, as we grow our operations internationally, we will become increasingly dependent on foreign distributors and sales agents for our compliance and adherence to foreign laws and regulations that we may not be familiar with, and we cannot assure you that these distributors and sales agents will adhere to such laws and regulations or adhere to our own business practices and policies. Any violation of laws and regulations by foreign distributors or sales agents or a failure of foreign distributors or sales agents to comply with our business practices and policies could result in legal or regulatory sanctions against us or potentially damage our reputation in that respective international market. If we fail to manage these risks effectively, we may not be able to grow our international operations, and our business and results of operations may be materially adversely affected.
Fluctuations in foreign exchange rates may adversely affect our financial condition and results of operations and may affect the comparability of our results between financial periods.
Our foreign operations expose us to currency fluctuations and exchange rate risks. We are exposed to the risk of currency fluctuations between the U.S. Dollar and the Euro, Pound Sterling, Canadian Dollar, Mexican Peso, Swiss Franc, Australian Dollar, Yen, Norwegian Krone, Danish Krone and Swedish Krona. Sales denominated in foreign currencies accounted for approximately 26.0% of our consolidated net sales for the year ended December 31, 2008, of which 14.4% were denominated in the Euro. Our exposure to fluctuations in foreign currencies arises because certain of our subsidiaries’ results are recorded in these currencies and then translated into U.S. Dollars for inclusion in our consolidated financial statements and certain of our subsidiaries enter into purchase or sale transactions using a currency other than our functional currency. In addition, certain costs associated with our Mexico-based manufacturing operations are incurred in Mexican Pesos. As of December 31, 2008, we had outstanding hedges in the form of forward contracts to purchase Mexican Pesos aggregating a U.S. dollar equivalent of $16.1 million. 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. Changes in currency exchange rates may adversely affect our financial condition and results of operations and may affect the comparability of our results between reporting periods.
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We may not be able to effectively manage our currency translation risks, and volatility in currency exchange rates may adversely affect our financial condition and results of operations.
If adequate levels of reimbursement coverage from third party payors for our products are not obtained, healthcare providers and patients may be reluctant to use our products, and our sales may decline.
Our sales depend largely on whether there is adequate reimbursement coverage by government healthcare programs, such as Medicare and Medicaid, and by private payors. We believe that surgeons, hospitals, physical therapists and other healthcare providers may not use, purchase or prescribe our products and patients may not purchase our products if these third party payors do not provide satisfactory coverage of and reimbursement for the costs of our products or the procedures involving the use of our products. Consequently, we may be unable to sell our products on a profitable basis if third party payors deny coverage, reduce their current levels of reimbursement or fail to cause their levels of reimbursement to rise quickly enough to cover cost increases.
Changes in the coverage of, and reimbursement for, our products by these third party payors could have a material adverse effect on our results of operations. Third party payors continue to review their coverage policies carefully for existing and new therapies and can, without notice, decide not to reimburse for treatments that include the use of our products. They may attempt to control costs by (i) authorizing fewer elective surgical procedures, including joint reconstructive surgeries, (ii) requiring the use of the least expensive product available or (iii) reducing the reimbursement for or limiting the number of authorized visits for rehabilitation procedures. For example, in the United States, Congress and the Centers for Medicare & Medicaid Services, which administers the Medicare program, frequently engages in efforts to contain costs, which may result in a reduction of coverage of, and reimbursement for, our products. Because many private payors model their coverage and reimbursement policies on Medicare policies, third party payors’ coverage of, and reimbursement for, our products could be negatively impacted by discussions like this one or elastic braces and by legislative, regulatory or other measures that reduce Medicare coverage and reimbursement generally.
Our international sales also depend in part upon the coverage and eligibility for reimbursement of our products through government-sponsored healthcare payment systems and third party payors, the amount of reimbursement and the cost allocation of payments between the patient and government-sponsored healthcare payment systems and third party payors. Coverage and 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 coverage and 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 reimbursement standards. For example, in Germany, our largest foreign country market, new regulations generally require adult patients to pay a portion of the cost of each medical technical device purchased. This may adversely affect our sales and profitability by making it more difficult for patients in Germany to pay for our products.
Any developments in the United States or our foreign markets that eliminate, reduce or materially modify coverage of, and reimbursement rates for, our products could have an adverse effect on our ability to sell our products.
Our success depends on receiving regulatory approval for our products, and failure to do so could adversely affect our growth and operating results.
Our products are subject to extensive regulation in the United States by the FDA and by similar governmental authorities in the foreign countries where we do business. The FDA regulates virtually all aspects of a medical device’s development, testing, manufacturing, labeling, promotion, distribution and marketing. In general, unless an exemption applies, a medical device must receive either pre-market approval or pre-market clearance from the FDA before it can be marketed in the United States. While in the past we have received such approvals, we may not be successful in the future in receiving such approvals in a timely manner or at all. If we begin to have significant difficulty obtaining such FDA approvals or clearances in a timely manner or at all, we could suffer a material adverse effect on our revenues and growth.
If we fail to obtain regulatory approval for the modification of, or new uses for, our products, our growth and operating results could suffer.
In order to market modifications to our existing products or market our existing products for new indications, we may be required to obtain pre-market approvals, pre-market approval supplements or pre-market clearances. The FDA requires device manufacturers themselves to make and document a determination of whether or not a modification requires a new approval, supplement or clearance; however, the FDA can review and disagree with a manufacturer’s decision. We may not be successful in receiving such approvals or the FDA may not agree with our decisions not to seek approvals,
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supplements or clearances for any particular device modification. The FDA may require an approval or clearance for any past or future modification or a new indication for our existing products. Such submissions may require the submission of additional clinical or preclinical data and may be time consuming and costly, and may not ultimately be cleared or approved by the FDA. If the FDA requires us to obtain pre-market approvals, pre-market approval supplements or pre-market 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, the FDA may not clear or approve such submissions in a timely manner, if at all. Because a significant portion of our revenues is generated by products that are modified or used for new treatments, delays or failures in obtaining such approvals could reduce our revenue and adversely affect our operating results.
We may fail to receive positive clinical results for our products in development that require clinical trials, and even if we receive positive clinical results, we may still fail to receive the necessary clearance or approvals to market our products.
In the development of new products or new indications for, or modifications to, existing products, we may conduct or sponsor clinical trials. Clinical trials are expensive and require significant investment of time and resources and may not generate the data we need to support a submission to the FDA. Clinical trials are subject to regulation by the FDA and, if federal funds are involved or if an investigator or site has signed a federal assurance, are subject to further regulation by the Office for Human Research Protections and the National Institutes of Health. Failure to comply with such regulation, including, but not limited to, failure to obtain adequate consent of subjects, failure to adequately disclose financial conflicts or failure to report data or adverse events accurately, could result in fines, penalties, suspension of trials, and the inability to use the data to support an FDA submission. In addition, the American Recovery and Reinvestment Act expands federal efforts to compare the effectiveness of different medical treatments; research supported by these efforts eventually could be used to guide public and private coverage and reimbursement policies. In the international market, we are subject to regulations for clinical studies in each respective country.
If we fail to comply with the various regulatory regimes for the foreign markets in which we operate, our operational results could be adversely affected.
In many of the foreign countries in which we market our products, we are subject to extensive regulations that are similar to those of the FDA, including those in Europe. The regulation of our products in Europe falls primarily within the European Economic Area, which consists of the twenty-seven member states of the European Union, as well as Iceland, Liechtenstein and Norway. Only medical devices that comply with certain conformity requirements are allowed to be marketed within the European Economic Area. In addition, the national health or social security organizations of certain foreign countries, including those outside Europe, require our products to be qualified before they can be marketed in those countries. Failure to receive or delays in the receipt of, relevant foreign qualifications in the European Economic Area or other foreign countries could have a material adverse effect on our business.
The FDA regulates the export of medical devices to foreign countries and certain foreign countries may require FDA certification that our products are in compliance with U.S. law. If we fail to obtain or maintain export certificates required for the export of our products, we could suffer a material adverse effect on our revenues and growth.
If the OIG, the FDA or another regulatory agency determines that we have promoted off-label use of our products, we may be subject to various penalties, including civil or criminal penalties, and the off-label use of our products may result in injuries that lead to product liability suits, which could be costly to our business.
The OIG, the FDA and other regulatory agencies actively enforce regulations prohibiting the promotion of a medical device for a use that has not been cleared or approved by the FDA. Use of a device outside its cleared or approved indications is known as “off-label” use. Physicians may use our products for off-label uses, as the FDA does not restrict or regulate a physician’s choice of treatment within the practice of medicine. However, if the OIG or the FDA or another regulatory agency determines that our promotional materials or training constitutes improper promotion of an off-label use, it could request that we modify our training or promotional materials or subject us to regulatory enforcement actions, including the issuance of a warning letter, injunction, seizure, civil fine and criminal penalties. Although our policy is to refrain from statements that could be considered off-label promotion of our products, the FDA, another regulatory agency, or the DOJ could disagree and conclude that we have engaged in off-label promotion and, potentially, aided and abetted in the submission of false claims. In addition, the off-label use of our products may increase the risk of injury to patients, and, in turn, the risk of product liability claims. Product liability claims are expensive to defend and could divert our management’s attention and result in substantial damage awards against us.
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Our compensation, marketing and sales practices may contain certain risks with respect to the manner in which these practices were historically conducted that could have a material adverse effect on us.
We have entered into written agreements for designing and consulting services with physicians for surgical implant products, and we compensate them under our designing physician agreements for services in developing products sold by us. We also seek the assistance of physicians in the design and evaluation of bracing and other rehabilitative products. The form of compensation for such services has historically been a royalty on the sale of our products in the cases where the physician has contributed to the design of the product. We compensate the physicians under consulting agreements for assistance with product development and clinical efforts. We believe that in each instance remuneration paid to physicians represents fair market value for the services provided and is otherwise in compliance with applicable laws. We also use an independent sales force for products for which we provide compliance-related training. The sales force has generally been compensated on commission based on a percentage of revenues generated by products sold as is typical in our industry. We also pay physicians certain rental and office support fees under our OfficeCare program. Under applicable federal and state healthcare fraud and abuse, anti-kickback, false claims and self-referral laws, it could be determined that our designing and consulting arrangements with surgeons, our marketing and sales practices, and our OfficeCare program fall outside permitted arrangements, thereby subjecting us to possible civil and/or criminal sanctions (including exclusion from the Medicare and Medicaid programs), which could have a material adverse effect on our surgical implant business and possibly on our other lines of business. The federal government has significantly increased investigations of medical device manufacturers with regards to alleged kickbacks and other forms of remuneration to physicians who use and prescribe their products and recently has entered into settlement, deferred prosecution and corporate integrity agreements with such manufacturers. Such investigations and enforcement activities often arise based on allegations of violations of the federal Anti-Kickback Statute, and sometimes of civil False Claims Act. Although we believe we maintain a satisfactory compliance program, it may not be adequate in the detection or prevention of violations. The form and effectiveness of our compliance program may be taken into account by the government in assessing sanctions, if any, should it be determined that violations of laws have occurred.
Audits or denials of our claims by government agencies could reduce our revenues or profits.
As part of our business operations, we submit claims on behalf of patients directly to, and receive payments directly from, the Medicare and Medicaid programs and private payors. Therefore, we are subject to extensive government regulation, including requirements for submitting reimbursement claims under appropriate codes and maintaining certain documentation to support our claims. Medicare contractors and Medicaid agencies periodically conduct pre- and post-payment reviews and other audits of claims and are under increasing pressure to more closely scrutinize healthcare claims and supporting documentation. We have historically been subject to pre-payment and post-payment reviews as well as audits of claims and may experience such reviews and audits of claims in the future. For example, as discussed above in “Item 1. Business-Government Regulation-Government Audits,” as a result of an audit in November 2008, CIGNA has asserted that we were overpaid in the amount of $6.0 million from January 1, 2006 to April 9, 2007 due to our failure to maintain a California Home Medical Device Exemptee License during such 15 month period. We believe that this licensing program does not apply to our business and have appealed the assessment of the overpayment. However, such reviews and/or similar audits of our claims could result in material delays in payment, as well as material recoupments or denials, which would reduce our net sales and profitability, or in exclusion from participation in the Medicare or Medicaid programs. Private payors may from time to time conduct similar reviews and audits.
Additionally, we participate in the government’s Federal Supply Schedule program for medical equipment, whereby we contract with the government to supply certain of our products. Participation in this program requires us to follow certain pricing practices and other contract requirements. Failure to comply with such pricing practices and/or other contract requirements could result in delays in payment or fines or penalties, which could reduce our revenues or profits.
We could be subject to governmental investigations under various healthcare “fraud and abuse” laws with respect to our business arrangements with prescribing physicians and other health care professionals.
We are directly, or indirectly through our customers, subject to various federal and state laws pertaining to healthcare fraud and abuse. These laws, which directly or indirectly affect our ability to operate our business include, but are not limited to, the following:
· the federal Anti-Kickback Statute, which prohibits persons from knowingly and willfully soliciting, offering, receiving or providing remuneration, directly or indirectly, in cash or in kind, to induce either the referral of an individual, or the furnishing or arranging for or recommending of a good or service, for which payment may be made under federal healthcare programs, such as Medicare and Medicaid, Veterans Administration health programs, and TRICARE;
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· several federal False Claims statutes, which impose civil and criminal liability on individuals and entities who submit, or cause to be submitted, false or fraudulent claims for payment to the government;
· HIPAA, which prohibits executing a scheme to defraud any healthcare benefit program, and also prohibits false statements, defined as knowingly and willfully falsifying, concealing or covering up a material fact or making any materially false statement in connection with the delivery of or payment for healthcare benefits, items or services;
· the federal physician self-referral prohibition, commonly known as the Stark Law, which, in the absence of a statutory or regulatory exception, prohibits the referral of Medicare and Medicaid patients by a physician to an entity for the provision of certain designated healthcare services, if the physician or a member of the physician’s immediate family has a direct or indirect financial relationship, including an ownership interest in, or a compensation arrangement with, the entity and also prohibits that entity from submitting a bill to a federal payor for services rendered pursuant to a prohibited referral; and
· state law equivalents to the Anti-Kickback Statute, the false claims provisions, the Stark Law and the physician self-referral prohibitions, some of which may apply even more broadly than their federal counterparts because they are not limited to government reimbursed items and include items or services reimbursed by any payor.
The federal government has significantly increased investigations of and enforcement activity involving medical device manufacturers with regard to alleged kickbacks and other forms of remuneration to physicians who use and prescribe their products. Such investigations often arise based on allegations of violations of the federal Anti-Kickback Statute and sometimes allege violations of the civil False Claims Act, in connection with off-label marketing of products to physicians and others.
These laws and regulations are complex and even minor, inadvertent irregularities in submissions can potentially give rise to claims that the law 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 one or more of our business practices to be in compliance with these laws. Required changes could be costly and time consuming. Any failure to make required changes could result in our losing business or our existing business practices being challenged as unlawful.
Healthcare reform, managed care and buying groups have put downward pressure on the prices of our products.
Healthcare reform and the healthcare industry’s response to rising healthcare costs have resulted in a significant expansion of managed care organizations and buying groups. This growth of managed care and the advent of buying groups in the United States have caused a shift toward coverage and payments based on more cost-effective treatment alternatives. Buying groups enter into preferred supplier arrangements with one or more manufacturers of medical products in return for price discounts to members of these buying groups. Our failure to obtain new preferred supplier commitments from major group purchasing organizations or our failure to retain our existing preferred supplier commitments could adversely affect our sales and profitability. In international markets where we sell our products, we have historically 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 a continued emphasis on healthcare reform and managed care in the United States and in these international markets, which could put further downward pressure on product pricing, which, in turn may adversely affect our sales and profitability.
Our products are subject to recalls even after receiving FDA or foreign regulatory clearance or approval. Product recalls could harm our reputation and business.
We are subject to ongoing medical device reporting regulations that require us to report to the FDA or similar governmental authorities in other countries if our products cause, or contribute to, death or serious injury, or malfunction in a way that would be likely to cause, or 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 us to recall our products in the event of actual or potential material deficiencies or defects in design manufacturing, or labeling, and we have been subject to product recalls in the past. In addition, in light of an actual or potential material deficiency, defect in design, manufacturing, or labeling, we may voluntarily elect to recall our products. A government mandated or voluntary recall by us could occur as a result of actual or potential 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 our customers and with the healthcare professionals that use, prescribe and recommend our products. We could have product recalls that result in significant costs to us in the future, and such recalls could have a material adverse effect on our business.
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Product liability claims may harm our business, particularly if the number of claims increases significantly or our product liability insurance proves inadequate.
The manufacture and sale of orthopedic devices and related products exposes us to a significant risk of product liability claims. From time to time, we have been, and we are currently, subject to a number of product liability claims alleging that the use of our products resulted in adverse effects. Even if we are successful in defending against any liability claims, such claims could nevertheless distract our management, result in substantial costs, harm our reputation, adversely affect the sales of all our products and otherwise harm our business. If there is a significant increase in the number of product liability claims, our business could be adversely affected.
We currently carry product liability insurance up to a limit of $25.0 million, subject to aggregate self-insurance retention of $750,000 and a deductible of $50,000 on non-invasive and $250,000 on invasive products. Our insurance policy is subject to annual renewal. Product liability claims made against us may exceed the coverage limit of our policy or such insurance coverage may not continue to be available on commercially reasonable terms or at all. Additionally, we are also subject to the risks that our insurers will exclude from coverage claims made against us or that our insurers may become insolvent. If we do not or cannot maintain adequate product liability insurance, our business and results of operations may be adversely affected.
As of December 31, 2008, we exceeded the coverage limits for certain historical product liability claims. The estimated exposure related to these claims is approximately $1.3 million and has been accrued in our consolidated balance sheet as of that date.
As a result of the DJO Merger, our concentration of manufacturing operations in Mexico increases our business and competitive risks.
Our most significant manufacturing facility is our facility in Tijuana, Mexico, and we also have a relatively small manufacturing operation in Tunisia. Our current and future foreign operations are subject to risks of political and economic instability inherent in activities conducted in foreign countries. Because there are no readily accessible alternatives to these facilities, any event that disrupts manufacturing at or distribution or transportation from these facilities would materially adversely affect our operations. 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.
If we lose one of our key suppliers or one of our contract manufacturers stops making the raw materials and components used in our products, we may be unable to meet customer orders for our products in a timely manner or within our budget.
We rely on a limited number of foreign and domestic suppliers for the raw materials and components used in our products. One or more of our suppliers may decide to cease supplying us with raw materials and components for reasons beyond our control. FDA regulations may require additional testing of any raw materials or components from new suppliers prior to our use of those materials or components. In addition, in the case of a device which is the subject of a pre-market approval, we may be required to obtain prior FDA permission (which may or may not be given), which could delay or prevent our access or use of such raw materials or components. If we are unable to obtain materials we need from our suppliers or our agreements with our suppliers are terminated, and we cannot obtain these materials from other sources, we may be unable to manufacture our products to meet customer orders in a timely manner or within our manufacturing budget. In that event, our business and results of operations could be adversely affected.
In addition, we rely on third parties to manufacture some of our products. For example, Medireha, which is 50% owned by us, has been a supplier for a significant portion of our CPM devices. CPM devices represented approximately 5% of our net sales for the year ended December 31, 2008. If we encounter a cessation, interruption or delay in the supply of the products purchased from Medireha, we may be unable to obtain such products through other sources on acceptable terms, within a reasonable amount of time or at all. We also use a single source for many of the devices Cefar and Compex distribute. In addition, if our agreements with the manufacturing companies were terminated, we may not be able to find suitable replacements within a reasonable amount of time or at all. Any such cessation, interruption or delay may impair our ability to meet scheduled deliveries of our products to our customers and may cause our customers to cancel orders. In that event, our reputation and results of operations may be adversely affected.
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Some of our important suppliers are in China and other parts of Asia and provide predominately finished soft goods products. In fiscal year 2008, we obtained approximately 22.7% 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 suppliers there. The loss of suppliers in China and other parts of Asia, any other interruption or delay in the supply of 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 OL1000 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.
If our patents and other intellectual property rights do not adequately protect our products, we may lose market share to our competitors and may not be able to operate our business profitably.
We rely on a combination of patents, trade secrets, copyrights, trademarks, license agreements and contractual provisions to establish and protect our intellectual property rights in our products and the processes for the development, manufacture and marketing of our products.
We use non-patented, proprietary know-how, trade secrets, processes and other proprietary information and currently employ various methods to protect this proprietary information, including confidentiality agreements, invention assignment agreements and proprietary information agreements with vendors, employees, independent sales agents, distributors, consultants, and others. However, these agreements may be breached. The FDA or another governmental agency may require the disclosure of such information in order for us to have the right to market a product. Trade secrets, know-how and other unpatented proprietary technology may also otherwise become known to or independently developed by our competitors.
In addition, we also hold 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 apply for additional patents in the ordinary course of our business, as we deem appropriate. However, these precautions offer only limited protection, and 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 a material adverse effect on our business, financial condition and results of operations. Additionally, we cannot assure you that our existing or future patents, if any, will afford us adequate protection or any competitive advantage, that any future patent applications will result in issued patents or that our patents will not be circumvented, invalidated or declared unenforceable. In addition, certain of our subsidiaries have not always taken commercially reasonable measures to protect their ownership of some of their patents. While such measures are currently employed and have been employed by us in the past, disputes may arise as to the ownership, or co-ownership, of certain of our patents. We do not consider patent protection to be a significant competitive advantage in the marketplace for electrotherapy devices. However, patent protection may be of significance with respect to our orthopedic technology.
Any proceedings before the U.S. Patent and Trademark Office could result in adverse decisions as to the priority of our inventions and the narrowing or invalidation of claims in issued patents. We could also incur substantial costs in any such proceedings. In addition, the laws of some of the countries in which our products are or may be sold may not protect our products and intellectual property to the same extent as U.S. laws, if at all. We may also be unable to protect our rights in trade secrets and unpatented proprietary technology in these countries.
In addition, we hold patent and other intellectual property licenses from third parties for some of our products and on technologies that are necessary in the design and manufacture of some of our products. The loss of such licenses would prevent us from manufacturing, marketing and selling these products, which in turn could harm our business.
Our operating results and financial condition could be adversely affected if we become involved in litigation regarding our patents or other intellectual property rights.
Litigation involving patents and other intellectual property rights is common in our industry, and companies in our industry have used intellectual property litigation in an attempt to gain a competitive advantage. We may become a party to lawsuits involving patents or other intellectual property. Such litigation is costly and time consuming. If we lose any of these proceedings, a court or a similar foreign governing body could invalidate or render unenforceable our owned or licensed patents, require us to pay significant damages, seek licenses and/or pay ongoing royalties to third parties, require us to redesign our products, or prevent us from manufacturing, using or selling our products, any of which would have an adverse effect on our results of operations and financial condition.
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We have brought, and may in the future also bring, actions against third parties for infringement of our intellectual property rights. We may not succeed in such actions. The defense and prosecution of intellectual property suits, proceedings before the U.S. Patent and Trademark Office or its foreign equivalents and related legal and administrative proceedings are both costly and time consuming. Protracted litigation to defend or enforce our intellectual property rights could seriously detract from the time our management would otherwise devote to running our business. Intellectual property litigation relating to our products could cause our customers or potential customers to defer or limit their purchase or use of the affected products until resolution of the litigation.
Our business strategy relies on certain assumptions concerning demographic and other trends that impact the market for our products. If these assumptions prove to be incorrect, demand for our products may be lower than we currently expect.
Our ability to achieve our business objectives is subject to a variety of factors, including the relative increase in the aging of the general population and an increase in participation in exercise and sports and more active lifestyles. In addition, our business strategy relies on an increasing awareness and clinical acceptance of non-invasive, non-systemic treatment and rehabilitation products, such as electrotherapy. We believe that these trends will increase the need for our orthopedic, physical therapy, regenerative and surgical implant products. The projected demand for our products could materially differ from actual demand if our assumptions regarding these trends and acceptance of our products by healthcare professionals and patients prove to be incorrect or do not materialize. If our assumptions regarding these factors prove to be incorrect, we may not be able to successfully implement our business strategy, which could adversely affect our results of operations. In addition, the perceived benefits of these trends may be offset by competitive or business factors, such as the introduction of new products by our competitors or the emergence of other countervailing trends.
We may expand into new markets through the development of new products and our expansion may not be successful.
We may attempt to expand into new markets through the development of new product applications based on our existing specialized technology and design capabilities. These efforts could require us to make substantial investments, including significant research, development, engineering and capital expenditures for new, expanded or improved manufacturing facilities which would divert resources from other aspects of our business. Expansion into new markets may be costly and may not result in any benefit to us. Specific risks in connection with expanding into new markets include the inability to transfer our quality standards into new products, the failure of customers in new markets to accept our products and price competition in new markets. Such expansion efforts into new markets could be unsuccessful.
Consolidation in the healthcare industry could have an adverse effect on our revenues and results of operations.
Many healthcare industry companies, including medical device, orthopedic and physical therapy products companies, are consolidating to create larger companies. As the healthcare industry consolidates, competition to provide products and services to industry participants may become more intense. In addition, many of our customers are also consolidating, and our customers and other industry participants may try to use their purchasing power to negotiate price concessions or reductions for the products that we manufacture and market. If we are forced to reduce our prices because of consolidation in the healthcare industry, our revenues could decrease, and our business, financial condition and results of operations could be adversely affected.
We could incur significant costs complying with environmental and health and safety requirements, or as a result of liability for contamination or other harm caused by hazardous materials that we use.
Our research and development and manufacturing processes involve the use of hazardous materials. We are subject to federal, state, local and foreign environmental requirements, including regulations governing the use, manufacture, handling, storage and disposal of hazardous materials discharge to air and water, the clean up of contamination and occupational health and safety matters. We cannot eliminate the risk of contamination or injury resulting from hazardous materials, and we may incur liability as a result of any contamination or injury. Under some environmental laws and regulations, we could also be held responsible for costs relating to any contamination at our past or present facilities and at third party waste disposal sites where we have sent workers. These could include costs relating to contamination that did not result from any violation of law, and in some circumstances, contamination that we did not cause. We may incur significant expenses in the future relating to any failure to comply with environmental laws. Any such future expenses or liability could have a significant negative impact on our financial condition. The enactment of stricter laws or regulations, the stricter interpretation of existing laws and regulations or the requirement to undertake the investigation or remediation of currently unknown environmental contamination at our own or third party sites may require us to make additional expenditures, which could be material.
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Our reported results may be adversely affected by increases in reserves for contractual allowances, rebates, product returns, rental credits, uncollectible accounts receivable and inventory.
Our net sales and profitability are affected by changes in reserves to account for contractual allowances, rebates, product returns, rental credits, uncollectible accounts receivable and inventory. Any increase in our reserves for contractual allowances, rebates, product returns, rental credits, uncollectible accounts receivable or inventory could adversely affect our reported financial results by reducing our net revenues and/or profitability for the reporting period.
We have established reserves to account for contractual allowances, rebates, product returns and reserves for rental credits. Significant management judgment must be used and estimates must be made in connection with establishing the reserves for contractual allowances, rebates, product returns, rental credits and other allowances in any accounting period.
We maintain provisions for estimated contractual allowances for reimbursement amounts from our third party payor customers based on negotiated contracts and historical experience for non-contracted payors. We provide for these reserves by reducing our gross revenue. We estimate the amount of the reduction based on historical experience and invoices generated in the period, and we consider the impact of new contract terms or modifications of existing arrangements with our customers. 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.
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. Our third party reimbursement customers including insurance companies, managed care companies and certain governmental payors, such as Medicare, include all of our OfficeCare customers and certain other customers of our Domestic Rehabilitation Segment. We estimate bad debt expense based upon historical experience and current relationships with our customers and providers. 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.
Our reserve for rebates accounts for incentives that we offer to certain of our distributors. These rebates generally are attributable to 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.
The reserve for product returns accounts for customer returns of our products after purchase. These returns are mainly attributable to a third party payor’s refusal to provide a patient release or reimbursement for the product or the inability of the product to adequately address the patient’s condition. If we increase the percentage of our sales made pursuant to agreements providing for reimbursement below invoice price or if customers return products at a higher than estimated rate, we may be required to increase our sales allowance and product return reserves beyond their current levels.
Our reserve for rental credits recognizes a timing difference between billing of a purchase and processing of a rental credit associated with some of our electrotherapy and traction devices. Many insurance providers require patients to rent our rehabilitation devices for a period of one to three months prior to purchase. If the patient has a long-term need for the device, these insurance companies may authorize purchase of the device after such time period. When the device is purchased, most providers require that rental payments previously made on the device be credited toward the purchase price. These credits are processed at the time the payment is received for the purchase of the device, which creates a time lag between billing of the purchase and processing of the rental credit. Our rental credit reserve accounts for unprocessed rental credits based on the number of devices converted to purchase. If the frequency of rental to purchase conversion increases, we may be required to increase our rental credit reserve beyond its current level.
The nature of our business requires us to maintain sufficient inventory on hand at all times to meet the requirements of our customers. 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.
All of our segments consign a portion of their inventory to allow their products to be immediately dispensed to patients. This requires a large amount of inventory to be on hand for the products we sell on consignment. It also increases the sensitivity of these products to obsolescence reserve estimates. As this inventory is not in our possession, we maintain additional reserves for these products based on the results of periodic inventory counts and historical trends.
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Certain administrative functions relating to the OfficeCare and Insurance channels have been outsourced to a third party contractor and this arrangement may not prove successful.
The OfficeCare sales channel maintains a range of products (mostly soft goods) on hand at over 1,300 healthcare facilities, primarily orthopedic practices, for immediate distribution to patients. In the Insurance channel, products primarily including custom-made rigid knee braces are provided directly to patients. In both situations, patients or their third party payors are billed after the product is provided to the patient. The revenue cycle of this program is outsourced, from billing to collections, to an independent third party contractor. The outsource contractor that we have used has undergone significant changes in its business operations in the last two years, including relocating some administrative functions overseas, in order to improve performance from order entry to collections. The contractor may also upgrade the software system used in these revenue cycle processes. The inability of this provider to successfully upgrade its processes or demonstrate acceptable billing and collection results could have an adverse effect on our operations and financial results in the OfficeCare and Insurance channels. In addition, we are terminating these administrative functions for the Insurance channel to internal departments during the first quarter of 2009 and that transition may not be successful.
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.
A significant portion of our rehabilitation products are manufactured in a facility in Tijuana, Mexico, with a number of products for the European market manufactured in a Tunisian facility. In Vista, California we manufacture our custom rigid bracing products, which remain in the United States to facilitate quick turn-around on custom orders, vascular products, and our regeneration product line. Our clinical electrotherapy devices, patient care products, physical therapy and chiropractic treatment tables and certain CPM devices are manufactured in our facilities located in Chattanooga, Tennessee. Our home electrotherapy devices sold in the United States as well as some components and related accessories are manufactured at our facility in Clear Lake, South Dakota. In our Surgical Implant Segment, we manufacture our products in our manufacturing facility at Austin, Texas. 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 such an event, we would face significant delays in manufacturing which would prevent us from being able to sell our products. In addition, our insurance may not be sufficient to cover all of the potential losses and may not continue to be available to us on acceptable terms, or at all.
We may pursue, but may not be able to identify, finance or successfully complete, other strategic acquisitions.
Our growth strategy may include the pursuit of acquisitions, both domestically and internationally. However, we may not be able to identify acceptable opportunities or complete acquisitions of targets in a timely manner or on acceptable terms. In addition, acquisitions involve a number of risks, including those set forth under the risk factor captioned “We may not be able to successfully integrate businesses that we have recently acquired, or businesses we may acquire in the future, and we may not be able to realize the anticipated cost savings, revenue enhancements or other synergies from such acquisitions.” To the extent we are unable to consummate acquisitions, we will experience slower than expected growth.
In addition, we may require additional debt or equity financing for future acquisitions, and such financing may not be available 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. If we complete acquisitions, or obtain financing for them, on unfavorable terms, or if we fail to properly integrate an acquired business, our financial condition and results of operations would be adversely affected.
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, including due to acquisitions, 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.
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The loss of the services of our key management and personnel could adversely affect our ability to operate our business.
Our future success will depend, in part, upon the continued service of key managerial, research and development staff and sales and technical personnel. In addition, our future success will depend on our ability to continue to attract and retain other highly qualified personnel. Our executive officers have substantial experience and expertise in our industry. Our future success depends, to a significant extent, on the abilities and efforts of our executive officers and other members of our management team. We compete for such personnel with other companies, academic institutions, government entities and other organizations. We may not be successful in retaining our current personnel or in hiring or retaining qualified personnel in the future. Our failure to do so could have a material adverse effect on our business.
Affiliates of Blackstone own substantially all of the equity interest in us and may have conflicts of interest with us or investors in the future.
Investment funds affiliated with Blackstone collectively beneficially own 98.82% of our capital stock, and Blackstone designees hold a majority of the seats on our board of directors. As a result, affiliates of Blackstone have control over our decisions to enter into any corporate transaction and have the ability to prevent any transaction that requires the approval of stockholders regardless of whether holders of the Notes believe that any such transactions are in their own best interests. For example, affiliates of Blackstone could collectively cause us to make acquisitions that increase the amount of indebtedness or to sell assets, or could cause us to issue additional capital stock or declare dividends. So long as investment funds affiliated with Blackstone continue to directly or indirectly own a significant amount of the outstanding shares of our common stock, affiliates of Blackstone will continue to be able to strongly influence or effectively control our decisions. In addition, Blackstone has no obligation to provide us with any additional debt or equity financing.
Additionally, Blackstone is in the business of making investments in companies and may from time to time acquire and hold interests in businesses that compete directly or indirectly with us. Blackstone may also pursue acquisition opportunities that may be complementary to our business and, as a result, those acquisition opportunities may not be available to us.
If we do not achieve and maintain effective internal controls over financial reporting, we could fail to accurately report our financial results.
During the course of the preparation of our financial statements, we evaluate our internal controls to identify and correct deficiencies in our internal controls over financial reporting. In the event we are unable to identify and correct deficiencies in our internal controls in a timely manner, we may not record, process, summarize and report financial information accurately and within the time periods required for our financial reporting under the terms of the agreements governing our indebtedness.
We have completed a significant number of acquisitions in the past several years, and may continue to pursue growth through strategic acquisitions. Among the risks associated with acquisitions are the risks of control deficiencies that result from the integration of the acquired business. In connection with the integration of our recent acquisitions and our continuous assessment of internal controls, including with respect to acquired foreign operations, we have identified certain internal control deficiencies that we have remedied or for which we have undertaken steps to remediate.
It is possible that control deficiencies could be identified by our management or independent registered public accounting firm in the future or may occur without being identified. Such a failure could negatively impact the market price and liquidity of the Notes, cause security holders to lose confidence in our reported financial condition, lead to a default under our Senior Secured Credit Facility and otherwise materially adversely affect our business and financial condition.
We may not be successful in the design and implementation of a Company-wide ERP system.
In 2008 we launched a major software design and installation project to replace six legacy accounting and finance systems and numerous other software systems with a single-entry ERP system that will be used by all locations and functions of the Company. This project is scheduled to be completed in three years and will require the dedication of significant financial and human resources. Our ability to complete this project successfully is subject to a variety of risks and uncertainties, among which are the following:
· we may have underestimated the time it will take to complete the design and installation and the project could extend on past the expected completion date;
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· we may have underestimated the aggregate cost of the design and installation of the ERP system, whether due to the need for additional scope to the project, a requirement for additional consulting assistance, the extension of the completion date, or other similar issues;
· we may have underestimated the extent and difficulty in adapting the Company’s business processes to function within and use effectively the new ERP system;
· we may discover that the functionality of the new ERP system is not adequate to process and manage the extensive and varied functions, operations and processes within the Company that we use to conduct our current and future business;
If the ERP project were to become subject to any one of these or similar risks, the result could be a significant increase in the costs of the project, a significant delay in completion of the project, with the resultant delay our realization of the operational and financial benefits of the new system, or even the risk that the project would ultimately fail in its basic goal of a Company-wide, single-entry system. Any of these outcomes could have a material, adverse impact on our business operations, operating results and financial condition.
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ITEM 2. PROPERTIES
Our corporate headquarters are in Vista, California. The operations of our Domestic Rehabilitation Segment are based in Vista, California; Chattanooga, Tennessee; and St. Paul, Minnesota. Our International Rehabilitation Segment’s headquarters are in Guildford, United Kingdom and Freiburg, Germany. We operate manufacturing facilities in Tijuana, Mexico; Sfax, Tunisia; Chattanooga, Tennessee; Clear Lake, South Dakota; and Austin, Texas. Our warehouse and distribution centers are in Clear Lake, South Dakota; Chattanooga, Tennessee; Indianapolis, Indiana; Tijuana, Mexico; Freiburg, Germany; Guildford, United Kingdom; Malmo, Sweden; Herentals, Belgium; Mouguerre, France; and various other cities throughout the world. The manufacturing facilities and operations for our Surgical Implant Segment are in Austin, Texas. Additional information about our material facilities and certain other foreign facilities is set forth in the following table:
Location | | Use | | Owned/
Leased | | Lease Termination
Date | | Size in
Square
Feet | |
Vista, California | | Corporate Headquarters, Domestic Rehabilitation Segment Operations, Manufacturing Facility, Research and Development | | Leased | | August 2021 | | 111,639 | |
Tijuana, Mexico | | Manufacturing and Distribution Facility | | Leased | | September 2016 | | 286,133 | |
Chattanooga, Tennessee | | Domestic Rehabilitation Segment Operations, Manufacturing and Distribution Facility, Research and Development | | Owned | | n/a | | 164,542 | |
Indianapolis, Indiana | | Distribution Facility | | Leased | | October 2016 | | 109,782 | |
St. Paul, Minnesota | | Domestic Rehabilitation Segment Operations, Research and Development | | Leased | | October 2011(a) | | 93,666 | |
Austin, Texas | | Surgical Implant Segment Operations and Manufacturing Facility, Warehouse, Research and Development | | Leased | | March 2012(b) | | 64,600 | |
Clear Lake, South Dakota | | Manufacturing, Distribution and Refurbishment and Repair Facility, NDC Shipping and Warehouse | | Owned | | n/a | | 54,000 | |
Mouguerre, France | | Office & Distribution | | Leased | | October 2016 | | 29,500 | |
Freiburg, Germany | | International Rehabilitation Segment Distribution Facility | | Leased | | November 2014 | | 26,479 | |
Herentals, Belgium | | Warehouse | | Leased | | December 2013 | | 25,800 | |
Sfax, Tunisia | | Manufacturing Facility | | Leased | | December 2013 | | 24,500 | |
Freiburg, Germany | | International Rehabilitation Segment Operations | | Leased | | December 2014 | | 22,195 | |
Chantonnay, France | | Administration Facility & Warehouse | | Leased | | May 2009 | | 16,932 | |
Malmö, Sweden | | International Rehabilitation Segment Operations, Warehouse and Distribution Facility | | Leased | | March 2011 | | 16,081 | |
Guildford, United Kingdom | | International Office and Distribution Facility | | Leased | | July 2016 | | 8,234 | |
Other various locations | | | | Leased | | Various | | 173,530 | |
(a) Renewable, at our option, for one additional five-year term.
(b) Renewable, at our option, for two additional five-year terms.
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ITEM 3. LEGAL PROCEEDINGS
From time to time, we are plaintiffs or defendants in various litigation matters in the ordinary course of our business, some of which involve claims for damages that are substantial in amount. We believe that the disposition of claims currently pending will not have a material adverse effect on our financial position or results of operations.
The manufacture and sale of orthopedic devices and related products exposes us to significant risks of product liability claims, lawsuits and product recalls. From time to time, we have been, and we are currently, the subject of a number of product liability claims and lawsuits relating to our products. We are currently defendants in approximately 30 product liability cases related to a disposable drug infusion pump product manufactured by two third party manufacturers that we distributed through our Bracing and Supports business unit of our Domestic Rehabilitation Segment. We intend to discontinue our sale of these products in the second quarter of 2009. These cases have been brought against the manufacturers and certain distributors of these pumps, the manufacturers of the anesthetics used in these pumps, and the healthcare professionals involved in providing the pumps to their patients. All of these lawsuits allege that the use of these pumps with certain anesthetics in certain shoulder surgeries over prolonged periods have resulted in cartilage damage to the plaintiffs. We have sought indemnity and tendered the defense of these cases both to the manufacturers who have supplied these pumps to us and to our product liability carrier. Both manufacturers have indicated they would accept our tender of defense and indemnity, subject to certain reservation of rights, and the product liability carrier of those two manufacturers is providing us a defense in these cases. Our product liability carrier has also accepted coverage of these cases, subject to customary reservations, and was providing the Company with defense until the time that the manufacturers’ carrier took up the Company’s defense. The lawsuits allege damages ranging from unspecified amounts to claims between $1.0 million and $10.0 million. These cases are in the early stages of discovery.
We currently carry product liability insurance up to a limit of $25.0 million, subject to a deductible of $50,000 on non-invasive products and a deductible of $250,000 on invasive products and an aggregate deductible of $750,000 for all product liability claims. Our insurance policy is subject to annual renewal. We believe our current product liability insurance coverage is adequate. In 2003, we exceeded the coverage limits in effect at that time for certain historical product liability claims involving one of the discontinued products in our Surgical Implant Segment and such products are excluded from coverage under our current policies. The estimated exposure for these claims has been accrued for in our condensed consolidated balance sheet as of that date. While we believe that our product liability coverage is adequate for the exposure we face today, future product liability claims that could be made against us could significantly exceed the coverage limit of our policies or such insurance coverage may not continue to be available on commercially reasonable terms or at all. Additionally, we are also subject to the risk that our insurers will exclude from coverage claims made against us or the risk that insurers may become insolvent.
We are an authorized Medicare supplier and provide a variety of our products directly to Medicare beneficiaries and seek reimbursement from the applicable Medicare Administrative Contractor. CIGNA Government Services (“CIGNA”) is that contractor in the western region of the United States. As a Medicare supplier, we are subject to periodic audits of our operations, and, in November 2008, we were advised that as a result of such an audit, CIGNA was asserting that we have been overpaid in the amount of approximately $6 million from January 1, 2006 to April 9, 2007. This figure represents Medicare reimbursements for claims we submitted on behalf of Medicare beneficiaries for our bone growth stimulator product during that period of time. The reason asserted by CIGNA that Medicare was not obligated to provide reimbursement on these claims is that we failed to maintain a California Home Medical Device Retail Exemptee License during such 15 month period. We believe that this licensing program does not apply to our business and have appealed the assessment of the overpayment. During the pendency of the appeal, we are not required to pay the assessed $6.0 million overpayment, but interest at the rate of 11.375% per annum will run on the amount, if any, eventually determined to be due.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
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PART II.
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS, AND ISSUER PURCHASES OF EQUITY SECURITIES
As a result of the Prior Transaction, the common stock of DJO is privately held, and there is no established trading market for our common stock. As of March 9, 2009, there were four holders of DJO’s common stock.
ITEM 6. SELECTED FINANCIAL DATA
Selected financial data set forth below is presented for the five years ended December 31, 2008. The following table sets forth selected financial data as of and for the periods indicated and has been derived from the Predecessor’s and the Successor’s audited historical consolidated financial statements. The selected financial data for the Predecessor period represents ReAble’s financial data prior to the acquisition of ReAble by Blackstone, and the selected financial data for the Successor periods represents financial data of DJOFL after the consummation of the Prior Transaction. For the year ended December 31, 2006, we have combined the Predecessor period and the Successor period and presented the unaudited results of operations on a combined basis because we believe it is useful to compare our financial results on an annualized basis. The Successor period reflects the acquisition of ReAble by Blackstone using the purchase method of accounting pursuant to the provision of Statement of Financial Accounting Standards No. 141, “Business Combinations.” Accordingly, the comparability of the results of the Successor for the full year 2007 to the combined results of the Successor and the Predecessor for the full year 2006 is affected by differences in the basis of presentation, which reflects purchase accounting in the Successor periods and historical cost in the Predecessor period. In addition, the comparability of the combined results is impacted by changes in our capital structure which occurred on the date the Prior Transaction was completed.
The selected financial data should be read in conjunction with the audited consolidated financial statements and related notes thereto, and Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in this Annual Report.
| | Successor | | Predecessor | | Combined
Basis | | Predecessor | |
| | Year Ended
December 31, | | Year Ended
December 31, | | November 4,
2006 through
December 31, | | January 1,
2006 through
November 3, | | (unaudited)
Year Ended
December 31, | | Year Ended
December 31, | |
($ in thousands) | | 2008 | | 2007 | | 2006 | | 2006 | | 2006 | | 2005 | | 2004 | |
Statement of Operations Data: | | | | | | | | | | | | | | | |
Net sales (1) | | $ | 980,194 | | $ | 492,134 | | 57,902 | | $ | 304,383 | | $ | 362,285 | | $ | 293,726 | | $ | 148,081 | |
Gross profit | | 606,114 | | 286,270 | | 31,115 | | 177,103 | | 208,218 | | 178,353 | | 81,639 | |
Income (loss) from continuing operations | | (97,786 | ) | (82,422 | ) | (41,596 | ) | (46,162 | ) | (87,758 | ) | 9,347 | | 5,128 | |
Net income (loss) | | (97,786 | ) | (82,422 | ) | (41,634 | ) | (46,776 | ) | (88,410 | ) | 12,330 | | 5,527 | |
| | | | | | | | | | | | | | | |
Other Financial Data: | | | | | | | | | | | | | | | |
Depreciation and amortization (2) | | 122,551 | | 48,240 | | 6,404 | | 14,804 | | 21,208 | | 13,749 | | 6,027 | |
Ratio of earnings to fixed charges (unaudited) (3) | | — | | — | | — | | — | | — | | 1.52x | | 2.12x | |
| | | | | | | | | | | | | | | |
Balance Sheet Data (at period end): | | | | | | | | | | | | | | | |
Cash and cash equivalents | | $ | 30,483 | | $ | 63,471 | | $ | 30,903 | | NA | | NA | | $ | 17,200 | | $ | 19,889 | |
Total assets | | 2,940,130 | | 3,086,272 | | 1,060,636 | | NA | | NA | | 552,037 | | 552,139 | |
Long-term debt, net of current portion | | 1,832,044 | | 1,818,598 | | 548,037 | | NA | | NA | | 307,794 | | 307,207 | |
Stockholders’ equity/membership equity | | 598,366 | | 704,988 | | 335,208 | | NA | | NA | | 167,107 | | 160,317 | |
| | | | | | | | | | | | | | | | | | | | | | |
(1) The data reported for each period includes net sales from businesses acquired in such period from the effective date of the acquisition. See Note 2 to our audited consolidated financial statements in this Annual Report for additional information related to these acquisitions.
