Hanger (HNGR) 10-Q 2008 Q2 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended  June 30, 2008

OR

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

For the transition period from                               to                               

Commission file number  1-10670

HANGER ORTHOPEDIC GROUP, INC.

(Exact name of registrant as specified in its charter)

Delaware	84-0904275
(State or other jurisdiction of	(IRS Employer Identification No.)
incorporation or organization)

Two Bethesda Metro Center, Suite 1200, Bethesda, MD	20814
(Address of principal executive offices)	(Zip Code)

Registrant’s telephone number, including area code:  (301) 986-0701

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

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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer”, “accelerated filer”, and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one).

Large accelerated filer o	Accelerated filer x
Non-accelerated filer o	Smaller reporting company o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x

As of July 31, 2008, 23,236,987 shares of common stock, $.01 par value per share, were outstanding.

HANGER ORTHOPEDIC GROUP, INC.

INDEX

		Page No.
Part I.	FINANCIAL INFORMATION
Item 1.	Consolidated Financial Statements (Unaudited)
Unaudited Consolidated Balance Sheets – June 30, 2008 and December 31, 2007		1
Unaudited Consolidated Statements of Operations for the Three and Six Months ended June 30, 2008 and 2007		3
Unaudited Consolidated Statements of Cash Flows for the Six Months ended June 30, 2008 and 2007		4
Notes to Consolidated Financial Statements (Unaudited)		5
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	25
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	45
Item 4.	Controls and Procedures	46
Part II.	OTHER INFORMATION
Item 1A.	Risk Factors	47
Item 4.	Submission of Matters to a Vote of Security Holders	48
Item 6.	Exhibits	49
SIGNATURES		50
Certifications of Chief Executive Officer and Chief Financial Officer

HANGER ORTHOPEDIC GROUP, INC.

CONSOLIDATED BALANCE SHEETS

(Dollars in thousands)

(Unaudited)

	June 30,		December 31,
	2008		2007
ASSETS
CURRENT ASSETS
Cash and cash equivalents	$	23,954	$	26,938
Short-term investments	6,902		7,500
Accounts receivable, less allowance for doubtful accounts of $3,678 and $3,965 in 2008 and 2007, respectively	97,764		99,117
Inventories	83,543		82,228
Prepaid expenses, other assets and income taxes receivable	13,151		10,747
Deferred income taxes	7,912		8,571
Total current assets	233,226		235,101
PROPERTY, PLANT AND EQUIPMENT
Land	949		975
Buildings	4,897		4,881
Furniture and fixtures	13,018		12,747
Machinery and equipment	32,482		31,093
Leasehold improvements	43,947		41,520
Computer and software	59,881		56,231
Total property, plant and equipment, gross	155,174		147,447
Less accumulated depreciation	108,024		100,133
Total property, plant and equipment, net	47,150		47,314
INTANGIBLE ASSETS
Excess cost over net assets acquired	463,759		459,562
Patents and other intangible assets, net	4,146		4,599
Total intangible assets, net	467,905		464,161
OTHER ASSETS
Debt issuance costs, net	8,393		9,304
Other assets	3,804		3,803
Total other assets	12,197		13,107
TOTAL ASSETS	$	760,478	$	759,683

The accompanying notes are an integral part of the consolidated financial statements.

1

	June 30,			December 31,
	2008			2007
LIABILITIES, CONVERTIBLE PREFERRED STOCK AND SHAREHOLDERS’ EQUITY
CURRENT LIABILITIES
Current portion of long-term debt	$	4,769		$	5,691
Accounts payable	15,581			17,257
Accrued expenses	11,776			11,316
Accrued interest payable	1,729			1,937
Accrued compensation related costs	23,247			33,106
Total current liabilities	57,102			69,307
LONG-TERM LIABILITIES
Long-term debt, less current portion	401,656			405,201
Deferred income taxes	30,765			30,574
Other liabilities	17,995			16,409
Total liabilities	507,518			521,491
COMMITMENTS AND CONTINGENCIES (Note H)
CONVERTIBLE PREFERRED STOCK
Series A Convertible Preferred stock, liquidation preference of $1,000 per share, 50,000 shares authorized, issued and outstanding	52,908			47,654
SHAREHOLDERS’ EQUITY
Common stock, $.01 par value; 60,000,000 shares authorized, 24,603,682 shares and 24,432,518 shares issued and outstanding in 2008 and 2007, respectively	246			244
Additional paid-in capital	165,046			161,955
Accumulated other comprehensive income	522			—
Retained earnings	34,894			28,995
	200,708			191,194
Treasury stock at cost (141,154 shares)	(656		)	(656		)
Total shareholders’ equity	200,052			190,538
TOTAL LIABILITIES, CONVERTIBLE PREFERRED STOCK AND SHAREHOLDERS’ EQUITY	$	760,478		$	759,683