(2) The 2008 data includes intangible asset impairment charges of approximately $22.4 million.
(3) For purposes of calculating the ratio of earnings to fixed charges, (a) earnings consist of income (loss) before provision (benefit) for income taxes plus fixed charges and (b) fixed charges is defined as interest expense (including capitalized interest and amortization of debt issuance costs) and the estimated portion of rent expense deemed by management to represent the interest component of rent expense. For the Successor years ended December 31, 2008 and 2007 and the period November 4, through December 31, 2006, and the Predecessor period January 1, 2006 through November 3, 2006, our earnings were insufficient to cover fixed charges by $146.9 million, $125.1 million, $50.4 million, and $57.7 million, respectively.
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ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Forward Looking Statements
The following management’s discussion and analysis contains “forward looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 that represent our expectations or beliefs concerning future events, including, but not limited to, statements regarding growth in sales of our products, profit margins and the sufficiency of our cash flow for future liquidity and capital resource needs. These forward-looking statements are further qualified by important factors that could cause actual results to differ materially from those in the forward-looking statements. These factors are described in Item 1A, Risk Factors, noted above. Results actually achieved may differ materially from expected results included in these statements as a result of these or other factors.
Introduction
This management’s discussion and analysis of financial condition and results of operations is intended to provide an understanding of our results of operations, financial condition and where appropriate, factors that may affect future performance.
The following discussion should be read in conjunction with the consolidated financial statements and related notes to those financial statements as well as the other financial data included elsewhere in this Annual Report.
Overview of Business
We are a leading global provider of high-quality, orthopedic devices, with a broad range of products used for rehabilitation, pain management and physical therapy. We also develop, manufacture and distribute a broad range of surgical reconstructive implant products. We are the largest non-surgical orthopedic rehabilitation device company in the United States and among the largest globally, as measured by revenues. Many of our products have leading market positions. We believe that our strong brand names, comprehensive range of products, focus on quality, innovation and customer service, extensive distribution network, and our strong relationships with orthopedic and physical therapy professionals have contributed to our leading market positions. We believe that we are one of only a few orthopedic device companies that offer healthcare professionals and patients a diverse range of orthopedic rehabilitation products addressing the complete spectrum of preventative, pre-operative, post-operative, clinical and home rehabilitation care. Our products are used by orthopedic specialists, spine surgeons, primary care physicians, pain management specialists, physical therapists, podiatrists, chiropractors, athletic trainers and other healthcare professionals to treat patients with musculoskeletal conditions resulting from degenerative diseases, deformities, traumatic events and sports-related injuries. In addition, many of our non-surgical medical devices and related accessories are used by athletes and patients for injury prevention and at-home physical therapy treatment.
We classify our operations, pursuant to SFAS 131 into three operating segments further described below:
Domestic Rehabilitation Segment
We market our Domestic Rehabilitation Segment products through the four main businesses described below.
· Bracing and Supports. Our Bracing and Supports business unit was acquired with the DJO Merger and offers DonJoy, ProCare, and Aircast products, including rigid knee bracing, orthopedic soft goods, cold therapy products, and vascular systems. This division also includes our OfficeCare business, through which we maintain an inventory of soft goods and other products at healthcare facilities, primarily orthopedic practices, for immediate distribution to patients.
· Empi. Our Empi business unit offers products in the category of home electrotherapy, iontophoresis, and home traction. This division also includes our Rehab Med + Equip business (“RME”) and until the end of 2008, included our EmpiCare business. RME sells a wide range of proprietary and third party rehabilitation products to physical therapists and chiropractors through a printed catalog and through an on-line e-commerce site. Our EmpiCare business maintained an inventory of soft goods and other products at healthcare facilities, primarily orthopedic practices, for immediate distribution to patients and was consolidated into the OfficeCare business during the fourth quarter of 2008.
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· Regeneration. Our Regeneration business unit consists of our bone growth stimulation products. These products are sold through a combination of DonJoy sales representatives and additional independent and employed sales representatives dedicated to selling these products either directly to patients or independent distributors. We arrange billing to these third party payors or patients for products directly sold to the patients.
· Chattanooga. Our Chattanooga business unit offers products in the clinical rehabilitation market in the category of clinical electrotherapy devices, clinical traction devices, and other clinical products and supplies such as treatment tables, continuous passive motion (“CPM”) devices and dry heat therapy.
International Rehabilitation Segment
Our International Rehabilitation Segment, which generates most of its revenues in Europe, is divided into three main businesses:
· Bracing and Supports. The international sales of our Bracing and Supports business unit, which offers DonJoy, ProCare, and Aircast products.
· Ormed.DJO. Our Ormed.DJO business, which provides bracing, CPM, electrotherapy and other products primarily in Germany.
· Cefar-Compex. Our Cefar-Compex business, which provides electrotherapy products for medical and consumer markets and other physical therapy and rehabilitation products primarily in Europe.
Surgical Implant Segment
Our Surgical Implant Segment develops, manufactures and markets a wide variety of knee, hip and shoulder implant products that serve the orthopedic reconstructive joint implant market.
Our three operating segments enable us to reach a diverse customer base through multiple distribution channels and give us the opportunity to provide a wide range of orthopedic devices and related products to orthopedic specialists operating in a variety of patient treatment settings. These three segments constitute our three reportable segments. See Note 11 to our consolidated financial statements in this Annual Report for additional information regarding our segments.
Set forth below is net revenue, gross profit and operating income information for our reporting segments for the years ended December 31. This information excludes intersegment revenues and certain expenses not allocated to segments (which are primarily comprised of general corporate expenses for all periods presented). The segment information includes the impact of purchase accounting and related amortization of acquired intangible assets related to our acquisitions as described in Note 2 to our audited consolidated financial statements in this Annual Report, as well as, certain integration costs and restructuring costs as described in Note 13 to our audited consolidated financial statements in this Annual Report. All prior periods presented have been reclassified to reflect these reportable segments.
($ in thousands) | | 2008 | | 2007 | | Combined
(unaudited) 2006 | |
Domestic Rehabilitation: | | | | | | | | | | |
Net revenues | | $ | 700,129 | | $ | 331,550 | | $ | 248,437 | |
Gross profit | | $ | 417,574 | | $ | 182,763 | | $ | 133,108 | |
Gross profit margin | | 59.6 | % | 55.1 | % | 53.6 | % |
Operating income (loss) | | $ | 66,065 | | $ | (7,540 | ) | $ | (14,403 | ) |
Operating income (loss) as a percent of net segment revenues | | 9.4 | % | (2.3 | )% | (5.8 | )% |
International Rehabilitation: | | | | | | | | | | |
Net revenues | | $ | 228,539 | | $ | 113,034 | | $ | 64,203 | |
Gross profit | | $ | 135,427 | | $ | 57,467 | | $ | 34,115 | |
Gross profit margin | | 59.3 | % | 50.8 | % | 53.1 | % |
Operating income (loss) | | $ | 29,232 | | $ | 1,133 | | $ | 116 | |
Operating income (loss) as a percent of net segment revenues | | 12.8 | % | 1.0 | % | 0.2 | % |
Surgical Implant: | | | | | | | | | | |
Net revenues | | $ | 73,429 | | $ | 66,591 | | $ | 59,094 | |
Gross profit | | $ | 54,857 | | $ | 47,037 | | $ | 40,991 | |
Gross profit margin | | 74.7 | % | 70.6 | % | 69.4 | % |
Operating income (loss) | | $ | 8,217 | | $ | 2,322 | | $ | (7,236 | ) |
Operating income (loss) as a percent of net segment revenues | | 11.2 | % | 3.5 | % | (12.2 | )% |
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Recent Acquisitions, Dispositions and Other Transactions
DJO Merger
On July 15, 2007, we entered into the Agreement and Plan of Merger with DJO Opco providing for a merger transaction pursuant to which DJO Opco became a wholly owned subsidiary of DJOFL, the entity filing this Annual Report. The total purchase price for the DJO Merger, which was consummated on November 20, 2007, was approximately $1.3 billion and consisted of $1.2 billion (at $50.25 a share) paid to former equity holders of DJO Opco, $15.2 million related to the fair value of stock options held by DJO Opco management that were exchanged for options to purchase DJO common stock, and $22.8 million in direct acquisition costs. The DJO Merger was financed through a combination of equity contributed by Blackstone, borrowings under the Senior Secured Credit Facility, and proceeds from the newly issued 10.875% Notes (see Note 2 to our audited consolidated financial statements in this Annual Report for further information).
The Prior Transaction
On November 3, 2006, Blackstone acquired all of the outstanding shares of capital stock of ReAble in a merger transaction (the “Prior Transaction”). ReAble is the parent company of Holdings, DJOFL and Finco. DJOFL, directly or indirectly through its subsidiaries, owns all of the operating assets of ReAble. The total purchase price for the Prior Transaction was approximately $529.2 million and consisted of $482.5 million paid to former holders of shares of common stock and options to purchase shares of common stock of ReAble, $7.2 million related to the fair value of options held by ReAble executives that continued to remain as outstanding options to purchase ReAble common stock after the Prior Transaction (the “Prior Transaction Management Rollover Options”), and $39.5 million in direct acquisition costs. The Prior Transaction was financed through a combination of equity contributed by Blackstone, cash on hand of ReAble, borrowings under our prior senior secured credit facility (“Old Senior Secured Credit Facility”), and proceeds from the 11.75% Notes. Upon the closing of the Prior Transaction, shares of ReAble’s common stock ceased to be traded on the NASDAQ Global Market.
The Prior Transaction was accounted for as a purchase under the guidance set forth in Statement of Financial Accounting Standards No. 141 “Business Combinations”. In this Annual Report, the consolidated statements of operations, changes in stockholders’ equity and comprehensive income (loss), and cash flows are identified as relating to either the Predecessor or the Successor, which include accounts and results for periods preceding the Prior Transaction and periods succeeding the Prior Transaction, respectively. We have prepared our discussion of the results of operations by comparing the mathematical combination, without making any adjustments, of the Successor and Predecessor periods, which have been consolidated in a materially consistent manner, for the year ended December 31, 2006 to the year ended December 31, 2007. When we refer to combined basis in this Annual Report, we refer to the mathematical computation of adding the Predecessor results with those of the Successor for comparative purposes. This mathematical combination does not comply with generally accepted accounting principles or with the rules for unaudited pro forma presentation, but is presented because we believe it is useful to compare our financial results on an annualized basis. The Successor period reflects the acquisition of ReAble by Blackstone using the purchase method of accounting pursuant to the provisions of Statement of Financial Accounting Standards No. 141, ‘‘Business Combinations’’. Therefore, the comparability of the results of ReAble and DJOFL are affected by the difference in basis of presentation of purchase accounting as compared to historical cost.
Other Recent Acquisitions
IOMED, Inc.
On August 9, 2007, a subsidiary of DJOFL acquired IOMED, which develops, manufactures and markets active drug delivery systems used primarily to treat acute local inflammation in the physical and occupational therapy and sports medicine markets. The purchase price was $23.3 million and consisted of $21.1 million in cash payments to former IOMED equity holders at $2.75 per share, $0.8 million related to the fair value of vested stock options that were outstanding at the time of the acquisition, and $1.4 million in direct acquisition costs. The acquisition was primarily financed with borrowings under our then existing revolving credit facility (see Note 2 to our audited consolidated financial statements in this Annual Report for further information).
The Saunders Group
On July 2, 2007, a subsidiary of DJOFL completed its purchase of substantially all of the assets of Saunders for total cash consideration of $40.9 million, including $0.9 million of acquisition costs. Saunders is a supplier of rehabilitation products to physical therapists, chiropractors, athletes, athletic trainers, physicians and patients, with a specialty in patented traction devices, back supports, and equipment for neck and back disorders. The Saunders Acquisition was financed with funds borrowed under our Old Senior Secured Credit Facility (see Note 2 to our audited consolidated financial statements in this Annual Report for further information).
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Cefar AB
On November 7, 2006, a subsidiary of DJOFL acquired all of the issued and outstanding shares of Cefar, a provider of electrotherapy and rehabilitation devices used for chronic pain, for women’s health (labor pain, incontinence, dysmenorrhea), for electroacupuncture, and for other rehabilitation activities. We have integrated the operations of Cefar with those of Compex SA, the European subsidiary of Compex. Our strategy for the merged company is to develop both the professional/medical and consumer markets for electrical stimulation across Europe and internationally while continuing to sell products under both the Cefar and Compex brands. The purchase price for Cefar of $27.1 million was comprised of $16.3 million in cash, issuance of shares of our common stock valued at $9.5 million, and approximately $1.3 million in acquisition costs. The cash portion of the acquisition was funded with $10.0 million of term loan borrowings under the Old Senior Secured Credit Facility and cash on hand (see Note 2 to our audited consolidated financial statements in this Annual Report for further information).
Compex Technologies, Inc.
On February 24, 2006, we completed the acquisition of Compex. Compex manufactured and sold a broad line of TENS and NMES products used for pain management, rehabilitation, fitness and sports performance enhancement in clinical, home healthcare, sports and occupational medicine settings. The domestic Compex operations have been integrated into our Empi division. The purchase price of approximately $102.9 million included shares of our common stock valued at approximately $90.0 million in exchange for all of the outstanding common stock of Compex, options to purchase shares of our common stock valued at $9.3 million in exchange for all of the outstanding options to purchase common stock of Compex, and $3.6 million in acquisition costs (see Note 2 to our audited consolidated financial statements in this Annual Report for further information).
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Results of Operations
For the year ended December 31, 2006, we have combined the Predecessor period and the Successor period and presented the unaudited results of operations on a combined basis because we believe it is useful to compare our financial results on an annualized basis. The Successor period reflects the acquisition of ReAble by Blackstone using the purchase method of accounting pursuant to the provision of Statement of Financial Accounting Standards No. 141, “Business Combinations”. Accordingly, the comparability of the results of the Successor for the full year 2007 to the combined results of the Successor and the Predecessor for the full year 2006 is affected by differences in the basis of presentation, which reflects purchase accounting in the Successor periods historical cost in the Predecessor period. In addition, the comparability of the combined results is impacted by changes in our capital structure which occurred on the date the Prior Transaction was completed. The following table sets forth our statements of operations as a percentage of sales for the periods indicated:
| | Successor | | Combined (unaudited) | |
($ in thousands) | | Year Ended
December 31, 2008 | | Year Ended
December 31, 2007 | | Year Ended
December 31, 2006 | |
Net sales | | $ | 980,194 | | 100.0 | % | $ | 492,134 | | 100.0 | % | $ | 362,285 | | 100.0 | % |
Cost of sales | | 374,080 | | 38.2 | | 205,864 | | 41.8 | | 154,067 | | 42.5 | |
Gross profit | | 606,114 | | 61.8 | | 286,270 | | 58.2 | | 208,218 | | 57.5 | |
Operating expenses: | | | | | | | | | | | | | |
Selling, general and administrative | | 445,396 | | 45.4 | | 271,163 | | 55.1 | | 220,263 | | 60.8 | |
Research and development | | 26,938 | | 2.7 | | 21,047 | | 4.3 | | 42,900 | | 11.8 | |
Amortization and impairment of acquired intangibles | | 98,954 | | 10.1 | | 33,496 | | 6.8 | | 10,000 | | 2.8 | |
Operating income (loss) | | 34,826 | | 3.5 | | (39,436 | ) | (8.0 | ) | (64,945 | ) | (17.9 | ) |
Other income (expense): | | | | | | | | | | | | | |
Interest income | | 1,662 | | 0.2 | | 1,132 | | 0.2 | | 839 | | 0.2 | |
Interest expense | | (173,162 | ) | (17.7 | ) | (72,409 | ) | (14.7 | ) | (34,619 | ) | (9.5 | ) |
Other (expense) income, net | | (9,134 | ) | (0.9 | ) | 742 | | 0.2 | | 110 | | — | |
Loss on early extinguishment of debt | | — | | — | | (14,539 | ) | (3.0 | ) | (9,154 | ) | (2.5 | ) |
Loss from continuing operations before income taxes and minority interests | | (145,808 | ) | (14.9 | ) | (124,510 | ) | (25.3 | ) | (107,769 | ) | (29.7 | ) |
Benefit for income taxes | | (49,071 | ) | (5.0 | ) | (42,503 | ) | (8.6 | ) | (20,208 | ) | (5.6 | ) |
Minority interests | | 1,049 | | 0.1 | | 415 | | — | | 197 | | 0.1 | |
Loss from continuing operations | | (97,786 | ) | (10.0 | ) | (82,422 | ) | (16.7 | ) | (87,758 | ) | (24.2 | ) |
Discontinued operations: | | | | | | | | | | | | | |
Loss from discontinued operations, net of tax | | — | | — | | — | | — | | (652 | ) | (0.2 | ) |
Net loss | | $ | (97,786 | ) | (10.0 | )% | $ | (82,422 | ) | (16.7 | )% | $ | (88,410 | ) | (24.4 | )% |
Year Ended December 31, 2008 Compared to Year Ended December 31, 2007
Net Sales. Our net sales for the year ended December 31, 2008 were $980.2 million, representing an increase of 99.2% from net sales of $492.1 million for the year ended December 31, 2007. The increase was primarily driven by business acquisitions, including the DJO Merger (November 2007), IOMED (August 2007) and Saunders (July 2007) and continued growth across our product lines. Revenues associated with business acquisitions were approximately $458.9 million for the year ended December 31, 2008. Net sales were also positively impacted for the year ended December 31, 2008 by $11.7 million due to favorable changes in foreign exchange rates compared to rates in effect for the year ended December 31, 2007. For the year ended December 31, 2008 and December 31, 2007, we generated 26.0% and 27.4%, respectively, of our net sales from customers outside the United States.
Sales of new products, which include products that have been on the market less than one year, were $27.2 million for the year ended December 31, 2008, compared to new product sales of $34.1 million for the year ended December 31, 2007.
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The following table sets forth the mix of our net sales for the years ended December 31, 2008 and 2007:
| | Years Ended | | | | | |
($ in thousands) | | December 31,
2008 | | % of Net
Revenues | | December 31,
2007 | | % of Net
Revenues | | Increase | | % Increase | |
Domestic Rehabilitation Segment | | $ | 700,129 | | 71.4 | % | $ | 331,550 | | 67.4 | % | $ | 368,579 | | 111.2 | % |
International Rehabilitation Segment | | 228,539 | | 23.3 | | 113,034 | | 23.0 | | 115,505 | | 102.2 | |
Surgical Implant Segment | | 73,429 | | 7.5 | | 66,591 | | 13.5 | | 6,838 | | 10.3 | |
Intersegment revenues | | (21,903 | ) | (2.2 | ) | (19,041 | ) | (3.9 | ) | (2,862 | ) | 15.0 | |
Consolidated net sales | | $ | 980,194 | | 100.0 | % | $ | 492,134 | | 100.0 | % | $ | 488,060 | | 99.2 | % |
Net sales in our Domestic Rehabilitation Segment were $700.1 million for the year ended December 31, 2008, reflecting an increase of 111.2% over net sales of $331.6 million for the year ended December 31, 2007. The increase was driven primarily by the addition of sales from the DJO Merger and the IOMED and Saunders acquisitions as discussed above and growth in our core product lines.
Net sales in our International Rehabilitation Segment for the year ended December 31, 2008 were $228.5 million, reflecting an increase of 102.2% from net sales of $113.0 million for the year ended December 31, 2007. The increase was driven primarily by the addition of sales from the DJO Merger and continued growth in our core international markets. Net sales were also positively impacted by $11.7 million for the year ended December 31, 2008 due to favorable changes in foreign exchange rates compared to rates in effect for the year ended December 31, 2007.
Net sales in our Surgical Implant Segment increased to $73.4 million from $66.6 million for the year ended December 31, 2008, representing a 10.3% increase over the prior year. The increase was driven primarily by growth in our knee, shoulder and hip implant product lines.
Gross Profit. Consolidated gross profit as a percentage of net sales increased to 61.8% for the year ended December 31, 2008 from 58.2% for the year ended December 31, 2007. The increase in our gross profit margin is primarily attributable to cost improvement initiatives implemented in the past year, favorable changes in the mix of products we sell as a result of our recent acquisitions of businesses with higher margin products, and favorable changes in foreign exchange rates of approximately $3.8 million. Additionally, the increase in consolidated gross profit was driven by reduced amortization of purchased inventory fair value adjustments related to prior year acquisitions. The amortization of purchased inventory fair value adjustments included in cost of sales was $4.7 million and $14.0 million for the years ended December 31, 2008 and 2007, respectively.
Gross profit in our Domestic Rehabilitation Segment as a percentage of net sales increased to 59.6% for the year ended December 31, 2008 from 55.1% for the year ended December 31, 2007. The increase in our gross margin was primarily attributable to cost improvement initiatives implemented in the past year and favorable changes in the mix of products we sell as a result of our recent acquisitions of businesses with higher margin products. Additionally, the increase in domestic rehabilitation gross profit was driven by reduced amortization of purchased inventory fair value adjustments related to prior year acquisitions. The amortization of purchased inventory fair value adjustments included in cost of sales was $4.7 million and $8.6 million for the years ended December 31, 2008 and 2007, respectively.
Gross profit in our International Rehabilitation Segment as a percentage of net sales increased to 59.3% for the year ended December 31, 2008 from 50.8% for the year ended December 31, 2007. The increase was primarily driven by cost improvement initiatives implemented in the past year, favorable changes in the mix of products we sell as a result of our recent acquisitions of businesses with higher margin products, and favorable changes in foreign exchange rates of approximately $3.8 million. Additionally, the increase in international rehabilitation gross profit was driven by reduced amortization of purchased inventory fair value adjustments related to prior year acquisitions. The amortization of purchased inventory fair value adjustments included in cost of sales was $2.1 million for the year ended December 31, 2007 and we had no such amortization in 2008.
Gross profit in our Surgical Implant Segment as a percentage of net sales increased to 74.7% for the year ended December 31, 2008 from 70.6% for the year ended December 31, 2007. The increase was primarily driven by cost improvement initiatives implemented in the past year and reduced amortization of purchased inventory fair value adjustments related to prior year acquisitions of $3.3 million. The amortization of purchased inventory fair value adjustments included in cost of sales was $3.3 million for the year ended December 31, 2007.
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Selling, General and Administrative. Our selling, general and administrative expenses increased to $445.4 million for the year ended December 31, 2008 from $271.2 million for the year ended December 31, 2007 primarily due to approximately $166.0 million of expenses, including wages, commissions, professional fees, and other expenses incurred by businesses we acquired, partially offset by a $1.5 million decrease in non-recurring incremental costs associated with the integration of our acquisitions and a favorable $1.1 million settlement of a litigation contingency related to one of our foreign subsidiaries. The following table sets forth certain non-recurring selling, general and administrative costs associated with the integration of our recent acquisitions:
| | Years Ended | |
($ in thousands) | | December 31,
2008 | | December 31,
2007 | | Increase
(Decrease) | | % Increase
(Decrease) | |
| | | | | | | | | |
Management retention bonuses | | $ | 5,775 | | $ | 542 | | 5,233 | | NM | |
Severance and relocation expenses | | 11,237 | | 16,372 | | (5,135 | ) | (31.4 | ) |
Integration expenses | | 27,313 | | 17,087 | | 10,226 | | 59.8 | |
Charges to bad debt expense related to revaluation of accounts receivable and anticipated integration related collection issues | | — | | 11,870 | | (11,870 | ) | NM | |
| | $ | 44,325 | | $ | 45,871 | | $ | (1,546 | ) | (3.4 | )% |
| | | | | | | | | | | | |
For the year ended December 31, 2008, severance and relocation consisted of $5.7 million of severance expenses related to the DJO Merger, $2.7 million of severance payments to employees in connection with other acquisitions, and $2.8 million of separation expense in connection with the termination of one of the Company’s executive officers. Severance expenses for the year ended December 31, 2007 include $13.3 million of payments made to former executives of ReAble. Remaining severance expenses are related to restructuring activities in connection with the IOMED, Saunders and Cefar acquisitions. Integration expenses for the year ended December 31, 2008 included $17.8 million, $1.6 million and $2.7 million of integration costs incurred in connection with the DJO Merger, the IOMED acquisition and other recent acquisitions, respectively. Also included within integration expense for the year ended December 31, 2008 is a $5.2 million expense related to the planned implementation of our new global ERP system. Integration expense for the year ended December 31, 2007 included costs incurred with the DJO Merger, Prior Transaction and other acquisitions. Management retention bonuses related to the DJO Merger were recorded and amortized over the period from the close of the transaction to December 31, 2008, resulting in expenses of $5.8 million and $0.5 million in 2008 and 2007, respectively. Furthermore, the year ended December 31, 2007 included a $11.9 million charge related to the impact of changes in methodologies used to estimate accounts receivable reserves, primarily in connection with the DJO Merger.
Research and Development. Our research and development expense increased to $26.9 million for the year ended December 31, 2008 from $21.0 million for the year ended December 31, 2007. The increase was primarily due to increased wages, facility and project costs incurred by businesses we acquired. As a percentage of net sales, research and development expense decreased to 2.7% compared to 4.3% in the year ended December 31, 2007.
Amortization and Impairment of Acquired Intangibles. Amortization and Impairment of Acquired intangible assets increased to $98.9 million for the year ended December 31, 2008 from $33.5 million for the year ended December 31, 2007. Included within the year ended December 31, 2008 are write-offs of approximately $10.1 million related to an indefinite lived intangible asset which was impaired and approximately $12.3 million resulting from the abandonment of a trade name. We test intangible assets with indefinite lives annually in accordance with SFAS 142. This test compares the fair value of the intangible with its carrying amount. To determine the fair value, we applied the relief from royalty method (“RFR”). Under the RFR method, the value of the trade name is determined by calculating the present value of the after-tax cost savings associated with owning the asset and therefore not being required to pay royalties for its use during the asset’s indefinite life. Significant judgments inherent in this analysis include the selection of appropriate discount rates, estimating the amount and timing of estimated future cash flows and the identification of appropriate terminal growth rate assumptions. Discount rate assumptions are based on an assessment of the risk inherent in the projected future cash flows generated by the respective intangible assets. Also subject to judgment are assumptions about royalty rates, which are based on the estimated rates at which similar brands and trademarks are being licensed in the marketplace.
Amortization of acquired intangibles includes amortization expense related to intangible assets acquired in connection with our acquisitions. The intangible assets are being amortized over the estimated lives ranging from two to twenty years. Our amortization of acquired intangibles increased to $76.5 million for the year ended December 31, 2008 compared to $33.5 million for the year ended December 31, 2007. At December 31, 2008, we expect the future amortization of intangibles to be approximately $76.1 million in 2009, $75.2 million in 2010, $73.8 million in 2011, $72.4 million in 2012, $67.5 million in 2013, and $458.1 million for the periods thereafter. Future acquisitions of businesses or intangible assets may cause these estimates to differ materially.
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Interest Expense. Our interest expense increased to $173.2 million for the year ended December 31, 2008 compared to interest expense of $72.4 million for the year ended December 31, 2007. The increase was principally driven by incremental borrowings of $1,209.0 million to fund the DJO Merger and $77.0 million to fund the IOMED and Saunders acquisitions.
Other Expense. Our other expense increased to $9.1 million for the year ended December 31, 2008 compared to other income of $0.7 million for the year ended December 31, 2007. The increase was principally driven by increased losses in the second half of 2008 on foreign currency exchange and the write-off of a strategic investment determined to have no value during the fourth quarter of 2008.
Benefit for Income Taxes. The effective tax rate for the years ended December 31, 2008 and December 31, 2007 was 33.7% and 34.1%, respectively. For the year ended December 31, 2008, we recorded a $49.1 million income tax benefit on a pre-tax loss of $145.8 million, net of offsetting tax expense related to foreign taxes, deferred taxes on the assumed repatriation of foreign earnings, and other non-deductible items. For the year ended December 31, 2007, we recorded a $42.5 million income tax benefit on a pre-tax loss of $124.5 million, net of offsetting tax expense related to foreign taxes, deferred taxes on the assumed repatriation of foreign earnings, and other non-deductible items.
Year Ended December 31, 2007 Compared to Year Ended December 31, 2006 (Combined Basis)
Net Sales. Our net sales for the year ended December 31, 2007 were $492.1 million, representing an increase of 35.8% over net sales of $362.3 million in 2006 (combined basis), driven by acquisitions and continued growth in our Domestic Rehabilitation, International Rehabilitation and Surgical Implant Segments. Sales in the Domestic Rehabilitation and International Rehabilitation Segments benefited from sales of products we acquired in the DJO Merger and the IOMED, Saunders, and Cefar acquisitions, which were completed in November 2007, August 2007, July 2007, and November 2006, respectively. For the year ended December 31, 2007, we generated 27.4% of our net sales from customers outside the United States as compared to 23.4% for the year ended December 31, 2006. With the recent DJO Merger and the Cefar acquisition, we anticipate that our international sales will continue to increase in future periods. International revenues for 2007 included $12.1 million and $27.2 million related to the DJO Merger and the Cefar acquisition, respectively.
The following table sets forth sales for our three reportable segments. The 2007 sales data for the Domestic Rehabilitation Segment includes $54.2 million and $2.9 million as a result of the DJO Merger and as a result of the IOMED acquisition on November 20, 2007 and August 9, 2007, respectively. Also included are estimated sales of $17.5 million as a result of the Saunders acquisition on July 2, 2007. Included in the International Rehabilitation Segment 2006 sales data is $2.9 million as a result of the Cefar acquisition on November 7, 2006, while a full year of sales revenue for this business is included in 2007.
| | Years Ended | | | | | |
($ in thousands) | | December 31,
2007 | | % of Net
Revenues | | Combined
December 31,
2006
(unaudited) | | % of Net
Revenues | | Increase | | % Increase | |
Domestic Rehabilitation | | $ | 331,550 | | 67.4 | % | $ | 248,437 | | 68.6 | % | $ | 83,113 | | 33.5 | % |
International Rehabilitation | | 113,034 | | 23.0 | | 64,203 | | 17.7 | | 48,831 | | 76.1 | |
Surgical Implant | | 66,591 | | 13.5 | | 59,094 | | 16.3 | | 7,497 | | 12.7 | |
Intersegment revenues | | (19,041 | ) | (3.9 | ) | (9,449 | ) | (2.6 | ) | (9,592 | ) | NM | |
Consolidated net sales | | $ | 492,134 | | 100.0 | % | $ | 362,285 | | 100.0 | % | $ | 129,849 | | 35.8 | % |
Net sales in our Domestic Rehabilitation Segment were $331.6 million for 2007, representing an increase of 33.5% over net sales of $248.4 million in 2006. The increase in net sales in our Domestic Rehabilitation Segment in 2007 was driven by continued growth across our rehabilitation product lines which contributed approximately $4.1 million in net sales during 2007 and the impact of revenue contribution from our recent acquisitions as discussed above, which contributed approximately $74.6 million of total net sales during 2007. In addition, during 2006 sales in our Domestic Rehabilitation Segment were negatively impacted by increased sales allowances aggregating $11.4 million related to revaluation of accounts receivable acquired in the Compex acquisition. Excluding the factors discussed above, sales in our Domestic Rehabilitation Segment increased 1.7% over the prior year.
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Net sales in our International Rehabilitation Segment were $113.0 million for 2007, representing an increase of 76.1% over net sales of $64.2 million in 2006. The increase in net sales in our International Rehabilitation Segment was principally driven by revenues associated with the Cefar acquisition, which contributed sales of $27.2 million in 2007, compared to $2.9 million in 2006, and revenues associated with the DJO Merger which contributed sales of $12.1 in 2007. In addition, net sales were positively impacted during 2007 by approximately $7.3 million due to favorable changes in foreign exchange rates compared to rates in effect in 2006.
Net sales in our Surgical Implant Segment for 2007 were $66.6 million, representing an increase of 12.7% over net sales of $59.1 million in 2006. The increase in our Surgical Implant Segment’s net sales in 2007 was driven primarily by growth in our shoulder and hip product lines of 32.2% and 18.8%, respectively. Sales in this segment were negatively impacted on a comparative basis by reduced sales from our spine product line of $1.3 million.
Sales of new products for all segments, which have been on the market less than one year, accounted for $34.1 million in 2007, compared to $23.3 million in 2006.
Gross Profit. Our consolidated gross profit as a percentage of net sales increased to 58.2% for 2007 compared to a gross profit of 57.5% in 2006 and was negatively impacted by $13.9 million, as compared to $4.5 million in the prior year, related to the write-up to fair market value of inventory acquired in connection with recent acquisitions and the Prior Transaction. Gross profit in our Domestic Rehabilitation Segment increased to 55.1% of net sales in 2007 from 53.6% in 2006. Gross profit in 2006 was impacted by increased sales allowances related to revaluation of accounts receivable acquired in the Compex acquisition. Gross profit in our International Rehabilitation Segment decreased to 50.8% of net sales in 2007 from 53.1% in 2006 and was negatively impacted by $2.1 million, as compared to $1.1 million in the prior year, related to the write-up to fair market value of inventory in connection with the Cefar acquisition and the Prior Transaction. Gross profit in our Surgical Implant Segment increased to 70.6% of net sales in 2007 compared to 69.4% in 2006 and was negatively impacted in 2007 by $3.3 million of expense, as compared to $0.5 million in the prior year, related to the write-up to fair market value of inventory in connection with the Prior Transaction. Gross profit in 2006 was negatively impacted by a $1.5 million charge for a discontinued product line related to inventory acquired in 2005 from Osteoimplant Technology, Inc..
Selling, General and Administrative. Our selling, general and administrative expenses increased to $271.2 million in 2007 compared to $220.3 million in 2006 due to additional expenses associated with the operations of our recent acquisitions. In addition, in both 2007 and 2006, we incurred certain non-cash and non-recurring expenses in connection with those acquisitions which we do not believe are reflective of the ongoing operations of our business. The following table sets forth these expenses incurred in connection with our recent acquisitions which we believe are directly attributable to the acquisitions.
($ in thousands) | | December 31,
2007 | | Combined
December 31,
2006
(unaudited) | | Increase
(Decrease) | | % Increase
(Decrease) | |
| | | | | | | | | |
Stock based compensation | | $ | 1,541 | | $ | 10,736 | | $ | (9,195 | ) | (85.6 | )% |
Management retention bonuses | | 542 | | 5,500 | | (4,958 | ) | (90.1 | ) |
Severance expenses | | 16,372 | | 1,232 | | 15,140 | | 1,228.9 | |
Restructuring expenses | | 10,917 | | 7,143 | | 3,774 | | 52.8 | |
Transaction expenses | | 6,170 | | 14,500 | | (8,330 | ) | (57.4 | ) |
Charges to bad debt expense related to revaluation of accounts receivable and anticipated integration related collection issues | | 11,870 | | 14,000 | | (2,130 | ) | (15.2 | ) |
| | $ | 47,412 | | $ | 53,111 | | $ | (5,699 | ) | (10.7 | )% |
Stock based compensation expense in 2006 includes costs incurred related to accelerated vesting of outstanding stock options of ReAble in connection with the Prior Transaction. Management retention bonuses related to the Prior Transaction were expensed in 2006. Management retention bonuses related to the DJO Merger are being amortized over the period from the close of the transaction to December 31, 2008 (expected service period). Severance expenses in 2007 include $13.3 million of payments made to former executives of ReAble. Remaining severance expenses are related to restructuring activities in connection with the IOMED, Saunders and Cefar acquisitions. Transaction expenses in 2006 include $14.5 million of costs incurred by ReAble in connection with the Prior Transaction. Finally, we recorded $9.8 million in 2007 and $14.0 million in 2006 as additional bad debt expense, primarily related to revaluation of accounts receivable acquired in connection with the DJO Merger and the Compex acquisition, respectively, due in part to anticipated integration related collection issues. Excluding these factors, our selling, general and administrative expenses increased to $223.8 million in 2007 compared to $167.2 million in 2006. As a percentage of net sales, selling, general and administrative expense decreased to 45.5% in 2007 compared to 46.1% in 2006.
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Research and Development. Our research and development expense decreased to $21.0 million in 2007 compared to $42.9 million in 2006. Excluding the impact of IPR&D costs incurred in the prior year of $3.9 million associated with the Compex acquisition and $25.2 million related to the Prior Transaction, and $3.0 million of costs incurred in the current year associated with the DJO Merger, our research and development expense increased $4.2 million to $18.0 million for fiscal year 2007 as compared to $13.8 million during 2006, primarily due to expenses incurred by the operations of our recent acquisitions. As a percentage of net sales, research and development expense was 3.6% compared to 3.8% in the prior year (excluding the impact of IPR&D).
Amortization of Acquired Intangibles. Amortization of acquired intangibles includes amortization expense related to intangible assets acquired in connection with recent acquisitions and the Prior Transaction, which are being amortized over lives ranging from one to twenty years. Our amortization of acquired intangibles increased to $33.5 million in 2007 compared to $10.0 million in 2006.
Interest Expense. Our interest expense increased to $72.4 million in 2007 from $34.6 million in 2006. The increase in interest expense was principally driven by (1) the impact of a full year of interest expense on debt associated with the Prior Transaction, which was completed on November 3, 2006, (2) incremental borrowings of approximately $77.0 million to fund the IOMED and Saunders acquisitions and $1,209.0 million to fund the DJO Merger, and (3) higher variable interest rates on our outstanding indebtedness resulting in an average interest rate of 8.8% in 2007 as compared to 8.4% in 2006.
Loss on Early Extinguishment of Debt. We recorded approximately $14.5 million of expense in 2007, compared to $9.2 million of expense in 2006. The expense in 2007 includes $9.7 of unamortized debt issuance costs associated with the Old Senior Secured Credit Facility that was repaid in connection with the DJO Merger. Also included is $4.8 million of expense due to the termination of interest rate swaps and related refinancing activities in connection with the DJO Merger. The expense in 2006 is related to the recognition of unamortized debt issuance and debt discount costs associated with the senior credit facility and the 9.75% senior subordinated notes due 2012 (the “9.75% Notes”) that were repaid in connection with the Prior Transaction.
Benefit for Income Taxes. In 2007, we recorded $42.5 million of income tax benefit on a pre-tax loss of $124.5 million, resulting in an effective rate of 34.1%. In 2006, we recorded $20.2 million of income tax benefit on a pre-tax loss of $107.8 million, resulting in an effective rate of 18.8%, which is substantially lower than our statutory tax rate, due in part to the impact of a charge of $29.1 million for IPR&D costs in 2006. Expense related to IPR&D is not deductible for tax purposes and is treated as a permanent difference for tax accounting purposes. In addition to the IPR&D impact, our 2006 effective tax rate was also negatively impacted by non-deductible stock-based compensation, transaction costs, and other non-deductible expenses.
Recent Accounting Pronouncements
For information on recent accounting pronouncements impacting our business, see Note 1 of the notes to the audited consolidated financial statements included in Part II. Item 8, herein.
Liquidity and Capital Resources
As of December 31, 2008, our primary source of liquidity consisted of cash and cash equivalents totaling $30.5 million and $76.0 million of available borrowings under our revolving credit facility described below. Working capital at December 31, 2008 was $179.6 million. We believe that our existing cash, plus the amounts we expect to generate from operations and amounts available through our revolving credit facility, will be sufficient to meet our operating needs for the next twelve months, including working capital requirements, capital expenditures, and debt and interest repayment obligations. While we currently believe that we will be able to meet all of our financial covenants imposed by our Senior Secured Credit Facility, there is no assurance that we will in fact be able to do so or that, if we do not, we will be able to obtain from our lenders waivers of default or amendments to the Senior Secured Credit Facility in the future. We and our subsidiaries, affiliates or significant shareholders (including Blackstone and its affiliates) may from time to time, in our or their sole discretion, purchase, repay, redeem or retire any of our outstanding debt or equity securities (including any publicly issued debt securities), in privately negotiated or open market transactions, by tender offer or otherwise.
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A summary of our changes in cash and cash equivalents for the years ended December 31, 2008 and 2007 is as follows (in thousands):
| | Years Ended December 31, | |
| | 2008 | | 2007 | |
Cash used in operating activities | | $ | (12,061 | ) | $ | (28,759 | ) |
Cash used in investing activities | | (29,596 | ) | (1,323,064 | ) |
Cash provided by financing activities | | 8,865 | | 1,383,558 | |
Effect of exchange rate changes on cash and cash equivalents | | (196 | ) | 833 | |
Net (decrease) increase in cash and cash equivalents | | $ | (32,988 | ) | $ | 32,568 | |
Cash Flows
Operating activities used $12.1 million of cash for the year ended December 31, 2008, compared to $28.8 million for the year ended December 31, 2007. Cash used for operating activities for the year ended December 31, 2008 primarily reflected an unfavorable net change in operating assets and liabilities mostly offset by our net income after adjustment for non-cash charges. Cash used in operating activities for the year ended December 31, 2007 primarily reflected our net loss and a negative net change in operating assets and liabilities. Cash paid for interest was $158.8 million for the year ended December 31, 2008 and $70.2 million for the year ended December 31, 2007.
Investing activities used $29.6 million of cash for the year ended December 31, 2008, compared to $1,323.1 million for the year ended December 31, 2007. Cash used in investing activities for the year ended December 31, 2008 primarily consisted of purchases of property and equipment totaling $25.9 million and the acquisition of businesses and intangibles for a total of $3.9 million. Cash used in investing activities for the year ended December 31, 2007 principally consisted of the acquisition of businesses for $1,313.1 million mainly related to the DJO Merger, and the acquisitions of IOMED and Saunders.
Financing activities provided for $8.9 million of cash for the year ended December 31, 2008, compared to $1,383.6 million for the year December 31, 2007. Cash provided by financing activities for the year ended December 31, 2008 represented net proceeds of $9.2 million on long-term debt and revolving lines of credit, including $24.0 million of proceeds related to our revolving lines of credit as compared to cash provided by financing activities for the year ended December 31, 2007, which included net proceeds of $1,005.9 million from long-term debt and revolving credit lines mainly related to net borrowings under the new Senior Secured Credit Facility of $1,052.4 million.
Indebtedness
As of December 31, 2008, we had approximately $1,843.6 million in aggregate indebtedness outstanding.
Senior Secured Credit Facility
Overview. The Senior Secured Credit Facility provides senior secured financing of $1,165.0 million, consisting of a $1,065.0 million term loan facility and a $100.0 million revolving credit facility. We issued the term loan facility of the Senior Secured Credit Facility at a 1.2% discount, resulting in net proceeds of $1,052.4 million. In addition, we are permitted, subject to receipt of additional commitments from participating lenders and certain other conditions, to incur up to an additional $150.0 million of borrowings under the Senior Secured Credit Facility.
Interest Rate and Fees. Borrowings under the Senior Secured Credit Facility bear interest at a rate equal to an applicable margin plus, at our option, either (a) a base rate determined by reference to the higher of (1) the prime rate of Credit Suisse and (2) the federal funds rate plus 0.50% or (b) the Eurodollar rate determined by reference to the costs of funds for deposits in U.S. dollars for the interest period relevant to each borrowing adjusted for required reserves. The initial applicable margins for borrowings under the term loan facility and the revolving credit facility is 2.00% with respect to base rate borrowings and 3.00% with respect to Eurodollar borrowings. The applicable margin for borrowings under the term loan facility and the revolving credit facility may be reduced subject to us attaining certain leverage ratios.
Historically, we have used derivative instruments to hedge portions of our exposure related to variable interest rates on our outstanding indebtedness. On November 20, 2007, we entered into an interest rate swap agreement for a notional amount of $515.0 million at a fixed LIBOR rate of 4.205% expiring in 2009. The swap agreement amortizes through a date in 2009. As of December 31, 2008, the remaining notional amount of the swap was $470.0 million. As of December 31, 2008, our weighted average interest rate for all borrowings under the Senior Secured Credit Facility was 3.91%.
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In February 2009, we entered into two interest rate swap agreements. One agreement is for a notional amount of $550.0 million with a term of February 2009 through December 2009. The second agreement is for a notional amount of $750.0 million with a term of January 2010 through December 2010. Under these agreements we have LIBOR fixed rates of 1.04% and 1.88%, respectively.
In addition to paying interest on outstanding principal under the Senior Secured Credit Facility, we are required to pay a commitment fee to the lenders under the revolving credit facility in respect of the unutilized commitments thereunder. The initial commitment fee rate is 0.50% per annum. The commitment fee rate may be reduced subject to us attaining certain leverage ratios. We must also pay customary letter of credit fees.
Amortization. We are required to pay annual amortization (payable in equal quarterly installments) on the loans under the term loan facility in an amount equal to 1.00% of the funded total principal amount during the first six years and three months following the closing of the Senior Secured Credit Facility, with the remaining amount payable at maturity, which is six and one-half years from the date of the closing of the Senior Secured Credit Facility. Principal amounts outstanding under the revolving credit facility are due and payable in full at maturity, which is six years from the date of the closing of the Senior Secured Credit Facility.
Certain Covenants and Events of Default. The Senior Secured Credit Facility contains a number of covenants that, among other things, restrict, subject to certain exceptions, our and our subsidiaries’ ability to:
· incur additional indebtedness;
· create liens on assets;
· change fiscal years;
· enter into sale and leaseback transactions;
· engage in mergers or consolidations;
· sell assets;
· pay dividends and make other restricted payments;
· make investments, loans or advances;
· repay subordinated indebtedness;
· make certain acquisitions;
· engage in certain transactions with affiliates;
· restrict the ability of restricted subsidiaries that are not Guarantors to pay dividends or make distributions;
· amend material agreements governing our subordinated indebtedness; and
· change our lines of business.
Pursuant to the terms of the credit agreement relating to the Senior Secured Credit Facility, we are required to maintain a ratio of consolidated senior secured debt to Adjusted EBITDA (or senior secured leverage ratio) starting at a maximum of 5.1:1 and stepping down over time to 3.25:1 by the end of 2011. Adjusted EBITDA represents net income (loss) plus interest expense, net, provision (benefit) for income taxes and depreciation and amortization, further adjusted for non-cash items, non-recurring items and other adjustment items permitted in calculating covenant compliance under our Senior Secured Credit Facility and the Indentures (“Adjusted EBITDA”). As of December 31, 2008, we were required to maintain a senior secured leverage ratio not to exceed 4.75:1. At December 31, 2008 our senior secured leverage ratio was 4.00:1.