The accompanying notes are an integral part of the consolidated financial statements.

2

HANGER ORTHOPEDIC GROUP, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

For the Three and Six Months Ended June 30,

(Dollars in thousands, except share and per share amounts)

(Unaudited)

	Three Months Ended				Six Months Ended
	June 30,				June 30,
	2008		2007		2008		2007
Net sales	$	181,184	$	160,366	$	338,840	$	304,217
Cost of goods sold (exclusive of depreciation and amortization)	88,223		78,945		167,292		151,494
Selling, general and administrative	67,285		59,714		127,492		114,872
Depreciation and amortization	4,289		3,878		8,470		7,626
Income from operations	21,387		17,829		35,586		30,225
Interest expense	8,045		9,125		16,303		18,465
Income before taxes	13,342		8,704		19,283		11,760
Provision for income taxes	5,337		3,612		7,713		4,884
Net income	8,005		5,092		11,570		6,876
Preferred stock dividend-Series A Convertible Preferred Stock	5,254		416		5,670		833
Net income applicable to common stock	$	2,751	$	4,676	$	5,900	$	6,043
Basic Per Common Share Data
Net income applicable to common stock	$	0.12	$	0.21	$	0.26	$	0.27
Shares used to compute basic per common share amounts	23,017,282		22,399,292		22,949,127		22,295,606
Diluted Per Common Share Data
Net income applicable to common stock	$	0.11	$	0.17	$	0.24	$	0.23
Shares used to compute diluted per common share amounts	24,208,631		30,049,735		24,121,834		29,908,304

The accompanying notes are an integral part of the consolidated financial statements.

3

HANGER ORTHOPEDIC GROUP, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

For the Six Months Ended June 30,

(Dollars in thousands)

(Unaudited)

	2008			2007
Cash flows from operating activities:
Net income	$	11,570		$	6,876
Adjustments to reconcile net income to net cash provided by operating activities:
Loss on disposal of assets	12			38
Provision for bad debt	7,766			8,774
Provision for deferred income taxes	1,188			2,628
Depreciation and amortization	8,470			7,626
Amortization of debt issuance costs	911			902
Compensation expense on stock options and restricted stock	2,131			1,404
Changes in assets and liabilities, net of effects of acquired companies:
Accounts receivable	(5,840		)	(5,541		)
Inventories	(1,076		)	882
Prepaid expenses, other current assets, and income taxes receivable	(2,395		)	(3,176		)
Other assets	(171		)	66
Accounts payable	(1,464		)	(235		)
Accrued expenses, accrued interest payable, and income taxes payable	(260		)	(3,631		)
Accrued compensation related costs	(9,858		)	(1,058		)
Other liabilities	1,585			4,551
Net cash provided by operating activities	12,569			20,106
Cash flows from investing activities:
Purchase of property, plant and equipment (net of acquisitions)	(7,840		)	(9,094		)
Acquisitions and contingent purchase price (net of cash acquired)	(2,191		)	(1,461		)
Proceeds from sale of property, plant and equipment	20			158
Net cash used in investing activities	(10,011		)	(10,397		)
Cash flows from financing activities:
Repayment of term loan	(3,485		)	(1,151		)
Scheduled repayment of long-term debt	(1,917		)	(1,219		)
Financing costs	—			(265		)
Proceeds from issuance of Common Stock	276			706
Preferred stock dividends paid	(416		)	(833		)
Net cash used in financing activities	(5,542		)	(2,762		)
Increase (decrease) in cash and cash equivalents	(2,984		)	6,947
Cash and cash equivalents, at beginning of period	26,938			23,139
Cash and cash equivalents, at end of period	$	23,954		$	30,086

The accompanying notes are an integral part of the consolidated financial statements.