10.875% Notes and 11.75% Notes
The Indentures governing the $575.0 million principal amount of 10.875% Notes and the $200.0 million principal amount of 11.75% Notes limit our (and most or all of our subsidiaries’) ability to:
· incur additional debt or issue certain preferred shares;
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· pay dividends on or make other distributions in respect of our capital stock or make other restricted payments;
· make certain investments;
· sell certain assets;
· create liens on certain assets to secure debt;
· consolidate, merge, sell or otherwise dispose of all or substantially all of our assets;
· enter into certain transactions with our affiliates; and
· designate our subsidiaries as unrestricted subsidiaries.
Under the Indentures governing our 10.875% Notes and our 11.75% Notes, our ability to incur additional debt, subject to specified exceptions, is tied to improving our Adjusted EBITDA to fixed charges ratio or having a ratio of at least 2.00:1 on a pro forma basis after giving effect to such incurrence. Additionally, our ability to make certain restricted payments is also tied to having an Adjusted EBITDA to fixed charge ratio of at least 2.00:1 on a pro forma basis. Our ratio of Adjusted EBITDA to fixed charges for the twelve months ended December 31, 2008, measured on that date, was 1.47:1. Notwithstanding these limitations, the aggregate amount of term loan increases and revolving commitment increases shall not exceed the greater of (i) $150.0 million and (ii) the additional aggregate amount of secured indebtedness which would be permitted to be incurred as of any date of determination (assuming for this purpose that the full amount of any revolving credit increase had been utilized as of such date) such that, after giving pro forma effect to such incurrence (and any other transactions consummated on such date), the senior secured leverage ratio for the immediately preceding test period would not be greater than 4.0:1. Fixed charges is defined in the Indentures as consolidated interest expense plus all cash dividends or other distributions paid on any series of preferred stock of any restricted subsidiary and all dividends or other distributions accrued on any series of disqualified stock.
Covenant Compliance
The following is a summary of our covenant requirements and pro forma ratios as of December 31, 2008:
| | Covenant
Requirements | | Actual Ratios | |
Senior Secured Credit Facility | | | | | |
Maximum ratio of consolidated net senior secured debt to Adjusted EBITDA | | 4.75:1 | | 4.00:1 | |
10.875% Notes and 11.75% Notes | | | | | |
Minimum ratio of Adjusted EBITDA to fixed charges required to incur additional debt pursuant to ratio provision | | 2.00:1 | | 1.47:1 | |
As described above, our Senior Secured Credit Facility consisting of a $1,065.0 million term loan facility and a $100.0 million revolving credit facility and the Indentures governing the $575.0 million of senior notes and the $200.0 million of senior subordinated notes represent significant components of our capital structure. Under our Senior Secured Credit Facility, we are required to maintain specified senior secured leverage ratios, which become more restrictive over time, and which are determined based on our Adjusted EBITDA. If we fail to comply with the senior secured leverage ratio under our Senior Secured Credit Facility, we would be in default under the credit facility. Upon the occurrence of an event of default under the Senior Secured Credit Facility, the lenders could elect to declare all amounts outstanding under the Senior Secured Credit Facility to be immediately due and payable and terminate all commitments to extend further credit. If we were unable to repay those amounts, the lenders under the Senior Secured Credit Facility could proceed against the collateral granted to them to secure that indebtedness. We have pledged a significant portion of our assets as collateral under the Senior Secured Credit Facility. Any acceleration under the Senior Secured Credit Facility would also result in a default under the Indentures governing the notes, which could lead to the noteholders electing to declare the principal, premium, if any, and interest on the then outstanding notes immediately due and payable. In addition, under the Indentures governing the notes, our ability to engage in activities such as incurring additional indebtedness, making investments, refinancing subordinated indebtedness, paying dividends and entering into certain merger transactions is governed, in part, by our ability to satisfy tests based on Adjusted EBITDA.
Adjusted EBITDA is defined as net income (loss) plus interest expense, net, provision (benefit) for income taxes and depreciation and amortization, further adjusted for non-cash items, non-recurring items and other adjustment items permitted in calculating covenant compliance under our Senior Secured Credit Facility and Indentures. We believe that the presentation of Adjusted EBITDA is appropriate to provide additional information to investors about the calculation of, and compliance with, certain financial covenants in our Senior Secured Credit Facility and the Indentures. Adjusted EBITDA is a material component of these covenants.
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Adjusted EBITDA should not be considered as an alternative to net income or other performance measures presented in accordance with GAAP, or as an alternative to cash flow from operations as a measure of our liquidity. Adjusted EBITDA does not represent net loss or cash flow from operations as those terms are defined by GAAP and does not necessarily indicate whether cash flows will be sufficient to fund cash needs. In particular, the definition of Adjusted EBITDA in the Indentures and our Senior Secured Credit Facility allows us to add back certain non-cash, extraordinary, unusual or non-recurring charges that are deducted in calculating net loss. However, these are expenses that may recur, vary greatly and are difficult to predict. While Adjusted EBITDA and similar measures are frequently used as measures of operations and the ability to meet debt service requirements, Adjusted EBITDA is not necessarily comparable to other similarly titled captions of other companies due to the potential inconsistencies in the method of calculation.
Our ability to meet the covenants specified above will depend on future events, many of which are beyond our control, and we cannot assure you that we will meet those covenants. A breach of any of these covenants in the future could result in a default under our Senior Secured Credit Facility and the Indentures, at which time the lenders could elect to declare all amounts outstanding under our Senior Secured Credit Facility to be immediately due and payable. Any such acceleration would also result in a default under the Indentures.
The following table provides a reconciliation from our net loss to Adjusted EBITDA for the year ended December 31, 2008. The terms and related calculations are defined in the credit agreement relating to our Senior Secured Credit Facility and the Indentures.
(in thousands) | | Year Ended
December 31, 2008 | |
| | (unaudited) | |
Net loss | | $ | (97,786 | ) |
Interest expense, net | | 171,500 | |
Income tax benefit | | (49,071 | ) |
Depreciation and amortization | | 122,551 | |
Non-cash items (a) | | 6,081 | |
Non-recurring items (b) | | 44,325 | |
Other adjustment items, before projected cost savings (c) | | 16,817 | |
Other adjustment items—projected cost savings (d) | | 45,200 | |
Adjusted EBITDA | | $ | 259,617 | |
(a) Non-cash items are comprised of the following:
(in thousands) | | Year Ended
December 31, 2008 | |
| | (unaudited) | |
Stock compensation expense | | $ | 1,381 | |
Purchase accounting adjustments(1) | | 4,700 | |
Total non-cash items | | $ | 6,081 | |
(1) For the year ended December 31, 2008, the $4.7 million represents expense related to the write-up to fair market value of acquired inventory in connection with the DJO Merger.
(b) Non-recurring items are comprised of the following:
(in thousands) | | Year Ended
December 31, 2008 | |
| | (unaudited) | |
Employee severance and relocation(1) | | $ | 11,237 | |
Integration expense(2) | | 33,088 | |
Total non-recurring items | | $ | 44,325 | |
(1) Severance for the year ended December 31, 2008, included $2.8 million of separation expense in connection with the termination of one of the Company’s executive officers, and $5.7 million and $2.7 million of employee severance incurred in connection with the DJO Merger and other recent acquisitions, respectively.
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(2) Integration expense for the year ended December 31, 2008 included $23.1 million, $1.6 million, and $2.7 million of integration costs incurred in connection with the DJO Merger, the IOMED acquisition, and other recent acquisitions, respectively. Also included for the year ended December 31, 2008 was $5.2 million related to the implementation of our new global ERP system.
(c) Other adjustment items, before cost savings, are comprised of the following:
(in thousands) | | Twelve Months Ended
December 31, 2008 | |
| | (unaudited) | |
Transaction expenses(1) | | $ | 7,525 | |
Minority interest | | 1,049 | |
Other(2) | | 8,243 | |
Total other adjustment items, before cost savings | | $ | 16,817 | |
(1) Included $7.0 million of Blackstone monitoring fees for the year ended December 31, 2008.
(2) Included net foreign currency transaction losses, a settlement of a litigation contingency related to one of our foreign subsidiaries, and the write-off of an investment.
(d) Includes projected cost savings related to headcount reductions, facilities consolidation and production efficiencies in connection with the DJO Merger.
Contractual Obligations, Commercial Commitments, and Leases
The following table summarizes our contractual obligations associated with our long-term debt, lease obligations and purchase obligations as of December 31, 2008 (in thousands):
| | Payment due by period | |
| | Total | | <1 year | | 1—3 years | | 3-5 years | | >5 years | |
Long-term debt obligations | | $ | 1,843,296 | | $ | 11,359 | | $ | 21,449 | | $ | 45,334 | | $ | 1,765,154 | |
Interest payments (a) | | 673,369 | | 140,544 | | 246,120 | | 191,682 | | 95,023 | |
Capital lease obligations | | 298 | | 190 | | 108 | | — | | — | |
Operating lease obligations | | 62,901 | | 11,235 | | 16,927 | | 12,404 | | 22,335 | |
Purchase obligations | | 120,132 | | 37,666 | | 26,466 | | 14,000 | | 42,000 | |
Total | | $ | 2,699,996 | | $ | 200,994 | | $ | 311,070 | | $ | 263,420 | | $ | 1,924,512 | |
(a) $775.0 million principal amount of long-term debt is subject to fixed interest rates and $1,078.3 million of principal amount of long-term debt is subject to a floating interest rate. The interest payments in the above table for the floating rate debt were based primarily on an assumed 3.461% interest rate which is the effective interest rate for the term loans under the Senior Secured Credit Facility at December 31, 2008. Also included is the effect on interest expense related to our interest rate swap for a notional amount of $515.0 million at a fixed LIBOR rate of 7.205% expiring in 2009.
As of December 31, 2008, we had entered into purchase commitments for inventory, capital acquisitions and other services totaling approximately $120.1 million in the ordinary course of business. The purchase obligations shown above, includes $20.4 million committed in 2009 related to purchase orders at our facilities in Chattanooga and Austin. In addition, under the amended transaction and monitoring fee agreement entered into in connection with the DJO Merger, the purchase obligations shown above includes DJO’s obligation to pay a $7.0 million annual monitoring fee to Blackstone Management Partners V L.L.C. through 2019. See Item 13. “Certain Relationships and Related Transactions and Director Independence” for a more detailed description of the amended agreement. In addition to contractual obligations noted above, we expect to spend up to an additional $30.7 million implementing our new ERP system capital project over approximately the next two years.
The amounts presented in the table above may not necessarily reflect our actual future cash funding requirement because the actual timing of future payments made may vary from the stated contractual obligation.
Critical Accounting Policies and Estimates
Our management’s discussion and analysis of financial condition and results of operations is based upon our 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
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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 reserves for contractual allowances, doubtful accounts, rebates, product returns and rental credits, goodwill and intangible assets, deferred tax assets and liabilities, and inventory. We base our 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. To the extent that actual events differ from our estimates and assumptions, there could be a material impact on our financial statements.
We believe the following critical accounting policies affect our more 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.
Reserves for Contractual Allowances, Doubtful Accounts, Rebates, Product Returns and Rental Credits
We have established reserves to account for contractual allowances, doubtful accounts, rebates, product returns and rental credits. Significant management judgment must be used and estimates must be made in connection with establishing these reserves.
We maintain provisions for estimated contractual allowances for reimbursement amounts from our third party payor customers based on negotiated contracts and historical experience for non-contracted payors. We report these allowances as reductions in our gross revenue. We estimate the amount of the reduction based on historical experience and invoices generated in the period, and we consider the impact of new contract terms or modifications of existing arrangements with our customers. 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 the years ended December 31, 2008 and 2007, we reserved for and reduced gross revenues from third party payors by 32% and 30%, respectively, for estimated allowances related to these contractual reductions.
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 72% and 65% of our net revenues for the years ended December 31, 2008 and 2007, respectively, and approximately 64% and 62% of our net accounts receivable at December 31, 2008 and 2007, respectively. We experienced write-offs of less than 1% of related net revenues for the years ended December 31, 2008. Our third party reimbursement customers including insurance companies, managed care companies and certain governmental payors, such as Medicare, include all of our OfficeCare customers, most of our Empi customers, and certain other customers of our Domestic Rehabilitation Segment. Our third-party payor customers represented approximately 28% and 35% of our net revenues for the years ended December 31, 2008 and 2007, respectively, and approximately 36% and 38% of our net accounts receivable at December 31, 2008 and 2007, respectively. For the years ended December 31, 2008 and 2007, we estimate bad debt expense to be approximately 6% and 7%, respectively, of gross revenues from 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. Additions to this reserve are reflected as selling, general and administrative expense.
Our reserve for rebates accounts for incentives that we offer to certain of our distributors. These rebates generally are attributable to 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.
Our reserve for product returns accounts for estimated customer returns of our products after purchase. These returns are mainly attributable to a third party payor’s refusal to provide reimbursement for the product or the inability of the product to adequately address the patient’s condition. We provide for this reserve by reducing gross revenue based on our historical rate of returns.
Our reserve for rental credit recognizes a timing difference between billing for a sale and processing a rental credit associated with some of our rehabilitation devices. Many insurance providers require patients to rent our rehabilitation devices for a period of one to three months prior to purchase. If the patient has a long-term need for the device, these insurance companies may authorize purchase of the device after such time period. When the device is purchased, most providers require that rental payments previously made on the device be credited toward the purchase price. These credits are processed at the time the payment is received for the purchase of the device, which creates a time lag between billing for a sale and processing the rental credit. Our rental credit reserve estimates unprocessed rental credits based on the number of devices converted to purchase. The reserve is calculated by first assessing the number of our products being rented during the relevant period and our historical conversion rate of rentals to sales, and then reducing our revenue by the applicable amount. We provide for these reserves by reducing our gross revenue. The cost to refurbish rented products is expensed as incurred as part of cost of sales.
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Inventory Reserves
We provide reserves for estimated excess and obsolete inventories equal to the difference between the costs 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.
We consign a portion of our inventory to allow our products to be immediately dispensed to patients. This requires a large amount of inventory to be on hand for the products we sell through consignment arrangements. It also increases the sensitivity of these products to obsolescence reserve estimates. As this inventory is not in our possession, we maintain additional reserves for estimated shrinkage of these inventories based on the results of periodic inventory counts and historical trends.
Goodwill and Intangible Assets
In accordance with SFAS No. 142, “Goodwill and Other Intangible Assets”, we do not amortize goodwill. In lieu of amortization, we are required to perform an annual review for impairment. Goodwill is recorded as the difference, if any, between the aggregate consideration paid for an acquisition and the fair value of the net tangible and intangible assets acquired. The amounts and useful lives assigned to intangible assets acquired, other than goodwill, impact the amount and timing of future amortization, and the amount assigned to in-process research and development which is expensed immediately. The value of our intangible assets, including goodwill, could be impacted by future adverse changes such as: (i) any future declines in our operating results, (ii) a further decline in the valuation of comparable company stocks, (iii) a further significant slowdown in the worldwide economy or our industry or (iv) any failure to meet the performance projections included in our forecasts of future operating results. We estimated the fair values of our reporting units primarily using the income approach valuation methodology that includes the discounted cash flow method, taking into consideration the market approach and certain market multiples as a validation of the values derived using the discounted cash flow methodology. The discounted cash flows for each reporting unit were based on discrete financial forecasts developed by management for planning purposes. Cash flows beyond the discrete forecasts were estimated using a terminal value calculation, which incorporated historical and forecasted financial trends for each identified reporting unit and considered long-term earnings growth rates for publicly traded peer companies. Future cash flows were discounted to present value by incorporating the present value techniques discussed in FASB Concepts Statement 7, “Using Cash Flow Information and Present Value in Accounting Measurements,” or Concepts Statement 7. Specifically, the income approach valuations included reporting unit cash flow discount rates ranging from 10.8% to 11.6% and terminal value growth rates of 3%. Publicly available information regarding the market capitalization was also considered in assessing the reasonableness of the cumulative fair values of our reporting units estimated using the discounted cash flow methodology. Significant management judgment is required in the forecasts of future operating results that are used in the discounted cash flow method of valuation. The estimates we have used are consistent with the plans and estimates that we use to manage our business. It is possible, however, that the plans may change and estimates used may prove to be inaccurate. If our actual results, or the plans and estimates used in future impairment analyses, are lower than the original estimates used to assess the recoverability of these assets, we could incur significant impairment charges.
We perform an impairment analysis on our goodwill on an annual basis in the fourth quarter and in certain other circumstances when impairment indicators are present. Our annual impairment test related to goodwill did not indicate any impairment.
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Furthermore, SFAS 142 states that intangible assets with indefinite lives should be tested annually in lieu of being amortized. This testwork compares the fair value of the intangible with its carrying amount. To determine the fair value we applied the relief from royalty method (“RFR”). Under the RFR method, the value of the trade name is determined by calculating the present value of the after-tax cost savings associated with owning the asset and therefore not being required to pay royalties for its use during the asset’s indefinite life. Significant judgments inherent in this analysis include the selection of appropriate discount rates, estimating future cash flows and the identification of appropriate terminal growth rate assumptions. Discount rate assumptions are based on an assessment of the risk inherent in the projected future cash generated by the respective intangible assets. Also subject to judgment are assumptions about royalty rates, which are based on the estimated rates at which similar brands and trademarks are being licensed in the marketplace. In the fourth quarter fiscal 2008, we determined that the fair value of our Chattanooga Group trade name was less than the carrying amount, resulting in an approximate $10.1 million impairment which was written off in amortization and impairment of intangibles within the consolidated statement of operations for the year ended December 31, 2008. In addition, we determined that the Encore Medical trade name was abandoned in the fourth quarter of 2008. As a result we recorded a $12.3 million write off within the consolidated statement of operations for the year ended December 31, 2008.
Deferred Tax Asset Valuation Allowance
We recognize deferred tax assets and liabilities based on the differences between the financial statement carrying amount and the tax bases of assets, liabilities and net operating loss carryforwards. We establish valuation allowances when the recovery of a deferred tax asset is not likely based on historical income, projected future income, the expected timing of the reversals of temporary differences and the implementation of tax-planning strategies.
Our gross deferred tax asset balance was approximately $171.0 million at December 31, 2008 and primarily related to reserves for accounts receivable and inventory, accrued expenses, and net operating loss carryforwards (see Note 12 to our consolidated financial statements). As of December 31, 2008, we maintained a valuation allowance of $7.1 million due to uncertainties related to our ability to realize certain net operating loss carryforwards acquired in connection with recent acquisitions and the Prior Transaction.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We are exposed to certain market risks as part of our ongoing business operations, primarily risks from changing interest rates and foreign currency exchange rates that could impact our financial condition, results of operations, and cash flows.
Interest Rate Risk
Our primary exposure is to changing interest rates. We have historically managed our interest rate risk by balancing the amounts of our fixed and variable debt. For our fixed rate debt, interest rate changes may affect the market value of the debt, but do not impact our earnings or cash flow. Conversely, for our variable rate debt, interest rate changes generally do not affect the fair market value of the debt, but do impact future earnings and cash flow, assuming other factors are held constant. We are exposed to interest rate risk as a result of our borrowings under our Senior Secured Credit Facility, which bear interest at floating rates based on the LIBOR or the prime rate of Credit Suisse. As of December 31, 2008, we had $1,054.4 million of borrowings under our Senior Secured Credit Facility. On November 20, 2007, we entered into an interest rate swap agreement related to the Senior Secured Credit Facility for a notional amount of $515.0 million at a fixed LIBOR rate of 4.205% amortizing through an expiration date of 2009 (the notional amount was $470.0 million as of December 31, 2008). The fair value of our interest rate swap agreement recorded in the accompanying condensed consolidated balance sheets as of December 31, 2008 and 2007 was a loss of approximately $13.3 million and $3.9 million, respectively, and is recorded in other non-current liabilities. A hypothetical 1% increase in variable interest rates for the remaining portion of the Senior Secured Credit Facility not covered by the swap would have impacted our earnings and cash flow, for the three months and year ended December 31, 2008, by approximately $1.5 million and $6.1 million, respectively. Our senior debt of approximately $775.0 million consisted of fixed rate debt at December 31, 2008. In February 2009, we entered into two interest rate swap agreements. One agreement is for a notional amount of $550.0 million with a term of February 2009 through December 2009. The second agreement is for a notional amount of $750.0 million with a term of January 2010 through December 2010. Under these agreements we have LIBOR fixed rates of 1.04% and 1.88%, respectively. We may use additional derivative financial instruments where appropriate to manage our interest rate risk. However, as a matter of policy, we do not enter into derivative or other financial investments for trading or speculative purposes.
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Foreign Currency Risk
Due to the global reach of our business, we are exposed to market risk from changes in foreign currency exchange rates, particularly with respect to the U.S. dollar compared to the Euro and the Mexican Peso. Our wholly owned foreign subsidiaries are consolidated into our financial results and are subject to risks typical of an international business including, but not limited to, differing economic conditions, changes in political climate, differing tax structures, other regulations and restrictions and foreign exchange volatility. To date, we have not used international currency derivatives to hedge against our investment in our European subsidiaries or their operating results, which are converted into U.S. Dollars at period-end and average rates, respectively. However, as we continue to expand our business through acquisitions and organic growth, the sales of our products that are denominated in foreign currencies has increased as well as the costs associated with our foreign subsidiaries which operate in currencies other than the U.S. dollar. Accordingly, our future results could be materially impacted by changes in these or other factors. For the year December 31, 2008, our average monthly sales denominated in foreign currencies was approximately $19.0 million, of which $15.1 million was derived from Euro denominated sales. In addition, our exposure to fluctuations in foreign currencies arises because certain of our subsidiaries enter into purchase or sale transactions using a currency other than its functional currency. Our Mexico-based manufacturing operations incur costs that are largely denominated in Mexican Pesos. Accordingly, our future results could be materially impacted by changes in foreign exchange rates or other factors. Occasionally, we seek to reduce the potential impact of currency fluctuations on our business through hedging transactions. As of December 31, 2008, we had outstanding hedges in the form of forward contracts to purchase Mexican Pesos aggregating a U.S. dollar equivalent of $16.1 million. For the year ended December 31, 2008, we recognized a loss in the statement of operations on Mexico Peso forward contracts of approximately $4.2 million. For the year ended December 31, 2007, we recognized a gain in the statement of operations on Mexico Peso forward contracts of approximately $0.1 million.
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ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
DJO Finance LLC
Annual Report on Form 10-K
For the year ended December 31, 2008
INDEX TO AUDITED CONSOLIDATED FINANCIAL STATEMENTS
| | Page No. |
Consolidated Financial Statements: | | |
Report of Independent Registered Public Accounting Firm — Ernst & Young LLP | | 66 |
Report of Independent Registered Public Accounting Firm — KPMG LLP | | 67 |
Consolidated Balance Sheets at December 31, 2008 and 2007 | | 68 |
Consolidated Statements of Operations for the Years Ended December 31, 2008 and 2007 and for the Successor Period November 4, 2006 through December 2006 | | 69 |
Consolidated Statement of Operations for the Predecessor Period January 1, 2006 through November 3, 2006 | | 69 |
Consolidated Statements of Changes in Membership Equity and Comprehensive Loss for the Years Ended December 31, 2008 and 2007 and for the Successor Period November 4, 2006 through December 31, 2006 | | 70 |
Consolidated Statement of Changes in Stockholders’ Equity and Comprehensive Income (Loss) for the Predecessor Period January 1, 2006 through November 3, 2006 | | 70 |
Consolidated Statements of Cash Flows for the Years Ended December 31, 2008 and 2007 and the Successor Period November 4, 2006 through December 31, 2006 | | 71 |
Consolidated Statement of Cash Flows for the Predecessor Period January 1, 2006 through November 3, 2006 | | 71 |
Notes to Consolidated Financial Statements | | 72 |
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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors
DJO Finance LLC
We have audited the accompanying consolidated balance sheets of DJO Finance LLC and subsidiaries as of December 31, 2008 and 2007, and the related consolidated statements of operations, changes in membership equity and comprehensive loss, and cash flows for the years then ended. Our audits also included the financial statement schedule listed in the Index at Item 15(a). These consolidated financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and schedule based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were not engaged to perform an audit of the Company’s internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of DJO Finance LLC and subsidiaries at December 31, 2008 and December 31, 2007 and the consolidated results of their operations and their cash flows for the years then ended, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
San Diego, California
March 10, 2009
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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors
DJO Finance LLC
We have audited the accompanying consolidated statements of operations, changes in membership equity and comprehensive loss, and cash flows of DJO Finance LLC and subsidiaries (formerly ReAble Therapeutics Finance LLC) (the “Successor”) for the period from November 4, 2006 through December 31, 2006 and the consolidated statements of operations, changes in stockholders’ equity and comprehensive income (loss) and cash flows of ReAble Therapeutics, Inc. (“RTI”) for the period January 1, 2006 through November 3, 2006. In connection with our audit of the consolidated financial statements, we have also audited the financial statement schedule II as it relates to 2006. These consolidated financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedule based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the results of operations and cash flows of the Successor for the period from November 4, 2006 through December 31, 2006, in conformity with accounting principles generally accepted in the United States of America. Further, in our opinion, the consolidated financial statements referred to above present fairly in all material respects, the results of operations and cash flows of RTI for the period from January 1, 2006 through November 3, 2006 in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.
As discussed in Note 1 to the consolidated financial statements, effective November 3, 2006, all of the outstanding stock of RTI was acquired in a business combination accounted for as a purchase. As a result of the acquisition, the consolidated financial information for the period after the acquisition is presented on a different cost basis that that for the periods before the acquisition and, therefore, is not comparable.
Austin, Texas
March 30, 2007, except as to Note 11,
which is as of March 6, 2009
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DJO Finance LLC
Consolidated Balance Sheets
(in thousands)
| | December 31,
2008 | | December 31,
2007 | |
Assets | | | | | |
Current assets: | | | | | |
Cash and cash equivalents | | $ | 30,483 | | $ | 63,471 | |
Accounts receivable, net | | 164,618 | | 154,767 | |
Inventories, net | | 103,166 | | 110,904 | |
Deferred tax assets, net | | 34,039 | | 28,999 | |
Prepaid expenses and other current assets | | 16,923 | | 17,319 | |
Total current assets | | 349,229 | | 375,460 | |
Property and equipment, net | | 86,262 | | 81,645 | |
Goodwill | | 1,191,566 | | 1,201,282 | |
Intangible assets, net | | 1,260,472 | | 1,360,361 | |
Other non-current assets | | 52,601 | | 67,524 | |
Total assets | | $ | 2,940,130 | | $ | 3,086,272 | |
| | | | | |
Liabilities, Minority Interests, and Membership Equity | | | | | |
Current liabilities: | | | | | |
Accounts payable | | $ | 42,752 | | $ | 43,576 | |
Accrued interest | | 10,966 | | 10,131 | |
Long-term debt and capital leases, current portion | | 11,549 | | 14,209 | |
Other current liabilities | | 104,401 | | 93,636 | |
Total current liabilities | | 169,668 | | 161,552 | |
Long-term debt and capital leases, net of current portion | | 1,832,044 | | 1,818,598 | |
Deferred tax liabilities, net | | 329,503 | | 386,659 | |
Other non-current liabilities | | 8,806 | | 13,260 | |
Total liabilities | | 2,340,021 | | 2,380,069 | |
| | | | | |
Minority interests | | 1,743 | | 1,215 | |
| | | | | |
Commitments and contingencies | | | | | |
| | | | | |
Membership equity: | | | | | |
Additional paid-in capital | | 824,235 | | 822,854 | |
Accumulated deficit | | (221,842 | ) | (124,056 | ) |
Accumulated other comprehensive income (loss) | | (4,027 | ) | 6,190 | |
Total membership equity | | 598,366 | | 704,988 | |
Total liabilities, minority interests, and membership equity | | $ | 2,940,130 | | $ | 3,086,272 | |
See accompanying notes to consolidated financial statements.
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DJO Finance LLC
Consolidated Statements of Operations
(in thousands)
| | Successor | | Predecessor | |
| | Year Ended
December 31,
2008 | | Year Ended
December 31,
2007 | | November 4,
2006 through
December 31,
2006 | | January 1, 2006
through
November 3,
2006 | |
Net sales | | $ | 980,194 | | $ | 492,134 | | $ | 57,902 | | $ | 304,383 | |
Cost of sales | | 374,080 | | 205,864 | | 26,787 | | 127,280 | |
Gross profit | | 606,114 | | 286,270 | | 31,115 | | 177,103 | |
Operating expenses: | | | | | | | | | |
Selling, general and administrative | | 445,396 | | 271,163 | | 41,099 | | 179,164 | |
Research and development | | 26,938 | | 21,047 | | 28,128 | | 14,772 | |
Amortization and impairment of acquired intangibles | | 98,954 | | 33,496 | | 4,035 | | 5,965 | |
Operating income (loss) | | 34,826 | | (39,436 | ) | (42,147 | ) | (22,798 | ) |
Other income (expense): | | | | | | | | | |
Interest income | | 1,662 | | 1,132 | | 312 | | 527 | |
Interest expense | | (173,162 | ) | (72,409 | ) | (8,611 | ) | (26,008 | ) |
Other income (expense), net | | (9,134 | ) | 742 | | 133 | | (23 | ) |
Loss on early extinguishment of debt | | — | | (14,539 | ) | — | | (9,154 | ) |
Loss from continuing operations before income taxes and minority interests | | (145,808 | ) | (124,510 | ) | (50,313 | ) | (57,456 | ) |
Benefit for income taxes | | (49,071 | ) | (42,503 | ) | (8,756 | ) | (11,452 | ) |
Minority interests | | 1,049 | | 415 | | 39 | | 158 | |
Loss from continuing operations | | (97,786 | ) | (82,422 | ) | (41,596 | ) | (46,162 | ) |
Discontinued operations: | | | | | | | | | |
Loss from discontinued operations (net of income tax benefit of $25, and $394, respectively) | | — | | — | | (38 | ) | (614 | ) |
Net loss | | $ | (97,786 | ) | $ | (82,422 | ) | $ | (41,634 | ) | $ | (46,776 | ) |
See accompanying notes to consolidated financial statements.
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DJO Finance LLC
Consolidated Statements of Changes in Stockholders’ Equity, Membership Equity, and Comprehensive Income (Loss)
(in thousands)
| | | | | | | | | | | | | | | | | | | | Total | |
| | Successor | | Predecessor | | Retained | | Accumulated | | Stockholders’ | |
| | Additional | | | | | | Additional | | Notes Received | | Cost of Repurchased | | Earnings | | Other | | Equity and | |
| | Paid-In | | Common Stock | | Paid-In | | for Sale of | | Stock | | (Accumulated | | Comprehensive | | Membership | |
| | Capital | | Shares | | Amount | | Capital | | Common Stock | | Shares | | Amount | | Deficit) | | Income (Loss) | | Equity | |
Predecessor: | | | | | | | | | | | | | | | | | | | | | |
Balance at December 31, 2005 | | | | 20,841 | | $ | 21 | | $ | 155,430 | | $ | (846 | ) | (204 | ) | $ | (1,647 | ) | $ | 15,906 | | $ | (1,757 | ) | $ | 167,107 | |
Net loss | | | | — | | — | | — | | — | | — | | — | | (46,776 | ) | — | | (46,776 | ) |
Change in fair value of derivatives | | | | — | | — | | — | | — | | — | | — | | — | | (464 | ) | (464 | ) |
Foreign currency translation adjustment | | | | — | | — | | — | | — | | — | | — | | — | | 5,077 | | 5,077 | |
Comprehensive loss | | | | — | | — | | — | | — | | — | | — | | — | | — | | (42,163 | ) |
Issuance of common stock and options in connection with the Compex acquisition | | | | 7,267 | | 7 | | 99,308 | | — | | — | | — | | — | | — | | 99,315 | |
Equity awards | | | | — | | — | | 10,460 | | — | | — | | — | | — | | — | | 10,460 | |
Exercise of common stock options | | | | 1,070 | | 1 | | 9,001 | | — | | — | | — | | — | | — | | 9,002 | |
Tax benefit associated with stock options | | | | — | | — | | 524 | | — | | — | | — | | — | | — | | 524 | |
Note payments | | | | — | | — | | — | | 846 | | — | | — | | — | | — | | 846 | |
Balance at November 3, 2006 | | | | 29,178 | | $ | 29 | | $ | 274,723 | | $ | — | | (204 | ) | $ | (1,647 | ) | (30,870 | ) | 2,856 | | 245,091 | |
Successor: | | | | | | | | | | | | | | | | | | | | | |
Net loss | | $ | — | | | | | | | | | | | | | | (41,634 | ) | — | | (41,634 | ) |
Foreign currency translation adjustments | | — | | | | | | | | | | | | | | — | | 3,373 | | 3,373 | |
Comprehensive loss | | — | | | | | | | | | | | | | | — | | — | | (38,261 | ) |
Equity awards | | 105 | | | | | | | | | | | | | | — | | — | | 105 | |
Capital contribution - Cefar acquisition | | 9,464 | | | | | | | | | | | | | | — | | — | | 9,464 | |
Investment by Parent | | 363,900 | | | | | | | | | | | | | | — | | — | | 363,900 | |
Balance at December 31, 2006 | | 373,469 | | | | | | | | | | | | | | (41,634 | ) | 3,373 | | 335,208 | |
Net loss | | — | | | | | | | | | | | | | | (82,422 | ) | — | | (82,422 | ) |
Change in fair value of derivatives, net of tax of $1,529 | | — | | | | | | | | | | | | | | — | | (2,383 | ) | (2,383 | ) |
Foreign currency translation adjustments | | — | | | | | | | | | | | | | | — | | 5,200 | | 5,200 | |
Comprehensive loss | | — | | | | | | | | | | | | | | — | | — | | (79,605 | ) |
Repurchase of Prior Transaction Management Rollover Options | | (1,248 | ) | | | | | | | | | | | | | — | | — | | (1,248 | ) |
Equity awards | | 1,541 | | | | | | | | | | | | | | — | | — | | 1,541 | |
Reversal of tax benefit associated with stock options | | (985 | ) | | | | | | | | | | | | | — | | — | | (985 | ) |
Investment by Parent | | 450,077 | | | | | | | | | | | | | | — | | — | | 450,077 | |
Balance at December 31, 2007 | | 822,854 | | | | | | | | | | | | | | (124,056 | ) | 6,190 | | 704,988 | |
Net loss | | | | | | | | | | | | | | | | (97,786 | ) | | | (97,786 | ) |
Change in fair value of derivatives, net of tax of $3,660 | | | | | | | | | | | | | | | | | | (5,699 | ) | (5,699 | ) |
Foreign currency translation adjustments | | | | | | | | | | | | | | | | | | (4,518 | ) | (4,518 | ) |
Comprehensive loss | | | | | | | | | | | | | | | | | | | | (108,003 | ) |
Equity awards | | 1,381 | | | | | | | | | | | | | | | | | | 1,381 | |
Balance at December 31, 2008 | | $ | 824,235 | | | | | | | | | | | | | | $ | (221,842 | ) | $ | (4,027 | ) | $ | 598,366 | |
See accompanying notes to consolidated financial statements.
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DJO Finance LLC
Consolidated Statements of Cash Flows
(in thousands)
| | Successor | | Predecessor | |
| | Year Ended
December 31,
2008 | | Year Ended
December 31,
2007 | | November 4,
2006
through
December 31,
2006 | | January 1,
2006
through
November 3,
2006 | |
OPERATING ACTIVITIES: | | | | | | | | | |
Net loss | | $ | (97,786 | ) | $ | (82,422 | ) | $ | (41,634 | ) | $ | (46,776 | ) |
Adjustments to reconcile net loss to net cash (used in) provided by operating activities: | | | | | | | | | |
Depreciation | | 23,597 | | 14,744 | | 2,369 | | 8,839 | |
Amortization and impairment of intangibles | | 98,954 | | 33,496 | | 4,035 | | 5,965 | |
Amortization of debt issuance costs and non-cash interest expense | | 13,177 | | 4,862 | | 654 | | 1,856 | |
Non-cash loss on early extinguishment of debt | | — | | 9,744 | | — | | 9,154 | |
Stock-based compensation | | 1,381 | | 1,541 | | 105 | | 10,631 | |
Asset impairments and loss on disposal of assets | | 3,069 | | 682 | | 1,228 | | 388 | |
Deferred income taxes | | (42,157 | ) | (47,221 | ) | (8,842 | ) | (13,284 | ) |
Provision for doubtful accounts and sales returns | | 26,277 | | 22,428 | | 513 | | 21,763 | |
Inventory reserves | | 8,637 | | 3,580 | | 957 | | 7,563 | |
Minority interests | | 1,049 | | 415 | | 39 | | 158 | |
Excess tax benefit associated with stock option exercises | | — | | (370 | ) | — | | (2,543 | ) |
Acquired in-process research and development | | — | | 3,000 | | 25,200 | | 3,897 | |
Net effect of discontinued operations, net of gain on disposal | | — | | 378 | | 457 | | 5,155 | |
Changes in operating assets and liabilities, net of acquired assets and liabilities: | | | | | | | | | |
Accounts receivable | | (37,064 | ) | (15,301 | ) | 6,061 | | 5,503 | |
Inventories | | (1,609 | ) | 7,075 | | 2,911 | | (9,734 | ) |
Prepaid expenses, other assets and liabilities | | 68 | | 1,567 | | 2,642 | | (1,818 | ) |
Accounts payable and accrued expenses | | (9,654 | ) | 13,043 | | (12,524 | ) | 9,958 | |
Net cash (used in) provided by operating activities | | (12,061 | ) | (28,759 | ) | (15,829 | ) | 16,675 | |
INVESTING ACTIVITIES: | | | | | | | | | |
Acquisition of businesses and intangibles, net of cash acquired | | (5,095 | ) | (1,313,110 | ) | (535,080 | ) | (1,793 | ) |
Purchases of property and equipment | | (25,905 | ) | (13,962 | ) | (1,331 | ) | (12,304 | ) |
Proceeds from sale of assets | | 14 | | 4,591 | | — | | 69 | |
Other | | 1,390 | | (583 | ) | — | | (244 | ) |
Net cash used in investing activities | | (29,596 | ) | (1,323,064 | ) | (536,411 | ) | (14,272 | ) |
FINANCING ACTIVITIES: | | | | | | | | | |
Investment by parent | | — | | 434,599 | | 357,000 | | — | |
Proceeds from long-term debt and revolving line of credit | | 46,540 | | 1,724,350 | | 550,370 | | 25,300 | |
Retirement of debt and payments on long-term debt and revolving line of credit | | (37,294 | ) | (718,421 | ) | (336,113 | ) | (25,420 | ) |
Payment of debt issuance costs | | — | | (55,866 | ) | (20,818 | ) | (10 | ) |
Excess tax benefit associated with stock option exercises | | — | | 370 | | — | | 2,543 | |
Repurchase of prior transaction management rollover options | | — | | (1,248 | ) | — | | — | |
Dividend paid to minority interests of subsidiary | | (381 | ) | (226 | ) | — | | — | |
Proceeds from issuance of common stock | | — | | — | | — | | 9,002 | |
Proceeds from notes received for sale of common stock | | — | | — | | — | | 846 | |
Net cash provided by financing activities | | 8,865 | | 1,383,558 | | 550,439 | | 12,261 | |
Effect of exchange rate changes on cash and cash equivalents | | (196 | ) | 833 | | 274 | | 566 | |
Net (decrease) increase in cash and cash equivalents | | (32,988 | ) | 32,568 | | (1,527 | ) | 15,230 | |
Cash and cash equivalents at beginning of period | | 63,471 | | 30,903 | | 32,430 | | 17,200 | |
Cash and cash equivalents at end of period | | $ | 30,483 | | $ | 63,471 | | $ | 30,903 | | $ | 32,430 | |
Supplemental disclosures of cash flow information: | | | | | | | | | |
Cash paid for interest | | $ | 158,798 | | $ | 70,249 | | $ | 3,446 | | $ | 26,584 | |
Cash paid for income taxes | | $ | 2,497 | | $ | 912 | | $ | 606 | | $ | 4,576 | |
Non-cash investing and financing activities: | | | | | | | | | |
Increases in property and equipment and in other liabilities in connection with capitalized software costs | | $ | 4,066 | | $ | — | | $ | — | | $ | — | |
Issuance of management rollover options | | $ | — | | $ | 15,478 | | $ | 6,900 | | $ | — | |
Issuance of common stock in connection with acquisition of businesses | | $ | — | | $ | — | | $ | 9,464 | | $ | 99,315 | |
See accompanying notes to consolidated financial statements.
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DJO Finance LLC
Notes to Consolidated Financial Statements
1. SUMMARY OF SIGNIFICANT ACCOUNTING PRINCIPLES
Basis of Presentation and Principles of Consolidation. We are a global provider of high-quality orthopedic devices, with a broad range of products used for rehabilitation, pain management and physical therapy. We also develop, manufacture and distribute a broad range of surgical reconstructive implant products. We offer healthcare professionals and patients a diverse range of orthopedic rehabilitation products addressing the complete spectrum of preventative, pre-operative, post-operative, clinical and home rehabilitation care. Our products are used by orthopedic specialists, spine surgeons, primary care physicians, pain management specialists, physical therapists, podiatrists, chiropractors, athletic trainers and other healthcare professionals to treat patients with musculoskeletal conditions resulting from degenerative diseases, deformities, traumatic events and sports-related injuries. In addition, many of our non-surgical medical devices and related accessories are used by athletes and patients for injury prevention and at-home physical therapy treatment.
We market and distribute our products through three operating segments: Domestic Rehabilitation, International Rehabilitation, and Surgical Implant. Our Domestic and International Rehabilitation Segments offer non-invasive medical products that are used before and after surgery to assist in the repair and rehabilitation of soft tissue and bone, and to protect against further injury; electrotherapy devices and accessories used to treat pain and restore muscle function; iontophoretic devices and accessories used to deliver medication; clinical therapy tables, traction equipment and other clinical therapy equipment; orthotic devices used to treat joint and spine conditions; orthopedic soft goods; rigid knee braces; and vascular systems which include products intended to prevent deep vein thrombosis following surgery. Our Surgical Implant Segment offers a comprehensive suite of reconstructive joint products.
On November 20, 2007, a subsidiary of ReAble Therapeutics, Inc. (“ReAble”) was merged into DJO Opco Holdings, Inc. (“DJO Opco”), with DJO Opco continuing as the surviving corporation (the “DJO Merger”). As a result of the DJO Merger, DJO Opco became a subsidiary of ReAble Therapeutics Finance LLC, the entity filing this Annual Report on Form 10-K, which is itself a subsidiary of ReAble. Following the DJO Merger, ReAble was renamed DJO Incorporated (“DJO”), ReAble Therapeutics Finance LLC was renamed DJO Finance LLC (“DJOFL”) and ReAble Finance Corporation, the co-issuer of both the 10.875% senior notes and 11.75% senior subordinated notes (see Note 8), was renamed DJO Finance Corporation (“Finco”).
Except as otherwise indicated, references to “us,” “we,” “DJOFL,” “our,” or “our Company,” refers to DJOFL and its consolidated subsidiaries.
On November 3, 2006, an affiliate of Blackstone Capital Partners V L.P. (“Blackstone”) acquired all of the outstanding shares of capital stock of ReAble in a merger transaction (the “Prior Transaction”). See further description of the Prior Transaction under Note 2. For purposes of discussing the Prior Transaction in the audited consolidated financial statements, we refer to DJO as ReAble or “Predecessor.”
DJOFL directly or indirectly through its subsidiaries, owns all of the operating assets of DJO. The accompanying consolidated financial statements include the accounts of DJOFL, and its wholly owned subsidiaries and those entities in which we hold a controlling interest from the date of the Prior Transaction. Prior to the date of the Prior Transaction, the financial statements reflect the accounts and activities of the Predecessor. The Successor period reflects the acquisition of ReAble using the purchase method of accounting pursuant to the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 141, “Business Combinations”. The Predecessor results of ReAble are not comparable to the Successor results of DJOFL due to the difference in basis of presentation incorporating the Prior Transaction purchase accounting as compared to historical cost for the Predecessor. Minority interests reflect the 50% separate ownership of Medireha GmbH (“Medireha”) not owned by us, which we have consolidated due to our controlling interest. Our controlling interest consists of our 50% ownership and our control of one of the two director seats, our rights to prohibit certain business activities that are not consistent with our plans for the business and our exclusive distribution rights for products manufactured by Medireha. All significant intercompany balances and transactions have been eliminated in consolidation.
Use of Estimates. The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make certain estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. On an ongoing basis, management evaluates its estimates, including those related to contractual allowances, doubtful accounts, inventories, rebates, product returns, warranty obligations, self insurance, income taxes, goodwill and intangible assets valuations and stock-based compensation. We base our estimates on historical experience and on various other assumptions that we believe are 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 could differ from those estimates.
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Cash and Cash Equivalents. Cash consists of deposits with financial institutions. We consider all short-term, highly liquid investments and investments in money market funds and commercial paper with original maturities of less than three months at the time of purchase to be cash equivalents. While our cash and cash equivalents are on deposit with high-quality institutions, such deposits exceed Federal Deposit Insurance Corporation insured limits.
Allowance for Doubtful Accounts. We make estimates of the collectability of accounts receivable. Management analyzes accounts receivable historical collection rates and bad debts write-offs, customer concentrations, customer credit-worthiness, and current economic trends when evaluating the adequacy of the allowance for doubtful accounts.
Sales Returns and Allowances. We make estimates of the amount of sales returns and allowances that will eventually be incurred. Management analyzes sales programs that are in effect, contractual arrangements, market acceptance and historical trends when evaluating the adequacy of sales returns and allowance accounts. We estimate contractual discounts and allowances for reimbursement amounts from our third-party payor customers based on negotiated contracts and historical experience.
Inventories. Inventory is valued at the lower of cost (determined on a first-in, first-out basis) or market. We establish reserves for slow moving and excess inventory, product obsolescence, shrinkage and other valuation impairments based on future demand and historical experience.
Property and Equipment. Property and equipment are stated at cost less accumulated depreciation and amortization. Depreciation is calculated for financial reporting purposes using the straight-line method over the estimated useful lives of the assets that range from three to twenty-five years. Leasehold improvements and assets subject to capital leases are amortized using the straight-line method over the terms of the leases or lives of the assets, if shorter. We capitalize surgical implant instruments that we provide to surgeons, free of charge, for use while implanting our products and the related depreciation expense is recorded as a component of selling, general and administrative expense. We also capitalize electrotherapy devices that we rent to patients and record the related depreciation expense in cost of sales.