4

HANGER ORTHOPEDIC GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE A – BASIS OF PRESENTATION

The unaudited interim consolidated financial statements as of and for the three and six months ended June 30, 2008 and 2007 have been prepared by Hanger Orthopedic Group, Inc. (the “Company”) pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”) for interim financial reporting.  These consolidated statements are unaudited and, in the opinion of management, include all adjustments (consisting of normal recurring adjustments and accruals) necessary for a fair statement for the periods presented.  The year-end consolidated data was derived from audited financial statements but does not include all disclosures required by accounting principles generally accepted in the United States of America (“GAAP”).

These consolidated financial statements should be read in conjunction with the consolidated financial statements of the Company and notes thereto included in the Annual Report on Form 10-K for the year ended December 31, 2007, filed with the SEC.

NOTE B – SIGNIFICANT ACCOUNTING POLICIES

Principles of Consolidation

The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries.  All intercompany transactions and balances have been eliminated.

Use of Estimates

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, 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.  Actual results could differ from those estimates.

Cash and Cash Equivalents

The Company considers all highly liquid investments with original maturities of three months or less at the date of purchase to be cash equivalents.  At various times throughout the year, the Company maintains cash balances in excess of Federal Deposit Insurance Corporation limits.

Short-Term Investments

We account for our short-term investments in accordance with SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities”.  Our investments are classified as cash equivalents if the original maturity, from the date of purchase, is ninety days or less, and as short-term investments if the original maturity, from the date of purchase, is in excess of ninety days since we intend to convert them into cash as necessary to meet our liquidity requirements.  At June 30, 2008, our short-term investments consist of two auction rate securities (“ARS”) with a credit rating of either AA or AAA.  ARS are securities that are structured with short-

5

NOTE B - SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

Short-Term Investments (continued)

term interest rate reset dates which generally occur every 28 days and are linked to LIBOR.  At the reset date, investors can sell or continue to hold the securities at par.  As of June 30, 2008, both investments failed at auction due to sell orders exceeding buy orders.  The funds associated with these securities will not be accessible until a successful auction occurs, a buyer is found outside of the auction process, the issuer refinances the underlying debt, or the underlying security matures.  The Company’s ARS are reported at fair value.

The Company believes there has been no marked deterioration in the credit risk of the underlying securities in our auction rate portfolio.  However, given the deterioration in liquidity of the auction rate market during the first and second quarter, we recorded an unrealized loss on our securities in the amount of $0.5 million and $0.1 million, respectively, to reflect the estimated decline in fair value associated with the current illiquidity in the auction rate market.  That estimated decline in fair value was calculated based upon a projected cash flow of the underlying securities, which is not necessarily indicative of the actual proceeds that could be received from sale of the securities on June 30, 2008.  Despite the unrealized loss recorded at June 30, 2008 as a component of comprehensive income, we anticipate that we will be able to convert these investments to cash at full par value within the next twelve months.  Further, the current illiquidity of these investments is not expected to impact our operating and capital expenditure needs.

Fair Value

Effective January 1, 2008, the Company adopted Statement of Financial Accounting Standard No. 157, Fair Value Measurements, or SFAS 157, which establishes a framework for measuring fair value and requires enhanced disclosures about fair value measurements.  SFAS 157 requires disclosure about how fair value is determined for assets and liabilities and establishes a hierarchy for which these assets and liabilities must be grouped, based on significant levels of inputs as follows:

Level 1quoted prices in active markets for identical assets or liabilities;

Level 2quoted prices in active markets for similar assets and liabilities and inputs that are observable for the asset or liability;

Level 3unobservable inputs, such as discounted cash flow models and valuations.

The determination of where assets and liabilities fall within this hierarchy is based upon the lowest level of input that is significant to the fair value measurement. The following is a listing of our assets and liabilities required to be measured at fair value on a recurring basis and where they are classified within the hierarchy as of June 30, 2008:

6

NOTE B - SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

Fair Value (continued)

(in thousands)	Level 1		Level 2		Level 3		Total
Assets
Auction rate securities	—		—		6,902		6,902
Interest rate swaps	—		1,955		—		1,955
	$	—	$	1,955	$	6,902	$	8,857

	Level 1		Level 2		Level 3		Total
Liabilities
Interest rate swaps	—		487		—		487
	$	—	$	487	$	—	$	487

Auction Rate Securities

The fair values of our ARS were estimated through discounted cash flow models.  These models consider, among other things, the timing of expected future successful auctions, collateralization of underlying security investments and the credit worthiness of the issuer. Since these inputs were not observable, they are classified as level 3 inputs.  The auctions for all of the ARS held by us were unsuccessful as of June 30, 2008, resulting in our continuing to hold them beyond their typical auction reset dates and causing the level of inputs used to determine their fair values to be unobservable (level 3 inputs). As a result of the lack of liquidity in the ARS market and not as a result of the quality of the underlying collateral, for the three and six months ended June 30, 2008, we recorded unrealized losses on our ARS of $0.1 million and $0.6 million, respectively, which is reflected in accumulated other comprehensive income in our consolidated balance sheet.

Interest Rate Swaps

In May 2008, the Company entered into two interest rate swap agreements under which $150.0 million of the Company’s variable rate Term Loans were converted to a fixed rate of 5.4%.  The agreements, which expire April 2011, qualify as cash flow hedges in accordance with Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities, or SFAS 133. The fair value of the interest rate swaps is an estimate of the present value of expected future cash flows the Company is to receive under the interest rate swap agreement. The valuation models used to determine the fair value of the interest rate swap are based upon forward yield curve of one month LIBOR, the hedged interest rate.  There was no ineffectiveness relating to the interest rate swaps for the three months ended June 30, 2008, with the unrealized gains of $1.5 million reported in accumulated other comprehensive income, a component of shareholders’ equity. The interest rate swap asset of $2.0 million is reported in other long-term assets, while the interest rate liability of $0.5 million is reported in accrued expenses on the Company’s balance sheet as of June 30, 2008.

7

NOTE B - SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

Revenue Recognition

Revenues on the sale of orthotic and prosthetic devices and associated services to patients are recorded when the device is accepted by the patient, provided that (i) delivery has occurred or services have been rendered; (ii) persuasive evidence of an arrangement exists; (iii) the sales price is fixed or determinable; and (iv) collectability is reasonably assured.  Revenues on the sale of orthotic and prosthetic devices to customers by our distribution segment are recorded upon the shipment of products, in accordance with the terms of the invoice, net of merchandise returns received and the amount established for anticipated returns.  Discounted sales are recorded at net realizable value.  Deferred revenue represents prepaid tuition and fees received from students enrolled in our practitioner education program.

Revenue at our patient-care centers segment is recorded net of all governmental adjustments, contractual adjustments and discounts.  We employ a systematic process to ensure that our sales are recorded at net realizable value and that any required adjustments are recorded on a timely basis.  The contracting module of our centralized, computerized billing system is designed to record revenue at net realizable value based on our contract with the patient’s insurance company.  Updated billing information is received periodically from payors and is uploaded into our centralized contract module and then disseminated to all patient-care centers electronically.

Disallowed sales generally relate to billings to payors with whom we do not have a formal contract.  In these situations we record the sale at usual and customary rates and simultaneously record a disallowed sale to reduce the sale to net value, based on our historical experience with the payor in question.  Disallowed sales may also result if the payor rejects or adjusts certain billing codes.  Billing codes are frequently updated within our industry.  As soon as updates are received, we reflect the change in our centralized billing system.

As part of our preauthorization process with payors, we validate our ability to bill the payor for the service we are providing before we deliver the device.  Subsequent to billing for our devices and services, there may be problems with pre-authorization or with other insurance coverage issues with payors.  If there has been a lapse in coverage, the patient is financially responsible for the charges related to the devices and services received.  If we do not collect from the patient, we record bad debt expense.  Occasionally, a portion of a bill is rejected by a payor due to a coding error on our part and we are prevented from pursuing payment from the patient due to the terms of our contract with the insurance company.  We appeal these types of decisions and are generally successful.  This activity is factored into our methodology to determine the estimate for the allowance for doubtful accounts.  We immediately record, as a reduction of sales, a disallowed sale for any claims that we know we will not recover and adjust our future estimates accordingly.