Computer Software Costs. Software is stated at cost less accumulated amortization and is amortized using the straight-line method over its estimated useful life ranging from three to seven years. In accordance with AICPA Statement of Position 98-1, “Accounting for the Costs of Computer Software Developed or Obtained for Internal Use” (“SOP 98-1”) we capitalize costs of internally developed software during the development stage of internally developed software applications. Additionally, we capitalize related costs including external consulting costs, cost of software licenses, and internal payroll and payroll-related costs for employees who are directly associated with a software project. Software assets are reviewed for impairment when events or circumstances indicate that the carrying value may not be recoverable over the remaining lives of the assets. Upgrades and enhancements are capitalized if they result in added functionality. Recently we began implementing a new ERP system resulting in approximately $4.5 million of capitalized software costs as of December 31, 2008.
Impairment of Long-Lived Assets. In accordance with SFAS 144, “Accounting for the Impairment of Long-Lived Assets” (“SFAS 144”) we test long-lived assets for impairment when events or changes in circumstances may indicate that the carrying amount of an asset may not be recoverable. Recoverability of long-lived assets is measured by a comparison of the carrying amount of an asset to the undiscounted future net cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured as amount by which the carrying amount of the assets exceed the discounted future net cash flows. Assets to be disposed of are reported at the lower of the carrying amount or estimated sale value less estimated costs to sell.
Goodwill and Intangible Assets. Goodwill represents the excess of the purchase price over the fair value of tangible and identifiable intangible assets acquired and liabilities assumed. In accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” we do not amortize goodwill. In lieu of amortization, we are required to perform an annual review for impairment. Goodwill is recorded as the difference, if any, between the aggregate consideration paid for an acquisition and the fair value of the net tangible and intangible assets acquired. The amounts and useful lives assigned to intangible assets acquired, other than goodwill, impact the amount and timing of future amortization, and the amount assigned to in-process research and development which is expensed immediately. The value of our intangible assets, including goodwill, could be impacted by future adverse changes such as: (i) any future declines in our operating results, (ii) a further decline in the valuation of comparable company stocks, (iii) a further significant slowdown in the worldwide economy or our industry or (iv) any failure to meet the performance projections included in our forecasts of future operating results. We estimated the fair values of our reporting units primarily using the income approach valuation methodology that
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includes the discounted cash flow method, taking into consideration the market approach and certain market multiples as a validation of the values derived using the discounted cash flow methodology. The discounted cash flows for each reporting unit were based on discrete financial forecasts developed by management for planning purposes. Cash flows beyond the discrete forecasts were estimated using a terminal value calculation, which incorporated historical and forecasted financial trends for each identified reporting unit and considered long-term earnings growth rates for publicly traded peer companies. Future cash flows were discounted to present value by incorporating the present value techniques discussed in FASB Concepts Statement 7, “Using Cash Flow Information and Present Value in Accounting Measurements,” or Concepts Statement 7. Specifically, the income approach valuations included reporting unit cash flow discount rates ranging from 10.8% to 11.6% and terminal value growth rates of 3%. Publicly available information regarding the market capitalization was also considered in assessing the reasonableness of the cumulative fair values of our reporting units estimated using the discounted cash flow methodology. Significant management judgment is required in the forecasts of future operating results that are used in the discounted cash flow method of valuation. The estimates we have used are consistent with the plans and estimates that we use to manage our business. It is possible, however, that the plans may change and estimates used may prove to be inaccurate. If our actual results, or the plans and estimates used in future impairment analyses, are lower than the original estimates used to assess the recoverability of these assets, we could incur significant impairment charges.
We perform an impairment analysis on our goodwill on an annual basis in the fourth quarter and in certain other circumstances when impairment indicators are present. Our annual impairment test related to goodwill did not indicate any impairment.
Identifiable intangible assets consist of trademarks, trade names, patents, distribution networks, intellectual property, non-compete agreements and customer lists and are carried at fair value on date of purchase less accumulated amortization. Amortization of identifiable intangibles is computed using the straight-line method over their estimated useful lives. Our customer and technology based intangibles have weighted average periods of 9 and 10 years, respectively. Our trade names were determined to have an indefinite life.
We test intangible assets with indefinite lives in accordance with SFAS 142, which states that intangible assets with indefinite lives should be tested annually in lieu of being amortized. This test compares the fair value of the intangible with its carrying amount. To determine the fair value we applied the relief from royalty method (“RFR”). Under the RFR method, the value of the trade name is determined by calculating the present value of the after-tax cost savings associated with owning the asset and therefore not being required to pay royalties for its use during the asset’s indefinite life. Significant judgments inherent in this analysis include the selection of appropriate discount rates, estimating future cash flows and the identification of appropriate terminal growth rate assumptions. Discount rate assumptions are based on an assessment of the risk inherent in the projected future cash generated by the respective intangible assets. Also subject to judgment are assumptions about royalty rates, which are based on the estimated rates at which similar brands and trademarks are being licensed in the marketplace. During the fourth quarter 2008, we determined that the fair value of our Chattanooga Group trade name was less than the carrying amount, resulting in an approximate $10.1 million impairment charge for the year ended December 31, 2008. In addition, we determined that the Encore Medical trade name was abandoned in the fourth quarter of 2008. As a result we recorded a $12.3 million write off within the consolidated statement of operations for the year ended December 31, 2008.
Debt Issuance Costs. Debt issuance costs are capitalized and are included in other non-current assets on our consolidated balance sheet. We amortize these costs over the lives of the related debt instruments (currently, approximately seven years) and classify the amortization expense with interest expense in the accompanying consolidated statements of operations. At December 31, 2008 and 2007, we have unamortized debt issuance costs of $49.9 million and $61.6 million, respectively.
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Warranty Costs. We provide expressed warranties on certain products for periods typically ranging from one to three years. We estimate our warranty obligations at the time of sale based upon historical experience and known product issues, if any.
A summary of the activity in our warranty reserves is as follows (in thousands):
| | Successor | | Predecessor | |
| | Year Ended
December 31,
2008 | | Year Ended
December 31,
2007 | | November 4,
2006 through
December 31,
2006 | | January 1, 2006
through
November 3,
2006 | |
Beginning balance | | $ | 1,720 | | $ | 1,348 | | $ | 1,275 | | $ | 643 | |
Amount charged to expense for estimated warranty costs | | 1,258 | | 509 | | 260 | | 1,354 | |
Deductions for actual costs incurred | | (1,217 | ) | (454 | ) | (187 | ) | (1,040 | ) |
Acquired through business acquisitions | | — | | 317 | | — | | 318 | |
Ending balance | | $ | 1,761 | | $ | 1,720 | | $ | 1,348 | | $ | 1,275 | |
Self Insurance. We are partially self insured for certain employee health benefits and product liability claims. Accruals for losses are provided based upon claims experience and actuarial assumptions, including provisions for incurred but not reported losses.
Revenue Recognition. We recognize revenue pursuant to Staff Accounting Bulletin No. 104, Revenue Recognition. Accordingly, revenue is recognized when all four of the following criteria are met: (i) persuasive evidence that an arrangement exists; (ii) shipment of goods and passage of title; (iii) the selling price is fixed or determinable; and (iv) collectibility is reasonably assured. We reduce revenue by estimates of potential future product returns and other allowances. Revenues are also reduced by rebates related to sales transacted through distribution agreements that provide the distributors with a right to return inventory or take certain pricing adjustments based on sales mix or volume. Provisions for product returns and other allowances are recorded as a reduction to revenue in the period sales are recognized.
Advertising Costs. We expense advertising costs as they are incurred. For the Successor years ended December 31, 2008 and 2007 and the period November 4, 2006 through December 31, 2006, advertising costs were approximately $6.4 million, $3.9 million and $0.7 million, respectively. For the Predecessor period January 1, 2006 through November 3, 2006, such costs approximated $5.6 million.
Shipping and Handling Expenses. Shipping and handling expenses are included with cost of sales in our consolidated statement of operations.
Stock Based Compensation. We maintain a stock option plan under which stock options have been granted to employees and non-employee members of the Board of Directors. Effective January 1, 2006, we adopted SFAS 123(R), which requires all share based payments to employees to be recognized in the financial statements based upon their respective grant date fair values. With the adoption of SFAS 123(R), we elected to amortize stock-based compensation for service-based awards granted on a straight-line basis over the requisite service (vesting) period for the entire award. Other awards vest over a specified performance period from the date of grant upon the achievement of certain pre-determined performance targets over time and compensation expense is recognized to the extent the achievement of the performance targets is deemed probable. Refer to Note 10 for further discussion.
Income Taxes. We account for income taxes under the asset and liability method as set forth in SFAS No. 109, “Accounting for Income Taxes” (“SFAS 109”). Under this method, deferred tax assets and liabilities are recognized and measured using enacted tax rates in effect for the year in which the differences are expected to be recognized. Valuation allowances are established when necessary to reduce deferred tax assets to amounts that are more likely than not to be realized. In addition, we adopted Financial Accounting Standards Board issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes — an Interpretation of FAB Statement No. 109 (“FIN 48”) on January 1, 2007 (see Note 12 to our audited consolidated financial statements).
Foreign Currency Translation. The financial statements of our 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 membership 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 condensed consolidated statements of operations.
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Derivative Financial Instruments. We use foreign exchange forward contracts to hedge expense commitments that are denominated in currencies other than the US dollar. The purpose of our foreign currency hedging activities is to fix the dollar value of specific commitments and payments to foreign vendors. We account for derivatives pursuant to SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” which requires that all derivative instruments be recognized in the financial statements and measured at fair value regardless of the purpose or intent for holding them. The classification of gains and losses resulting from changes in the fair values of derivatives is dependent on the intended use of the derivative and its resulting designation. The change in fair value of the ineffective portion of a hedge, and changes in fair values of derivatives that are not considered highly effective hedges are immediately recognized in earnings. If the derivative is designated as a cash flow hedge, the effective portions of changes in the fair value of the derivative are recorded in other comprehensive income and are subsequently recognized in earnings when the hedged item affects earnings.
Comprehensive Income (Loss). Comprehensive income (loss) includes net income and other comprehensive income. Other comprehensive income (loss) refers to unrealized gains and losses that are excluded from current earnings and are recorded directly as an adjustment to stockholders’ equity/membership equity. These gains and losses often fluctuate before being realized, and are often long—term in nature. Our other comprehensive income (loss) is comprised of foreign currency translation adjustments and unrealized interest rate hedge gains and losses, net of tax.
Concentration of Credit Risk. We sell the majority of our products in the United States to orthopedic professionals, hospitals, distributors, specialty dealers, insurance companies, managed care companies and certain governmental payors such as Medicare. International sales comprised 26.0%, 27.4%, 29.0%, and 22.3% of our net revenues for the Successor years ended December 31, 2008 and 2007, the period November 4, 2006 through December 31, 2006 and for the Predecessor period January 1, 2006 through November 3, 2006, respectively. International sales are generated from a diverse group of customers through our wholly owned subsidiaries and certain independent distributors. Credit is extended based on an evaluation of the customer’s financial condition and generally collateral is not required. We provide a reserve for estimated bad debts. Management reviews and revises its estimates for credit losses from time to time and such credit losses have generally been within management’s estimates.
During the three years ending December 31, 2008, we had no individual customer or distributor that accounted for 10% or more of our total annual revenues.
Fair Value of Financial Instruments. The carrying amounts of our short—term financial instruments, including cash and cash equivalents, accounts receivable and accounts payable, approximate fair values due to their short—term nature. The fair values of our variable rate debt, including borrowings under our Senior Secured Credit Facility, are currently below the carrying value. We estimated the fair value of our long—term fixed rate notes based on trading prices for the notes on or near December 31, 2008 and 2007 (see Note 8).
Reclassifications. The consolidated financial statements and accompanying footnotes reflect certain reclassifications to prior year consolidated financial statements to conform to the current year presentation.
Recent Accounting Pronouncements
In March 2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities” which requires entities to disclose the fair values of derivative instruments and their gains and losses in a tabular format and to disclose derivative features that are credit risk—related. The statement is effective for fiscal years beginning after November 15, 2008. We will adopt this statement as of the beginning of 2009 and are currently assessing the potential impact of adoption.
In December 2007, the FASB issued SFAS No. 160, “Non—controlling Interests in Consolidated Financial Statements” which requires entities to report non—controlling (minority) interests in subsidiaries in the same way as equity in the consolidated financial statements. The statement is effective for fiscal years beginning after December 15, 2008. We will adopt this statement as of the beginning of 2009 and are currently assessing the potential impact of adoption.
In December 2007, the FASB issued SFAS No. 141 (R), “Business Combinations” (“SFAS 141 (R)”) which requires the acquiring entity in a business combination to recognize all the assets acquired and liabilities assumed in the transaction; establishes the acquisition—date fair value as the measurement objective for all assets acquired and liabilities assumed; and requires the acquirer to disclose to investors and other users all of the information they need to evaluate and understand the nature and financial effect of the business combination. The statement is effective for business combinations commencing subsequent to December 15, 2008.
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In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities—Including an amendment to FASB Statement No. 115” which permits entities to choose to measure many financial instruments and certain other items at fair value. We adopted this statement during 2008. The provisions of SFAS 159 did not have a material impact in our consolidated financial statements.
In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurement” which defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles (“GAAP”) and expands disclosure about fair value measurements. We adopted this statement during 2008. The provisions of SFAS 157 did not have a material impact in our consolidated financial statements.
2. ACQUISITIONS AND OTHER TRANSACTIONS
We account for acquisitions in accordance with SFAS 141 (R) with the results of operations attributable to each acquisition included in the consolidated financial statements from the date of acquisition.
Acquisition of DJO Opco Holdings, Inc.
On July 15, 2007, we entered into an Agreement and Plan of Merger (the “DJO Merger Agreement”) with DJO Opco, formerly known as DJO Incorporated, providing for the DJO Merger pursuant to which DJO Opco became a wholly owned subsidiary of DJOFL. The total purchase price for the DJO Merger, which was consummated on November 20, 2007, was approximately $1.3 billion and consisted of $1.2 billion paid to former equity holders (or $50.25 in cash for each share of common stock of DJO Opco they then held), $15.2 million related to the fair value of stock options held by DJO Opco management that were exchanged for options to purchase DJO common stock, and $22.8 million in direct acquisition costs. The DJO Merger was financed through a combination of equity contributed by our primary shareholder, an affiliate of Blackstone Capital Partners V, L.P. (“Blackstone”), borrowings under our senior secured credit facility (the “Senior Secured Credit Facility”), and proceeds from the newly issued 10.875% senior notes due 2014 (the “10.875% Notes”) (see Note 8 for further information).
Acquisition of IOMED, Inc.
On August 9, 2007, a subsidiary of DJOFL acquired IOMED, Inc. (“IOMED”), which develops, manufactures and markets active drug delivery systems used primarily to treat acute local inflammation in the physical and occupational therapy and sports medicine markets. The purchase price was $23.3 million and consisted of $21.1 million in cash payments to former IOMED equity holders at $2.75 per share, $0.8 million related to the fair value of vested stock options that were outstanding at the time of the acquisition, and $1.4 million in direct acquisition costs. The IOMED acquisition was primarily financed with borrowings under our then existing revolving credit facility.
Acquisition of The Saunders Group, Inc.
On July 2, 2007, a subsidiary of DJOFL completed its purchase of substantially all of the assets of The Saunders Group, Inc. (“Saunders”) for total cash consideration of $40.9 million, including $0.9 million of acquisition costs (the “Saunders Acquisition”). Saunders is a supplier of rehabilitation products to physical therapists, chiropractors, athletes, athletic trainers, physicians and patients, with a specialty in patented traction devices, back supports, and equipment for neck and back disorders. The Saunders Acquisition was financed with funds borrowed under our then existing senior credit facilities.
Acquisition of Cefar AB
On November 7, 2006, a subsidiary of DJOFL acquired all of the issued and outstanding shares of Cefar AB (“Cefar”), a provider of electrotherapy and rehabilitation devices used for chronic pain, for women’s health, for electroacupuncture, and for other rehabilitation activities. The purchase price of $27.1 million was comprised of the payment of $16.3 million in cash, issuance of shares of our common stock valued at $9.5 million, and $1.3 million of acquisition costs. The fair value of the common stock issued was determined as $16.46 per share based on the per share price used in the Prior Transaction. We funded the cash portion of the acquisition with $10.0 million of term loan borrowings under the Old Senior Secured Credit Facility and cash on hand. Pursuant to the terms of the acquisition agreement, additional amounts were payable to certain of the former stockholders of Cefar if certain EBITDA targets were met by December 31, 2008. During 2008, $1.8 million was paid to the former stockholders of Cefar. As of December 31, 2008, we had a remaining accrual of $1.8 million, which was subsequently paid to the shareholders of Cefar in January 2009.
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The Prior Transaction
On November 3, 2006, Blackstone acquired all of the outstanding shares of capital stock of ReAble in a merger transaction (the “Prior Transaction”). The total purchase price for the Prior Transaction was approximately $529.2 million and consisted of $482.5 million paid to former holders of shares of common stock, $7.2 million related to the fair value of management rollover options that continued to remain as outstanding options to purchase ReAble common stock after the Prior Transaction (the “Prior Transaction Management Rollover Options”), and $39.5 million in direct acquisition costs. The Prior Transaction was financed through a combination of equity contributed by an affiliate of Blackstone, cash on hand of ReAble, borrowings under the Old Senior Secured Credit Facility and proceeds from our 11.75% senior subordinated notes (the “11.75% Notes”, see Note 8). Upon the closing of the Prior Transaction, shares of ReAble’s common stock ceased to be traded on the NASDAQ Global Market.
Acquisition of Compex Technologies, Inc.
On February 24, 2006, pursuant to the terms of a merger agreement dated November 11, 2005, we acquired all of the issued and outstanding shares of Compex Technologies, Inc. (“Compex”), a Minnesota corporation. Compex manufactured and sold a broad line of transcutaneous electrical nerve stimulation (“TENS”) and neuromuscular electrical nerve stimulation (“NMES”) products used for pain management, rehabilitation, fitness and sports performance enhancement in clinical, home healthcare, sports and occupational medicine settings. The domestic Compex operations were integrated into our Empi division. The total purchase price of approximately $102.9 million was comprised of 7.3 million shares of our common stock valued at $90.0 million, options to purchase 900,000 shares of our common stock valued at $9.3 million, and $3.6 million in acquisition costs. We funded the cash portion of the acquisition with $25.3 million of borrowings.
Other Acquisitions
During 2007, we completed the acquisition of various other businesses, including Endeavor Medical, Inc. (“Endeavor”) and Performance Modalities, Inc. (“PMI”). On April 13, 2007, we acquired Endeavor for total consideration of $2.9 million. On February 16, 2007, we acquired certain assets of PMI for total consideration of $4.3 million. The preliminary allocation of the aggregate purchase price for both acquisitions, which is subject to change upon our further evaluation of the assets acquired and liabilities assumed, resulted in the recognition of $2.4 million of goodwill.
The fair values of the assets acquired and the liabilities assumed were estimated in accordance with SFAS 141. The purchase prices for our acquisitions were 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 December 31, 2008 (see Note 6):
(in thousands): | | DJO Opco | | IOMED | | Saunders | | Cefar | | Prior
Transaction | | Compex | | Wtd. Avg. Useful Life | |
Current assets | | $ | 171,929 | | $ | 8,971 | | $ | 6,783 | | $ | 11,342 | | $ | 209,011 | | $ | 69,129 | | | |
Tangible non-current assets | | 67,385 | | 853 | | 273 | | 1,036 | | 49,853 | | 8,340 | | | |
Liabilities assumed (see Note 13) | | (697,465 | ) | (6,679 | ) | (628 | ) | (10,697 | ) | (538,526 | ) | (51,092 | ) | | |
Acquired in-process research and development | | 3,000 | | — | | — | | — | | 25,200 | | 3,897 | | | |
Identifiable intangible assets: | | | | | | | | | | | | | | | |
Technology-based | | 354,000 | | 6,616 | | 10,171 | | 1,800 | | 83,900 | | 8,213 | | 3 – 20 years | |
Customer-based | | 328,000 | | 2,512 | | 6,369 | | 3,200 | | 133,800 | | 14,610 | | 10 – 16 years | |
Trademarks and tradenames | | 356,000 | | 1,777 | | 4,423 | | 3,400 | | 92,000 | | 5,771 | | Indefinite | |
Non-compete | | — | | — | | — | | — | | 1,600 | | — | | 1 year | |
Goodwill | | 691,884 | | 9,255 | | 13,537 | | 17,036 | | 472,414 | | 43,995 | | N/A | |
Purchase price | | $ | 1,274,733 | | $ | 23,305 | | $ | 40,928 | | $ | 27,117 | | $ | 529,252 | | $ | 102,863 | | | |
Goodwill represents the excess of the purchase price over the fair value of tangible and identifiable intangible assets acquired and liabilities assumed.
The purchase price allocation for the DJO Merger included values assigned to certain specific identifiable intangible assets aggregating $1,038.0 million. An aggregate value of $354.0 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 our ownership of the patents and technology acquired. An aggregate value of $328.0 million was assigned to certain DJO Opco customer relationships for group purchase organization (“GPO”) customers and certain other customers existing on the acquisition date based upon an estimate of the future discounted cash flows that would be derived from those GPOs and other customers. A value of $356.0 million was assigned to tradenames and trademarks, determined primarily by estimating the present value of future royalty costs that will be avoided due to our ownership of the tradenames and trademarks acquired.
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Goodwill represents the excess of the purchase price over the fair value of tangible and identifiable intangible assets acquired and liabilities assumed. A value of $691.9 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. We acquired DJO Opco to expand our product offerings, increase our addressable market, increase the size of our international business and increase our revenues. We also believe there are significant cost reduction synergies that may be realized as we integrate the acquired business. These are among the factors that contributed to a purchase price for the DJO Merger acquisition that resulted in the recognition of goodwill.
The purchase price allocation for the Prior Transaction included values assigned to certain specific identifiable intangible assets aggregating $311.3 million. An aggregate value of $83.9 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 our ownership of the patents and technology acquired. An aggregate value of $133.8 million was assigned to certain ReAble customer relationships for hospitals, distributors, third party payors, and certain other customers 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 $92.0 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 our ownership of the trade names and trademarks acquired. A value of $1.6 million was assigned to non—compete restrictions included in the employment agreements of certain of ReAble’s executive officers and senior management. A value of $472.4 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.
3. ACCOUNTS RECEIVABLE RESERVES
A summary of activity in our accounts receivable reserves for doubtful accounts and sales returns is presented below (in thousands):
| | Successor | | Predecessor | |
| | Year
Ended
December
31, 2008 | | Year Ended
December 31,
2007 | | November 4,
2006 through
December 31,
2006 | | January 1,
2006
through
November
3, 2006 | |
| | | | | | | | | |
Balance, beginning of period | | $ | 30,954 | | $ | 513 | | $ | — | | $ | 4,016 | |
| | | | | | | | | |
Acquired through business acquisitions | | — | | 14,709 | | — | | — | |
| | | | | | | | | |
Provision for doubtful accounts and sales returns | | 26,277 | | 22,521 | | 513 | | 21,763 | |
| | | | | | | | | |
Write-offs, net of recoveries | | (21,885 | ) | (6,789 | ) | — | | (6,610 | ) |
| | | | | | | | | |
Balance, end of period | | $ | 35,346 | | $ | 30,954 | | $ | 513 | | $ | 19,169 | |
Reserve balances subsequent to the Prior Transaction were netted against the related accounts receivable as part of the Prior Transaction purchase accounting.
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4. INVENTORIES
Inventories consist of the following (in thousands):
| | December 31,
2008 | | December 31,
2007 | |
Components and raw materials | | $ | 34,138 | | $ | 35,534 | |
Work in process | | 5,187 | | 6,626 | |
Finished goods | | 54,776 | | 54,411 | |
Inventory held on consignment | | 21,804 | | 22,159 | |
| | 115,905 | | 118,730 | |
Less – inventory reserves | | (12,739 | ) | (7,826 | ) |
| | $ | 103,166 | | $ | 110,904 | |
A summary of the activity in our reserves for estimated slow moving, excess, obsolete and otherwise impaired inventory is presented below (in thousands):
| | Successor | | Predecessor | |
| | Year Ended
December 31,
2008 | | Year Ended
December 31,
2007 | | November 4,
2006 through
December 31,
2006 | | January 1,
2006
through
November
3, 2006 | |
Balance, beginning of period | | $ | 7,826 | | $ | 918 | | $ | — | | $ | 7,397 | |
Acquired through business acquisitions | | — | | 3,867 | | — | | — | |
Provision charged to cost of sales | | 8,637 | | 3,580 | | 957 | | 7,563 | |
Write-offs | | (3,724 | ) | (539 | ) | (39 | ) | (2,651 | ) |
Balance, end of period | | $ | 12,739 | | $ | 7,826 | | $ | 918 | | $ | 12,309 | |
The write-offs to the reserve were principally related to the disposition of fully reserved inventory. Reserves existing at the date of the Prior Transaction were netted against the related inventory as part of the Prior Transaction purchase accounting.
5. PROPERTY AND EQUIPMENT, NET
Property and equipment consists of the following (in thousands):
| | December 31,
2008 | | December 31,
2007 | | Depreciable lives
(years) | |
Land | | $ | 1,442 | | $ | 1,713 | | Indefinite | |
Buildings and improvements | | 21,179 | | 19,788 | | 5 to 25 | |
Equipment | | 54,943 | | 45,526 | | 3 to 8 | |
Software | | 13,974 | | 11,714 | | 3 to 5 | |
Furniture and fixtures | | 7,647 | | 7,115 | | 3 to 10 | |
Surgical implant instrumentation | | 13,662 | | 9,800 | | 5 | |
Construction in progress | | 15,432 | | 6,483 | | n/a | |
| | 128,279 | | 102,139 | | | |
Less - accumulated depreciation and amortization | | (42,017 | ) | (20,494 | ) | | |
Property and equipment, net | | $ | 86,262 | | $ | 81,645 | | | |
Depreciation and amortization expense relating to property and equipment was approximately $23.6 million, $14.7 million and $2.4 million for the Successor years ended December 31, 2008 and 2007 and the period November 4, 2006 through December 31, 2006, respectively. Depreciation expense was $8.8 million for the Predecessor period January 1, 2006 through November 3, 2006. Depreciation expense includes amounts associated with surgical implant instruments that we provide to surgeons, free of charge, for use while implanting our products, and is reported as a selling, general and administrative expense in the amounts of $2.9 million, $2.5 million, and $0.4 million for the Successor years ended December 31, 2008 and 2007 and the period from November 4, 2006 through December 31, 2006, respectively, and $1.8 million for the Predecessor period from January 1, 2006 through November 3, 2006. We also capitalize electrotherapy devices that we rent to patients and record the related depreciation expense in cost of sales.
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6. GOODWILL AND INTANGIBLE ASSETS
A summary of the activity in goodwill is presented below (in thousands):
| | Year Ended
December 31,
2008 | | Year Ended
December 31,
2007 | |
Balance, beginning of period | | $ | 1,201,282 | | $ | 475,722 | |
Tax Adjustments | | (18,118 | ) | 4,178 | |
Prior Transaction | | — | | 8,303 | |
Acquisition of Cefar | | (73 | ) | 3,863 | |
Acquisition of IOMED | | 579 | | 8,676 | |
Acquisition of Saunders | | — | | 13,537 | |
Acquisition of DJO Opco | | 12,780 | | 679,104 | |
Acquisition of other businesses | | — | | 2,446 | |
Foreign currency translation | | (5,737 | ) | 5,453 | |
Other | | 853 | | — | |
Balance, end of period | | $ | 1,191,566 | | $ | 1,201,282 | |
For the year ended December 31, 2008, we recorded approximately $12.8 million related to the DJO Opco acquisition to reflect changes in our preliminary estimates of approximately $8.1 million of deferred tax assets and liabilities assumed, including approximately $6.0 million for Medicare reimbursement claims. The fair values of the assets acquired and the liabilities assumed were estimated in accordance with SFAS 141. Goodwill represents the excess of the purchase price over the fair value of tangible and identifiable intangible assets acquired and liabilities assumed. Additionally, we reduced goodwill by $18.1 million related to various tax adjustments (refer to Note 12).
For the year ended December 31, 2007, we recorded approximately $679.1 million, $8.7 million and $13.5 million of goodwill associated with the acquisition of DJO Opco, IOMED and Saunders, respectively. We also completed the acquisitions of various other businesses during the year which resulted in the recognition of approximately $2.4 million of goodwill in the aggregate.
During the fourth quarter 2008, we performed an impairment test of our goodwill and indefinite lived intangible assets in accordance with SFAS 142 we determined that the fair value of our Chattanooga Group trade name was less than the carrying amount, resulting in an approximate $10.1 million impairment charge within the consolidated statement of operations for the year ended December 31, 2008. In addition, we determined that the Encore Medical trade name was abandoned in the fourth quarter of 2008. As a result, we recorded a $12.3 million impairment charge within the consolidated statement of operations for the year ended December 31, 2008.
Identifiable intangible assets consisted of the following as of December 31, 2008 (in thousands):
| | Gross Carrying
Amount | | Accumulated
Amortization | | Intangibles,
Net | |
Amortizable intangible assets: | | | | | | | |
Technology-based | | $ | 458,612 | | $ | (56,501 | ) | $ | 402,111 | |
Customer-based | | 478,387 | | (57,537 | ) | 420,850 | |
| | $ | 936,999 | | $ | (114,038 | ) | 822,961 | |
Indefinite-lived intangible assets: | | | | | | | |
Trademarks | | | | | | 435,267 | |
Foreign currency translation | | | | | | 2,244 | |
Total identifiable intangible assets | | | | | | $ | 1,260,472 | |
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Identifiable intangible assets consisted of the following as of December 31, 2007 (in thousands):
| | Gross Carrying
Amount | | Accumulated
Amortization | | Intangibles,
Net | |
Amortizable intangible assets: | | | | | | | |
Technology-based | | $ | 457,463 | | $ | (18,484 | ) | $ | 438,979 | |
Customer-based | | 477,942 | | (19,047 | ) | 458,895 | |
| | $ | 935,405 | | $ | (37,531 | ) | 897,874 | |
Indefinite-lived intangible assets: | | | | | | | |
Trademarks | | | | | | 457,686 | |
Foreign currency translation | | | | | | 4,801 | |
Total identifiable intangible assets | | | | | | $ | 1,360,361 | |
Our amortizable intangible assets will continue to be amortized over their useful lives of 10 and 9 years on a weighted average basis for Technology and Customer based intangibles, respectively.
Our estimated amortization expense related to acquired intangible assets for the next five years and thereafter is as follows (in thousands):
Year Ending December 31, | | | | |
2009 | | $ | 76,094 | |
2010 | | 75,155 | |
2011 | | 73,788 | |
2012 | | 72,387 | |
2013 | | 67,474 | |
Thereafter | | 458,063 | |
At December 31, 2008 and 2007, our goodwill and intangible assets are allocated by segment as follows (in thousands):
2008 | | Goodwill | | Intangibles, Net | |
Domestic Rehabilitation Segment | | $ | 1,073,284 | | $ | 1,202,329 | |
International Rehabilitation Segment | | 70,876 | | 31,600 | |
Surgical Implant Segment | | 47,406 | | 26,543 | |
Total | | $ | 1,191,566 | | $ | 1,260,472 | |
| | | | | |
2007 | | Goodwill | | Intangibles, Net | |
Domestic Rehabilitation Segment | | $ | 1,084,982 | | $ | 1,294,765 | |
International Rehabilitation Segment | | 68,894 | | 36,170 | |
Surgical Implant Segment | | 47,406 | | 29,426 | |
Total | | $ | 1,201,282 | | $ | 1,360,361 | |
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7. OTHER CURRENT LIABILITIES
Other current liabilities consist of the following (in thousands):
| | December 31,
2008 | | December 31,
2007 | |
Wages and related expenses | | $ | 21,695 | | $ | 31,232 | |
Commissions and royalties | | 13,799 | | 13,114 | |
Taxes | | 4,943 | | 6,119 | |
Restructuring costs (see Note 13) | | 1,742 | | 9,563 | |
Professional fees | | 2,453 | | 6,693 | |
Rebates | | 4,812 | | 4,328 | |
Accrued ERP costs | | 6,763 | | — | |
Interest rate swap derivative | | 13,272 | | — | |
Reimbursement claims | | 6,012 | | — | |
Other accrued liabilities | | 28,910 | | 22,587 | |
| | $ | 104,401 | | $ | 93,636 | |
8. LONG-TERM DEBT AND CAPITAL LEASES
Long-term debt (including capital lease obligations) at December 31, 2008 and 2007 consists of the following (in thousands):
| | December 31,
2008 | | December 31,
2007 | |
Term loan under Senior Secured Credit Facility, net of a 1.2% discount ($10.9 million at December 31, 2008) | | $ | 1,043,404 | | $ | 1,052,514 | |
Revolving loans outstanding under Senior Secured Credit Facility | | 24,000 | | — | |
10.875% Senior notes | | 575,000 | | 575,000 | |
11.75% Senior subordinated notes | | 200,000 | | 200,000 | |
Loans and revolving credit facilities at various European Banks | | 891 | | 4,239 | |
Capital lease obligations and other | | 298 | | 1,054 | |
| | 1,843,593 | | 1,832,807 | |
Less — current portion | | (11,549 | ) | (14,209 | ) |
Long-term debt and capital leases, net of current portion | | $ | 1,832,044 | | $ | 1,818,598 | |
Senior Secured Credit Facility
On November 20, 2007, in connection with the DJO Merger, DJOFL and DJO Holdings LLC (“Holdings”) entered into the Senior Secured Credit Facility. The Senior Secured Credit Facility consists of a six and a half-year $1,065.0 million term loan facility and a six-year $100.0 million revolving credit facility. We issued the term loan facility of the Senior Secured Credit Facility at a 1.2% discount, resulting in net proceeds of $1,052.4 million. The $12.6 million discount is being amortized as additional interest expense over the term of the term loan facility. As of December 31, 2008, $24.0 million is outstanding related to our revolving credit facility.
Interest Rate and Fees. Borrowings under the Senior Secured Credit Facility bear interest at a rate equal to an applicable margin plus, at our option, either (a) a base rate determined by reference to the higher of (1) the prime rate of Credit Suisse and (2) the federal funds rate plus 0.50% or (b) the Eurodollar rate determined by reference to the costs of funds for deposits in U.S. dollars for the interest period relevant to each borrowing adjusted for required reserves. The initial applicable margin for borrowings under the term loan facility and the revolving credit facility is 2.00% with respect to base rate borrowings and 3.00% with respect to Eurodollar borrowings. The applicable margin for borrowings under the term loan facility and the revolving credit facility may be reduced subject to us attaining certain leverage ratios.
On November 20, 2007, we entered into an interest rate swap agreement for a notional amount of $515.0 million in an effort to hedge our exposure to fluctuating interest rates related to a portion of our Senior Secured Credit Facility. The swap agreement amortizes through a date in 2009. As of December 31, 2008, the remaining notional amount of the swap was $470.0 million. As of December 31, 2008, our weighted average interest rate for all borrowings under the Senior Secured Credit Facility was 3.91%.
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In February 2009, we entered into two interest rate swap agreements. One agreement is for a notional amount of $550.0 million with a term of February of 2009 through December 2009. The second agreement is for a notional amount of $750.0 million with a term of January 2010 through December 2010. Under these agreements we have LIBOR fixed rates of 1.04% and 1.88%, respectively.
In addition to paying interest on outstanding principal under the Senior Secured Credit Facility, we are required to pay a commitment fee to the lenders under the revolving credit facility with respect to the unutilized commitments thereunder. The initial commitment fee rate is 0.50% per annum. The commitment fee rate may be reduced subject to us attaining certain leverage ratios. We must also pay customary letter of credit fees.
Principal Payments. We are required to pay annual payments in equal quarterly installments on the loans under the term loan facility in an amount equal to 1.00% of the funded total principal amount during the first six years and three months following the closing of the Senior Secured Credit Facility, with any remaining amount payable at maturity. Principal amounts outstanding under the revolving credit facility are due and payable in full at maturity.
Prepayments. The Senior Secured Credit Facility requires us to prepay outstanding term loans, subject to certain exceptions, with (1) 50% (which percentage can be reduced to 25% or 0% upon our attaining certain leverage ratios) of our annual excess cash flow, as defined; (2) 100% of the net cash proceeds above an annual amount to be agreed from non-ordinary course asset sales (including insurance and condemnation proceeds) by DJOFL and its restricted subsidiaries, subject to exceptions to be agreed upon, including a 100% reinvestment right if reinvested or committed to reinvest within 15 months of such sale or disposition so long as reinvestment is completed within 180 days thereafter; and (3) 100% of the net cash proceeds from issuances or incurrences of debt by DJOFL and its restricted subsidiaries, other than proceeds from debt permitted to be incurred under the Senior Secured Credit Agreement. The foregoing mandatory prepayments will be applied to the term loan facilities in direct order of maturity. We may voluntarily prepay outstanding loans under the Senior Secured Credit Facility at any time without premium or penalty, provided that voluntary prepayments of Eurodollar loans made on a date other than the last day of an interest period applicable thereto shall be subject to customary breakage costs.
Guarantee and Security. All obligations under the Senior Secured Credit Facility are unconditionally guaranteed by Holdings and each existing and future direct and indirect wholly-owned domestic subsidiary of DJOFL other than immaterial subsidiaries, unrestricted subsidiaries and subsidiaries that are precluded by law or regulation from guaranteeing the obligations (collectively, the “Guarantors”).
All obligations under the Senior Secured Credit Facility, and the guarantees of those obligations, are secured by pledges of 100% of the capital stock of DJOFL, 100% of the capital stock of each wholly owned domestic subsidiary and 65% of the capital stock of each wholly owned foreign subsidiary that is, in each case, directly owned by DJOFL or one of the Guarantors; and a security interest in, and mortgages on, substantially all tangible and intangible assets of Holdings, DJOFL and each Guarantor.
Certain Covenants and Events of Default. The Senior Secured Credit Facility contains a number of covenants that, among other things, restrict, subject to certain exceptions, our and our subsidiaries’ ability to:
· incur additional indebtedness;
· create liens on assets;
· change fiscal years;
· enter into sale and leaseback transactions;
· engage in mergers or consolidations;
· sell assets;
· pay dividends and other restricted payments;
· make investments, loans or advances;
· repay subordinated indebtedness;
· make certain acquisitions;
· engage in certain transactions with affiliates;
· restrict the ability of restricted subsidiaries that are not Guarantors to pay dividends or make distributions;
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· amend material agreements governing our subordinated indebtedness; and
· change our lines of business.
In addition, the Senior Secured Credit Facility requires us to maintain a declining maximum senior secured leverage ratio of 4.75:1 as of the twelve months ended December 31, 2008 and stepping down over time to 3.25:1 by the end of 2011. The Senior Secured Credit Facility also contains certain customary affirmative covenants and events of default. Our maximum senior secured leverage ratio was within the covenant level as of December 31, 2008.
10.875% Senior Notes Payable
On November 20, 2007, DJOFL and Finco (collectively, the “Issuers”) issued $575.0 million aggregate principal amount of 10.875% Senior Notes under an agreement dated as of November 20, 2007 (the “10.875% Indenture”) among the Issuers, the guarantors party thereto and The Bank of New York Mellon (formerly known as The Bank of New York), as trustee. On July 2, 2008, our amended registration statement, filed in June 2008 on Form S-4 with the Securities and Exchange Commission (the “Commission”) relating to an offer to exchange these privately issued 10.875% Notes, for registered 10.875% Notes was declared effective. The exchange offer was completed July 31, 2008.
The 10.875% Notes require semi-annual interest payments of approximately $31.3 million each May 15 and November 15 and are due November 15, 2014. The market value of the 10.875% Notes was approximately $402.5 million as of December 31, 2008 and was determined using trading prices for the 10.875% Notes on or near that date. We believe the trading prices reflect certain differences between prevailing market terms and conditions and the actual terms of our 10.875% Notes.
Optional Redemption. Under the 10.875% Indenture, prior to November 15, 2011, the Issuers have the option to redeem some or all of the 10.875% Notes for cash at a redemption price equal to 100% of the then outstanding principal balance plus an applicable make-whole premium plus accrued and unpaid interest. Beginning on November 15, 2011, the Issuers may redeem some or all of the 10.875% Notes at a redemption price of 105.438% of the then outstanding principal balance plus accrued and unpaid interest. The redemption price decreases to 102.719% and 100% of the then outstanding principal balance at November 2012 and November 2013, respectively. Additionally, from time to time, before November 15, 2010, the Issuers may redeem up to 35% of the 10.875% Notes at a redemption price equal to 110.875% of the principal amount then outstanding, in each case, with proceeds we raise, or a direct or indirect parent company raises, in certain offerings of equity of DJOFL or its direct or indirect parent companies, as long as at least 65% of the aggregate principal amount of the notes issued remains outstanding.
Change of Control. Upon the occurrence of a change of control, unless DJOFL has previously sent or concurrently sends a notice exercising its optional redemption rights with respect to all of the then-outstanding 10.875% Notes, DJOFL will be required to make an offer to repurchase all of the then-outstanding 10.875% Notes at 101% of their principal amount, plus accrued and unpaid interest.
Covenants. The 10.875% Indenture contains covenants limiting, among other things, our and our restricted subsidiaries’ ability to incur additional indebtedness or issue certain preferred and convertible shares, pay dividends on, redeem, repurchase or make distributions in respect of the capital stock of DJO or make other restricted payments, make certain investments, sell certain assets, create liens on certain assets to secure debt, consolidate, merge, sell or otherwise dispose of all or substantially all of our assets, enter into certain transactions with affiliates, and designate our subsidiaries as unrestricted subsidiaries. As of December 31, 2008, we were in compliance with all applicable covenants.
11.75% Senior Subordinated Notes Payable
The Issuers issued $200.0 million aggregate principal amount of 11.75% Senior Subordinated Notes in November 2006 (the “11.75% Notes”). The 11.75% Notes require semi-annual interest payments of approximately $11.8 million each May 15 and November 15 and are due November 15, 2014.
The market value of the 11.75% Notes was approximately $132.0 million as of December 31, 2008 and was determined using trading prices for the 11.75% Notes on or near that date. We believe the trading prices reflect certain differences between prevailing market terms and conditions and the actual terms of our 11.75% Notes.
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The 11.75% Notes contain similar provisions as the 10.875% Notes with respect to change of control and covenant requirements. Under the Indenture governing the 11.75% Notes (the “11.75% Indenture”), prior to November 15, 2010, the Issuers have the option to redeem some or all of the 11.75% Notes for cash at a redemption price equal to 100% of the then outstanding principal balance plus an applicable make-whole premium plus accrued and unpaid interest. Beginning on November 15, 2010, the Issuers may redeem some or all of the 11.75% Notes at a redemption price of 105.875% of the then outstanding principal balance plus accrued and unpaid interest on the 11.75% Notes. The redemption price decreases to 102.938% and 100% of the then outstanding principal balance at November 2011 and November 2012, respectively. Additionally, from time to time, before November 15, 2009, the Issuers may redeem up to 35% of the 11.75% Notes at a redemption price equal to 111.75% of the principal amount then outstanding, in each case, with proceeds we raise, or a direct or indirect parent company raises, in certain offerings of equity of DJOFL or its direct or indirect parent companies, as long as at least 65% of the aggregate principal amount of the notes issued remains outstanding.
Our ability to continue to meet the covenants related to our indebtedness specified above in future periods will depend, in part, on events beyond our control, and we may not continue to meet those ratios. A breach of any of these covenants in the future could result in a default under the Senior Secured Credit Facility, the 11.75% Indenture and the 10.875% Indenture (collectively, the “Indentures”), at which time the lenders could elect to declare all amounts outstanding under the Senior Secured Credit Facility to be immediately due and payable. Any such acceleration would also result in a default under the Indentures.
At December 31, 2008, the aggregate amounts of annual principal maturities of long-term debt and capital leases for the next five years and thereafter is as follows (in thousands):
Years Ending December 31, | | | | |
2009 | | $ | 11,549 | |
2010 | | 10,828 | |
2011 | | 10,729 | |
2012 | | 10,677 | |
2013 | | 34,657 | |
Thereafter | | 1,765,153 | |
Total | | 1,843,593 | |
Debt Issue Costs
We incurred $30.7 million, $24.5 million, and $10.2 million of debt issue costs in connection with the Senior Secured Credit Facility, the 10.875% Notes, and the 11.75% Notes, respectively. These costs have been capitalized and are included in other non-current assets in the consolidated balance sheets at December 31, 2008 and 2007. Debt issue costs are being amortized over the terms of the respective debt instruments through November 2014.
9. MEMBERSHIP EQUITY
In connection with the Prior Transaction, shares of ReAble’s common stock were adjusted such that every 62.8 shares of common stock outstanding prior to the Prior Transaction were revalued as one share of ReAble’s common stock. Subsequently, on November 8, 2006, following the closing of the Prior Transaction, we effected a 25 for one stock split, which resulted in every one share of ReAble’s common stock becoming 25 shares of ReAble’s common stock. The consolidated financial statements have been retroactively adjusted to reflect these share adjustments for all periods presented.
In connection with the Prior Transaction, an affiliate of Blackstone acquired all equity interests of ReAble for $357.0 million (see Note 2). Simultaneously with this transaction, ReAble, through Holdings, acquired all Membership Equity of DJOFL. Options to acquire shares of common stock of ReAble owned by the then current executive officers that had not been exercised at or prior to the effective time of the Prior Transaction continued to remain as outstanding and continued as options to purchase 805,150 shares of ReAble’s common stock (the “Prior Transaction Management Rollover Options”). The fair value of these options approximated $7.2 million and was recorded as a component of the cost of the acquisition of ReAble.
On November 7, 2006, we acquired all of the issued and outstanding shares of Cefar for a total of $27.1 million (see Note 2). Of the total purchase price, $9.5 million was paid through the issuance of shares of our common stock. The fair value of the common stock issued was determined to be $16.46 per share based on the per share price used in the Prior Transaction.