Certain accounts receivable may be uncollectible, even if properly pre-authorized and billed.  Regardless of the balance, accounts receivable amounts are periodically evaluated to assess collectability.  In addition to the actual bad debt expense recognized during collection activities, we estimate the amount of potential bad debt expense that may occur in the future.  This estimate is based upon

8

NOTE B – SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

Revenue Recognition (continued)

our historical experience as well as a review of our receivable balances.  On a quarterly basis, we evaluate cash collections, accounts receivable balances and write-off activity to assess the adequacy of our allowance for doubtful accounts.  Additionally, a company-wide evaluation of collectability of receivable balances older than 180 days is performed at least semi-annually, the results of which are used in the next allowance analysis.  In these detailed reviews, the account’s net realizable value is estimated after considering the customer’s payment history, past efforts to collect on the balance and the outstanding balance, and a specific reserve is recorded if needed.  From time to time, the Company may outsource the collection of such accounts to outsourced agencies after internal collection efforts are exhausted.  In the cases when valid accounts receivable cannot be collected, the uncollectible account is written off to bad debt expense.

Inventories

Inventories, which consist principally of raw materials, work-in-process and finished goods, are stated at the lower of cost or market using the first-in, first-out method.  At our patient-care centers segment, we calculate cost of goods sold in accordance with the gross profit method for all reporting periods.  We base the estimates used in applying the gross profit method on the actual results of the most recently completed fiscal year and other factors, such as sales mix and purchasing trends, among other factors, affecting cost of goods sold during the current reporting periods.  Cost of goods sold during the period is adjusted when the annual physical inventory is taken.  We treat these adjustments as changes in accounting estimates.  At our distribution segment, a perpetual inventory is maintained.  Management adjusts our reserve for inventory obsolescence whenever the facts and circumstances indicate that the carrying cost of certain inventory items is in excess of its market price.  Shipping and handling costs are included in cost of goods sold.

Property, Plant and Equipment

We record property, plant and equipment at cost.  Equipment acquired under capital leases is recorded at the lower of fair market value or the present value of the future lease payments.  The cost and related accumulated depreciation of assets sold, retired or otherwise disposed of are removed from the respective accounts, and any resulting gains or losses are included in the Consolidated Statements of Operations.  Depreciation is computed for financial reporting purposes using the straight-line method over the estimated useful lives of the related assets as follows:

Furniture and fixtures	5 years
Machinery and equipment	5 years
Computers and software	5 years
Buildings	10 to 40 years
Assets under capital leases	Shorter of asset life or term of lease
Leasehold improvements	Shorter of asset life or term of lease

9

NOTE B – SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

Property, Plant and Equipment (continued)

We capitalize internally developed computer software costs incurred during the development stage of the software in accordance with Statement of Position 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use.

Stock-Based Compensation

The Company issues options and restricted shares of common stock under two active share-based compensation plans, one for employees and the other for non-employee members of the Board of Directors.  At June 30, 2008, 4.7 million shares of common stock are authorized for issuance under the Company’s share-based compensation plans.  Shares of common stock issued under the share-based compensation plans are released from the Company’s authorized shares.  Stock option and restricted share awards are granted at the fair market value of the Company’s common stock on the date immediately preceding the date of grant.  Stock option awards vest over a period determined by the compensation plan, ranging from one to three years, and generally have a maximum term of ten years. Restricted shares of common stock vest over a period of time determined by the Compensation Committee of the Board of Directors ranging from one to four years.

The Company follows the provisions of Statement of Financial Accounting Standards 123R, Share-Based Payment (“SFAS 123R”), which requires companies to measure and recognize compensation expense for all share-based payments at fair value.  The Company recognized $1.1 million and $0.7 million in compensation expense for the three months periods ended June 30, 2008 and 2007, respectively.  The Company recognized $2.1 million and $1.4 million in compensation expense for the six months periods ended June 30, 2008 and 2007, respectively.  Compensation expense primarily relates to restricted share grants, as the amount of expense related to options is immaterial in all periods presented. The Company calculates the fair value of stock options using the Black-Scholes model.  The total value of the share based awards is expensed ratably over the requisite service period of the employees receiving the awards.