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In connection with the DJO Merger, an affiliate of Blackstone made a cash equity contribution of $434.6 million. Additionally, we repurchased 264,525 of the Prior Transaction Management Rollover Options from certain ReAble executives who were terminated in connection with the DJO Merger at a per share price of $16.46. At the closing of the DJO Merger, these former ReAble executives also forfeited all unvested stock options previously issued to them under the 2006 Stock Incentive Plan at the closing of the DJO Merger. Furthermore, certain members of DJO Opco management chose to rollover certain of their DJO Opco options which were exchanged into options to purchase 1,912,577 shares under the 2007 Incentive Stock Plan on a tax-deferred basis (the “DJO Management Rollover Options”). The fair value of these options approximated $15.2 million and was recorded as a component of the cost of the DJO Merger. Also, on November 20, 2007, we granted an executive officer 24,300 shares (net of taxes) of restricted stock under the 2007 Incentive Stock Plan, which were subsequently cancelled during the third quarter of 2008 as a result of his Separation of Employment Agreement (See Note 10 for further information).
10. STOCK OPTION PLANS AND STOCK-BASED COMPENSATION
2006 Stock Incentive Plan
In connection with the Prior Transaction, the compensation committee of the board of directors of ReAble adopted the 2006 Stock Incentive Plan (the “2006 Plan”) effective November 3, 2006. The 2006 Plan provided for the grant of stock options and other stock-based awards to key employees, directors and consultants, including executive officers. In connection with the DJO Merger and change in management, we terminated the 2006 Plan and as of that date, outstanding options to purchase our stock originally issued under the 2006 Plan are now governed by the terms of the DJO Incorporated 2007 Incentive Stock Plan (“the 2007 Plan”). Furthermore, former ReAble executives forfeited all stock options previously issued under the 2006 Plan.
Summary of Plans — Predecessor
Before the Prior Transaction, ReAble had a number of stock option plans. All stock option plans in effect at the date of the Prior Transaction were terminated. With the exception of 805,150 Prior Transaction Management Rollover Options held by former ReAble executive officers, outstanding vested options to purchase common stock of ReAble were cancelled in exchange for cash in the amount equal to the excess of $16.46 over the exercise price per share multiplied by the number of shares of common stock. We recorded a charge of $7.5 million for the Predecessor period January 1, 2006 through November 3, 2006 related to the accelerated vesting of these shares upon the change in control on November 3, 2006. During the fourth quarter of 2007, in connection with the DJO Merger, we repurchased 264,525 of the Prior Transaction Management Rollover Options at a per share price of $16.46. The remaining Prior Transaction Management Rollover Options are fully vested and continue as options to purchase our common stock, have a weighted-average exercise price of $12.22, an average contractual term of 7.6 years, and an intrinsic value of approximately $2.2 million.
Non-employee stock compensation expense was approximately $0.2 million for the Predecessor period January 1, 2006 through November 3, 2006, which is included in selling, general and administrative expenses in the consolidated statements of operations for the respective period.
2007 Incentive Stock Plan
In connection with the DJO Merger, we terminated the 2006 Plan and adopted the 2007 Plan, which provides for the grant of stock options and other stock-based awards to key employees, directors and consultants. Outstanding options to purchase ReAble common stock originally issued under the 2006 Plan are now governed by the terms of the 2007 Plan. The total number of shares of common stock of DJO that may be issued under the 2007 Plan is 7,500,000 shares, subject to adjustment in certain events. Options issued under the 2007 Plan can be either incentive stock options or non-qualified stock options. The exercise price of stock options granted under the 2007 Plan will not be less than 100% of the fair market value of the underlying shares on the date of grant, as determined under the 2007 Plan, and will expire no more than ten years from the date of grant.
Employee Stock Options
During the year ended December 31, 2008 we granted 4,490,414 stock options under the 2007 Plan to our executive officers, senior management, and certain other employees. DJO adopted a form of non-statutory stock option agreement (the “DJO Form Option Agreement”) for employee stock option awards under the 2007 Plan. Under the DJO Form Option Agreement, one-third of stock options will vest over a specified period of time (typically five years) contingent solely upon the awardees’ continued employment with us (“Time-Based Tranche”). Another one-third of stock options will vest over a specified performance period (typically four to five years) from the date of grant upon the achievement of certain pre-determined performance targets based on Adjusted EBITDA and free cash flow on an annual basis (“Performance-Based Tranche”), as defined in the DJO Form Option Agreement, while the final one-third vests based upon achieving enhanced pre-determined performance targets based on Adjusted EBITDA and free cash flow (“Enhanced Performance-Based Tranche”). The DJO Form Option Agreement includes certain forfeiture provisions upon an awardees’ separation from service with us.
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In addition, in an effort to align our objectives following the DJO Merger with vesting requirements for previously issued stock options under the 2006 Plan, we cancelled all stock options originally granted under the 2006 Plan, except for 63,806 vested Time-Based Tranche options held by 72 employees, and concurrently issued the same or a greater number of options to each 2006 Plan participant under the 2007 Plan (the “Replacement Options”). These Replacement Options were valued in accordance with the modification provisions pursuant to SFAS No. 123(R), “Share-Based Payment” (“SFAS 123(R)”), whereby the fair value of the options immediately prior to the date of modification is compared to the fair value of the options at the date of modification, with the incremental fair value, if any, being recognized as future compensation expense. However, under no circumstances can compensation expense be reduced to an amount lower than the original fair value at the date of grant. Replacement Options have an exercise price of $16.46 per share, vest ratably over a predefined period as further described below, and have a contractual term of ten years from the date of modification. The assumptions utilized to determine fair value for Replacement Options were the same as those used to compute the fair value of new options granted during the current year. We did not recognize any additional compensation expense for the year ended December 31, 2008 as a result of the modification.
Both new options granted and Replacement Options contain change-in-control provisions that cause the vesting of a portion of the tranches upon the occurrence of a change-in-control, as follows: 1) the option shares in the Time-Based Tranche will become immediately exercisable upon the occurrence of a change-in-control if the optionee remains in continuous employment of the Company until the consummation of the change-in-control and 2) the option shares of the Performance-Based Tranche and the Enhanced Performance-Based Tranche for the year in which such change-in-control is consummated and for any subsequent performance periods will become immediately exercisable if the optionee remains in continuous employment of the Company until the consummation of the change-in-control.
We record compensation expense for awards with a performance condition only to the extent deemed probable of achievement, with the exception of expense related to market-based options originally issued under the 2006 Plan which were exchanged for performance based options during the first quarter of 2008, which is recognized ratably over the expected term regardless of the probability of achieving the performance conditions. We reassess at each reporting period whether achievement of the pre-determined performance targets based on Adjusted EBITDA and free cash flow is probable for the options related to the Performance Based Tranche to vest. The Company did not meet 2008 performance targets and therefore the Performance-Based tranche and Enhanced Performance-Based Tranche options did not vest during 2008.
For the Successor years ended December 31, 2008 and 2007 and the Period November 4, 2006 through December 31, 2006, we recognized approximately $1.3 million, $1.5 million, and $0.1 million of non-cash compensation stock based expense, respectively. For the Predecessor period January 1, 2006 through November 3, 2006, we recognized approximately $10.5 million of non-cash compensation expense.
The fair value of each option award is estimated on the date of grant, or modification, using the Black-Scholes-Merton option pricing model for service and performance based awards, and a binomial model for market based awards. In estimating fair value for both new options issued under the 2007 Plan and Replacement Options, expected volatility was based completely on implied volatility of comparable publicly-traded companies. Expected life assumptions were derived from a review of annual historical employee exercise behavior of option grants with similar vesting periods, modified to consider our current status as a privately-owned company. Expected life is calculated in two tranches based on the employment level defined as executive or employee. The risk-free rate used in calculating fair value of service and performance-based stock options for periods within the expected term of the option is based on the U.S. Treasury yield bond curve in effect at the time of grant.
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The assumptions used to calculate the fair value of options granted are evaluated and revised, as necessary, to reflect market conditions and experience. The following table presents the assumptions we used in calculating the fair value of employee stock options for the Successor years ended December 31, 2008 and 2007, and the period November 4, 2006 through December 31, 2006 and for the Predecessor period January 1, 2006 through November 3, 2006:
| | Successor | | Predecessor | |
| | Year Ended
December 31,
2008 | | Year Ended
December 31,
2007 | | November 4,
2006 through
December 31,
2006 | | January 1, 2006
through
November 3,
2006 | |
Expected dividends | | 0.0 | % | 0.0 | % | 0.0 | % | 0.0 | % |
Expected volatility | | 27.4% - 60.0 | % | 27.4% - 60.0 | % | 43.7% - 60.0 | % | 61.0 | % |
Risk-free rate | | 2.8% - 4.7 | % | 3.5% - 4.7 | % | 4.7 | % | 4.5% - 4.8 | % |
Expected term (in years) | | 4.7 - 7.1 | | 4.7 - 7.1 | | 2.6 - 5.7 | | 4.5 - 5.6 | |
Non-Employee Stock Options
On May 22, 2008, we granted 37,800 stock options under the 2007 Plan to non-employees (“non-employee options”). The non-statutory stock option agreement for the non-employees states that the options have an exercise price of $16.46 per share, which was equal to 100% of the estimated fair market value of the stock and will become effective upon the defined effective date and expire ten years from that date. A number of shares equal to 25% of the options granted become vested and exercisable at the end of each of the first four years subsequent to the effective date, provided the optionee is still affiliated with and providing services to the Company. The non-employee option agreement does not include any performance requirements on the optionee’s part in order for the options granted to vest.
Non-employee options are accounted for in accordance with the guidance in Emerging Issues Task Force (“EITF”) Issue No. 96-18, “Accounting for Equity Instruments That are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services” (“EITF 96-18”). In accordance with EITF 96-18, the fair value of each option will be re-measured at the end of each reporting period until vested, when the final fair value of the vesting of the option is determined.
In estimating fair value for options issued, expected volatility was based completely on implied volatility of comparable publicly-traded companies. A contractual life of ten years was used in place of the expected term. The risk-free rate used in calculating the fair value of the non-employee stock options for periods within the contractual life is based on the U.S. Treasury yield bond curve in effect at the time of grant.
The assumptions used to calculate the fair value of options granted are evaluated and revised, as necessary, to reflect market conditions and experience. The following table presents the assumptions we used in calculating the fair value of the non-employee stock options for the year ended December 31, 2008:
| | Year Ended
December 31, 2008 | |
Expected dividends | | 0.0 | % |
Expected volatility | | 27.41 | % |
Risk-free rate | | 3.92 | % |
Contractual term (in years) | | 10 years | |
We recorded non-cash compensation expense of approximately $0.1 million for the year ended December 31, 2008, associated with non-employee stock options issued under the 2007 Incentive Stock Plan.
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A summary of option activity under the 2007 Plan for the years ended December 31, 2007 and 2008 is presented below:
| | Number of
Shares | | Weighted-
Average
Exercise Price | | Weighted-Average
Remaining
Contractual Term
(Years) | | Aggregate Intrinsic
Value | |
| | | | | | | | | |
Outstanding at January 1, 2006 | | 3,044,650 | | $ | 15.34 | | | | | |
Repurchase of Prior Transaction management rollover options | | (264,525 | ) | $ | 11.74 | | | | | |
Granted, including Replacement Options | | 252,500 | | $ | 16.46 | | | | | |
DJO Management Rollover Options | | 1,912,577 | | $ | 11.09 | | | | | |
Exercised | | — | | — | | | | | |
Forfeited, including options cancelled | | (1,394,575 | ) | $ | 12.97 | | | | | |
Outstanding at December 31, 2007 | | 3,550,627 | | $ | 12.97 | | 8.2 | | $ | 12,461,487 | |
Granted, including Replacement Options | | 4,528,214 | | $ | 16.46 | | | | | |
Exercised | | — | | | | | | | |
Forfeited, including options cancelled | | (2,003,927 | ) | $ | 16.35 | | | | | |
Outstanding at December 31, 2008 | | 6,074,914 | | $ | 14.46 | | 8.18 | | $ | 12,221,730 | |
Exercisable at December 31, 2008 | | 2,683,942 | | $ | 11.93 | | 7.13 | | $ | 12,221,730 | |
For the Successor years ended December 31, 2008 and 2007 and the Period November 4, 2006 through December 31, 2006, and the Predecessor period January 1, 2006 through December 31, 2006, the weighted-average grant-date fair value of stock options granted was $5.36, $8.09, $8.96, and $9.25, respectively.
Total unrecognized stock-based compensation expense, related to nonvested stock options under the 2007 Plan, net of expected forfeitures, was $11.3 million as of December 31, 2008. We anticipate this expense to be recognized over a weighted-average period of approximately four years. However, compensation expense associated with performance-based options under the 2007 Plan, with the exception of those that were issued in connection with a modification, will be recognized only to the extent achievement of certain performance targets are deemed probable.
Restricted Stock
On March 13, 2007, we granted 15,189 shares of restricted stock options to an executive officer pursuant to the terms of a restricted stock agreement under the 2006 Plan. The shares were subject to a vesting schedule over a period of three years with the final vesting on November 3, 2009. On November 20, 2007, we granted 24,300 shares of restricted stock awards to the same executive officer pursuant to the terms of a restricted stock agreement under the 2007 Incentive Stock Plan, which would vest on January 1, 2009. On August 14, 2008, we entered into a Separation of Employment Agreement and General Release with this executive officer which waived any and all of his rights to any stock option or equity grants, including but not limited to restricted stock (refer to Note 12 for more detail). As such, all restricted stock options were cancelled during the third quarter and we reversed approximately $244,000 of previously recorded compensation expense related to the restricted stock.
11. SEGMENT AND GEOGRAPHIC INFORMATION
We classify our operations, pursuant to SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information,” into three operating segments further described below.
Domestic Rehabilitation Segment
Our Domestic Rehabilitation Segment, which generates most of its revenues in the United States, is divided into four main businesses:
· Bracing and Supports. Our Bracing and Supports business unit offers our DonJoy, ProCare and Aircast products, including rigid knee bracing, orthopedic soft goods, cold therapy products, and vascular systems.
· Empi. Our Empi business unit offers products in the category of home electrotherapy, iontophoresis, and home traction.
· Regeneration. Our Regeneration business unit consists of our bone growth stimulation products.
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· Chattanooga. Our Chattanooga Group business unit offers products in the clinical rehabilitation market in the category of clinical electrotherapy devices, clinical traction devices, and other clinical products and supplies such as treatment tables, continuous passive motion (“CPM”) devices and dry heat therapy.
International Rehabilitation Segment
Our International Rehabilitation Segment, which generates most of its revenues in Europe, is divided into three main businesses:
· Bracing and Supports. The international sales of our Bracing and Supports business unit offers DonJoy, ProCare and Aircast products, including rigid knee bracing, orthopedic soft goods, cold therapy products, and vascular systems.
· Ormed.DJO. Our Ormed.DJO business provides bracing, CPM, electrotherapy and other products primarily in Germany.
· Cefar-Compex. Our Cefar-Compex business provides electrotherapy products for medical and consumer markets and other physical therapy and rehabilitation products primarily in Europe.
We sell our Domestic and International Rehabilitation Segment products through a variety of distribution channels. We sell our home therapy products to wholesale customers and directly to patients. We recognize wholesale revenue when we ship our products to our wholesale customers. We recognize home therapy retail revenue, both rental and purchase, when our product has been dispensed to the patient and the patient’s insurance has been verified. We recognize revenue for product shipped directly to the patient at the time of shipment. For retail products that are sold from our inventories consigned at clinic locations, we recognize revenue when we receive notice that the device has been prescribed and dispensed to the patient and the insurance has been verified or preauthorization from the insurance company has been obtained, when required.
We sell our DonJoy products through a network of independent sales representatives. We record revenues from sales made by sales representatives, who are paid commissions, when the product is shipped to the customer. For certain of our other products, we sell directly to the patient and bill a third party payor, if applicable, on behalf of the patient.
We sell our ProCare, Aircast and clinical rehabilitation products to distributors. We record revenue at the time product is shipped to the distributor. Distributors take title to the products, assume credit and product obsolescence risks, must pay within specified periods regardless of when they sell or use the products and have no price protection except for distributors who participate in our rebate program.
We sell our products to customers outside the United States through wholly owned subsidiaries or independent distributors. We record revenue from sales to distributors at the time product is shipped to the distributor. Our international distributors take title to the products, assume credit and product obsolescence risks, must pay within specified periods regardless of when they sell the products and have no price protection. We record revenue from sales made by our wholly owned subsidiaries at the time product is shipped to the customer.
Surgical Implant Segment
Our Surgical Implant Segment develops, manufactures and markets a wide variety of knee, hip and shoulder implant products that serve the orthopedic reconstructive joint implant market. We currently market and sell our Surgical Implant Segment products to hospitals and orthopedic surgeons through independent commissioned sales representatives in the United States and through independent distributors outside the United States.
We sell our Surgical Implant Segment products through a network of independent sales representatives in the United States, as well as distributors outside the United States. We record revenues from sales made by sales representatives, who are paid commissions at the time the product is used in a surgical procedure (implanted in a patient) and a purchase order is received from the hospital. We record revenues from sales to customers outside the United States at the time the product is shipped to the distributor. We include amounts billed to customers for freight in revenue. Our international distributors, who sell the products to their customers, take title to the products, have no rights of return and assume the risk for credit and obsolescence. Distributors are obligated to pay us within specified terms, regardless of when they sell the products. In addition, there is no price protection available to distributors.
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Information regarding our reportable business segments is presented below (in thousands). This information excludes the impact of certain expenses not allocated to segments, primarily general corporate expenses. All prior periods presented have been restated to reflect our current reportable segments.
| | Successor | | Predecessor | |
| | Year Ended
December 31,
2008 | | Year Ended
December 31,
2007 | | November 4, 2006
through December
31, 2006 | | January 1, 2006
through November 3,
2006 | |
Net sales: | | | | | | | | | |
Domestic Rehabilitation Segment | | $ | 700,129 | | $ | 331,550 | | $ | 36,963 | | $ | 211,474 | |
International Rehabilitation Segment | | 228,539 | | 113,034 | | 14,626 | | 49,577 | |
Surgical Implant Segment | | 73,429 | | 66,591 | | 7,763 | | 51,331 | |
Intersegment revenues (a) | | (21,903 | ) | (19,041 | ) | (1,450 | ) | (7,999 | ) |
Consolidated net sales | | $ | 980,194 | | $ | 492,134 | | $ | 57,902 | | $ | 304,383 | |
| | | | | | | | | |
Gross profit: | | | | | | | | | |
Domestic Rehabilitation Segment | | $ | 417,574 | | $ | 182,763 | | $ | 18,841 | | $ | 114,267 | |
International Rehabilitation Segment | | 135,427 | | 57,467 | | 6,517 | | 27,598 | |
Surgical Implant Segment | | 54,857 | | 47,037 | | 5,779 | | 35,212 | |
Expenses not allocated to segments/Eliminations | | (1,744 | ) | (997 | ) | (22 | ) | 26 | |
Consolidated gross profit | | $ | 606,114 | | $ | 286,270 | | $ | 31,115 | | $ | 177,103 | |
| | | | | | | | | |
Operating income: | | | | | | | | | |
Domestic Rehabilitation Segment | | $ | 66,065 | | $ | (7,540 | ) | $ | (17,713 | ) | $ | 3,310 | |
International Rehabilitation Segment | | 29,232 | | 1,133 | | (548 | ) | 664 | |
Surgical Implant Segment | | 8,217 | | 2,322 | | (12,640 | ) | 5,404 | |
Expenses not allocated to segments/Eliminations | | (68,688 | ) | (35,351 | ) | (11,246 | ) | (32,176 | ) |
Consolidated operating income (loss) | | $ | 34,826 | | $ | (39,436 | ) | $ | (42,147 | ) | $ | (22,798 | ) |
(a) Includes amounts of $11.5 million, $2.0 million $1.2 million, and $6.1 million for the Successor years ended December 31, 2008 and 2007 and Successor period from November 4, 2006 through December 31, 2006 and the Predecessor period January 1, 2006, through November 3, 2006, respectively, for intrasegment revenues.
The accounting policies of the reportable segments are the same as the accounting policies of the Company. We allocate resources and evaluate the performance of segments based on net sales, gross profit, operating income and Adjusted EBITDA as defined. Moreover, we do not allocate assets to reportable segments because a significant portion of assets are shared by the segments.
Geographic Area
Following are our net sales by geographic area (in thousands):
| | Successor | | Predecessor | |
| | Year Ended
December 31,
2008 | | Year Ended
December 31,
2007 | | November 4, 2006
through
December 31,
2006 | | January 1, 2006
through November
3, 2006 | |
Net sales: | | | | | | | | | |
United States | | $ | 742,007 | | $ | 371,077 | | $ | 42,135 | | $ | 242,790 | |
Germany | | 73,296 | | 47,332 | | 6,740 | | 31,982 | |
Other Europe, Middle East, and Africa | | 144,760 | | 61,613 | | 7,768 | | 18,858 | |
Asia Pacific | | 12,595 | | 5,435 | | 164 | | 4,273 | |
Other | | 29,439 | | 25,718 | | 2,545 | | 14,479 | |
Intersegment revenues | | (21,903 | ) | (19,041 | ) | (1,450 | ) | (7,999 | ) |
| | $ | 980,194 | | $ | 492,134 | | $ | 57,902 | | $ | 304,383 | |
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* Net sales are attributed to countries based on location of customer. For the Successor years ended December 31, 2008 and 2007, and the period November 4, 2006 through December 31, 2006 and the Predecessor period January 1, 2006 through November 3, 2006, we had no individual customer or distributor that accounted for 10% or more of total annual revenues.
Following are our long-lived assets by geographic area as of December 31, 2008 and 2007 (in thousands):
| | December 31,
2008 | | December 31,
2007 | |
United States | | $ | 2,423,171 | | $ | 2,537,968 | |
International | | 167,730 | | 172,844 | |
| | $ | 2,590,901 | | $ | 2,710,812 | |
12. INCOME TAXES
DJO is the taxpayer in the U.S., while our foreign subsidiaries are subjected to income tax in the applicable local jurisdictions. Although DJOFL is not a U.S. taxpayer, pursuant to the provisions of Statement of Financial Accounting Standards No. 109, “Accounting for Income Taxes,” the tax expense of DJO has been pushed down to the stand alone financial statements of DJOFL.
The components of losses from continuing operations before income taxes for the applicable periods consist of the following (in thousands):
| | Successor | | Predecessor | |
| | Year Ended
December 31,
2008 | | Year Ended
December 31,
2007 | | November 4,
2006 through
December 31,
2006 | | January 1,
2006 through
November 3,
2006 | |
U.S. operations | | $ | (152,600 | ) | $ | (123,228 | ) | $ | (49,380 | ) | $ | (56,905 | ) |
Foreign operations | | 6,792 | | (1,282 | ) | (933 | ) | (551 | ) |
| | $ | (145,808 | ) | $ | (124,510 | ) | $ | (50,313 | ) | $ | (57,456 | ) |
The income tax benefit for the applicable periods consists of the following (in thousands):
| | Successor | | Predecessor | |
| | Year Ended
December 31,
2008 | | Year Ended
December 31,
2007 | | November 4,
2006 through
December 31,
2006 | | January 1, 2006
through
November 3,
2006 | |
Current income taxes: | | | | | | | | | |
U.S. Federal and State | | $ | (6,103 | ) | $ | 1,321 | | $ | 27 | | $ | 489 | |
Foreign | | 3,303 | | 3,397 | | 59 | | 1,343 | |
Deferred income taxes: | | | | | | | | | |
U.S. Federal and State | | (45,195 | ) | (43,944 | ) | (8,474 | ) | (12,325 | ) |
Foreign | | (1,076 | ) | (3,277 | ) | (368 | ) | (959 | ) |
| | $ | (49,071 | ) | $ | (42,503 | ) | $ | (8,756 | ) | $ | (11,452 | ) |
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The difference between the income tax benefit derived by applying the U.S. Federal statutory income tax rate of 35% to net loss and the income tax benefit recognized in the consolidated financial statements is as follows (in thousands):
| | Successor | | Predecessor | |
| | Year Ended
December 31,
2008 | | Year Ended
December 31,
2007 | | November 4,
2006 through
December 31,
2006 | | January 1, 2006
through
November 3,
2006 | |
Benefit derived by applying the Federal statutory income tax rate to income (loss) before income taxes | | $ | (51,033 | ) | $ | (43,579 | ) | $ | (17,609 | ) | $ | (20,110 | ) |
Add (deduct) the effect of: | | | | | | | | | |
State tax benefit, net | | (2,369 | ) | (3,211 | ) | (816 | ) | (1,343 | ) |
Nondeductible IPR&D | | — | | 1,050 | | 8,820 | | 1,364 | |
Nondeductible transaction costs | | — | | — | | 1,426 | | 4,750 | |
SFAS 123(R), related to incentive stock options | | 106 | | — | | — | | 2,561 | |
Change in German tax laws | | — | | (1,458 | ) | — | | — | |
Permanent differences and other, net | | 4,225 | | 4,695 | | (577 | ) | 1,326 | |
| | $ | (49,071 | ) | $ | (42,503 | ) | $ | (8,756 | ) | $ | (11,452 | ) |
The components of deferred income tax assets and liabilities as of December 31, 2008 and 2007 are as follows (in thousands):
| | 2008 | | 2007 | |
Deferred tax assets: | | | | | |
Net operating loss carryforwards | | $ | 118,237 | | $ | 112,678 | |
Inventory reserve | | 7,648 | | 5,671 | |
Receivables reserve | | 17,449 | | 15,344 | |
Accrued compensation | | 1,724 | | 1,672 | |
Accrued expenses | | 9,025 | | 3,050 | |
Interest rate Swap | | 5,189 | | 1,530 | |
Transfer pricing | | 2,823 | | 2,373 | |
Other | | 8,922 | | 63 | |
Gross deferred tax assets | | 171,017 | | 142,381 | |
Valuation allowance | | (7,129 | ) | (16,489 | ) |
Net deferred tax assets | | 163,888 | | 125,892 | |
| | | | | |
Deferred tax liabilities: | | | | | |
Property and equipment | | (3,661 | ) | (5,428 | ) |
Intangible assets | | (437,938 | ) | (454,280 | ) |
Foreign currency translation | | (2,222 | ) | (7,648 | ) |
Repatriation | | (12,504 | ) | (13,755 | ) |
Other | | (3,027 | ) | (2,441 | ) |
| | (459,352 | ) | (483,552 | ) |
Net deferred tax liabilities | | $ | (295,464 | ) | $ | (357,660 | ) |
As a result of the DJO Merger and the Prior Transaction, we recorded significant acquired intangible assets for which no tax basis exists and, as such, a significant deferred tax liability was recorded under purchase accounting. Taxable temporary differences will reverse within the carryforward period for the existing deferred tax assets.
At December 31, 2008, we maintain approximately $441.9 million of net operating loss carryforwards in the U.S., which expire over a period of 1 to 20 years. Our European net operating loss carryforwards of approximately $26.8 million generally are not subject to expiration dates, unless we trigger certain events. Included in prepaid expenses and other current assets are $8.4 million and $1.9 million of income tax receivables as of December 31, 2008 and 2007, respectively.
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At December 31, 2008 and 2007, we recorded deferred tax assets of $171.0 million and $142.4 million and valuation allowances of $7.1 million and $16.5 million, respectively. We have recorded a valuation allowance against European net operating loss carryforwards due to uncertainties regarding our ability to realize these deferred tax assets. The majority of the valuation allowance was recorded as an adjustment to goodwill as these loss carryforwards were acquired in connection with the Empi, Compex and the Prior Transaction (see Note 2).
As a result of the DJO Merger and the Prior Transaction, we no longer intend to permanently reinvest in our foreign operations. In connection with the Prior Transaction, we recorded deferred tax liabilities of $5.3 million in purchase accounting and a deferred tax benefit of $0.7 million for the period November 4, 2006 through December 31, 2006. In connection with the DJO Merger, deferred tax liabilities of $6.4 million were recorded in purchase accounting. We recorded a deferred tax expense of $0.6 million and $0.9 million for the twelve months ended December 31, 2008 and 2007, respectively.
We and our subsidiaries file income tax returns in the U.S. federal, state and local, and foreign jurisdictions. With few exceptions, we are no longer subject to U.S. federal, state and local, or non-U.S. income tax examinations by tax authorities for years before 2004. We adopted the provisions of FIN 48 on January 1, 2007. As a result of the implementation of FIN 48, we recognized a $5.9 million increase in liabilities for gross unrecognized tax benefits, which was accounted for as an increase to the balance of goodwill. A reconciliation of the beginning and ending amount of gross unrecognized tax benefits for the years ended December 31, 2007 and 2008 are as follows:
(in thousands) | | | |
| | | |
Balance at January 1, 2007 | | $ | 6,979 | |
Additions based on tax positions related to the current year | | 458 | |
Additions for tax positions of prior years | | 8,016 | |
Additions due to acquisition of businesses | | 1,829 | |
Reductions for tax positions of prior years | | (1,059 | ) |
Balance at December 31, 2007 | | 16,223 | |
Additions based on tax positions related to the current year | | 1,054 | |
Additions for tax positions of prior years | | 2,570 | |
Reductions for tax positions of prior years | | (93 | ) |
Reductions due to lapse of statue of limitations | | (4,187 | ) |
Reductions for settlements of tax positions | | (159 | ) |
Balance at December 31, 2008 | | $ | 15,408 | |
To the extent our gross unrecognized tax benefits are recognized in the future, a reduction of $2.2 million of federal tax benefit for related state income tax deductions would result. Included in the balance at December 31, 2008, is $0.6 million of gross uncertain tax positions that we anticipate will decrease in the next twelve months related to our Compex acquisition. In addition, we anticipate that $0.3 million of our currently remaining unrecognized tax positions, each of which are individually immaterial, may be recognized by December 31, 2009 as a result of a lapse of the statute of limitations. Due to the adoption of SFAS 141R on January 1, 2009, all unrecognized tax benefits listed above will impact the effective tax rate upon recognition. We believe that it is reasonably possible that an increase of $0.4 million in unrecognized tax benefits related to state exposures may be necessary within the next 12 months. We recognize interest accrued and penalties related to unrecognized tax benefits as a component of income tax expense. During the Successor year ended December 31, 2008, we recognized an increase of $0.4 million in interest and penalties. During the Successor year ended December 31, 2007, we recognized a reduction of $0.7 million in interest and penalties. We accrued for $1.3 million and $0.9 million for the payment of interest and penalties at December 31, 2008 and 2007, respectively.
13. RESTRUCTURING AND RELATED CHARGES
We have implemented several restructuring and reorganization programs, including workforce reductions and the exit and consolidation of facilities, related primarily to the integration of businesses we have acquired. At present, our restructuring efforts are primarily related to the integration of DJO Opco following the DJO Merger. As of December 31, 2008, these restructuring activities are ongoing and additional expenses are expected to be incurred in future periods.
At the time of the DJO Merger, management had begun to assess and formulate plans to restructure the operations of DJO to eliminate certain duplicative activities, reduce the cost structure and better align product and operating expenses with the existing markets in which we compete. The plan was approved and initiated after the consummation of the DJO Merger. In the fourth quarter of 2007, we announced the relocation of our headquarters to Vista, California. Activities were also initiated with respect to the relocation of certain manufacturing operations from our Chattanooga, Tennessee location to Tijuana, Mexico. We also announced the future termination of certain employees related to the move of certain activities of
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our Bone Growth Stimulation (“BGS”) product line operations from Vista, California to St. Paul, Minnesota. Internationally, we closed a facility in Germany and anticipate facility closures in certain other locations in an effort to integrate and realize cost synergies in our international operations. As of December 31, 2008, approximately $1.6 million was accrued related to severance and facility exit costs that has not yet been paid. Additionally, approximately $0.2 million has been accrued as of December 31, 2008 related to the purchase of rights to distributor territories in connection with the DJO Merger. We also assumed $1.9 million of severance due to a former executive officer of a business acquired by DJO prior to the DJO Merger, which was paid in the first quarter of 2008.
In certain cases, estimated severance and facility exit costs have been accrued as a liability with a corresponding increase to goodwill in accordance with the guidance specified in Emerging Issues Task Force Issue Number 95-3, “Recognition of Liabilities in Connection with a Purchase Business Combination” (“EITF 95-3”). However, not all of our restructuring costs meet the accrual requirements of EITF 95-3, and certain integration costs are expensed as incurred.
A summary of the activity relating to the restructuring for the Successor twelve month periods ended December 31, 2008 and 2007 and for the period from November 4, through December 31, 2006, and for the Predecessor period from January 1, 2006 through November 3, 2006 is as follows (in thousands):
| | Lease
Termination
Costs | | Severance | | Purchase of
Rights to
Distributor
Territories | | Total | |
Predecessor | | | | | | | | | |
Balance at January 1, 2006 | | $ | — | | $ | — | | $ | — | | $ | — | |
Expensed during period | | — | | 751 | | — | | 751 | |
Compex acquisition costs | | 391 | | 457 | | — | | 848 | |
Payments made during period | | — | | (124 | ) | — | | (124 | ) |
Balance at November 3, 2006 | | 391 | | 1,084 | | — | | 1,475 | |
Successor | | | | | | | | | |
Expensed during period | | (45 | ) | 430 | | — | | 385 | |
Adjustments to goodwill | | — | | — | | — | | — | |
Payments made during period | | — | | (125 | ) | — | | (125 | ) |
Balance at December 31, 2006 | | 346 | | 1,389 | | — | | 1,735 | |
Expensed during period | | — | | 1,953 | | — | | 1,953 | |
Adjustments to goodwill | | 1,331 | | 5,131 | | 2,127 | | 8,589 | |
Payments made during period | | (385 | ) | (2,325 | ) | — | | (2,710 | ) |
Adjustments to reserve | | 24 | | (53 | ) | — | | (29 | ) |
Foreign currency translation | | 33 | | (8 | ) | — | | 25 | |
Balance at December 31, 2007 | | 1,349 | | 6,087 | | 2,127 | | 9,563 | |
Expensed during period | | — | | 3,998 | | — | | 3,998 | |
Adjustments to goodwill | | 625 | | (769 | ) | (458 | ) | (602 | ) |
Payments made during period | | (739 | ) | (8,543 | ) | (1,366 | ) | (10,648 | ) |
Adjustments to reserve | | (312 | ) | (35 | ) | (123 | ) | (470 | ) |
Foreign currency translation | | (45 | ) | (54 | ) | — | | (99 | ) |
Balance at December 31, 2008 | | $ | 878 | | $ | 684 | | $ | 180 | | $ | 1,742 | |
14. COMMITMENTS AND CONTINGENCIES
Commitments
As of December 31, 2008, we had entered into purchase commitments for inventory, capital acquisitions and other services totaling approximately $120.1 million in the ordinary course of business. This amount includes a commitment of $7.0 million for annual monitoring fees to be paid to Blackstone Management Partners V L.L.C. (“BMP”) through 2019.
The following table summarizes our contractual obligations as of December 31, 2008 associated with fixed commitments for purchase and service obligations for the next five years and thereafter (in thousands):
Years Ending December 31, | | | | |
2009 | | $ | 37,666 | |
2010 | | 15,751 | |
2011 | | 10,715 | |
2012 | | 7,000 | |
2013 | | 7,000 | |
Thereafter | | 42,000 | |
Total | | 120,132 | |
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Operating Leases. We lease building space, manufacturing facilities and equipment under non-cancelable operating lease agreements that expire at various dates. We record rent incentives as deferred rent and amortize as reductions to lease expense over the lease term in accordance with FASB Statement No. 13, “Accounting for Leases (as amended)”. The aggregate minimum rental commitments under non-cancelable leases for the periods shown at December 31, 2008, are as follows (in thousands):
Years Ending December 31 | | | | |
2009 | | $ | 11,235 | |
2010 | | 9,389 | |
2011 | | 7,538 | |
2012 | | 6,340 | |
2013 | | 6,065 | |
Thereafter | | 22,334 | |
| | 62,901 | |
Rental expense under operating leases totaled approximately $12.4 million, $4.3 million and $0.6 million for the Successor years ended December 31, 2008 and 2007 and for the period November 4, 2006 through December 31, 2006, respectively. Rent expense was approximately $2.6 million for the Predecessor period January 1, 2006 through November 3, 2006. Scheduled increases in rent expense are amortized on a straight line basis over the life of the lease.
Capital Leases. Leased equipment under capital leases, included in property and equipment in the accompanying consolidated financial statements are as follows (in thousands):
| | December 31,
2008 | | December 31,
2007 | |
Equipment | | $ | 505 | | $ | 550 | |
Furniture and fixtures | | 51 | | 266 | |
Less — accumulated amortization | | (244 | ) | (222 | ) |
| | $ | 312 | | $ | 594 | |
Litigation
In December 2006, we recorded approximately $1.1 million as a contingent liability with an offsetting adjustment to goodwill relating to litigation against Compex Technologies, Inc. (“Compex”) regarding a dispute over custom duties and VAT on imported goods as part of the purchase accounting of Compex. In February 2007, a judgment in the dispute with the custom officials was issued by the court which resulted in partial unfavorable rulings for each side. In June 2008, the Appeal Court of Paris announced a preliminary judgment in our favor. In August 2008, we received written notice that the French custom would not appeal the ruling. As such, we reversed our contingent liability previously accrued for and recorded it as a reduction to expense within the condensed consolidated statements of operations in the third quarter of 2008.
In August 2007 and September 2007, two purported shareholder class action lawsuits were filed in California Superior Court, in the County of San Diego, on behalf of DJO Opco’s public stockholders, challenging DJO Opco’s proposed merger with ReAble. The court ordered the two lawsuits consolidated for all purposes in September 2007.
The two original complaints named DJO Opco, ReAble and the current members of DJO Opco’s board of directors as defendants. One of the original complaints also named Blackstone as a defendant. The two substantially similar original complaints alleged, among other things, that the individual defendants breached their fiduciary duties of care, good faith and loyalty by approving the proposed merger with an allegedly inadequate price, without adequately informing themselves of DJO Opco’s highest transactional value, and without adequately marketing DJO Opco to other potential buyers. The original complaints also alleged that the individual defendants and DJO Opco failed to make full and adequate disclosures in the preliminary proxy statement regarding the proposed merger. The original complaints request, among other things, class certification, declaratory relief, an injunction of the proposed merger or a rescission order, corrective disclosures to the proxy statement, damages, interest, attorneys’ fees, expert fees and other costs; and such other relief as the court may find just and proper.
In November 2007, the parties entered into a memorandum of understanding, pursuant to which the parties agreed to settle the consolidated action subject to court approval. In March 2008, the parties entered into a settlement agreement which provided for dismissal of the consolidated action with prejudice upon approval of a stipulation by the court. Pursuant to the terms of the settlement agreement, the defendants acknowledged that the consolidated action resulted in a decision to provide
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additional information to DJO Opco’s shareholders in the definitive proxy statement concerning the proposed merger and to modify certain terms in the merger agreement and to pay certain attorneys’ fees, costs, and expenses incurred by the plaintiffs. As stated in the settlement agreement, defendants denied all allegations of wrongdoing, fault, liability or damage to the plaintiffs and the putative class in the consolidated action and denied that they were engaged in any wrongdoing or violation of law or breach of duty. Defendants also did not make any admission that the supplemental disclosures were material. On June 13, 2008, the court entered an order granting final approval of the settlement after providing notice and opportunity to be heard to the members of the class. The order and settlement became final and not subject to appeal on August 20, 2008.
On July 7, 2006, a purported class action complaint, Louis Dudas et al. v. Encore Medical Corporation et al., was filed against DJO and its directors in the District Court of Travis County, Texas, 345th Judicial District (the “Texas Action”). Recently, Blackstone was added as a defendant. On July 18, 2006, a second purported class action complaint, Robert Kemp et al. v. Alastair J. Clemow et al. (the “Delaware Action”) was filed by a putative stockholder of DJO in the Court of Chancery of the State of Delaware, New Castle County, against DJO and its directors. Blackstone and Grand Slam Holdings, LLC were also named as defendants in the Delaware Action. The Delaware Action was dismissed in February 2007 with no liability accruing to DJO or the other defendants.
The Texas Action is still in preliminary stages and we cannot presently predict the outcome of the lawsuit, although we believe it is without merit. The Texas Action complaint alleges that DJO’s directors breached their fiduciary duties by, inter alia, agreeing to an allegedly inadequate acquisition price in connection with the Blackstone Merger Agreement. The complaint seeks, among other things, to rescind any actions that have already been taken to consummate the Blackstone Merger Agreement, rescissory damages and the plaintiffs’ reasonable costs and attorneys’ and experts’ fees.
The manufacture and sale of orthopedic devices and related products exposes us to significant risks of product liability claims, lawsuits and product recalls. From time to time, we have been, and we are currently, the subject of a number of product liability claims and lawsuits relating to our products. We are defendants in approximately 30 product liability cases related to a disposable drug infusion pump product manufactured by two third party manufacturers that we distributed through our Bracing and Supports business unit of our Domestic Rehabilitation Segment. We intend to discontinue our sale of these products in the second quarter of 2009. These cases have been brought against the manufacturers and certain distributors of these pumps, the manufacturers of the anesthetics used in these pumps, and the healthcare professionals involved in providing the pumps to their patients. All of these lawsuits allege that the use of these pumps with certain anesthetics in certain shoulder surgeries over prolonged periods have resulted in cartilage damage to the plaintiffs. We have sought indemnity and tendered the defense of these cases both to the manufacturers who have supplied these pumps to us and to our product liability carrier. Both manufacturers have indicated they would accept our tender of defense and indemnity, subject to certain reservation of rights, and the product liability carrier of those two manufacturers is providing us a defense in these cases. Our product liability carrier has also accepted coverage of these cases, subject to customary reservations, and was providing the Company with defense until the time that the manufacturers’ carrier took up the Company’s defense. The lawsuits allege damages ranging from unspecified amounts to claims between $1.0 million and $10.0 million. These cases are in the early stages of discovery.
We currently carry product liability insurance up to a limit of $25.0 million, subject to a deductible of $50,000 on non-invasive products and a deductible of $250,000 on invasive products and an aggregate deductible of $750,000 for all product liability claims. Our insurance policy is subject to annual renewal. We believe our current product liability insurance coverage is adequate. If a product liability claim or series of claims is brought against us for uninsured liabilities or in excess of our insurance coverage, our business could suffer materially. In addition, in certain instances a product liability claim could also result in our having to recall some of our products, which could result in significant costs to us. As of December 31, 2008 and 2007, we have accrued approximately $1.8 million and $1.9 million, respectively, for product liability claims expense based upon previous claim experience in part due to the fact that we have exceeded the coverage limits on certain historical product liability claims involving our Surgical Implant Segment.
Due to the nature of our business, we are subject to a variety of audits by government agencies and other private interests. In connection with audits of our compliance with federal requirements for our facilities and related quality and manufacturing processes, the U.S. Food and Drug Administration (the “FDA”) had previously informed us in January 2007 that they believed that certain discrete processes related to our Surgical Implant Segment did not conform with Current Good Manufacturing Practices (“CGMP”). During 2007, we submitted a response and met with FDA representatives, and instituted the necessary changes and improvements in our policies and procedures to correct these issues. During the first quarter of 2008, the FDA concluded their follow-up investigation concerning the January 2007 warning letter. We received no observations and all areas of concern were addressed satisfactorily.
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We are an authorized Medicare supplier and provide a variety of our products directly to Medicare beneficiaries and seek reimbursement from the applicable Medicare Administrative Contractor. CIGNA Governmental Services (“CIGNA”) is that contractor in the western region of the United States. As a Medicare supplier, we are subject to periodic audits of our operations, and in November 2008 we were advised that as a result of such an audit, CIGNA was asserting that we have been overpaid in the amount of approximately $6 million from January 1, 2006 to April 9, 2007. This figure represents Medicare reimbursements for claims we submitted on Medicare beneficiaries for our bone growth stimulator product during that period of time. The reason asserted by CIGNA that Medicare was not obligated to provide reimbursement on these claims is that we failed to maintain a California Home Medical Device Retail Exemptee License during such 15 month period. We believe that this licensing program does not apply to our business and have appealed the assessment of the overpayment. During the pendency of the appeal, we are not required to pay the assessed $6 million overpayment, but interest at the rate of 11.375% per annum will run on the amount, if any, eventually determined to be due. The $6.0 million is accrued in our consolidated balance sheet as of December 31, 2008.
15. RELATED PARTY TRANSACTIONS
Management Stockholder’s Agreement
Certain members of DJO’s management are parties to DJO’s management stockholders agreement, dated November 3, 2006, among DJO, Grand Slam Holdings, LLC (“BCP Holdings”), Blackstone, certain of its affiliates, and such members of DJO’s management and current executive officers (the “Management Stockholders Agreement”). In conjunction with the DJO Merger, certain incoming executives of DJO (the “new management stockholders”) have become parties to the Management Stockholders Agreement on the same terms and conditions as set forth therein, subject to the following exceptions, which by amendment (the “Amendment”) will apply only to the new management stockholders and any other persons becoming a party thereto after November 20, 2007. The Management Stockholders Agreement currently provides that if a management stockholder voluntarily resigns from DJO for any reason other than “good reason” (as defined in the Management Stockholders Agreement) and a Blackstone Parent Stockholder exercises its call rights after such termination, the management stockholder would receive the lower of fair market value or “cost” for the management stockholder’s callable shares. The Amendment provides that, unless a new management stockholder was terminated by DJO for “cause” (as defined in the Amendment) or unless the new management stockholder voluntarily terminated employment and such termination would have constituted a termination for “cause” if it would have been initiated by DJO, such new management stockholder would receive fair market value for such new management stockholder’s shares callable upon the exercise of a call right.
The Management Stockholders Agreement imposes significant restrictions on transfers of shares of DJO’s common stock held by management stockholders and provides a right of first refusal to DJO (or Blackstone), if DJO fails to exercise such right) on any proposed sale of DJO’s common stock held by a management stockholder following the lapse of the transfer restrictions and prior to the occurrence of a ‘‘qualified public offering’’ (as such term is defined in that agreement) of DJO. In addition, prior to a qualified public offering, Blackstone will have drag-along rights, and management stockholders will have tag-along rights, in the event of a sale of DJO’s common stock by Blackstone to a third party (or in the event of a sale of BCP Holdings’ equity interests to a third party) in the same proportion as the shares or equity interests sold by Blackstone. If, prior to either the lapse of the transfer restrictions or a qualified public offering, a management stockholder’s employment is terminated, DJO will have the right to repurchase all shares of its common stock held by such management stockholder for a period of one year from the date of termination of employment (or the until the date that is one year following the exercise of the stock options used to acquire such common stock, if later). If DJO does not exercise this repurchase right during the applicable repurchase period, then Blackstone will generally have the right to repurchase such shares for a period of 30 days thereafter. The Management Stockholders Agreement also provides that, after the occurrence of a qualified public offering, the management stockholders will receive customary piggyback registration rights with respect to shares of DJO common stock held by them.