Segment Information

The Company applies a “management” approach to disclosure of segment information.  The management approach designates the internal organization that is used by management for making operating decisions and assessing performance as the basis of the Company’s reportable segments.  The description of the Company’s reportable segments and the disclosure of segment information are presented in Note M.

Income Taxes

The Company adopted the provisions of Financial Accounting Standards Board (FASB) Interpretation No. 48, “Accounting for Uncertainty in Income Taxes”, on January 1, 2007. As a result of adoption, the Company recognized a decrease of approximately $0.2 million to the January 1, 2007 retained earnings balance. As of the adoption date, the Company had gross tax

10

NOTE B – SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

Income Taxes (continued)

affected unrecognized tax benefits of $3.3 million of which $1.1 million, if recognized, would affect the effective tax rate. Over the next 12 months the Company may recognize gross tax affected unrecognized tax benefits of up to $1.5 million, of which $0.2 million is expected to impact the effective tax rate, due to the pending expiration of the period of limitations for assessing tax deficiencies for certain income tax returns. As of the adoption date, the Company had accrued interest expense and penalties related to the unrecognized tax benefits of $0.4 million and $0.4 million, respectively. The Company recognizes interest accrued and penalties related to unrecognized tax benefits as a component of income tax expense. Total penalties and interest accrued as of June 30, 2008 was $1.0 million, including less than $0.1 million in the current income tax provision for the three month period ended June 30, 2008. The Company files numerous consolidated and separate income tax returns in the United States Federal jurisdiction and in many state jurisdictions. The Company is no longer subject to US Federal income tax examinations for years before 2003 and with few exceptions is no longer subject to state and local income tax examinations by tax authorities for years before 2002.

New Accounting Guidance

In December 2007, the FASB issued SFAS 141(R), Business Combinations (“SFAS 141(R)”). SFAS 141(R) provides revised guidance to improve the relevance, representational faithfulness, and comparability of the information that a reporting entity provides in its financial reports about a business combination and its effects. SFAS 141(R) revises the accounting literature previously issued under SFAS 141, Business Combinations.  SFAS 141(R) is effective for fiscal years beginning after December 15, 2008. The Company is currently evaluating the impact that adopting SFAS 141(R) will have on our financial statements.

In December 2007, the FASB issued SFAS 160, Noncontrolling Interest in Consolidated Financial Statements (“SFAS 160”). SFAS 160 revises ARB 51 accounting for non-controlling interests in subsidiaries. SFAS 160 is effective for fiscal years beginning after December 15, 2008. SFAS 160 will not have a material impact on the Company’s financial statements.

In February 2008, the FASB issued FSP No. FAS 157-2, Effective Date of FASB Statement No. 157 (“SFAS 157-2”).  SFAS 157-2 delays the application of SFAS 157 for all non-financial assets and liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis, to fiscal years beginning after November 15, 2008. SFAS 157 provides guidance on the application of fair value measurement objectives required in existing GAAP literature to ensure consistency and comparability.  Additionally, SFAS 157 requires additional disclosures on the fair value measurements used.  The Company is currently evaluating the impact that adopting SFAS 157 will have on non-financial assets or liabilities disclosed in the Company’s financial statements.

11

NOTE B – SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

New Accounting Guidance (continued)

In March 2008, the FASB issued SFAS 161, Disclosures about Derivative Instruments and Hedging Activities (“SFAS 161”), an amendment of FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities. SFAS 161 is intended to enhance the current disclosure framework in SFAS 133.  SFAS 161 requires that objectives for using derivative instruments be disclosed in terms of underlying risk and accounting designation.  SFAS 161 is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008, with early application encouraged.  The Company is currently evaluating the impact that adopting SFAS 161 will have on our financial statements.