On December 13, 2006, DJO, BCP Holdings, Blackstone and certain of its affiliates entered into a stockholders agreement with Sidney Braginsky, one of DJO’s directors. The terms and conditions of the stockholders agreement with Mr. Braginsky are the same, in all material respects, as the management stockholders agreement described above. As new directors join the Board and receive stock options, they are required to enter into a similar agreement.
Transaction and Monitoring Fee Agreement
Under the Transaction and Monitoring Fee Agreement, we paid Blackstone Management Partners V L.L.C. (“BMP”), at the closing of the DJO Merger, a $15.0 million transaction fee and $0.6 million for related expenses. Also, pursuant to this agreement, at the closing of the DJO Merger, we paid Blackstone Advisory Services, L.P., an affiliate of BMP, a $3.0 million advisory fee in consideration of the provision of certain strategic and other advice and assistance by BAS on behalf of BMP.
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In connection with the DJO Merger, BMP has agreed to provide certain monitoring, advisory and consulting services to us for an annual monitoring fee equal to the greater of $7.0 million or 2% of consolidated EBITDA as defined in the Transaction and Monitoring Fee Agreement, payable in the first quarter of each year. Prior to the DJO Merger, the annual BMP monitoring fee was equal to $3.0 million. At any time in connection with or in anticipation of a change of control of DJOFL, a sale of all or substantially all of DJOFL’s assets or an initial public offering of common stock of DJOFL, BMP may elect to receive, in lieu of remaining annual monitoring fee payments, a single lump sum cash payment equal to the then-present value of all then-current and future annual monitoring fees payable under the transaction and monitoring fee agreement, assuming a hypothetical termination date of the agreement to be the twelfth anniversary of such election. The monitoring fee agreement will continue until the earlier of the twelfth anniversary of the date of the agreement or such date as DJOFL and BMP may mutually determine. DJOFL will agree to indemnify BMP and its affiliates, directors, officers, employees, agents and representatives from and against all liabilities relating to the services contemplated by the transaction and monitoring fee agreement and the engagement of BMP pursuant to, and the performance of BMP and its affiliates of the services contemplated by, the transaction and monitoring fee agreement. For the Successor years ended December 31, 2008 and 2007, we expensed $7.0 million and $3.0 million, respectively, related to the annual monitoring fee. This is recorded as a component of selling, general and administrative expense in the audited consolidated statements of operations.
16. DERIVATIVE INSTRUMENTS
We operate internationally and are therefore exposed to foreign currency exchange rate fluctuations in the normal course of our business, in particular to changes in the Mexican Peso due to our Mexico-based manufacturing operations that incur costs that are largely denominated in Mexican Pesos. As part of our risk management strategy, we use derivative instruments to hedge portions of our exposure. Before acquiring a derivative instrument to hedge a specific risk, potential natural hedges are evaluated. Derivative instruments are only utilized to manage underlying exposures that arise from our business operations. Factors considered in the decision to hedge an underlying market exposure include the materiality of the risk, the volatility of the market, the duration of the hedge, and the availability, effectiveness and cost of derivative instruments. As of December 31, 2008, we had outstanding hedges in the form of forward contracts to purchase Mexican Pesos aggregating a U.S. dollar equivalent based on the fair market value of the $16.1 million. For the Successor year ended December 31, 2008, we recognized a loss in the statement of operations on Mexico Peso forward contracts of approximately $4.2 million. For the Successor year ended December 31, 2007, we recognized a gain in the statement of operations on Mexico Peso forward contracts of approximately $0.1 million.
We make use of debt financing as a source of funds and are therefore exposed to interest rate fluctuations in the normal course of our business. Our credit facilities are subject to floating interest rates. We manage the risk of unfavorable movements in interest rates by hedging a portion of the outstanding loan balance, thereby locking in a fixed rate on a portion of the principal, reducing the effect of possible rising interest rates and making interest expense more predictable. In February 2007, we swapped variable rates for fixed rates on $175.0 million of the borrowings under the then existing revolving credit facility. We had two agreements in place for a notional amount of $100.0 million and $75.0 million, expiring in 2010 and 2012, respectively. Under these agreements, we paid a fixed rate of 5.17% and received a variable rate equal to the then current three month LIBOR rate. On November 19, 2007, in anticipation of the DJO Merger and incurrence of new indebtedness, we terminated these swaps and recognized $4.8 million of related interest expense. On November 20, 2007, we entered into a new interest rate swap agreement for a notional amount of $515.0 million at a fixed LIBOR rate of 4.205% amortizing through an expiration date in 2009 (the notional amount was $470.0 million as of December 31, 2008).
The fair value of our interest rate swap agreement recorded in the accompanying condensed consolidated balance sheets as of December 31, 2008 and 2007 was a loss of approximately $13.3 million and $3.9 million, respectively, and is recorded in other non-current liabilities. For these derivatives, we report the after-tax gain or loss from the effective portion of the hedge as a component of accumulated other comprehensive income (loss) and reclassify it into earnings in the same period or periods in which the hedged transaction affects earnings, and within the same income statement line item as the impact of the hedged transaction. Derivative net gains (losses) on our interest rate swap agreement of ($3.4) million and $0.7 million, on a pre-tax basis, were included in interest expense for the Successor years ended December 31, 2007 and 2008, respectively.
In accordance with SFAS No. 157, “Fair Value Measurement”, we follow the three levels of the fair value hierarchy for disclosure of the inputs to valuation. This hierarchy prioritizes the inputs into three broad levels as follows. Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities. Level 2 inputs are quoted prices for similar assets and liabilities in active markets or inputs that are observable for the asset or liability, either directly or indirectly
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through market corroboration, for substantially the full term of the financial instrument. Level 3 inputs are unobservable inputs based on our own assumptions used to measure assets and liabilities at fair value. A financial asset or liability’s classification within the hierarchy is determined based on the lowest level input that is significant to the fair value measurement. At December 31, 2008, the fair value of our interest rate swap agreement was determined through the use of models that consider various assumptions, including time value, yield curves, as well as other relevant economic measures, which are inputs that are classified as Level 2 in the valuation hierarchy. The fair value of our Mexican Peso forward contracts was determined based on market rates to settle the instruments. These values represent the estimated amounts we would receive or pay to terminate the contracts, taking into consideration current market rates.
17. UNAUDITED QUARTERLY CONSOLIDATED FINANCIAL DATA
The following represents the unaudited quarterly consolidated financial data for the periods presented (in thousands):
| | Successor | |
| | For the three months ended | |
| | Mar 29,
2008 | | Jun 28,
2008 | | Sep 27,
2008 | | Dec 31,
2008 | |
Net sales | | $ | 239,728 | | $ | 249,801 | | $ | 243,637 | | $ | 247,028 | |
Gross Profit | | 144,644 | | 157,970 | | 150,669 | | 152,831 | |
Operating income (loss) | | 8,240 | | 15,063 | | 19,352 | | (7,829 | ) |
Net loss | | (24,162 | ) | (20,798 | ) | (14,429 | ) | (38,397 | ) |
| | | | | | | | | | | | | |
| | Successor | |
| | For the three months ended | |
| | Mar 31,
2007 | | Jun 30,
2007 | | Sep 29,
2007 | | Dec 31,
2007 | |
Net sales | | $ | 106,707 | | $ | 106,253 | | $ | 108,431 | | $ | 170,743 | |
Gross Profit | | 61,425 | | 62,392 | | 66,149 | | 96,304 | |
Operating income (loss) | | 310 | | 333 | | 2,800 | | (42,879 | ) |
Net loss | | (11,087 | ) | (8,077 | ) | (5,939 | ) | (57,319 | ) |
| | | | | | | | | | | | | |
18. EMPLOYEE BENEFIT PLANS
We have multiple qualified defined contribution plans, which allow for voluntary pre-tax contributions by employees. We pay all general and administrative expenses of the plans and may make contributions to the plans. Based on 50% of the first 6% of employee contributions, we made matching contributions of $3.3 million, $1.6 million and $0.2 million to the plan for the Successor years ended December 31, 2008 and 2007 and the period from November 4, 2006 through December 31, 2006, respectively. We also made a contribution of approximately $1.2 million to the plan in existence for both the Predecessor period January 1, 2006 through November 3, 2006. The plans provide for discretionary contributions by us as approved by the Board of Directors. There have been no such discretionary contributions through December 31, 2008. In addition, we made pension contributions of approximately $0.6 million related to our international pension plans.
19. SUBSEQUENT EVENTS
In February 2009, we acquired Donjoy Orthopaedics Pty., Ltd., an unaffiliated Australian distributor of our products, as part of our strategy to expand our international sales for approximately $3.0 million. We are still evaluating allocation of the purchase price.
In February 2009, we entered into two interest rate swap agreements. One agreement is for a notional amount of $550.0 million with a term of February 2009 through December 2009. The second agreement is for a notional amount of $750.0 million with a term of January 2010 through December 2010. Under these agreements we have LIBOR fixed rates of 1.04% and 1.88%, respectively.
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20. SUPPLEMENTAL GUARANTOR CONDENSED CONSOLIDATING FINANCIAL STATEMENTS
On November 20, 2007, in connection with the DJO Merger, DJOFL and its direct wholly-owned subsidiary, Finco, issued $575.0 million aggregate principal amount of the 10.875% Notes. Finco has only nominal assets and does not conduct any operations. The 10.875% Indenture generally prohibits Finco from holding any assets, becoming liable for any obligations, or engaging in any business activity. The 10.875% Notes are jointly and severally, fully and unconditionally guaranteed, on an unsecured senior subordinated basis by all of the DJOFL’s domestic subsidiaries (other than the co-issuer) that are 100% owned, directly or indirectly, by DJOFL (the “Guarantors”). Our foreign subsidiaries (the “Non-Guarantors”), do not guarantee the 10.875% notes. The Guarantors also unconditionally guarantee the Senior Secured Credit Facility.
On November 3, 2006, in connection with the Prior Transaction, DJOFL and its direct wholly-owned subsidiary, Finco, issued $200.0 million aggregate principal amount of the 11.75% Notes. Finco was formed solely to act as a co-issuer of the 11.75% Notes, has only nominal assets and does not conduct any operations. The 11.75% Indentured generally prohibit Finco from holding any assets, becoming liable for any obligations, or engaging in any business activity. The 11.75% Notes are jointly and severally, fully and unconditionally guaranteed, on an unsecured senior subordinated basis by all of the Guarantors. The Non-Guarantors, do not guarantee the 11.75% Notes. The Guarantors also unconditionally guarantee the Senior Secured Credit Facility.
The following tables present the financial position, results of operations and cash flows of DJOFL, the Guarantors, the Non-Guarantors and Eliminations as of the years ended December 31, 2008 and 2007. In addition, the following tables present the results of operations and cash flows of DJOFL, the Guarantors, the Non-Guarantors and certain eliminations of the Successor years ended December 31, 2008 and 2007 and the period from November 4, 2006 through December 31, 2006 and the Predecessor period from January 1, 2006 through November 3, 2006. The Guarantors in the tables relating to the Predecessor period include EMIHC, a previously wholly owned direct subsidiary of DJOFL which was liquidated on December 31, 2006. Encore medical, Inc. (“EMIHC’) was the borrower under the credit facility in place to the Old Senior Secured Credit Facility which was fully repaid in connection with the Prior Transaction and the issuer of the 9.75% Notes, which was repurchased pursuant to a tender offer in connection with the Prior Transaction.
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DJO Finance LLC
Condensed Consolidating Balance Sheets
As of December 31, 2008
(in thousands)
| | DJOFL | | Guarantors | | Non-
Guarantors | | Eliminations | | Consolidated | |
Assets | | | | | | | | | | | |
Current assets: | | | | | | | | | | | |
Cash and cash equivalents | | $ | — | | $ | 14,373 | | $ | 16,110 | | $ | — | | $ | 30,483 | |
Accounts receivable, net | | — | | 130,151 | | 34,467 | | — | | 164,618 | |
Inventories, net | | — | | 86,533 | | 21,183 | | (4,550 | ) | 103,166 | |
Deferred tax assets, net | | — | | 34,756 | | — | | (717 | ) | 34,039 | |
Prepaid expenses and other current assets | | 303 | | 13,516 | | 1,388 | | 1,716 | | 16,923 | |
Total current assets | | 303 | | 279,329 | | 73,148 | | (3,551 | ) | 349,229 | |
Property and equipment, net | | — | | 75,875 | | 12,316 | | (1,929 | ) | 86,262 | |
Goodwill | | — | | 1,120,690 | | 70,876 | | — | | 1,191,566 | |
Intangible assets, net | | — | | 1,228,872 | | 31,600 | | — | | 1,260,472 | |
Investment in subsidiaries | | 1,119,504 | | 1,119,058 | | 52,461 | | (2,291,023 | ) | — | |
Intercompany receivable | | 1,295,225 | | — | | — | | (1,295,225 | ) | — | |
Other non-current assets | | 49,951 | | 2,173 | | 477 | | — | | 52,601 | |
Total assets | | $ | 2,464,983 | | $ | 3,825,997 | | $ | 240,878 | | $ | (3,591,728 | ) | $ | 2,940,130 | |
Liabilities, Minority Interests and Membership Equity | | | | | | | | | | | |
Current liabilities: | | | | | | | | | | | |
Accounts payable | | $ | — | | $ | 33,566 | | $ | 9,100 | | $ | 86 | | $ | 42,752 | |
Long-term debt and capital leases, current portion | | 10,650 | | 187 | | 712 | | — | | 11,549 | |
Other current liabilities | | 24,213 | | 69,249 | | 22,243 | | (338 | ) | 115,367 | |
Total current liabilities | | 34,863 | | 103,002 | | 32,055 | | (252 | ) | 169,668 | |
Long-term debt and capital leases, net of current portion | | 1,831,754 | | 100 | | 190 | | — | | 1,832,044 | |
Deferred tax liabilities, net | | — | | 318,826 | | 9,195 | | 1,482 | | 329,503 | |
Intercompany payable, net | | — | | 1,209,321 | | 85,904 | | (1,295,225 | ) | — | |
Other non-current liabilities | | — | | 8,716 | | 90 | | — | | 8,806 | |
Total liabilities | | 1,866,617 | | 1,639,965 | | 127,434 | | (1,293,995 | ) | 2,340,021 | |
Minority interests | | — | | — | | 1,743 | | — | | 1,743 | |
Membership equity | | 598,366 | | 2,186,032 | | 111,701 | | (2,297,733 | ) | 598,366 | |
Total liabilities, minority interests and membership equity | | $ | 2,464,983 | | $ | 3,825,997 | | $ | 240,878 | | $ | (3,591,728 | ) | $ | 2,940,130 | |
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DJO Finance LLC ,
Condensed Consolidating Balance Sheet
As of December 31, 2007
(in thousands)
| | DJOFL | | Guarantors | | Non-
Guarantors | | Eliminations | | Consolidated | |
Assets | | | | | | | | | | | |
Current assets: | | | | | | | | | | | |
Cash and cash equivalents | | $ | 519 | | $ | 44,694 | | $ | 18,258 | | $ | — | | $ | 63,471 | |
Accounts receivable, net | | — | | 120,949 | | 33,818 | | — | | 154,767 | |
Inventories, net | | — | | 94,908 | | 22,868 | | (6,872 | ) | 110,904 | |
Deferred tax assets, net | | — | | 29,145 | | — | | (146 | ) | 28,999 | |
Prepaid expenses and other current assets | | 9 | | 13,669 | | 3,641 | | — | | 17,319 | |
Total current assets | | 528 | | 303,365 | | 78,585 | | (7,018 | ) | 375,460 | |
Property and equipment, net | | — | | 70,413 | | 12,949 | | (1,717 | ) | 81,645 | |
Goodwill | | — | | 1,132,388 | | 68,894 | | — | | 1,201,282 | |
Intangible assets, net | | — | | 1,324,191 | | 36,170 | | — | | 1,360,361 | |
Investment in subsidiaries | | 1,140,111 | | 184,420 | | 53,114 | | (1,377,645 | ) | — | |
Intercompany receivable | | 1,344,358 | | — | | — | | (1,344,358 | ) | — | |
Other non-current assets | | 61,587 | | 4,220 | | 1,717 | | — | | 67,524 | |
Total assets | | $ | 2,546,584 | | $ | 3,018,997 | | $ | 251,429 | | $ | (2,730,738 | ) | $ | 3,086,272 | |
Liabilities, Minority Interests and Membership Equity | | | | | | | | | | | |
Current liabilities: | | | | | | | | | | | |
Accounts payable | | $ | 54 | | $ | 34,722 | | $ | 8,800 | | $ | — | | $ | 43,576 | |
Long-term debt and capital leases, current portion | | 10,116 | | 66,985 | | 26,666 | | — | | 103,767 | |
Other current liabilities | | 10,650 | | 752 | | 2,807 | | — | | 14,209 | |
Total current liabilities | | 20,820 | | 102,459 | | 38,273 | | — | | 161,552 | |
Long-term debt and capital leases, net of current portion | | 1,816,864 | | 287 | | 1,447 | | — | | 1,818,598 | |
Deferred tax liabilities, net | | — | | 376,778 | | 9,881 | | — | | 386,659 | |
Intercompany payable, net | | — | | 1,255,008 | | 89,350 | | (1,344,358 | ) | — | |
Other non-current liabilities | | 3,912 | | 9,348 | | — | | — | | 13,260 | |
Total liabilities | | 1,841,596 | | 1,743,880 | | 138,951 | | (1,344,358 | ) | 2,380,069 | |
Minority interests | | — | | — | | 1,215 | | — | | 1,215 | |
Membership equity | | 704,988 | | 1,275,117 | | 111,263 | | (1,386,380 | ) | 704,988 | |
Total liabilities, minority interests and membership equity | | $ | 2,546,584 | | $ | 3,018,997 | | $ | 251,429 | | $ | (2,730,738 | ) | $ | 3,086,272 | |
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DJO Finance LLC
Condensed Consolidating Statements of Operations
For the Successor Year Ended December 31, 2008
(in thousands)
| | DJOFL | | Guarantors | | Non- Guarantors | | Eliminations | | Consolidated | |
Net sales | | $ | — | | $ | 821,685 | | $ | 255,414 | | $ | (96,905 | ) | $ | 980,194 | |
Cost of sales | | — | | 322,669 | | 151,650 | | (100,239 | ) | 374,080 | |
Gross profit | | — | | 499,016 | | 103,764 | | 3,334 | | 606,114 | |
Operating expenses: | | | | | | | | | | | |
Selling, general and administrative | | — | | 359,801 | | 85,601 | | (6 | ) | 445,396 | |
Research and development | | — | | 23,965 | | 2,973 | | — | | 26,938 | |
Amortization and impairment of acquired intangibles | | — | | 96,894 | | 2,060 | | — | | 98,954 | |
Operating income | | — | | 18,356 | | 13,130 | | 3,340 | | 34,826 | |
Other income (expense): | | | | | | | | | | | |
Interest income | | 45,032 | | 4,230 | | 808 | | (48,408 | ) | 1,662 | |
Interest expense | | (172,286 | ) | (45,193 | ) | (4,091 | ) | 48,408 | | (173,162 | ) |
Other income (expense), net | | 29,468 | | (6,324 | ) | (2,810 | ) | (29,468 | ) | (9,134 | ) |
Income (loss) from continuing operations before income taxes and minority interests | | (97,786 | ) | (28,931 | ) | 7,037 | | (26,128 | ) | (145,808 | ) |
Provision (benefit) for income taxes | | — | | (51,533 | ) | 2,462 | | — | | (49,071 | ) |
Minority interests | | — | | — | | 1,049 | | — | | 1,049 | |
Net income (loss) | | $ | (97,786 | ) | $ | 22,602 | | $ | 3,526 | | $ | (26,128 | ) | $ | (97,786 | ) |
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DJO Finance LLC
Condensed Consolidating Statement of Operations
For the Successor Year Ended December 31, 2007
(in thousands)
| | DJOFL | | Guarantors | | Non-
Guarantors | | Eliminations | | Consolidated | |
Net sales | | $ | — | | $ | 396,302 | | $ | 113,057 | | $ | (17,225 | ) | $ | 492,134 | |
Cost of sales | | — | | 165,789 | | 57,073 | | (16,998 | ) | 205,864 | |
Gross profit | | — | | 230,513 | | 55,984 | | (227 | ) | 286,270 | |
Operating expenses: | | | | | | | | | | | |
Selling, general and administrative | | 2,942 | | 220,969 | | 47,304 | | (52 | ) | 271,163 | |
Research and development | | — | | 16,998 | | 4,049 | | — | | 21,047 | |
Amortization of acquired intangibles | | — | | 30,803 | | 2,693 | | — | | 33,496 | |
Operating income (loss) | | (2,942 | ) | (38,257 | ) | 1,938 | | (175 | ) | (39,436 | ) |
Other income (expense): | | | | | | | | | | | |
Interest income | | 21,590 | | 5,101 | | 344 | | (25,903 | ) | 1,132 | |
Interest expense | | (72,085 | ) | (22,216 | ) | (4,011 | ) | 25,903 | | (72,409 | ) |
Other income (expense), net | | (14,446 | ) | (22,876 | ) | 496 | | 37,568 | | 742 | |
Loss on early extinguishment of debt | | (14,539 | ) | — | | — | | — | | (14,539 | ) |
Income (loss) from continuing operations before income taxes and minority interests | | (82,422 | ) | (78,248 | ) | (1,233 | ) | 37,393 | | (124,510 | ) |
Benefit for income taxes | | — | | (42,262 | ) | (241 | ) | — | | (42,503 | ) |
Minority interests | | — | | — | | 415 | | | | 415 | |
Loss from continuing operations | | (82,422 | ) | (35,986 | ) | (1,407 | ) | 37,393 | | (82,422 | ) |
Discontinued operations: | | | | | | | | | | | |
Income from discontinued operations, net of tax | | — | | — | | — | | — | | — | |
Net loss | | $ | (82,422 | ) | $ | (35,986 | ) | $ | (1,407 | ) | $ | 37,393 | | $ | (82,422 | ) |
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DJO Finance LLC
Condensed Consolidating Statement of Operations
For the Successor Period November 4, 2006 through December 31, 2006
(in thousands)
| | DJOFL | | Guarantors | | Non-
Guarantors | | Eliminations | | Consolidated | |
Net sales | | $ | — | | $ | 43,556 | | $ | 14,626 | | $ | (280 | ) | $ | 57,902 | |
Cost of sales | | — | | 18,959 | | 8,113 | | (285 | ) | 26,787 | |
Gross profit | | — | | 24,597 | | 6,513 | | 5 | | 31,115 | |
Operating expenses: | | | | | | | | | | | |
Selling, general and administrative | | 1,088 | | 33,707 | | 6,304 | | — | | 41,099 | |
Research and development | | — | | 27,377 | | 751 | | — | | 28,128 | |
Amortization of acquired intangibles | | — | | 3,608 | | 427 | | — | | 4,035 | |
Operating income (loss) | | (1,088 | ) | (40,095 | ) | (969 | ) | 5 | | (42,147 | ) |
Other income (expense): | | | | | | | | | | | |
Interest income | | 2,517 | | 751 | | 43 | | (2,999 | ) | 312 | |
Interest expense | | (8,560 | ) | (2,776 | ) | (274 | ) | 2,999 | | (8,611 | ) |
Other income (expense), net | | (34,503 | ) | 87 | | 46 | | 34,503 | | 133 | |
Loss from continuing operations before income taxes and minority interests | | (41,634 | ) | (42,033 | ) | (1,154 | ) | 34,508 | | (50,313 | ) |
Benefit for income taxes | | — | | (8,513 | ) | (243 | ) | — | | (8,756 | ) |
Minority interests | | — | | — | | 39 | | — | | 39 | |
Loss from continuing operations | | (41,634 | ) | (33,520 | ) | (950 | ) | 34,508 | | (41,596 | ) |
Discontinued operations: | | | | | | | | | | | |
Loss from discontinued operations, net of tax | | — | | (38 | ) | — | | — | | (38 | ) |
Net loss | | $ | (41,634 | ) | $ | (33,558 | ) | $ | (950 | ) | $ | 34,508 | | $ | (41,634 | ) |
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DJO Finance LLC
Condensed Consolidating Statement of Operations
For the Predecessor Period January 1, 2006 through November 3, 2006
(in thousands)
| | DJO | | Guarantors | | Non- Guarantors | | Eliminations | | Consolidated | |
Net sales | | $ | — | | $ | 256,744 | | $ | 49,579 | | $ | (1,940 | ) | $ | 304,383 | |
Cost of sales | | — | | 107,259 | | 21,984 | | (1,963 | ) | 127,280 | |
Gross profit | | — | | 149,485 | | 27,595 | | 23 | | 177,103 | |
Operating expenses: | | | | | | | | | | | |
Selling, general and administrative | | — | | 157,191 | | 21,973 | | — | | 179,164 | |
Research and development | | — | | 11,482 | | 3,290 | | — | | 14,772 | |
Amortization of acquired intangibles | | — | | 4,150 | | 1,815 | | — | | 5,965 | |
Operating income (loss) | | — | | (23,338 | ) | 517 | | 23 | | (22,798 | ) |
Other income (expense): | | | | | | | | | | | |
Interest income | | — | | 14,741 | | 113 | | (14,327 | ) | 527 | |
Interest expense | | — | | (40,077 | ) | (258 | ) | 14,327 | | (26,008 | ) |
Other income (expense), net | | (46,776 | ) | (24,293 | ) | (926 | ) | 71,972 | | (23 | ) |
Loss on early extinguishment of debt | | — | | (9,154 | ) | — | | — | | (9,154 | ) |
Loss from continuing operations before income taxes and minority interests | | (46,776 | ) | (82,121 | ) | (554 | ) | 71,995 | | (57,456 | ) |
Provision (benefit) for income taxes | | — | | (12,263 | ) | 752 | | 59 | | (11,452 | ) |
Minority interests | | — | | — | | 158 | | — | | 158 | |
Loss from continuing operations | | (46,776 | ) | (69,858 | ) | (1,464 | ) | 71,936 | | (46,162 | ) |
Discontinued operations: | | | | | | | | | | | |
Income from discontinued operations, net of tax | | — | | (614 | ) | — | | — | | (614 | ) |
Net loss | | $ | (46,776 | ) | $ | (70,472 | ) | $ | (1,464 | ) | $ | 71,936 | | $ | (46,776 | ) |
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DJO Finance LLC
Condensed Consolidating Statements of Cash Flows
For the Successor Year Ended December 31, 2008
(in thousands)
| | DJOFL | | Guarantors | | Non-
Guarantors | | Eliminations | | Consolidated | |
OPERATING ACTIVITIES: | | | | | | | | | | | |
Net income (loss) | | $ | (97,786 | ) | $ | 23,418 | | $ | 3,526 | | $ | (26,944 | ) | $ | (97,786 | ) |
| | | | | | | | | | | |
Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: | | | | | | | | | | | |
Depreciation | | — | | 20,113 | | 4,189 | | (705 | ) | 23,597 | |
Amortization and impairment of intangibles | | — | | 96,894 | | 2,060 | | — | | 98,954 | |
Amortization of debt issuance costs | | 13,177 | | — | | — | | — | | 13,177 | |
Stock-based compensation | | — | | 1,381 | | — | | — | | 1,381 | |
Loss on disposal of assets | | — | | 2,610 | | 602 | | (143 | ) | 3,069 | |
Deferred income taxes | | — | | (41,927 | ) | (230 | ) | — | | (42,157 | ) |
Non-cash income from subsidiaries | | (29,468 | ) | 11,980 | | — | | 17,488 | | — | |
Provision for doubtful accounts and sales returns | | — | | 25,421 | | 856 | | — | | 26,277 | |
Inventory reserves | | — | | 7,922 | | 715 | | — | | 8,637 | |
Minority interests | | — | | — | | 1,049 | | — | | 1,049 | |
Changes in operating assets and liabilities, net of acquired assets and liabilities: | | | | | | | | | | | |
Accounts receivable | | — | | (34,543 | ) | (2,521 | ) | — | | (37,064 | ) |
Inventories | | — | | 972 | | 136 | | (2,717 | ) | (1,609 | ) |
Prepaid expenses, other assets and liabilities | | (293 | ) | (2,760 | ) | 3,125 | | (4 | ) | 68 | |
Accounts payable and accrued expenses | | 770 | | (9,188 | ) | (1,325 | ) | 89 | | (9,654 | ) |
Net cash provided by (used in) operating activities | | (113,600 | ) | 102,293 | | 12,182 | | (12,936 | ) | (12,061 | ) |
INVESTING ACTIVITIES: | | | | | | | | | | | |
Acquisition of businesses and intangibles, net of cash acquired | | — | | (3,234 | ) | (1,861 | ) | — | | (5,095 | ) |
Proceeds from sale of assets held for sale | | — | | 2 | | 12 | | — | | 14 | |
Purchases of property and equipment | | — | | (22,412 | ) | (4,502 | ) | 1,009 | | (25,905 | ) |
Other | | — | | 1,696 | | (306 | ) | — | | 1,390 | |
Net cash used in investing activities | | — | | (23,948 | ) | (6,657 | ) | 1,009 | | (29,596 | ) |
FINANCING ACTIVITIES: | | | | | | | | | | | |
Intercompany | | 99,731 | | (107,914 | ) | (3,744 | ) | 11,927 | | — | |
Payments on long-term debt and revolving line of credit | | (29,650 | ) | (752 | ) | (6,892 | ) | — | | (37,294 | ) |
Proceeds from long- debt and revolving line of credit | | 43,000 | | — | | 3,540 | | — | | 46,540 | |
Dividend paid to minority interests of subsidiary | | — | | — | | (381 | ) | — | | (381 | ) |
Net cash provided by financing activities | | 113,081 | | (108,666 | ) | (7,477 | ) | 11,927 | | 8,865 | |
Effect of exchange rate changes on cash and cash equivalents | | — | | — | | (196 | ) | — | | (196 | ) |
Net increase (decrease) in cash and cash equivalents | | (519 | ) | (30,321 | ) | (2,148 | ) | — | | (32,988 | ) |
Cash and cash equivalents at beginning of period | | 519 | | 44,694 | | 18,258 | | — | | 63,471 | |
Cash and cash equivalents at end of period | | $ | — | | $ | 14,373 | | $ | 16,110 | | $ | — | | $ | 30,483 | |
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DJO Finance LLC
Condensed Consolidating Statements of Cash Flows
For the Successor Year Ended December 31, 2007
(in thousands)
| | DJOFL | | Guarantors | | Non- Guarantors | | Eliminations | | Consolidated | |
OPERATING ACTIVITIES: | | | | | | | | | | | |
Net loss | | $ | (82,422 | ) | $ | (35,986 | ) | $ | (1,407 | ) | $ | 37,393 | | $ | (82,422 | ) |
| | | | | | | | | | | | | | | | |
Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: | | | | | | | | | | | |
Depreciation | | — | | 11,430 | | 4,072 | | (758 | ) | 14,744 | |
Amortization of intangibles | | — | | 30,802 | | 2,694 | | — | | 33,496 | |
Amortization of debt issuance costs | | 4,862 | | — | | — | | — | | 4,862 | |
Loss on early extinguishment of debt | | 9,744 | | — | | — | | — | | 9,744 | |
Stock-based compensation | | — | | 1,541 | | — | | — | | 1,541 | |
Loss on disposal of assets | | — | | 252 | | 544 | | (114 | ) | 682 | |
Deferred income taxes | | — | | (43,134 | ) | (4,087 | ) | — | | (47,221 | ) |
Non-cash income from subsidiaries | | 14,447 | | 23,122 | | — | | (37,569 | ) | — | |
Provision for doubtful accounts and sales returns | | — | | 21,581 | | 847 | | — | | 22,428 | |
Inventory reserves | | — | | 2,975 | | 605 | | — | | 3,580 | |
Minority interests | | — | | — | | 415 | | — | | 415 | |
Excess tax benefit associated with stock option exercises | | — | | (370 | ) | — | | — | | (370 | ) |
Acquired in-process research and development | | — | | 3,000 | | — | | — | | 3,000 | |
Net effect of discontinued operations | | — | | 378 | | — | | — | | 378 | |
Changes in operating assets and liabilities, net of acquired assets and liabilities: | | | | | | | | | | | |
Accounts receivable | | — | | (14,442 | ) | (859 | ) | — | | (15,301 | ) |
Inventories | | — | | 5,278 | | 1,289 | | 508 | | 7,075 | |
Prepaid expenses, other assets and liabilities | | 92 | | 1,111 | | 364 | | — | | 1,567 | |
Accounts payable and accrued expenses | | 2,258 | | 11,616 | | (831 | ) | — | | 13,043 | |
Net cash provided by (used in) operating activities | | (51,019 | ) | 19,154 | | 3,646 | | (540 | ) | (28,759 | ) |
INVESTING ACTIVITIES: | | | | | | | | | | | |
Acquisition of businesses, net of cash acquired | | — | | (1,312,678 | ) | (432 | ) | — | | (1,313,110 | ) |
Proceeds from sale of assets held for sale | | — | | 4,500 | | 91 | | — | | 4,591 | |
Purchases of property and equipment | | — | | (10,622 | ) | (3,880 | ) | 540 | | (13,962 | ) |
Other | | — | | (583 | ) | — | | — | | (583 | ) |
Net cash used in investing activities | | — | | (1,319,383 | ) | (4,221 | ) | 540 | | (1,323,064 | ) |
FINANCING ACTIVITIES: | | | | | | | | | | | |
Intercompany | | (1,170,504 | ) | 1,160,126 | | 10,378 | | — | | — | |
Investment by Parent | | — | | 434,599 | | — | | — | | 434,599 | |
Payments on long-term obligations | | (446,126 | ) | (271,868 | ) | (427 | ) | — | | (718,421 | ) |
Proceeds from long-term obligations | | 1,724,022 | | 294 | | 34 | | — | | 1,724,350 | |
Payment of debt issuance costs | | (55,866 | ) | — | | — | | — | | (55,866 | ) |
Excess tax benefit associated with stock option exercises | | — | | 370 | | — | | — | | 370 | |
Repurchase of Prior Transaction Management Rollover Options | | | | (1,248 | ) | | | | | (1,248 | ) |
Dividend paid to minority interests | | — | | — | | (226 | ) | — | | (226 | ) |
Net cash provided by financing activities | | 51,526 | | 1,322,273 | | 9,759 | | — | | 1,383,558 | |
Effect of exchange rate changes on cash and cash equivalents | | — | | — | | 833 | | — | | 833 | |
Net increase (decrease) in cash and cash equivalents | | 507 | | 22,044 | | 10,017 | | — | | 32,568 | |
Cash and cash equivalents at beginning of period | | 12 | | 22,650 | | 8,241 | | — | | 30,903 | |
Cash and cash equivalents at end of period | | $ | 519 | | $ | 44,694 | | $ | 18,258 | | $ | — | | $ | 63,471 | |
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DJO Finance LLC
Condensed Consolidating Statement of Cash Flows
For the Successor Period November 4, 2006 through December 31, 2006
(in thousands)
| | DJOFL | | Guarantors | | Non-
Guarantors | | Eliminations | | Consolidated | |
OPERATING ACTIVITIES: | | | | | | | | | | | |
Net loss | | $ | (41,634 | ) | $ | (33,558 | ) | $ | (950 | ) | $ | 34,508 | | $ | (41,634 | ) |
| | | | | | | | | | | | | | | | |
Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: | | | | | | | | | | | |
Depreciation | | — | | 1,721 | | 627 | | 21 | | 2,369 | |
Amortization of intangibles | | — | | 3,608 | | 427 | | — | | 4,035 | |
Amortization of debt issuance costs | | 654 | | — | | — | | — | | 654 | |
Stock-based compensation | | — | | 105 | | — | | — | | 105 | |
Asset impairment | | — | | 1,282 | | 134 | | (188 | ) | 1,228 | |
Deferred income taxes | | — | | (8,427 | ) | (415 | ) | — | | (8,842 | ) |
Non-cash income from subsidiaries | | 34,503 | | (259 | ) | — | | (34,244 | ) | — | |
Provision for doubtful accounts and sales returns | | — | | 492 | | 21 | | — | | 513 | |
Inventory reserves | | — | | 944 | | 13 | | — | | 957 | |
Minority | | — | | — | | 39 | | — | | 39 | |
In process research and development | | — | | 25,200 | | — | | — | | 25,200 | |
Net effect of discontinued operations | | — | | 457 | | — | | — | | 457 | |
Changes in operating assets and liabilities, net of acquired assets and liabilities: | | | | | | | | | | | |
Accounts receivable | | — | | 6,043 | | 18 | | — | | 6,061 | |
Inventories | | — | | 1,346 | | 1,726 | | (161 | ) | 2,911 | |
Prepaid expenses, other assets and liabilities | | (21 | ) | 2,340 | | 323 | | — | | 2,642 | |
Accounts payable and accrued expenses | | 1,631 | | (12,691 | ) | (1,464 | ) | — | | (12,524 | ) |
Net cash provided by (used in) operating activities | | (4,867 | ) | (11,397 | ) | 499 | | (64 | ) | (15,829 | ) |
INVESTING ACTIVITIES: | | | | | | | | | | | |
Acquisition of businesses, net of cash acquired | | — | | — | | (13,008 | ) | — | | (13,008 | ) |
Acquisition of ReAble (Prior Transaction) | | — | | (522,072 | ) | — | | — | | (522,072 | ) |
Purchases of property and equipment | | — | | (1,046 | ) | (349 | ) | 64 | | (1,331 | ) |
Net cash used in investing activities | | — | | (523,118 | ) | (13,357 | ) | 64 | | (536,411 | ) |
FINANCING ACTIVITIES: | | | | | | | | | | | |
Investment by Blackstone | | — | | 357,000 | | — | | — | | 357,000 | |
Intercompany | | (523,428 | ) | 508,702 | | 14,726 | | — | | — | |
Proceeds from long-term obligations | | 550,000 | | — | | 370 | | — | | 550,370 | |
Payments on long-term obligations | | (875 | ) | (335,238 | ) | — | | — | | (336,113 | ) |
Payment of debt issuance costs | | (20,818 | ) | — | | — | | — | | (20,818 | ) |
Net cash provided by financing activities | | 4,879 | | 530,464 | | 15,096 | | — | | 550,439 | |
Effect of exchange rate changes on cash and cash equivalents | | — | | 824 | | (550 | ) | — | | 274 | |
Net increase (decrease) in cash and cash equivalents | | 12 | | (3,227 | ) | 1,688 | | — | | (1,527 | ) |
Cash and cash equivalents at beginning of period | | — | | 25,101 | | 7,329 | | — | | 32,430 | |
Cash and cash equivalents at end of period | | $ | 12 | | $ | 21,874 | | $ | 9,017 | | $ | — | | $ | 30,903 | |
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DJO Finance LLC
Condensed Consolidating Statement of Cash Flows
For the Predecessor Period January 1, 2006 through November 3, 2006
(in thousands)
| | DJO | | Guarantors | | Non-
Guarantors | | Eliminations | | Consolidated | |
OPERATING ACTIVITIES: | | | | | | | | | | | |
Net loss | | $ | (46,776 | ) | $ | (70,472 | ) | $ | (1,464 | ) | $ | 71,936 | | $ | (46,776 | ) |
| | | | | | | | | | | | | | | | |
Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: | | | | | | | | | | | |
Depreciation | | — | | 6,471 | | 2,804 | | (436 | ) | 8,839 | |
Amortization of intangibles | | — | | 4,150 | | 1,815 | | — | | 5,965 | |
Amortization of debt issuance costs | | — | | 1,765 | | — | | — | | 1,765 | |
Loss on early extinguishment of debt | | — | | 9,154 | | — | | — | | 9,154 | |
Non-cash interest expense | | — | | 91 | | — | | — | | 91 | |
Stock-based compensation | | — | | 10,631 | | — | | — | | 10,631 | |
Asset impairment and loss on disposal of assets | | — | | 321 | | 317 | | (250 | ) | 388 | |
Deferred income taxes | | 335 | | (12,856 | ) | (822 | ) | 59 | | (13,284 | ) |
Non-cash income from subsidiaries | | 46,777 | | 25,474 | | — | | (72,251 | ) | — | |
Provision for doubtful accounts and sales returns | | — | | 21,604 | | 159 | | — | | 21,763 | |
Inventory reserves | | — | | 7,473 | | 90 | | — | | 7,563 | |
Excess tax benefit associated with stock option exercises | | — | | (2,543 | ) | — | | — | | (2,543 | ) |
Minority interests | | — | | — | | 158 | | — | | 158 | |
Acquired in-process research and development | | — | | 2,103 | | 1,794 | | — | | 3,897 | |
Net effect of discontinued operations | | — | | 5,155 | | — | | — | | 5,155 | |
Changes in operating assets and liabilities, net of acquired assets and liabilities: | | | | | | | | | | | |
Accounts receivable | | — | | 3,116 | | 2,387 | | — | | 5,503 | |
Inventories | | — | | (10,457 | ) | 294 | | 429 | | (9,734 | ) |
Prepaid expenses, other assets and liabilities | | 3,299 | | (5,009 | ) | (108 | ) | — | | (1,818 | ) |
Accounts payable and accrued expenses | | 1,215 | | 10,869 | | (2,126 | ) | — | | 9,958 | |
Net cash provided by (used in) operating activities | | 4,850 | | 7,040 | | 5,298 | | (513 | ) | 16,675 | |
INVESTING ACTIVITIES: | | | | | | | | | | | |
Acquisition of businesses, net of cash acquired | | — | | (4,340 | ) | 2,547 | | — | | (1,793 | ) |
Acquisition of intangible assets | | — | | (110 | ) | (134 | ) | — | | (244 | ) |
Purchases of property and equipment | | — | | (10,297 | ) | (2,520 | ) | 513 | | (12,304 | ) |
Proceeds from sale of assets | | — | | 69 | | — | | — | | 69 | |
Net cash used in investing activities | | — | | (14,678 | ) | (107 | ) | 513 | | (14,272 | ) |
FINANCING ACTIVITIES: | | | | | | | | | | | |
Intercompany | | (9,477 | ) | 7,330 | | 2,147 | | — | | — | |
Proceeds from long-term obligations | | — | | 25,300 | | — | | — | | 25,300 | |
Payments on long-term obligations | | — | | (20,791 | ) | (4,629 | ) | — | | (25,420 | ) |
Payment of debt issuance costs | | — | | (10 | ) | — | | — | | (10 | ) |
Excess tax benefit associated with stock options | | — | | 2,543 | | — | | — | | 2,543 | |
Proceeds from issuance of common stock | | 9,002 | | — | | — | | — | | 9,002 | |
Proceeds from notes received for sale of common stock | | 846 | | — | | — | | — | | 846 | |
Net cash provided by (used in) financing activities | | 371 | | 14,372 | | (2,482 | ) | — | | 12,261 | |
Effect of exchange rate changes on cash and cash equivalents | | — | | — | | 566 | | — | | 566 | |
Net increase in cash and cash equivalents | | 5,221 | | 6,734 | | 3,275 | | — | | 15,230 | |
Cash and cash equivalents at beginning of period | | 308 | | 13,588 | | 3,304 | | — | | 17,200 | |
Cash and cash equivalents at end of period | | $ | 5,529 | | $ | 20,322 | | $ | 6,579 | | $ | — | | $ | 32,430 | |
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ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A(T). CONTROLS AND PROCEDURES
MANAGEMENT’S EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES
We maintain disclosure controls and procedures (as the term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934) 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 SEC’s rules and forms, and that such information is accumulated and communicated to management, including our Chief Executive Officer and our Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.
Any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives. Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of our disclosure controls and procedures. Based on this evaluation and subject to the foregoing, our Chief Executive Officer and our Chief Financial Officer concluded that, our disclosure controls and procedures were effective at December 31, 2008, to accomplish their objectives at the reasonable assurance level.
In addition, there has been no change in our internal control over financial reporting (as that term is defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934) that occurred during the fourth quarter ended December 31, 2008 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING
Our management is responsible for establishing and maintaining adequate internal control over financial reporting. The Company’s internal control over financial reporting is designed to provide reasonable assurances regarding the reliability of financial reporting and the preparation of the consolidated financial statements of the Company in accordance with U.S. generally accepted accounting principles. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree or compliance with the policies or procedures may deteriorate.
With the participation of our Chief Executive Officer and our Chief Financial Officer, our management conducted an evaluation of the effectiveness of our internal control over financial reporting as of December 31, 2008 based on the framework in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on our evaluation under the framework in Internal Control—Integrated Framework, our management has concluded that the Company’s internal control over financial reporting is effective as of December 31, 2008.
This annual report does not include an attestation report of our registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by our registered public accounting firm pursuant to temporary rules of the Securities and Exchange Commission that permit us to provide only management’s report in this Annual Report.
ITEM 9B. OTHER INFORMATION
None.
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PART III.
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
The following table sets forth information about our directors and executive officers of our parent, DJO. The executive officers of DJO are also the executive officers of DJOFL.
Name | | Age | | Position |
Leslie H. Cross | | 58 | | President, Chief Executive Officer and Director |
Vickie L. Capps | | 47 | | Executive Vice President, Chief Financial Officer and Treasurer |
Luke T. Faulstick | | 45 | | Executive Vice President and Chief Operating Officer |
Donald M. Roberts | | 60 | | Executive Vice President, General Counsel and Secretary |
Thomas A. Capizzi | | 50 | | Executive Vice President, Global Human Resources |
Chinh E. Chu | | 42 | | Chairman of the Board |
Julia Kahr | | 30 | | Director |
Sidney Braginsky | | 71 | | Director |
Bruce McEvoy | | 31 | | Director |
Phillip J. Hildebrand | | 56 | | Director |
Lesley Howe | | 64 | | Director |
Paul LaViolette | | 51 | | Director |
Leslie H. Cross—President, Chief Executive Officer and Director. Mr. Cross was appointed Chief Executive Officer of DJO and DJOFL as of the effective date of the DJO Merger and was appointed President in May 2008. Prior to the DJO Merger, Mr. Cross was the Chief Executive Officer and President and a member of the board of directors of DJO Opco since August 2001. He served as the Chief Executive Officer and a Manager of DonJoy, L.L.C., from June 1999 until November 2001, and has served as President of DJO, LLC, or its predecessor, the Bracing & Support Systems division of Smith & Nephew, Inc., since June 1995. From 1990 to 1994, Mr. Cross held the position of Senior Vice President of Marketing and Business Development of the Bracing & Support Systems division of Smith & Nephew. He was a Managing Director of two different divisions of Smith & Nephew from 1982 to 1990. Prior to that time, he worked at American Hospital Supply Corporation. Mr. Cross earned a diploma in medical technology from Sydney Technical College in Sydney, Australia and studied business at the University of Cape Town in Cape Town, South Africa.
Vickie L. Capps—Executive Vice President, Chief Financial Officer and Treasurer. Ms. Capps was appointed Executive Vice President, Chief Financial Officer and Treasurer of DJO and DJOFL as of the effective date of the DJO Merger. Ms. Capps is also responsible for managing our international business. Prior to the DJO Merger, Ms. Capps served as the Executive Vice President, Chief Financial Officer and Treasurer of DJO Opco since July 2002. From September 2001 until July 2002, Ms. Capps was employed by AirFiber, a privately held provider of broadband wireless solutions, where she served as Senior Vice President, Finance and Administration and Chief Financial Officer. From July 1999 to July 2001, Ms. Capps served as Vice President of Finance and Administration and Chief Financial Officer for Maxwell Technologies, Inc., a publicly traded technology company. From 1992 to 1999, Ms. Capps served in various positions, including Chief Financial Officer, with Wavetek Wandel Goltermann, Inc., a multinational communications equipment company. Ms. Capps also served as a senior audit and accounting professional for Ernst & Young LLP from 1982 to 1992. Ms. Capps is a California Certified Public Accountant and received a B.S. degree in business administration/accounting from San Diego State University. Ms Capps currently serves on the board of directors and is a member of the audit committee of SenoRx, Inc., a publicly traded medical device company.
Luke T. Faulstick—Executive Vice President and Chief Operating Officer. Mr. Faulstick was appointed President, Global Operations as of the effective date of the DJO Merger and his title was changed to Executive Vice President and Chief Operating Officer in May 2008. Previously, Mr. Faulstick served as Chief Operating Officer of DJO Opco from March 2006 to November 2007, Senior Vice President of Operations from August 2003 to March 2006 and Vice President of Operations from August 2001 to August 2003. From 1998 to June 2001, Mr. Faulstick served as General Manager for Tyco Healthcare. From 1996 to 1998, Mr. Faulstick served as Plant Manager for Mitsubishi Consumer Electronics. In 1994, he started a contract manufacturing business that supplied products to the medical, electronic and photographic industries. Mr. Faulstick began his career in 1985 working for Eastman Kodak Company in Rochester New York where he held various positions in Engineering, Marketing, and Product Research and Development. He currently serves on the board of directors of Power Partners, Inc., a privately held power transmission manufacturer. Mr. Faulstick received a B.S. in engineering from Michigan State University and an M.S. in engineering from Rochester Institute of Technology.
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Donald M. Roberts—Executive Vice President, General Counsel and Secretary. Mr. Roberts was appointed Executive Vice President, General Counsel and Secretary of DJO and DJOFL as of the effective date of the DJO Merger. Prior to the DJO Merger, Mr. Roberts served as Senior Vice President, General Counsel and Secretary of DJO Opco since December 2002. From 1994 to December 2002, Mr. Roberts served as Vice President, Secretary and General Counsel for Maxwell Technologies, Inc., a publicly held technology company. Previous to that, he was with the Los Angeles—based law firm of Parker, Milliken, Clark, O’Hara & Samuelian for 21 years. Mr. Roberts was a shareholder in the firm, having served as partner in a predecessor partnership. Mr. Roberts received his undergraduate degree in political science from Yale University and earned his J.D. at the University of California, Berkeley, Boalt Hall School of Law.
Thomas A. Capizzi—Executive Vice President, Global Human Resources. Mr. Capizzi was appointed Executive Vice President, Global Human Resources of DJO and DJOFL as of the effective date of the DJO Merger. Prior to the DJO Merger, Mr. Capizzi served as Senior Vice President, Human Resources of DJO Opco since July 2007. From 2001 to July 2007, Mr. Capizzi served as Vice President, Worldwide Human Resources & Administration for Magellan GPS a Consumer Electronics Company. Previous to that from 1999 to 2001, he was Vice President, HR, Chief Administrative Officer for PCTEL a publicly held Telecommunications and Modem Technology Company. From 1997 to 1999 he served as Corporate Vice President, Human Resources for McKesson a Medical Distribution and Pharmaceutical Solution company. Mr. Capizzi has held various other Human Resources Management positions in companies such as Charles Schwab, Genentech, PepsiCo and The Hertz Corporation. Mr. Capizzi brings well over 25 years of Human Resources experience. Mr. Capizzi received his undergraduate degree in Psychology and Philosophy from Cathedral College/St. John University and his post graduate work in Organizational Development from the New School.
Chinh E. Chu—Chairman of the Board. Mr. Chu became one of DJO’s directors and one of our managers immediately after the completion of the Prior Transaction and became Chairman of the Board in January 2009. Mr. Chu is a senior managing director of The Blackstone Group. Since joining Blackstone in 1990, Mr. Chu has led the execution of Blackstone’s investments in Healthmarkets, Inc., SunGuard Data Systems Inc., Nalco, Celanese, Nycomed and LIFFE. He has also been involved in the execution of Blackstone’s investments in Graham Packaging, Sirius Satellite Radio, StorageApps, Haynes International, Prime Succession/Rose Hills, Interstate Hotels, HFS and Alco Holdings. Before joining Blackstone, Mr. Chu worked at Salomon Brothers in the Mergers & Acquisitions Department. Mr. Chu currently serves on the boards of directors of Catalent, Celanese Corporation, Financial Guaranty Insurance Company, Graham Packaging, SunGard Data Systems Inc. and Healthmarkets, Inc.
Julia Kahr—Director. Ms. Kahr became one of DJO’s directors and one of our managers immediately after the completion of the Prior Transaction. Ms. Kahr is currently a principal of The Blackstone Group. Before joining Blackstone in 2004, Ms. Kahr was a Project Leader at the Boston Consulting Group, where she worked with companies in a variety of industries, including financial services, pharmaceuticals, media and entertainment, and consumer goods. Ms. Kahr is also the sole author of Working Knowledge, a book published by Simon & Schuster in 1998.
Sidney Braginsky—Director. Mr. Braginsky became one of DJO’s directors on December 14, 2006. Mr. Braginsky has been President, Chief Executive Officer and Chairman of the Board of Atropos Technology, LLC since July 2000. Mr. Braginsky also serves as chairman and managing Director of Double D (Devices and Diagnostics) a Venture Capital Fund and is Chairman and CEO of Digilab LLC, a molecular spectroscopy division acquired by Atropos in 2001. Double D and Digilab LLC are both affiliated with Atropos Technology, LLC. Before joining Atropos, Mr. Braginsky served as President of Olympus America, Inc. where he built a large business focused on optical products. Prior to Olympus America, Mr. Braginsky served as President and Chief Operating Officer of Mediscience Technology Corp., a designer and developer of diagnostic medical devices for cancer detection. Mr. Braginsky currently serves on the board of directors and audit committees of Noven Pharmaceuticals, Inc., Diomed Holdings, Inc., Electro—Optical Sciences, Inc. and Geneva Acquisition Corp.
Bruce McEvoy—Director. Mr. McEvoy became one of DJO’s directors in August 2007. Mr. McEvoy has been an Associate at The Blackstone Group since 2006. Before joining Blackstone, Mr. McEvoy worked as an Associate at General Atlantic from 2002 to 2004 and was a consultant at McKinsey & Company from 1999 to 2002. Mr. McEvoy received an M.B.A. from Harvard Business School in 2006. Mr. McEvoy currently serves on the boards of directors of Catalent, RGIS Inventory Services and Vistar.
Phillip J. Hildebrand — Director. Mr. Hildebrand became one of DJO’s directors in December 2008. Mr. Hildebrand serves as President, Chief Executive Officer and a director of HealthMarkets, Inc., a company in which affiliates of The Blackstone Group own a 55.6% equity interest. An affiliate of The Blackstone Group owns substantially all of the capital stock of DJO Incorporated. Mr. Hildebrand is also Chairman, President and Chief Executive Officer of The MEGA Life and Health Insurance Company, Mid—West National Life Insurance Company of Tennessee, The Chesapeake Life Insurance Company and Fidelity First Insurance Company. Before joining HealthMarkets, Mr. Hildebrand spent 33 years at the New York Life Insurance Company, retiring in 2008 as Vice Chairman.
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Lesley Howe – Director. Mr. Howe became one of DJO’s directors in January 2009. Mr. Howe has over 40 years of financial accounting and management experience. He was with KPMG for 30 years until his retirement as Area Managing Partner/Managing Partner of that firm’s Los Angeles office. From 2001 until its sale in 2007, Mr. Howe served as CEO of Consumer Networks LLC, a privately owned San Diego based internet marketing firm. Mr. Howe served on the Board of Directors of DJO Opco from October 2002 to the date of the DJO Merger. Mr. Howe currently serves on the boards of directors of NuVasive, Inc.,Volcano Corporation, P.F. Chang’s China Bistro Inc. and Jamba Inc.
Paul LaViolette – Director. Mr. LaViolette became one of DJO’s directors in January 2009. Mr. LaViolette is a Venture Partner with SV Life Sciences, a capital advisor and manger in the human life sciences sector. Mr. LaViolette served as Chief Operating Officer of Boston Scientific Corporation, a worldwide leader in less invasive medical devices, from 2004 until the end of 2008. Prior to 2004, Mr. LaViolette held marketing and general management positions at CR Bard, and various marketing roles at The Kendall Company, at that time a subsidiary of Colgate Palmolive. He currently serves on the boards of directors of TranS1, Inc. (public), DirectFlow Medical, Inc. (private) and Conceptus Incorporated (private). He previously served on the board of directors and on the Executive Committee of the Advanced Medical Technology Association (ADVAMED), the world’s largest medical technology association as well as on the boards of directors of Urologix, Inc. (public) and Percutaneous Valve Technologies, Inc. (private).
CORPORATE GOVERNANCE MATTERS
Code of Ethics. Our Business Ethics Policy and Code of Conduct, Code of Conduct for the Board of Directors, and Code of Ethics for the Chief Executive Officer and Senior Executives and Financial Officers are available, free of charge, on the Company’s website at www.DJOglobal.com. Please note, however, that the information contained on the website is not incorporated by reference in, or considered part of, this Annual Report. We will post any amendments to the Code of Ethics, and any waivers that are required to be disclosed by the SEC rules on our website within the required time period. We will also provide copies of these documents, free of charge, to any securityholder upon written request to: Director, Investor Relations, DJO Incorporated, 1430 Decision Street, Vista, California 92081-8553.
Audit Committee. Until January 2009, our Audit Committee consisted of three appointed Directors, Mr. Sidney Braginsky (Chairman), Ms. Kahr and Mr. McEvoy. In January 2009, Mr. Howe was appointed to the Audit Committee and as Chairman of that Committee. As a privately held company, our Audit Committee is not required to be composed of only independent directors. We believe that Messrs. Howe and Braginsky each meet the definition of an independent director under the Rules of the New York Stock Exchange. Our Board of Directors has determined that Mr. Howe is an “audit committee financial expert” as defined in SEC Regulation S-K Item 407 (d)(5). Our Board of Directors also believes that the other members of the Audit Committee have requisite levels of financial literacy and financial sophistication to enable the Audit Committee to be effective in relation to the purposes outlined in its charter and in light of the scope and nature of our business and financial statements.
Compensation Committee. The Compensation Committee of the DJO Board consists of three appointed Directors, Mr. Chu, Ms. Kahr, and Mr. McEvoy. Because DJO is a privately held company, the Compensation Committee is not required to be composed of independent directors.
ITEM 11. EXECUTIVE COMPENSATION
Compensation Discussion and Analysis
Overview
The following Compensation Discussion and Analysis describes the objectives of our executive Compensation Program and the material elements of compensation for our executive officers identified under Item 11. “Executive Compensation — Summary Compensation Table” (the “Named Executive Officers” or “NEOs”), along with the role the Compensation Committee of the DJO Board of Directors (the “Compensation Committee”) in reviewing and making decisions regarding our executive compensation program.
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Role of the Compensation Committee in Establishing Compensation
The Compensation Committee establishes salaries and reviews benefit programs for the Chief Executive Officer (“CEO”) and each of our other executive officers; reviews, approves, recommends and administers our annual incentive compensation and stock option plans for employees and other compensation plans; advises the DJO Board and makes recommendations with respect to plans that require Board approval; and approves employment agreements with our executive officers. The Compensation Committee establishes and maintains our executive compensation program through internal evaluations of performance, consultation with various executive compensation consultants, and analysis of compensation practices in industries where we compete for experienced senior management. The Compensation Committee reviews our compensation programs and philosophy regularly, particularly in connection with its evaluation and approval of changes in the compensation structure for a given year. The Compensation Committee met five times during 2008. Three of the five meetings were not separate from the DJO Board and the other two meetings included only Compensation Committee members. The CEO makes recommendations for the salaries for executive officers other than himself and reviews such recommendations with the Compensation Committee.
Objectives of Our Compensation Program
Our executive compensation program is designed to attract, retain, and reward talented senior management who can contribute to our growth and success and thereby build long-term value for our stockholders. We believe that an effective executive compensation program is critical to our long-term success. By having an executive compensation program that is competitive with current market practice and focused on driving superior and enduring performance, we believe we can align the interests of our executive officers with the interests of stockholders and reward our executive officers for successfully improving stockholder returns. Our compensation program has the following objectives:
· | | attract and retain talented senior management to ensure our future success; |
· | | encourage a pay-for-performance mentality by directly relating variable compensation elements to the achievement of financial and strategic objectives; |
· | | promote a direct relationship between executive compensation and the interests of our stockholders, with long-term incentive compensation that links a significant portion of executive compensation to our sustained performance through stock option and restricted stock awards; and |
· | | structure a compensation program that appropriately rewards our executive officers for their skills and contributions to our company based on competitive market practice. |
The Elements of Our Executive Compensation Program
The elements of our executive compensation program are as follows:
· | | Base salary; |
· | | Annual and quarterly cash incentive compensation (performance-based bonuses); |
· | | Equity-based awards; |
· | | Other benefits; and |
· | | Benefits upon termination of employment |
Base Salary. Base salaries provide a fixed form of compensation designed to reward our executive officer’s core competence in his or her role. The Compensation Committee determines base salaries by taking into consideration such factors as competitive industry salaries; the nature of the position; the contribution and experience of the officers; and the length of service.
Annual and Quarterly Cash Incentive Compensation. Performance-based cash incentive compensation is provided to motivate our executive officers for each quarter and for the full year to pursue objectives that the Compensation Committee believes are consistent with the overall goals and long-term strategic direction that the DJO Board has set for our company.
In November 2006, the Compensation Committee adopted a multi-year bonus plan (“the “Prior Bonus Plan”). The Prior Bonus Plan contained most of the elements of the 2008 bonus plan described below. Following the DJO Merger in 2007, the Compensation Committee replaced the Prior Bonus Plan with a new bonus plan which reflected the significant increase in size and changes in structure of the Company. This new bonus plan was effective on January 1, 2008 (the “2008 Bonus Plan”). The basic structure of the 2008 Bonus Plan was intended to remain in effect from year to year, although the
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targets would be separately established for each year. In February 2009, the Compensation Committee approved modifications to the 2008 Bonus Plan applicable to the NEOs for the fiscal year 2009, as described in “2009 Changes to Bonus Plan” below. The 2008 Bonus Plan in effect for 2008 consisted of two separate components as described below:
· Target Bonus. For 2008, each NEO was eligible to earn a target bonus amount of up to 60% of the NEO’s base salary in effect during the year, calculated on a weighted average monthly basis using the base salary in effect on the first day of each month, based upon the achievement of free cash flow and Adjusted EBITDA (each as defined below) targets for each quarter and the full year. Payment of the target bonus is contingent upon (1) the NEO’s fulfillment of individual performance goals, and (2) the NEO’s continued employment with us through the specified payment date for the bonus. Subject to these contingencies the target bonus is earned and payable on a quarterly and annual basis, with 12.5% of the target bonus available to be earned each quarter based on Adjusted EBITDA and free cash flow results for the quarter and 50% available to be earned based on annual results. For the quarterly and annual target bonus, partial achievement is available. For each quarter and for the year, 40% of the target bonus is payable if at least 90% of the performance targets are met, with payout amounts prorated on a pre-determined scale between 90% and 100% of performance target achievement.
· Supplemental Bonus. For 2008, each NEO was eligible to earn a supplemental bonus amount of up to an additional 60% of the NEO’s base salary in effect during the year, calculated on a weighted average monthly basis using the base salary in effect on the first day of each month, based upon the achievement of certain higher amounts of free cash flow and Adjusted EBITDA targets for such plan year. As with the target bonus, payment of the supplemental bonus is contingent upon the NEO’s fulfillment of individual performance goals, and the NEO’s continued employment with us through the specified payment date for the bonus. The supplemental bonus is payable only on an annual basis, with the full 60% supplemental bonus payable if 110% or more of the performance targets are achieved and the NEO meets individual performance goals. The supplemental bonus payout will be prorated on a pre-determined scale between zero and 60% of target bonus for achievement between 100% and 110% of annual performance targets.
For determining whether the performance targets are met, Adjusted EBITDA will be weighted at 70% and free cash flow at 30%. Free cash flow, for the purposes of the 2008 Bonus Plan, is calculated as Adjusted EBITDA, as defined below, less capital expenditures, and adjusted for changes in operating working capital. Adjusted EBITDA, for the purposes of the Bonus Plan, is calculated as earnings before interest, income taxes, depreciation and amortization, further adjusted for non-cash items, non-recurring items and other adjustment items pursuant to the definition of consolidated EBITDA contained in the credit agreement for our Senior Secured Credit Facility, excluding forward cost savings as determined by the Board of Directors. The Compensation Committee selected Adjusted EBITDA and free cash flow as the relevant company-wide performance criteria because the Compensation Committee believes that these criteria are consistent with the overall goals and long-term strategic direction that the DJO Board has set for DJO. Further, these criteria are closely related to or reflective of DJO’s financial and operational improvements, growth and return to shareholders. Adjusted EBITDA is an important non-GAAP valuation tool that potential investors use to measure our company’s profitability and liquidity against other companies in our industry. Free cash flow is another non-GAAP measurement tool that our management uses to assess how well we are achieving our goal of reducing our outstanding debt over time, which also contributes to creation of value for our shareholders and creditors. The particular targets for these performance metrics selected for purposes of the 2008 Bonus Plan were the same targets that apply to determine whether recipients of stock options vest in part of their stock options in 2008, as discussed further in the equity compensation discussion. We have not disclosed the specific performance targets because the Compensation Committee believes such information constitutes confidential financial information, the disclosure of which would cause competitive harm to DJO. As a result of the actual performance in 2008, approximately 70% of the target bonus was achieved and no portion of the supplemental bonus was achieved.
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2009 Changes to Bonus Plan. In February 2009, the Compensation Committee approved the bonus plan for 2009 (“2009 Bonus Plan”) for the executive officers of the Company based upon the structure of the 2008 Bonus Plan, with certain modifications to the financial metrics used for determining whether the performance bonus portion has been met. As with the 2008 Bonus Plan, each executive officer will have the opportunity to earn up to 60% of such executive’s annual base salary as a target bonus, and 50% of the annual bonus can be earned based on certain quarterly financial results and the remaining 50% can be earned based on the overall 2009 financial results. The portion of the bonus that can be earned in each of the fiscal quarters will be divided among the four quarters in proportion to the budgeted quarterly contribution of the particular quarter to the annual 2009 budgeted amount of each of the financial performance goals described below. The 2009 Bonus Plan contains quarterly and annual Adjusted EBITDA goals that will determine whether 60% of the applicable bonus opportunity is earned; quarterly and annual operating free cash flow goals that will determine whether 20% of the applicable bonus opportunity is earned; and quarterly and annual revenue goals that will determine whether the remaining 20% of the applicable bonus opportunity is earned. At the end of each quarter and the full year, the bonus opportunity will be determined based on whether the applicable financial targets have been met, and if one or more such targets have been met, the available portion of the target bonus will be paid if the individual executive officer has otherwise met individual performance goals. The 2009 Bonus Plan provides for the payment of as little as 40% of the target bonus if the Company’s financial performance falls short of the applicable goal by less than 2.5% for revenue, 5% for operating free cash flow and 6.5% for Adjusted EBITDA. Likewise, the 2009 Plan provides for the payment of an additional supplemental bonus of up to the amount of the target bonus if the Company’s financial performance exceeds the applicable goal by up to 2.5% of revenue, 5% of operating free cash flow and 6.5% of Adjusted EBITDA. The effects of foreign currency translation are excluded from the financial calculations under the 2009 Bonus Plan, and if one or more quarterly bonuses have been paid but the Company’s annual adjusted EBITDA for 2009 falls below a minimum threshold, the executive officers will be required to repay all such quarterly bonuses that had previously been paid during 2009. The Compensation Committee’s decision to include the level of revenues as a performance metric reflects the Committee’s view that it is important to the Company to provide additional focus on revenue growth in 2009.
Retention Bonus. In connection with the DJO Merger, each of our executive officers entered into an agreement to receive a retention bonus, of which 50% was paid in January 2008 and 50% was paid in January 2009. The terms of the retention bonus agreement required each executive officer to repay the retention bonus received if his or her employment with us was terminated prior to January 1, 2009, the date through which the bonus was earned, other than by reason of death, disability, or a termination by us without cause. Except for Peter Baird, the Company’s former President whose employment was terminated in May 2008, all the NEOs served until December 31, 2008 and received their full retention bonus. Mr. Baird received certain severance benefits pursuant to a Separation Agreement and General Release, including the right to retain the retention bonus previously paid to him.
Equity Compensation. In connection with the acquisition of ReAble by Blackstone in November 3, 2006, the Compensation Committee adopted the 2006 Stock Incentive Plan (the “2006 Stock Incentive Plan”). The purpose of the 2006 Stock Incentive Plan was to promote the interests of us and our shareholders by enabling selected key employees to participate in our long-term growth by receiving the opportunity to acquire shares of ReAble common stock and to provide for additional compensation based on appreciation in ReAble common stock. In connection with the DJO Merger, we terminated the 2006 Stock Incentive Plan and adopted the DJO Incorporated 2007 Incentive Stock Plan (the “2007 Incentive Stock Plan”) which provides for the grant of stock options and other stock-based awards to key employees, directors and consultants, including the executive officers. Outstanding options to purchase DJO common stock originally issued under the 2006 Stock Incentive Plan are now governed by the terms of the 2007 Incentive Stock Plan. In addition, DJO adopted a form of stock option agreement (the “DJO Form Option Agreement”) for awards under the 2007 Incentive Stock Plan. Under the DJO Form Option Agreement, one-third of the stock options will vest over a specified period of time (typically five years) contingent solely upon the awardee’s continued employment with us. Another one-third of the stock options will vest over a specified performance period (typically five years) from the grant date upon the achievement of pre-determined performance targets over time, consisting of Adjusted EBITDA and free cash flow as defined in the DJO Form Option Agreement, while the final one-third vests based upon achieving a higher level of such Adjusted EBITDA and free cash flow performance targets. The DJO Form Option Agreement includes certain forfeiture provisions upon an awardee’s separation from service with us. The Compensation Committee determines whether to grant options and the exercise price of the options granted. The Committee has broad discretion in determining the terms, restrictions and conditions of each award granted under the 2007 Incentive Stock Plan, provided that no options may be granted after November 20, 2017 and no option may be exercisable after ten years from the date of grant. All option awards granted under the 2007 Incentive Stock Plan will have an exercise price equal to the fair market value of DJO’s common stock on the date of grant. Fair market value is defined under the 2007 Incentive Stock Plan to be the closing market price of a share of DJO’s common stock on the date of grant or if no market price is available, the fair market value as determined by the Board of Directors. The Compensation Committee retains the discretion to make equity awards at any time in connection with the initial hiring of a new employee, for retention purposes, or otherwise. We do not have any program, plan or practice to time annual or ad hoc grants of stock options or other equity-based awards in coordination with the release of material non-public information or otherwise. The 2007 Incentive Stock Plan may be amended or terminated at any time by the DJO Board. However, any amendment that would require shareholder approval in order for the 2007 Incentive Stock Plan to continue to meet any applicable legal or regulatory requirements will be effective only if it is approved by DJO’s shareholders. A total of 7,500,000 shares of DJO common stock are authorized for issuance under the 2007 Incentive Stock Plan. Equity awards under the 2007 Incentive Stock Plan may be in the form of options or other stock-based awards. Options can be either incentive stock options or non-qualified stock options.
In connection with the DJO Merger, certain members of DJO Opco management were permitted to exchange a portion of their DJO Opco stock options for options to purchase an aggregate of 1,912,577 shares of DJO common stock granted under the 2007 Incentive Stock Plan on a tax-deferred basis (the “DJO Management Rollover Options”). The exercise price and number of shares underlying such options were each adjusted in proportion to the relative market values of DJO Opco’s and DJO’s common stock upon the closing of the DJO Merger. All of the DJO Management Rollover Options were fully vested and the replacement options remained subject to the same terms as were applicable to the original options.
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In February 2008, we granted options for a total of 1,860,055 shares (“Options”) under the 2007 Stock Incentive Plan to our executive officers who are NEOs, Mr. Cross, Ms. Capps, Mr. Roberts, Mr. Faulstick, Mr. Capizzi, as well as to Mr. Baird, our former President. The Options have a term of ten years from the date of grant and an exercise price of $16.46 per share. The Options vest in accordance with the following schedule: (a) one-third of the Option shares constitute, and may be purchased pursuant to the provisions of the Time-Based Tranche (defined below), (b) one-third of the Option shares constitute and may be purchased pursuant to the provisions of the Performance-Based Tranche (defined below), and (c) one-third of the Option shares constitute and may be purchased pursuant to the provisions of the Enhanced Performance-Based Tranche (defined below). The Options became exercisable with respect to 25% of the Time-Based Tranche on December 31, 2008, and become exercisable with respect to 20% of the Time-Based Tranche on December 31, 2009, 18.33% of the Time-Based Tranche on December 31, 2010 and 2011, and 18.34% on December 31, 2012 if such optionee remains employed with us or any of our subsidiaries or affiliates as of each such date. Each of the Performance-Based and Enhanced Performance-Based Tranches contain Adjusted EBITDA and Free Cash Flow targets, with the Enhanced Performance-Based Tranche requiring greater performance than the Performance-Based Tranche. The optionee was entitled to earn the right to exercise the Option to purchase 25% of the Performance-Based or both the Performance-Based and Enhanced Performance-Based Tranches on December 31, 2008 if the applicable performance targets were achieved, and may earn the right to exercise the option to purchase 20% of the Performance-Based or both the Performance-Based and Enhanced Performance-Based Tranches on December 31, 2009 if the applicable performance targets are achieved, 18.33% of the Performance-Based or both the Performance-Based and Enhanced Performance-Based Tranches on December 31, 2010 and 2011, and 18.34% of the Performance-Based or both the Performance-Based and Enhanced Performance-Based Tranches on December 31, 2012, if the applicable performance targets are achieved as of such dates, and provided that the optionee remains employed with us or any of our subsidiaries or affiliates as of each such date. The optionee may earn 90% of the annual portion of a given performance Tranche, upon acheivement of an established threshold “base case” for the Adjusted EBITDA and free cash flow. The Adjusted EBITDA and free cash flow targets established by the Compensation Committee for vesting purposes as described above represent, as to the target levels, reasonably challenging performance criteria in the judgment of the Compensation Committee, particularly in light of the significant integration challenges and synergy goals relating to the DJO Merger. Meeting the enhanced performance criteria will be difficult and will require superior performance by the Company’s management. The financial targets for the Performance-Based and Enhanced Performance-Based Tranches were not met for 2008.
Changes to 2008 Option Awards. In March 2009, the Compensation Committee determined that it would be in the best interests of the Company and its shareholders to make certain modifications to the options that were granted in 2008 to the NEOs and other members of management to reflect the significant challenges faced by management and the Company in connection with the integration activities associated with the DJO Merger and as a result of the severe economic environment. The Compensation Committee also desired to broaden management’s focus to include certain measures of longer-term shareholder value. As a result, the Compensation Committee made the following modifications to the outstanding options and to the 2007 Incentive Stock Plan:
1. No changes were made to the Time-Based Tranche.
2. The performance conditions for the portion of the options within the Performance-Based Tranche that vest based on 2009 financial performance were modified to require achievement of the levels of Adjusted EBITDA and free cash flow that were recently established in February 2009 in connection with the Company’s 2009 budget process. As with the original terms of such options, the optionees may earn 80% or more of such portion of options upon achievement of at least 93.5% of the budgeted Adjusted EBITDA and 95% of the free cash flow targets for 2009. The financial targets for the Performance-Based Tranches for years 2010-2012 remain unchanged.
3. The vesting provisions of the Performance-Based Tranche were modified to provide that upon achievement of the annual target for a given year, the annual portion of the tranche associated with all prior years will also vest to the extent not previously vested. For example, the financial targets for 2008 were not met and if the financial performance targets for 2009 and 2010 are not met, but the financial target for 2011 is met, then the portion of the Performance-Based Tranche that did not previously vest for years 2008, 2009 and 2010 would also vest at that time. The provisions that allow for 80% of the annual component to vest upon achieving the established lower thresholds related to each target shall also apply to this provision.
4. The financial performance targets for the entire Enhanced Performance-Based Tranche were replaced by targets with different financial metrics. These new targets require achievement of a minimum internal rate of return (IRR) and money on invested capital (MOIC) to be achieved by Blackstone following a complete liquidation of its investment in the Company’s capital stock. Both the IRR and MOIC requirements must be achieved or none of the options in the Enhanced Performance-Based Tranche will vest. Achievement of the IRR and MOIC targets will also result in vesting of the portion of the tranche related to the 2008 annual targets which did not vest at the end of 2008.
5. The terms described above will also apply to any new options awarded under the 2007 Incentive Stock Plan; provided, however, the Compensation Committee shall establish additional financial targets for succeeding years to allow for vesting of such options over a five year period.
The Options granted in 2008 to our executive officers and other members of management contain change-in-control provisions that cause the vesting of a portion of the tranches upon the occurrence of a change-in-control, as follows: 1) the Option shares in the Time-Based Tranche will become immediately exercisable upon the occurrence of a change-in-control if the optionee remains in continuous employment of the Company until the consummation of the change-in-control and 2) the Option shares of the Performance-Based Tranche for the year in which such change-in-control is consummated and for any subsequent performance periods will become immediately exercisable if the optionee remains in continuous employment of the Company until the consummation of the change-in-control. This provision does not operate to vest the Enhanced Performance-Based tranche which requires the achievement of the IRR and MOIC targets following a complete liquidation by Blackstone of its equity investment in the Company.
Other Benefits. Other benefits to the executive officers include a 401(k) plan,which covers the NEOs. We maintain this 401(k) plan for our employees, including our NEOs, because we wish to encourage our employees to save some percentage of their cash compensation, through voluntary deferrals, for their eventual retirement. We may, in our discretion, match employee deferrals. For the 2008 plan year, we made matching contributions equal to up to 50% of the first 6% of compensation deferred by employees (subject to Internal Revenue Service limits and non-discrimination testing). For the 2009 plan year, the employer contribution percentage will remain unchanged. DJO Opco maintains a non-qualified deferred compensation plan for its most senior management, and that plan may be made generally available to senior management of DJO. Under this non-qualified plan, an eligible executive may contribute up to 100% of his or her salary and bonuses to the plan, and the amounts are held in trust and invested in a portfolio of mutual funds which correspond to the funds available under the 401(k) plan. DJO Opco has the discretion to contribute matching contributions, but no such matching contributions have yet been made.
Benefits Upon Termination of Employment. As discussed more fully below in “Potential Payments Upon Termination or Change-in-Control,” prior to the DJO Merger, we entered into employment agreements with Mr. Baird and certain other former executive officers. All such employment agreements have terminated and none of the NEOs currently are parties to employment agreements with the Company. The Compensation Committee does not contemplate entering into employment agreements with the NEOs at this time. However, the current NEOs, who were former executives of DJO Opco, are parties to change-in-control severance agreements entered into prior to the DJO Merger that remain in effect. Under those severance agreements, the DJO Merger constituted a change-in-control event. As a result, in the event that an executive subject to such agreement is terminated without cause or terminates for good reason within two years of the DJO Merger, the executive will receive a severance benefit of 1.5 times (2 times in the case of Mr. Cross) the executive’s base salary and target bonus, plus extended health and life insurance benefits. These agreements also contain customary confidentiality and noncompetition covenants. The narrative and table included in “Potential Payments Upon Termination or Change-in-Control” reflects potential payments upon termination of employment of our NEOs.
The Tax and Accounting Considerations
Section 162(m) of the Internal Revenue Code of 1986, as amended, provides that compensation in excess of $1,000,000 paid to the CEO or to any of the other four most highly compensated executive officers of a public company will not be deductible for federal income tax purposes unless such compensation is paid pursuant to one of the enumerated exceptions set forth in Section 162(m). As a privately held company, we are no longer required to comply with Section 162 (m) to ensure tax deductibility of executive compensation.
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Summary Compensation Table
The following table sets forth summary information about the compensation during 2008, 2007 and 2006 for services rendered in all capacities by our Chief Executive Officer, Chief Financial Officer and each of our three other most highly compensated executive officers. Also included in the table below is information regarding Mr. Baird, who was not serving as an executive officer as of the end of 2008 but for whom disclosure would have been provided but for the fact that he was not serving as an executive officer as of the end of 2008. All of the individuals listed in the following table are referred herein collectively as the “Named Executive Officers” or “NEOs.”
Name and
Principal Position | | Year | | Salary (1) | | Bonus (2) | | Stock
Awards
(3) | | Option
Awards
(4) | | Non-Equity
Incentive
Plan
Compensation
(5) | | Change in
Pension Value
and
Nonqualified
Deferred
Compensation
Earnings | | All Other
Compensation
(6) | | Total $( ) | |
| | | | | | | | | | | | | | | | | | | |
Leslie H. Cross | | 2008 | | $ | 625,000 | | $ | 800,000 | | $ | — | | $ | 139,538 | | $ | 336,511 | | $ | — | | $ | 8,050 | | $ | 1,909,099 | |
Chief Executive Officer and
Director | | 2007 | | 60,135 | | 248,438 | | — | | 1,327,352 | | — | | — | | — | | 1,635,925 | |
| | | | | | | | | | | | | | | | | | | |
Vickie L. Capps | | 2008 | | 450,000 | | 800,000 | | — | | 114,681 | | 181,538 | | — | | 8,050 | | 1,554,269 | |
Executive Vice President, Chief Financial Officer and Treasurer | | 2007 | | 35,740 | | 118,125 | | — | | 703,687 | | — | | — | | — | | 857,552 | |
| | | | | | | | | | | | | | | | | | | |
Luke T. Faulstick | | 2008 | | 400,000 | | 700,000 | | — | | 101,939 | | 174,492 | | — | | 8,050 | | 1,384,481 | |
Executive Vice President and Chief Operating Officer | | 2007 | | 35,740 | | 118,125 | | — | | 544,766 | | — | | — | | — | | 698,631 | |
| | | | | | | | | | | | | | | | | | | |
Donald M. Roberts | | 2008 | | 300,000 | | 500,000 | | — | | 62,119 | | 145,400 | | — | | 8,050 | | 1,015,569 | |
Executive Vice President, General Counsel and Secretary | | 2007 | | 31,202 | | 103,125 | | — | | 568,066 | | — | | — | | — | | 702,393 | |
| | | | | | | | | | | | | | | | | | | |
Thomas A. Capizzi | | 2008 | | 270,000 | | 500,000 | | — | | 62,119 | | 94,504 | | — | | 8,050 | | 934,673 | |
Executive Vice President, Global Human Resources | | 2007 | | 31,250 | | 56,456 | | — | | — | | — | | — | | — | | 87,706 | |
| | | | | | | | | | | | | | | | | | | |
Peter W. Baird (7) | | 2008 | | 301,453 | | 200,000 | | (136,728 | ) | — | | — | | — | | 2,100,000 | | 2,464,725 | |
Former President | | 2007 | | 334,615 | | 200,000 | | 136,728 | | 208,380 | | — | | — | | 306,750 | | 1,186,473 | |
| | 2006 | | 69,231 | | 500,000 | | — | | 2,046,448 | | — | | — | | — | | 2,615,679 | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | |
(1) | | Except for Mr. Baird, amounts for the year ended 2007 represent salary earned from the date of the DJO Merger through December 31, 2007. Amounts for Mr. Baird for 2006 reflect his date of hire in October 2006. |
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(2) | | The amounts shown in this column for 2007 for all persons except Mr. Baird consist of bonuses that were paid during 2008 related to performance by DJO Opco under the 2007 DJO Opco bonus plan for the fourth quarter and full fiscal year. Amounts shown in this column for 2008 consist of retention bonuses which were entered into in November 2007 with each of our executive officers in connection with the DJO Merger, of which 50% of the retention bonus was paid in January 2008 and 50% was paid in January 2009 and were contingent upon the executive’s continued service through December 31, 2008. |
| | |
(3) | | The amount shown in this column for 2007 represents the dollar amount recognized in connection with stock awards for financial statement reporting purposes for the 2007 fiscal year in accordance with SFAS 123(R). This expense related to two restricted stock awards granted to Mr. Baird in 2007, consisting of an award of 15,189 shares of restricted stock in March 2007 and 24,300 shares of restricted stock in November 2007, vesting over time with the final vesting in November 2009 and January 2009, respectively. The amount shown in this column for 2008 represents the reversal of SFAS 123(R) expense in the amount of $136,728 in connection with the repurchase and cancellation, pursuant to Mr. Baird’s Separation Agreement and General Release, of these 39,489 shares of restricted stock that were granted in 2007. |
| | |
(4) | | Except as described further below, the amounts shown in this column represent the dollar amounts recognized for the 2008, 2007 and 2006 fiscal years for the fair value of stock options granted in those years as well as prior fiscal years in accordance with SFAS 123(R). Pursuant to SEC rules, the amounts shown exclude the impact of estimated forfeitures related to service-based vesting conditions. These amounts reflect our accounting expense and do not correspond to the actual value that will be realized by the NEOs. See Note 10 to the audited consolidated financial statements included in this Annual Report for a discussion of the relevant assumptions. The amounts for Mr. Baird in 2006 represent options granted under the 2006 Incentive Stock Plan in connection with his initial employment in October 2006. The amounts in 2007 for Messrs. Cross, Roberts and Faulstick and Ms. Capps represents the grant date fair value of the DJO Management Rollover Options, less the intrinsic value of vested DJO Opco options that each exchanged for the DJO Management Rollover Options in the following approximate amounts: Mr. Cross: $3.0 million, Ms. Capps: $2.0 million, Mr. Roberts: $1.0 million and Mr. Faulstick: $1.0 million. The amounts in 2007 for Baird represent amounts recognized in 2007 related to options granted in November 2006 in connection with the Prior Transaction that vested during 2007. Additional information regarding grants awarded in 2008 is presented in the “Grants of Plan Based Awards in 2008” table below. |
| | |
(5) | | The amounts shown in this column represent amounts earned in 2008 based on the results of the 2008 Bonus Plan, some of which was paid in 2009. |
| | |
(6) | | Perquisites and other personal benefits are valued on the basis of the aggregate incremental cost to the Company of such perquisites and other personal benefits. A breakdown of the amounts shown in this column for 2008 for each of the NEOs is set forth in the following table: |
For the Year Ended December 31, 2008
| | Mr. Cross | | Ms. Capps | | Mr. Faulstick | | Mr. Roberts | | Mr. Capizzi | | Mr. Baird | |
Severance (a) | | $ | — | | $ | — | | $ | — | | $ | — | | $ | — | | $ | 2,100,000 | |
401(k) matching contribution | | 8,050 | | 8,050 | | 8,050 | | 8,050 | | 8,050 | | — | |
Total | | $ | 8,050 | | $ | 8,050 | | $ | 8,050 | | $ | 8,050 | | $ | 8,050 | | $ | 2,100,000 | |
| | (a) | | Represents payments pursuant to the Separation Agreement and General Release entered into with Mr. Baird, consisting of $750,000 for provision of certain transition services and continued cooperation, $900,000 in satisfaction of employment and other agreements and rights under stock options and other equity grants, and payment of $450,000 in consideration of continued confidentiality and non-compete obligations. |
| | | | |
| | (7) | | Mr. Baird’s employment terminated effective August 2008. |
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Grants of Plan-Based Awards in 2008
The following table sets forth certain information with respect to grants of plan-based awards made to the NEOs during 2008.
| | | | Estimated Future Payouts Under Non-Equity | | Estimated Future Payouts Under Equity | | All Other | | | | | | | |
| | | | Incentive Plan Awards | | Incentive Plan Awards | | Stock | | All Other | | | | | |
| | | | | | | | | | | | | | | | Awards: | | Option | | Exercise | | | |
| | | | | | | | | | | | | | | | Number | | Awards: | | or Base | | | |
| | | | | | | | | | | | | | | | of Shares | | Number of | | Price of | | | |
| | | | | | | | | | | | | | | | of Stock | | Securities | | Option | | Grant Date Fair | |
| | | | Threshold | | Target | | Maximum | | Threshold | | Target | | Maximum | | or Units | | Underlying | | Awards | | Value of Option | |
Name | | Grant Date | | ($) | | ($) | | ($) | | (#) | | (#) | | (#) | | (#) | | Options (#) | | ($/Sh) | | Awards ($) (3) | |
Mr. Cross | | 1/1/2008 | (1) | $ | 150,000 | | $ | 375,000 | | $ | 750,000 | | — | | — | | — | | — | | — | | $ | — | | $ | — | |
| | 2/21/2008 | (2) | — | | — | | — | | 129,866 | | 162,333 | | 324,666 | | — | | 162,333 | | 16.46 | | 2,366,377 | |
| | | | | | | | | | | | | | | | | | | | | | | |
Ms. Capps | | 1/1/2008 | (1) | 108,000 | | 270,000 | | 540,000 | | — | | — | | — | | — | | — | | — | | — | |
| | 2/21/2008 | (2) | — | | — | | — | | 106,731 | | 133,414 | | 266,828 | | — | | 133,415 | | 16.46 | | 1,944,821 | |
| | | | | | | | | | | | | | | | | | | | | | | |
Mr. Faulstick | | 1/1/2008 | (1) | 96,000 | | 240,000 | | 480,000 | | — | | — | | — | | — | | — | | — | | — | |
| | 2/21/2008 | (2) | — | | — | | — | | 94,873 | | 118,591 | | 237,182 | | — | | 118,590 | | 16.46 | | 1,728,732 | |
| | | | | | | | | | | | | | | | | | | | | | | |
Mr. Roberts | | 1/1/2008 | (1) | 72,000 | | 180,000 | | 360,000 | | — | | — | | — | | — | | — | | — | | — | |
| | 2/21/2008 | (2) | — | | — | | — | | 57,813 | | 72,266 | | 144,532 | | — | | 72,266 | | 16.46 | | 1,053,443 | |
| | | | | | | | | | | | | | | | | | | | | | | |
Mr. Capizzi | | 1/1/2008 | (1) | 64,800 | | 162,000 | | 324,000 | | — | | — | | — | | — | | — | | — | | — | |
| | 2/21/2008 | (2) | — | | — | | — | | 57,813 | | 72,266 | | 144,532 | | — | | 72,266 | | 16.46 | | 1,053,443 | |
| | | | | | | | | | | | | | | | | | | | | | | |
Mr. Baird | | 1/1/2008 | (1) | 72,000 | | 180,000 | | 360,000 | | — | | — | | — | | — | | — | | — | | — | |
| | 2/21/2008 | (2) | — | | — | | — | | 102,982 | | 128,727 | | 257,454 | | — | | 128,728 | | 16.46 | | 2,316,495 | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | |
(1) | | The amounts set forth in these rows under the column “Estimated Future Payouts Under Non-Equity Incentive Plan Awards” represent the threshold, target and maximum bonus potential under the 2008 Bonus Plan. See discussion of “Target Bonus” and “Supplemental Bonus” in “Compensation Discussion and Analysis” above for a description of the vesting conditions for the 2008 Bonus Plan. |
| | |
(2) | | The share amounts set forth in these rows under the column “Estimated Future Payouts under Equity Incentive Plan Awards” represent the Performance- Based and Enhanced Performance-Based Tranches of the options granted to the NEOs in February 2008, with the “Threshold” amounts representing 80% of the Performance-Based Tranche, the “Target” amount representing the Performance-Based Tranche and the “Maximum” amount representing the sum of the Performance-Based Tranche and the Enhanced Performance-Based Tranches. The share amounts set forth in these rows under the column “All Other Option Awards” represent the “Time-Based Tranche” of the options granted to the NEOs in February 2008. See “Compensation Discussion and Analysis — The Elements of Our Compensation Program — Equity Compensation” for a description of the vesting conditions for these options. |
| | |
(3) | | The grant date fair value is the value of awards granted in 2008 as determined in accordance with SFAS 123(R). |
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Outstanding Equity Awards at 2008 Fiscal Year-End
The following table sets forth certain information regarding options held by each of the NEOs as of December 31, 2008. There were no stock awards outstanding as of December 31, 2008.
| | Option Awards | |
| | Number of
Securities
Underlying
Unexercised
Options
(#) Exercisable | | Number of
Securities
Underlying
Unexercised
Options
(#) Unexercisable
(3) | | Equity Incentive
Plan Awards:
Number of
Securities
Underlying
Unexercised
Unearned Options
(#) (4) | | Option
Exercise Price
($) | | Option
Expiration Date | |
| | | | | | | | | | | |
Leslie H. Cross | | 40,584 | (1) | 121,749 | | 243,498 | | 16.46 | | 2/21/2018 | |
| | 213,700 | (2) | — | | — | | 13.10 | | 5/12/2017 | |
| | 82,427 | (2) | — | | — | | 12.91 | | 4/3/2016 | |
| | 193,254 | (2) | — | | — | | 8.29 | | 12/9/2013 | |
| | 43,351 | (2) | — | | — | | 7.00 | | 12/8/2014 | |
| | 573,316 | | 121,749 | | 243,498 | | | | | |
| | | | | | | | | | | |
Vickie L. Capps | | 33,354 | (1) | 100,061 | | 200,120 | | 16.46 | | 2/21/2018 | |
| | 91,586 | (2) | — | | — | | 13.10 | | 5/12/2017 | |
| | 48,846 | (2) | — | | — | | 12.91 | | 4/3/2016 | |
| | 91,585 | (2) | — | | — | | 8.29 | | 12/9/2013 | |
| | 76,321 | (2) | — | | — | | 7.00 | | 12/8/2014 | |
| | 5,343 | (2) | — | | — | | 7.18 | | 2/26/2014 | |
| | 347,035 | | 100,061 | | 200,120 | | | | | |
| | | | | | | | | | | |
Luke T. Faulstick | | 29,648 | (1) | 88,942 | | 177,886 | | 16.46 | | 2/21/2018 | |
| | 91,586 | (2) | — | | — | | 13.10 | | 5/12/2017 | |
| | 48,846 | (2) | — | | — | | 12.91 | | 4/3/2016 | |
| | 45,792 | (2) | — | | — | | 8.29 | | 12/9/2013 | |
| | 10,032 | (2) | — | | — | | 7.00 | | 12/8/2014 | |
| | 225,904 | | 88,942 | | 177,886 | | | | | |
| | | | | | | | | | | |
Donald M. Roberts | | 18,067 | (1) | 54,199 | | 108,398 | | 16.46 | | 2/21/2018 | |
| | 91,586 | (2) | — | | — | | 13.10 | | 5/12/2017 | |
| | 48,846 | (2) | — | | — | | 12.91 | | 4/3/2016 | |
| | 30,528 | (2) | — | | — | | 8.84 | | 5/25/2015 | |
| | 35,080 | (2) | — | | — | | 8.29 | | 12/9/2013 | |
| | 224,107 | | 54,199 | | 108,398 | | | | | |
| | | | | | | | | | | |
Tom Capizzi | | 18,067 | (1) | 54,199 | | 108,398 | | 16.46 | | 2/21/2018 | |
| | 18,067 | | 54,199 | | 108,398 | | | | | |
| | | | | | | | | | | |
Peter W. Baird (5) | | — | | — | | — | | — | | — | |
(1) | | These amounts reflect the number of shares underlying the “Time-Based Tranche” of options that are vested and exercisable that were granted in 2008 under the 2007 Stock Incentive Plan. These options represent 25% of the options granted in 2008 and became vested and exercisable on December 31, 2008. |
| | |
(2) | | These amounts reflect the number of shares underlying the DJO Management Rollover Options which were fully vested upon issuance in connection with the DJO Merger. |
| | |
(3) | | The amounts set forth in this column reflect the number of shares underlying the “Time-Based Tranche” of options that are not vested and not exercisable that were granted in 2008 under the 2007 Stock Incentive Plan. These options represent the remaining 75% of the grant made in 2008 and vest as follows: 20% of the original grant vest on December 31, 2009, 18.33% of the original grant vest on December 31, 2010 and 2011, and 18.34% of the original grant vest on December 31, 2012. |
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| | |
(4) | | The amounts set forth in this column reflect the number of shares underlying the “Performance-Based Tranche” of options that have not been earned (i.e., their performance conditions have not been satisfied) that were granted in 2008 under the 2007 Incentive Stock Plan. These options vest on December 31, 2009-2012 in the same percentages as the Time-Based Tranche of options if the performance requirements are achieved for such years. See “Compensation Discussion and Analysis — The Elements of our Executive Compensation Program — Equity Compensation” for further information regarding the vesting of these options. These amounts exclude the 25% of the “Performance-Based Tranche” and the “Enhanced Performance-Based Tranche” of options that did not vest on December 31, 2008 and cannot be earned in the future due to the failure to meet the 2008 performance targets. |
| | |
(5) | | Mr. Baird’s employment terminated in August 2008 and all restricted stock and all options were cancelled pursuant to the terms of his Separation Agreement and General Release. |
Option Exercises and Stock Vested During 2008
No options were exercised and no stock vested during the year ended December 31, 2008 for our NEOs.
Non-Qualified Deferred Compensation for 2008
Certain executives may defer receipt of part or all of their cash compensation under the DJO, LLC Executive Deferred Compensation Plan (the “Deferred Plan”), a plan established by DJO, LLC, a subsidiary of DJO Opco. The Deferred Plan allows executives to save for retirement in a tax-effective way at minimal cost to DJO, LLC. Under this program, amounts deferred by the executive are deposited into a trust for investment and eventual benefit payment. The obligations of DJO, LLC under the Deferred Plan are unsecured obligations to pay deferred compensation in the future from the assets of the trust. Participants will have the status of unsecured general creditors with respect to the benefit obligations of the Deferred Plan, and the assets set aside in the trust for those benefits will be available to creditors of DJO, LLC in the event of bankruptcy or insolvency. Each participant may elect to defer under the Deferred Plan all or a portion of his or her cash compensation that may otherwise be payable in a calendar year. A participant’s compensation deferrals are credited to the participant’s account under the Deferred Plan and the trust. Each participant may elect to have the amounts in such participant’s account invested in one or more investment options available under the Deferred Plan, which investment options are substantially the same investment options available to participants in DJO, LLC’s 401(k) Savings Plan. The Deferred Plan also permits DJO, LLC to make contributions to the Deferred Plan, including matching contributions, at its discretion, but no such contributions have been made to date. To the extent that Company contributions are made to the Deferred Plan, the Committee may impose vesting criteria to aid in the employment retention of participants. A participant’s eventual benefit will depend on his or her level of contributions, DJO, LLC’s contributions, if any, and the investment performance of the particular investment options selected. The following table sets forth information for each of the Named Executive Officers who participated in DJO, LLC’s Nonqualified Deferred Compensation Plan during 2008.
Name | | Executive
Contributions
in Last
Fiscal Year(1) | | Registrant
Contributions
in Last Fiscal Year | | Aggregate
Earnings/
(Losses)
in Last
Fiscal Year | | Aggregate
Withdrawals/
Distributions | | Aggregate
Balance at Last
Fiscal Year | |
Donald M. Roberts | | $ | 54,792 | | $ | — | | $ | (33,721 | ) | $ | — | | $ | 69,940 | |
| | | | | | | | | | | | | | | | |
(1) | | Amounts deferred by the executive under the Deferred Plan have been reported as 2008 compensation to such executive in the “Salary” column in the Summary Compensation Table above. Amounts in the aggregate balance include amounts earned as compensation prior to the DJO Merger when Mr. Roberts was an executive officer of DJO Opco. |
Potential Payments Upon Termination or Change-in-Control
DJO entered into an Employment Agreement with Mr. Baird in October 2006 which provided for certain payments and other benefits if his employment terminated under specific circumstances. In August 2008, DJO entered into a Separation Agreement and General Release with Mr. Baird which provided for a severance payment of $2.1 million, all as described in more detail in footnote (a) to Footnote (6) of the “Summary Compensation Table” above.
In September 2007, DJO Opco entered into change-in-control severance agreements (the “Change-in-Control Agreements”) with Mr. Cross, Ms. Capps, Mr. Faulstick, Mr. Capizzi, and Mr. Roberts. Following a change-in-control, the Change-in-Control Agreements remain in effect for a period of two years. The DJO Merger constituted a change-in-control for purposes of these Change-in-Control Agreements. Pursuant to the Change-in-Control Agreements, if the NEO’s employment is terminated “without cause” or by such executive’s resignation for “good reason” (as such terms are defined in the Change-in-Control Agreements), in each case within two years after the DJO Merger, the executive is entitled, in addition to accrued salary and bonus and related benefits, to the following benefits:
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(1) A lump sum payment equal to the sum of the executive’s highest annual rate of base salary during the 12 month period preceding the termination date multiplied by 1.5 (or 2 in the case of Mr. Cross), plus (a) the executive’s aggregate annual target bonus for the year of termination; and (b) a pro rata portion of the executive’s aggregate annual target bonus for the portion of the year of termination during which the executive served as an employee, less any amounts paid from our annual incentive plan for the year of termination;
(2) A lump sum cash payment of an amount equal to (a) 18 (or 24 in the case of Mr. Cross), multiplied by (b) the amount by which the monthly premium the executive would be required to pay for continued coverage pursuant to COBRA, for such executive and his or her eligible dependents covered under our health plans as of the termination date, exceeds the contributions required by the executive immediately prior to the termination date; and
(3) A lump sum cash payment of an amount equal to (a) 18 (or 24 in the case of Mr. Cross), multiplied by (b) the amount by which the total monthly premium paid for accidental death and dismemberment and life insurance coverage as of the termination date exceeds the contributions required by the executive immediately prior to the termination date.
Pursuant to the Change-in-Control Agreements, the termination of employment as a result of the death or disability of the executive is not considered a qualifying termination and does not result in the payment of the amounts described above other than the accrued salary and related benefits the executive would be entitled to absent the Change-in-Control Agreements. As a condition to receiving the severance benefits under the Change-in-Control Agreements, an executive must execute a waiver and release of any claims he or she may have against DJO Opco. The Change-in-Control Agreements also provide that during the term of the agreement and for a period of two years following any qualifying termination, the executive will not solicit any customer of DJO Opco or its subsidiaries and not solicit any employee of DJO Opco or its subsidiaries.
The Options granted in February 2008 to our executive officers and other members of management contain change-in-control provisions that cause the vesting of a portion of the tranches upon the occurrence of a change-in-control, as follows: 1) the Option shares in the Time-Based Tranche will become immediately exercisable upon the occurrence of a change-in-control if the optionee remains in continuous employment of the Company until the consummation of the change-in-control and 2) the Option shares of the Performance-Based Tranche and the Enhanced Performance-Based Tranche for the year in which such change-in-control is consummated and for any subsequent performance periods will become immediately exercisable if the optionee remains in continuous employment of the Company until the consummation of the change-in-control.
The following table shows the amount of potential cash payments and the value of other severance benefits each of the NEOs would be entitled to if his or her employment were terminated “without cause” or if he or she resigned for “good reason” as of December 31, 2008:
Name | | Base
Salary Payment
($) | | Bonus
Payment
($) | | Health
Benefits ($) | | Life and Accidental
Death &
Dismemberment
Benefits
($) | | Total ($) | |
Leslie H. Cross | | $ | 1,250,000 | | $ | 750,000 | | $ | 16,100 | | $ | 1,908 | | $ | 2,018,008 | |
Vickie L. Capps | | 675,000 | | 540,000 | | 12,075 | | 851 | | 1,227,926 | |
Luke T. Faulstick | | 600,000 | | 480,000 | | 12,075 | | 851 | | 1,092,926 | |
Donald M. Roberts | | 450,000 | | 360,000 | | 12,075 | | 743 | | 822,818 | |
Tom Capizzi | | 405,000 | | 324,000 | | 12,075 | | 743 | | 741,818 | |
| | | | | | | | | | | | | | | | |
Compensation of Directors
The Compensation Committee of the DJO Board reviews the compensation of our Directors on an annual basis. Until December 4, 2008, our Board of Directors consisted of seven persons: 1) Chinh E. Chu 2) Julia Kahr, 3) Bruce McEvoy, 4) Sidney Braginsky, 5) Kenneth W. Davidson, 6) Leslie H. Cross, and 7) Paul D. Chapman. In January 2009, Mr. Davidson and Mr. Chapman resigned from the Board of Directors and Phillip Hildebrand, Lesley Howe and Paul LaViolette were appointed to the Board of Directors in their place. Mr. Kahr, Mr. Chu, and Mr. McEvoy, are affiliated with Blackstone and are not compensated for serving as members of our Board of Directors.
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During the first two quarters of 2008, the standard compensation package for directors who are not employed by the Company or by any Blackstone-controlled entity (“Eligible Directors”), namely Messrs. Davidson, Braginsky and Chapman, consisted of an annual fee for each such director, a per meeting fee and stock option grants. As Chairman of the Board, Mr. Davidson was entitled to receive an annual fee of $60,000 and Messrs. Braginsky and Chapman received an annual fee of $50,000. Mr. Braginsky also was entitled to receive a $10,000 fee for his services as Audit Committee Chairman during 2008 and a meeting fee of $1,500 per day for attending Board meetings. The Eligible Directors were also eligible for annual option awards under the 2007 Incentive Stock Plan. In February 2008, the Compensation Committee awarded Messrs. Davidson, Braginsky and Chapman options to purchase 1,500 shares of Common Stock with an exercise price of $16.46 per share, which was determined to be the fair market value of such shares on the date of grant. One-third of these options were scheduled to vest on each anniversary of the date of grant and any shares issued on exercise of such options will be subject to the Management Stockholders Agreement. In May 2008, the Compensation Committee approved changes to the director compensation program, effective as of the beginning of the third quarter, increasing the annual retainer payable to the Eligible Directors to $75,000, providing for an annual retainer of $25,000 to the Chairman of the Board and to the Chairman of the Audit Committee and providing for an annual retainer of $15,000 to the other Eligible Directors who are members of the Audit Committee. In August 2008, the Compensation Committee awarded options to purchase 4,600 shares to each of Messrs. Davidson, Braginsky and Chapman with the same exercise price and vesting schedule. Effective upon their resignations in January 2009, all unvested options issued to Messrs. Davidson and Chapman terminated and the Compensation Committee approved an amendment to their outstanding vested options to provide that such options would continue in effect until their original exercise date and not terminate early due to the terminations of Messrs. Davidson and Chapman as directors.
The following table sets forth the compensation earned by our non-employee directors for their services in 2008:
| | Directors Compensation for 2008 | |
Name | | Fees
Earned or
Paid in
Cash
($) | | Stock
Awards ($) | | Option
Awards
($) (1) | | Non-Equity
Incentive Plan
Compensation
($) | | Change in
Pension Value
and
Nonqualified
Deferred
Compensation
Earnings | | All Other
Compensation
($) | | Total ($) | |
Chinh E. Chu | | $ | — | | $ | — | | $ | — | | $ | — | | $ | — | | $ | — | | $ | — | |
Julia Kahr | | — | | — | | — | | — | | — | | — | | — | |
Sidney Braginsky (2) | | 81,500 | | — | | 4,171 | | — | | — | | — | | 85,671 | |
Bruce McEvoy | | — | | — | | — | | — | | — | | — | | — | |
Kenneth W. Davidson | | 80,000 | | — | | 4,171 | | — | | — | | — | | 84,171 | |
Paul D. Chapman | | 65,500 | | — | | 4,171 | | — | | — | | — | | 69,671 | |
| | | | | | | | | | | | | | | | | | | | | | |
(1) | | Amounts shown for the option awards to Messrs. Davidson, Chapman, and Braginsky reflect the dollar value recognized in connection with the option awards for financial statement purposes for fiscal 2008 in accordance with SFAS 123(R). Pursuant to SEC rules, the amounts shown exclude the impact of estimated forfeitures related to service-based vesting conditions. The full grant date fair value of stock options granted to Messrs. Davidson, Chapman and Braginsky during the fiscal year ended December 31, 2008 was $22,767 for each as computed in accordance with FAS 123(R). A discussion of the relevant assumptions used in the valuation is contained in Note 10 to our audited consolidated financial statements contained in this Annual Report. As of December 31, 2008, Messrs. Davidson, Chapman and Braginsky had a total of 313,075, 137,175, and 6,850 stock options outstanding, respectively. |
| | |
(2) | | Messrs. Davidson and Chapman resigned as directors in January 2009. |
Compensation Committee Interlocks and Insider Participation
During 2008, our Compensation Committee consisted of three designees of Blackstone, Mr. Chu, Ms. Kahr and Mr. McEvoy. None of the members of the Compensation Committee is or have been an officer or employee of DJO. See “Item 13. Certain Relationships and Related Transactions, and Director Independence” below for a description of certain agreements with Blackstone. None of our executive officers has served as a director or a member of the compensation committee (or other committee serving an equivalent function) of any other entity, which has one or more executive officers serving as a director of DJO or member of our Compensation Committee.
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Compensation Committee Report
The Compensation Committee of the DJO Board of Directors oversees our company’s compensation program on behalf of the Board. In fulfilling its oversight responsibilities, the Compensation Committee reviewed and discussed with management the Compensation Discussion and Analysis set forth in this Annual Report. Based upon the review and discussions referred to above, the Compensation Committee recommended to the DJO Board that the Compensation Discussion and Analysis be included in this Annual Report.
Submitted by the Compensation Committee:
Chinh E. Chu (Chair)
Julia Kahr
Bruce McEvoy
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
DJOFL is a wholly owned subsidiary of DJO, which owns all of our issued and outstanding capital stock. The following table sets forth as of March 11, 2009, certain information regarding the beneficial ownership of the voting securities of DJO by each person who beneficially owns more than five percent of DJO’s common stock, and by each of the directors and NEOs of DJO, individually, and by our directors and executive officers as a group.
| | |
| | Aggregate Number of Shares Beneficially Owned (1) | |
Name and Address of Beneficial Owner | | Number of Issued
Shares | | Acquirable within
60 days (2) | | Percent of Class | |
Grand Slam Holdings, LLC (3) | | 48,098,209 | | — | | 98.82 | % |
Directors and Executive Officers | | | | | | | |
Leslie H. Cross
President, Chief Executive Officer and Director | | — | | 573,316 | | 1.16 | % |
Vickie L. Capps
Executive Vice President, Chief Financial Officer and Treasurer | | — | | 347,035 | | | |
Donald M. Roberts,
Executive Vice President, General Counsel and Secretary | | — | | 224,107 | | | * |
Luke T. Faulstick
Executive Vice President and Chief Operating Officer | | — | | 225,904 | | | * |
Tom Capizzi
Executive Vice President, Global Human Resources | | — | | 18,067 | | | * |
Chinh E. Chu
Chairman of the Board (4) | | 48,098,209 | | — | | 98.82 | % |
Julia Kahr
Director (5) | | — | | — | | — | |
Sidney Braginsky
Director | | — | | 1,495 | | | * |
Bruce McEvoy
Director (5) | | — | | — | | — | |
Phillip J. Hildebrand
Director (5) | | — | | — | | — | |
Lesley Howe
Director | | — | | — | | — | |
Paul LaViolette
Director | | — | | — | | — | |
Peter W. Baird
Former President | | — | | — | | — | |
All Directors and executive officers as a group | | 48,098,209 | | 1,389,924 | | 98.85 | % |
* Less than 1%
(1) | | Includes shares held in the beneficial owner’s name or jointly with others, or in the name of a bank, nominee or trustee for the beneficial owner’s account. Unless otherwise indicated in the footnotes to this table and subject to community property laws where applicable, we believe that each stockholder named in this table has sole voting and investment power with respect to the shares indicated as beneficially owned. |
| | |
(2) | | Includes the number of shares that could be purchased by exercise of options on or within 60 days after March 11, 2009 under DJO’s stock option plans. For the NEOs, this number includes the “DJO Management Rollover Options” which are fully vested and the portion of the “Time-Based Tranche” of options that have vested or will vest in 60 days, but no portion of the “Performance-Based Tranche” or “Enhanced Performance-Based Tranche.” |
| | |
(3) | | Shares of common stock of DJO held by Grand Slam Holdings, LLC (“BCP Holdings”) may also be deemed to be beneficially owned by the following entities and persons: (i) Blackstone Capital Partners V L.P., a Delaware limited partnership (“BCP V”), Blackstone Family Investment Partnership V L.P., a Delaware limited partnership (“BFIP”), Blackstone Family Investment Partnership V-A L.P., a Delaware limited partnership (“BFIP-A”), and Blackstone Participation Partnership V L.P., a Delaware limited partnership (together with BCP V, BFIP and BFIP-A, the |
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| | “Blackstone Partnerships”), which collectively own all of the equity in BCP Holdings; (ii) Blackstone Management Associates V L.L.C., a Delaware limited liability company (“BMA”), the general partner of the Blackstone Partnerships; (iii) BMA V L.L.C., a Delaware limited liability company (“BMA V”), the sole member of BMA; and (iv) Peter G. Peterson and Stephen A. Schwarzman, the founding members and controlling persons of BMA V. Each of Messrs. Peterson and Schwarzman disclaims beneficial ownership of such shares, except to the extent of his pecuniary interest therein. The address of BCP Holdings and each of the entities and individuals listed in this footnote is c/o The Blackstone Group, L.P., 345 Park Avenue, New York, New York 10154. |
| | |
(4) | | Mr. Chu, a director of DJO, is a member of BMAV and a senior managing director of The Blackstone Group, L.P. The number of shares disclosed for Mr. Chu are also included in the above table in the number of shares disclosed for “Grand Slam Holdings, LLC.” Mr. Chu disclaims beneficial ownership of any shares owned or controlled by BMA V, except to the extent of his pecuniary interest therein. |
| | |
(5) | | Ms. Kahr and Mr. McEvoy are employees of The Blackstone Group, L.P. but do not have any investment or voting control over the shares beneficially owned by BCP Holdings. |
Securities Authorized for Issuance Under Equity Compensation Plans
The following table provides information as of December 31, 2008 with respect to the number of shares to be issued upon the exercise of outstanding stock options under our 2007 Incentive Stock Plan, which is our only equity compensation plan and has been approved by the stockholders:
Plan Category | | (a) Number of
securities to be
issued upon
exercise of
outstanding
options, warrants
and rights | | Weighted-average
exercise price of
outstanding
options, warrants
and rights | | Number of securities
remaining available for
future issuance under
equity compensation plans
(excluding securities
reflected in column (a)) | |
Equity compensation plans approved by stockholders | | 6,074,914 | | 14.46 | | 1,425,086 | |
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
Management Stockholder’s Agreement
Certain members of DJO’s management are parties to DJO’s Management Stockholders Agreement, dated November 3, 2006, among DJO, Grand Slam Holdings, LLC (“BCP Holdings”), Blackstone Capital Partners V L.P. (“Blackstone”), certain of its affiliates, and such members of DJO’s management and current executive officers (the “Management Stockholders Agreement”). In conjunction with the DJO Merger, certain incoming executives of DJO (the “new management stockholders”) have become parties to the Management Stockholders Agreement on the same terms and conditions as set forth therein, subject to the following exceptions, which by amendment (the “Amendment”) will apply only to the new management stockholders and any other persons becoming a party thereto after November 20, 2007. The Management Stockholders Agreement currently provides that if a management stockholder voluntarily resigns from DJO for any reason other than “good reason” (as defined in the Management Stockholders Agreement) and a Blackstone Parent Stockholder exercises its call rights after such termination, the management stockholder would receive the lower of fair market value or “cost” for the management stockholder’s callable shares. The Amendment provides that, unless a new management stockholder was terminated by DJO for “cause” (as defined in the Amendment) or unless the new management stockholder voluntarily terminated employment and such termination would have constituted a termination for “cause” if it would have been initiated by DJO, such new management stockholder would receive fair market value for such new management stockholder’s shares callable upon the exercise of a call right.
The Management Stockholders Agreement imposes significant restrictions on transfers of shares of DJO’s common stock held by management stockholders and provides a right of first refusal to DJO (or Blackstone), if DJO fails to exercise such right) on any proposed sale of DJO’s common stock held by a management stockholder following the lapse of the transfer restrictions and prior to the occurrence of a ‘‘qualified public offering’’ (as such term is defined in that agreement) of DJO. In addition, prior to a qualified public offering, Blackstone will have drag-along rights, and management stockholders will have tag-along rights, in the event of a sale of DJO’s common stock by Blackstone to a third party (or in the event of a sale of BCP Holdings’ equity interests to a third party) in the same proportion as the shares or equity interests sold by Blackstone. If, prior to either the lapse of the transfer restrictions or a qualified public offering, a management stockholder’s employment is terminated, DJO will have the right to repurchase all shares of its common stock held by such management stockholder for a period of one year from the date of termination of employment (or the until the date that is one year following the exercise of the stock options used to acquire such common stock, if later). If DJO does not exercise this repurchase right during the applicable repurchase period, then Blackstone will generally have the right to repurchase such shares for a period of 30 days thereafter. The Management Stockholders Agreement also provides that, after the occurrence of a qualified public offering, the management stockholders will receive customary piggyback registration rights with respect to shares of DJO common stock held by them.
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On December 13, 2006, DJO, BCP Holdings, Blackstone and certain of its affiliates entered into a stockholders agreement with Sidney Braginsky, one of DJO’s directors. The terms and conditions of the stockholders agreement with Mr. Braginsky are the same, in all material respects, as the management stockholders agreement described above.
Transaction and Monitoring Fee Agreement
In connection with the DJO Merger, on November 20, 2007, DJO and Blackstone Management Partners V L.L.C. (“BMP”) amended and restated the transaction and monitoring fee agreement in existence at that time (the “Old Transaction and Monitoring Fee Agreement”) between them, with effect from and after the closing of the DJO Merger (such agreement, as amended and restated, the “New Transaction and Monitoring Fee Agreement”).
Under the New Transaction and Monitoring Fee Agreement, DJO paid BMP, at the closing of the DJO Merger, a $15.0 million transaction fee and $0.6 million for related expenses. Also pursuant to this agreement, at the closing of the DJO Merger, DJO paid Blackstone Advisory Services, L.P., an affiliate of BMP (“BAS”), a $3.0 million advisory fee in consideration of the provision of certain strategic and other advice and assistance by BAS on behalf of BMP.
Under the New Transaction and Monitoring Fee Agreement, BMP (including through its affiliates and representatives) will continue to provide certain monitoring, advisory and consulting services to DJO, on substantially the same terms and conditions as the Old Transaction and Monitoring Fee Agreement, for an annual monitoring fee which has been increased from $3.0 million to the greater of $7.0 million or 2.0% of consolidated EBITDA (as defined in the New Transaction and Monitoring Fee Agreement).
The New Transaction and Monitoring Fee Agreement also provides, on substantially the same terms and conditions as the Old Transaction and Monitoring Fee Agreement, that:
· at any time in connection with or in anticipation of a change of control of DJO, a sale of all or substantially all of its assets or an initial public offering of common stock of DJO or its successor, BMP may elect to receive, in lieu of remaining annual monitoring fee payments, a single lump sum cash payment equal to the then-present value of all then-current and future annual monitoring fees payable under the agreement, assuming a hypothetical termination date of the agreement to be the twelfth anniversary of such election;
· the New Transaction and Monitoring Fee Agreement will continue until the earlier of the twelfth anniversary of the date of the agreement or such date as DJO and BMP may mutually agree; and
· DJO will indemnify BMP and its affiliates, and their respective partners, members, shareholders, directors, officers, employees, agents and representatives from and against all liabilities relating to the services performed under the Old Transaction and Monitoring Fee Agreement or by the New Transaction and Monitoring Fee Agreement and the engagement of BMP pursuant to, and the performance of BMP and its affiliates and their respective representatives of the services contemplated by, each such agreement.
Policy and Procedures with Respect to Related Person Transactions
The Board of Directors has not adopted a formal written policy for the review and approval of transactions with related persons. However, all such transactions will be reviewed by the Board on an as-needed basis.
Director Independence
As a privately held company, the DJO Board is not required to have a majority of its directors be independent. We believe that Messrs. Braginsky, Howe and LaViolette would be deemed independent directors according to the independence definition promulgated under the New York Stock Exchange listing standards.
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES
Fees Paid to the Independent Auditor
The following table sets forth the aggregate fees billed by Ernst & Young LLP for audit services rendered in connection with the consolidated financial statements and reports for fiscal years 2008 and 2007 and for other services rendered during fiscal years 2008 and 2007 on behalf of DJO and its subsidiaries, as well as all out-of-pocket costs incurred
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in connection with these services, which have been billed to DJO. All audit and audit related services were pre-approved by the audit committee.
| | 2008 | | 2007 | |
| | | | | |
Audit fees | | $ | 1,276,123 | | $ | 2,282,000 | |
Audit-related fees | | 31,245 | | 44,000 | |
Tax fees | | — | | — | |
All other fees | | — | | — | |
| | | | | | | |
Audit Fees: Consists of fees billed for professional services rendered for the audit of DJO’s consolidated financial statements, review of interim condensed consolidated financial statements included in quarterly reports and services that are normally provided by auditors in connection with statutory and regulatory filings. In 2008, audit fees included fees related to the registration of the 10.875% Notes issued in connection with the DJO Merger. In 2007, audit fees included audit services provided in connection with the offering memorandum related to the issuance of 10.875% Notes issued in connection with the DJO Merger and related to the registration of the 11.75% Notes issued in connection with the Prior Transaction.
Audit-Related Fees: Consists of fees billed for assurance and related services that are reasonably related to the performance of the audit or review of DJO’s consolidated financial statements and are not reported under “Audit Fees”. During 2008 and 2007 all audit-related fees were specifically pre-approved pursuant to the Audit Committee Pre-Approval Policy discussed below.
Tax Fees: Consists of tax compliance and consultation services. There were no tax fees in 2008 and 2007.
All Other Fees: Consists of fees for all other services other than those reported above. There were no other fees in 2008 and 2007.
Audit Committee Pre-Approval Policy
All services to be performed for us by our independent auditors must be pre-approved by the audit committee, or a designated member of the audit committee, to assure that the provision of such services does not impair the auditor’s independence.
The annual audit services engagement terms and fees are subject to the specific pre-approval of the audit committee. The audit committee will approve, if necessary, any changes in terms, conditions, and fees resulting from changes in audit scope or other matters. All other audit services not otherwise included in the annual audit services engagement must be specifically pre-approved by the audit committee.
Audit-related services are services that are reasonably related to the performance of the audit or review of our financial statements or traditionally performed by the independent auditors. Examples of audit-related services include employee benefit and compensation plan audits, due diligence related to mergers and acquisitions, attestations by the auditors that are not required by statute or regulation, consulting on financial accounting/reporting standards and internal controls, and consultations related to compliance with Section 404 of the Sarbanes-Oxley Act of 2002. All audit-related services must be specifically pre-approved by the audit committee.
The audit committee may grant pre-approval of other services that are permissible under applicable laws and regulations and that would not impair the independence of the auditors. All of such permissible services must be specifically pre-approved by the audit committee.
Requests or applications for the independent auditors to provide services that require specific approval by the audit committee are considered after consultation with management and the auditors. Questions about whether the scope of a proposed service requires specific pre-approval, or is permitted by applicable laws and regulations, are to be referred to our legal department.
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PART IV
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES
(a) The following documents are filed as part of this Annual Report:
1. The following consolidated financial statements of DJO Finance LLC, including the reports thereon of Ernst & Young LLP and KPMG LLP, are filed as part of this report under Part II, Item 8. Financial Statements and Supplementary Data:
· Reports of Independent Registered Public Accounting Firms.
· Consolidated Balance Sheets as of December 31, 2008 and 2007.
· Consolidated Statements of Operations for the Successor years ended December 31, 2008 and 2007 and for the period November 4, 2006 through December 31, 2006 and for the Predecessor period January 1, 2006 through November 3, 2006.
· Consolidated Statements of Changes in Membership Equity and Comprehensive Loss for the Successor years ended December 31, 2008 and 2007 and for the period November 4, 2006 through December 31, 2006.
· Consolidated Statements of Changes in Stockholders’ Equity and Comprehensive Income (Loss) for the Predecessor period January 1, 2006 through November 3, 2006.
· Consolidated Statements of Cash Flows for the Successor years ended December 31, 2008 and 2007 and for the period November 4, 2006 through December 31, 2006 and for the Predecessor period January 1, 2006 through November 3, 2006.
· Notes to Audited Consolidated Financial Statements.
2. Financial Statement Schedules:
Schedule II – Valuation and Qualifying Accounts
All other financial statement schedules are not required under the related instructions or are inapplicable and therefore have been omitted.
3. Exhibits:
2.1 | | Agreement and Plan of Merger, dated as of July 15, 2007, among DJO Finance LLC (f/k/a ReAble Therapeutics Finance LLC) (“DJOFL”), Reaction Acquisition Merger Sub, Inc., and DJO Opco Holdings Inc. (f/k/a DJO Incorporated) (“DJO Opco”) (incorporated by reference to Exhibit 2.1 to DJOFL’s Current Report on Form 8-K, filed on July 20, 2007). |
| | |
3.1 | | Certificate of Formation of DJOFL and amendments thereto (incorporated by reference to Exhibit 3.1 to DJOFL’s Annual Report on Form 10-K for the fiscal year ended December 31, 2007). |
| | |
3.2 | | Limited Liability Company Agreement of DJOFL (incorporated by reference to Exhibit 3.2 of DJOFL’s Registration Statement on Form S-4, filed on April 18, 2007 (File No. 333-142188)). |
| | |
4.1 | | Indenture, dated as of November 3, 2006, among DJOFL, DJO Finance Corporation (f/k/a Encore Medical Finance Corp. and ReAble Therapeutics Finance Corporation) (“DJO Finco”), the Guarantors named therein and The Bank of New York as Trustee, governing the 113/4 Senior Subordinated Notes (incorporated by reference to Exhibit 4.1 of DJOFL’s Registration Statement on Form S-4, filed on April 18, 2007 (File No. 333-142188)). |
| | |
4.2 | | Registration Rights Agreement, dated as of November 3, 2006, by and among DJOFL, DJO Finco, the Guarantors named therein, Banc of America Securities LLC and Credit Suisse Securities (USA) LLC (incorporated by reference to Exhibit 4.2 of DJOFL’s Registration Statement on Form S-4, filed on April 18, 2007 (File No. 333-142188)). |
| | |
4.3 | | Indenture, dated November 20, 2007, among DJOFL, DJO Finco, the Guarantors party thereto and The Bank of New York, as trustee (incorporated by reference to Exhibit 4.1 to DJOFL’s Current Report on |
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| | Form 8-K, filed on November 27, 2007). |
| | |
4.4 | | Registration Rights Agreement, dated November 20, 2007, among DJOFL, DJO Finco, the Guarantors party thereto and Credit Suisse Securities (USA) LLC and Banc of America Securities LLC (incorporated by reference to Exhibit 4.2 to DJOFL’s Current Report on Form 8-K, filed on November 27, 2007). |
| | |
4.5 | | Credit Agreement, dated November 20, 2007, among DJOFL, as borrower, DJO Holdings, Credit Suisse, as administrative agent, the lenders from time to time party thereto and the other agents named therein (incorporated by reference to Exhibit 4.3 to DJOFL’s Current Report on Form 8-K, filed on November 27, 2007). |
| | |
4.6 | | Security Agreement, dated November 20, 2007, among DJOFL, as borrower, DJO Holdings and certain subsidiaries named therein, and Credit Suisse, as collateral agent (incorporated by reference to Exhibit 4.5 to DJOFL’s Current Report on Form 8-K, filed on November 27, 2007). |
| | |
4.7 | | Guaranty Agreement, dated November 20, 2007, among DJOFL, as borrower, DJO Holdings and certain subsidiaries named therein, and Credit Suisse, as collateral agent (incorporated by reference to Exhibit 4.4 to DJOFL’s Current Report on Form 8-K, filed on November 27, 2007). |
| | |
10.1* | | 2007 Incentive Stock Plan, dated November 20, 2007 (incorporated by reference to Exhibit 10.7 to DJOFL’s Current Report on Form 8-K, filed on November 27, 2007). |
| | |
10.2* | | Amendment to 2007 Incentive Stock Plan, dated April 25, 2008 (incorporated by reference to Exhibit 10.1 to DJOFL’s Current Report on Form 8-K, filed on May 1, 2008). |
| | |
10.3* | | Form of Nonstatutory Stock Option Agreement under 2007 Incentive Stock Plan (incorporated by reference to Exhibit 10.6 to DJOFL’s Annual Report on Form 10-K for the fiscal year ended December 31, 2007). |
| | |
10.4* | | Form of DJO Incorporated Directors’ Nonstatutory Stock Option Agreement under 2007 Incentive Stock Plan (incorporated by reference to Exhibit 10.7 to DJOFL’s Annual Report on Form 10-K for the fiscal year ended December 31, 2007). |
| | |
10.5* | | Form of Nonstatutory Stock Option Agreement under 2007 Incentive Stock Plan (Replacement Version) (incorporated by reference to Exhibit 10.8 to DJOFL’s Annual Report on Form 10-K for the fiscal year ended December 31, 2007). |
| | |
10.6* | | Form of Nonstatutory Stock Option Rollover Agreement under 2007 Incentive Stock Plan (incorporated by reference to Exhibit 10.9 to DJOFL’s Annual Report on Form 10-K for the fiscal year ended December 31, 2007). |
| | |
10.7* | | Form of Incentive Stock Option Rollover Agreement under 2007 Incentive Stock Plan (incorporated by reference to Exhibit 10.10 to DJOFL’s Annual Report on Form 10-K for the fiscal year ended December 31, 2007). |
| | |
10.8* | | Restricted Stock Award Agreement, granted pursuant to the 2007 Incentive Stock Plan, dated November 20, 2007, by and between DJO and Peter Baird (incorporated by reference to Exhibit 10.5 to DJOFL’s Current Report on Form 8-K, filed on November 27, 2007). |
| | |
10.9* | | Term Sheet for Paul D. Chapman, dated November 20, 2007, by and between DJO and Paul D. Chapman (incorporated by reference to Exhibit 10.3 to DJOFL’s Current Report on Form 8-K, filed on November 27, 2007). |
| | |
10.10* | | Term Sheet for Kenneth W. Davidson, dated November 20, 2007, by and between DJO and Kenneth W. Davidson (incorporated by reference to Exhibit 10.4 to DJOFL’s Current Report on Form 8-K, filed on November 27, 2007). |
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10.11* | | Outline of 2008 Incentive Bonus Plan (incorporated by reference to Exhibit 10.33 to DJOFL’s Annual Report on Form 10-K for the fiscal year ended December 31, 2007). |
| | |
10.12* | | Forms of Retention Bonus Agreement, dated November 20, 2007, by and between certain executives and DJO (incorporated by reference to Exhibit 10.6 to DJOFL’s Current Report on Form 8-K, filed on November 27, 2007). |
| | |
10.13* | | Forms of Change in Control and Severance Agreements, dated September 19, 2007, between DJO Opco and executive officers and certain members of management (incorporated by reference to Exhibits 10.1 and 10.2 to DJO Opco’s Current Report on Form 8-K, filed on September 25, 2007). |
| | |
10.14 | | Management Stockholders Agreement, dated as of November 3, 2006, by and among DJO and the management stockholders party thereto (incorporated by reference to Exhibit 10.22 of DJOFL’s Registration Statement on Form S-4, filed on April 18, 2007 (File No. 333-142188)). |
| | |
10.15 | | First Amendment to Management Stockholders Agreement, dated November 20, 2007, by and between DJO, certain Blackstone stockholders and certain management stockholders (incorporated by reference to Exhibit 10.2 to DJOFL’s Current Report on Form 8-K, filed on November 27, 2007). |
| | |
10.16 | | Transaction and Monitoring Fee Agreement, dated November 3, 2006, between DJO and Blackstone Management Partners V L.L.C. (incorporated by reference to Exhibit 10.24 of DJOFL’s Registration Statement on Form S-4, filed on April 18, 2007 (File No. 333-142188)). |
| | |
10.17 | | Amended and Restated Transaction and Monitoring Fee Agreement, dated November 20, 2007, between DJO and Blackstone Management Partners V L.L.C. (incorporated by reference to Exhibit 10.1 to DJOFL’s Current Report on Form 8-K, filed on November 27, 2007). |
| | |
10.18 | | Debt Commitment Letter from Credit Suisse, Credit Suisse Securities (USA) LLC, Bank of America, N.A., Banc of America Bridge LLC, and Banc of America Securities LLC, dated as of July 15, 2007 (incorporated by reference to Exhibit 10.1 to DJOFL’s Current Report on Form 8-K, filed on July 20, 2007). |
| | |
10.19 | | Equity Commitment Letter from Blackstone Capital Partners V L.P., dated as of July 15, 2007 (incorporated by reference to Exhibit 10.2 to DJOFL’s Current Report on Form 8-K, filed on July 20, 2007). |
| | |
10.20* | | Transition Agreement, dated August 14, 2008, and Separation of Employment Agreement and General Release, dated as of August 31, 2008, between DJO and Peter Baird (incorporated by reference to Exhibit 10.1 to DJOFL’s Quarterly Report on Form 10-Q for the quarter ended September 27, 2008). |
| | |
10.21* | | Employment Agreement between DJO and Scott A. Klosterman, dated June 2, 2003 (incorporated by reference to Exhibit 10.24 to DJO’s Registration Statement on Form S-1, filed on July 3, 2003 (Commission File No. 333-106821)). |
| | |
10.22* | | Amendment to Employment Agreement between DJO and Scott A. Klosterman, dated November 15, 2003 (incorporated by reference to Exhibit 10.15.1 to DJO’s Annual Report on Form 10-K for the fiscal year ended December 31, 2004 (Commission File No. 000-26538)). |
| | |
10.23* | | Amendment to Employment Agreement between DJO and Scott A. Klosterman, dated November 3, 2006 (incorporated by reference to Exhibit 10.20 of DJOFL’s Registration Statement on Form S-4, filed on April 18, 2007 (File No. 333-142188)). |
| | |
10.24* | | Employment Agreement between DJO and Peter W. Baird, executed effective October 1, 2006 (incorporated by reference to Exhibit 10.1 to DJO’s Current Report on Form 8-K, filed on October 4, 2006) |
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10.25 | | Lease Agreement between Professional Real Estate Services, Inc. and dj Orthopedics, LLC (now known as DJO, LLC), dated October 20, 2004 (Vista facility) (Incorporated by reference to Exhibit 10.1 to DJO Opco’s Current Report on Form 8-K filed on October 26, 2004). |
| | |
10.26 | | Lease Agreement, dated February 17, 2006, between MetroAir Partners, LLC, and dj Orthopedics, LLC (Indianapolis facility) (Incorporated by reference to Exhibit 10.2 to DJO Opco’s Quarterly Report on Form 10-Q for the quarter ended April 1, 2006) |
| | |
10.27+ | | Lease Agreement, dated June 11, 1996, between Met 94, Ltd. and Encore Orthopedics, Inc. covering 52,800 sq. ft. facility in Austin, Texas, together with amendments thereto. |
| | |
10.28+ | | Office/Light Manufacturing Lease, dated June 14, 2996, between Cardigan Investments Limited Partnership and EMPI, Inc., covering 93,666 sq. ft. facility in St. Paul, Minnesota, together with amendments thereto. |
| | |
10.29+ | | Lease Agreement, dated December 10, 2003, between BBVA Bancomer Servicios, S.A. and DJ Orthopedics de Mexico, S.A. de C.V., covering 200,000 sq. ft. facility in Tijuana, Mexico. |
| | |
10.30+ | | Agreement, dated April 4, 2006, between BBVA Bancomer Servicios, S.A. and DJ Orthopedics de Mexico, S.A. de C.V., amending Leases covering 200,000 sq. ft., 58,400 sq. ft. and 27,733 sq. ft. facilities in Tijuana Mexico. |
| | |
12.1+ | | Computation of Ratio of Earnings to Fixed Charges |
| | |
21.1+ | | Subsidiaries of DJO Finance LLC |
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31.1+ | | Certification (pursuant to Securities Exchange Act Rule 13a-14a) by Chief Executive Officer. |
| | |
31.2+ | | Certification (pursuant to Securities Exchange Act Rule 13a-14a) by Chief Financial Officer. |
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32.1+ | | Section 1350 — Certification (pursuant to Section 906 of the Sarbanes-Oxley Act of 2002) by Chief Executive Officer. |
| | |
32.2+ | | Section 1350 — Certification (pursuant to Section 906 of the Sarbanes-Oxley Act of 2002) by Chief Financial Officer. |
* | | constitutes management contract or compensatory arrangement |
+ | | filed herewith |
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DJO FINANCE LLC
SCHEDULE II—VALUATION AND QUALIFYING ACCOUNTS
(in thousands)
| | Allowance for
Doubtful
Accounts | | Allowance
for Sales
Returns | | Allowance for
Sales
Discounts and
Other Allowances (1) | |
Predecessor: | | | | | | | |
Balance as of December 31, 2005 | | 3,664 | | 352 | | 10,320 | |
Provision | | 21,832 | | (69 | ) | 72,872 | |
Write-offs, net of recoveries | | (6,610 | ) | — | | (56,882 | ) |
Balance as of November 3, 2006 | | $ | 18,886 | | $ | 283 | | $ | 26,310 | |
Successor: | | | | | | | |
Provision | | 329 | | 184 | | 11,313 | |
Write-offs, net of recoveries | | — | | — | | — | |
Balance as of December 31, 2006 | | 329 | | 184 | | 11,313 | |
Provision | | 21,971 | | 550 | | 99,803 | |
Acquired through business acquisitions | | 14,229 | | 480 | | 39,186 | |
Write-offs, net of recoveries | | (6,654 | ) | (135 | ) | (99,138 | ) |
Balance as of December 31, 2007 | | 29,875 | | 1,079 | | 51,164 | |
Provision | | 26,022 | | 255 | | 161,524 | |
Write-offs, net of recoveries | | (21,615 | ) | (270 | ) | (147,004 | ) |
Balance as of December 31, 2008 | | $ | 34,282 | | $ | 1,064 | | $ | 65,684 | |
(1) Amounts are excluded from the provisions included in the consolidated statements of cash flows as the inclusion would not provide meaningful information.
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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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.
Date: March 11, 2009 | DJO FINANCE LLC |
| | |
| By: | /s/ Leslie H. Cross |
| | Leslie H. Cross |
| | President, Chief Executive Officer and Director |
Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
Signature | | Title | | Date |
| | | | |
/s/ Leslie H. Cross | | President, Chief Executive Officer and Director | | March 11, 2009 |
Leslie H. Cross | | (Principal Executive Officer) | | |
| | | | |
/s/ Vickie L. Capps | | Executive Vice President, Chief Financial Officer and | | March 11, 2009 |
Vickie L. Capps | | Treasurer (Principal Financial and Accounting Officer) | | |
| | | | |
/s/ Chinh E. Chu | | Chairman of the Board of Directors | | March 11, 2009 |
Chinh E. Chu | | | | |
| | | | |
/s/ Julia Kahr | | Director | | March 11, 2009 |
Julia Kahr | | | | |
| | | | |
/s/ Sidney Braginsky | | Director | | March 11, 2009 |
Sidney Braginsky | | | | |
| | | | |
/s/ Bruce McEvoy | | Director | | March 11, 2009 |
Bruce McEvoy | | | | |
| | | | |
/s/ Phillip J. Hildebrand | | Director | | March 11, 2009 |
Phillip J. Hildebrand | | | | |
| | | | |
/s/ Lesley Howe | | Director | | March 11, 2009 |
Lesley Howe | | | | |
| | | | |
/s/ Paul LaViolette | | Director | | March 11, 2009 |
Paul LaViolette | | | | |
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