In April 2008, the FASB issued FSP No. FAS 142-3, Determination of the Useful Life of Intangible Assets (“SFAS 142-3”).  SFAS 142-3 amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset under FASB Statement No. 142, Goodwill and Other Intangible Assets. The intent of SFAS 142-3 is to improve the consistency between the useful life of a recognized intangible asset under Statement 142 and the period of expected cash flows used to measure the fair value of the asset under SFAS 141(R), and other U.S. generally accepted accounting principles (GAAP).  SFAS 142-3 is effective for financial statements issued for fiscal years and interim periods beginning after December 15, 2008.  The Company is currently evaluating the impact that adopting SFAS 142-3 will have on our financial statements.

In May 2008, the FASB issued SFAS 162, The Hierarchy of Generally Accepted Accounting Principles (“SFAS 162”). SFAS 162 identifies the sources of accounting principles and the framework for selecting the principles used in the preparation of financial statements of nongovernmental entities that are presented in conformity with generally accepted accounting principles (GAAP) in the United States (the GAAP hierarchy). This Statement shall be effective 60 days following the SEC’s approval of the Public Company Accounting Oversight Board (PCAOB) amendments to AU Section 411, The Meaning of Present Fairly in Conformity With Generally Accepted Accounting Principles. SFAS 162 will not have a material impact on the Company’s the financial statements.

In May 2008, the FASB issued SFAS 163, Accounting for Financial Guarantee Insurance Contracts, an interpretation of FASB Statement No. 60 (“SFAS 163”). SFAS 163 clarifies how Statement 60 applies to financial guarantee insurance contracts, including the recognition and measurement of premium revenue and claim liabilities. SFAS 163 also requires expanded disclosures about financial guarantee insurance contracts.  This Statement shall be effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years.  SFAS 163 will not have a material impact on the Company’s financial statements.

12

NOTE C - SUPPLEMENTAL CASH FLOW FINANCIAL INFORMATION

The supplemental disclosure requirements for the statements of cash flows are as follows:

	Six Months Ended
	June 30,
(In thousands)	2008			2007
Cash paid during the period for:
Interest	$	16,026		$	18,264
Income taxes	7,075			4,024
Non-cash financing and investing activities:
Dividend on preferred stock	5,254			—
Unrealized loss on auction rate securities	(359		)	—
Unrealized gain on interest rate swaps	881			—
Issuance of notes in connection with acquistions	936			930
Issuance (cancellation) of restricted shares of common stock	897			7,114

NOTE D – ACQUISITIONS

During the three and six month periods ended June 30, 2008 the Company acquired six patient care centers for an aggregate purchase price of $2.4 million, consisting of $1.2 million in cash, $1.0 million in promissory notes, and a $0.2 million holdback.  During the three and six month periods ended June 30, 2007 the Company acquired one orthotic and prosthetics company that operated a total of 4 patient-care centers, for which it paid an aggregate purchase price of $1.5 million, consisting of $0.7 million cash, and a $0.8 million promissory note. The Company acquired the assets of a footwear company during the six month period ended June 30, 2007, for which it paid an aggregate purchase price of $0.5 million, consisting of $0.3 million in cash, a $0.2 million promissory note and other transaction costs.

The Company accounts for its acquisitions using the purchase method of accounting. In conjunction with the acquisitions completed during the three and six months ended June 30, 2008, the Company recorded approximately $1.8 million of goodwill.  The results of operations for these acquisitions are included in the Company’s results of operations from their date of acquisition.  Pro forma results would not be materially different.

In connection with acquisitions, the Company occasionally agrees to pay contingent consideration if post-acquisition cash collection targets are reached that verify the value of the target negotiated at acquisition.  Contingent consideration is defined in the purchase agreement and is accrued based on attainment of these targets. In connection with these agreements, the Company made payments of $0.4 million and $0.2 million during the six month periods ended June 30, 2008 and 2007, respectively. The Company has accounted for these amounts as additional purchase price, resulting in an increase in excess cost over net assets acquired.  The Company estimates that it may pay up to a total of $6.7 million related to contingent consideration provisions in future periods.

13

NOTE E - GOODWILL

The Company determined that it has two reporting units with goodwill, which are the same as its reportable segments: (i) patient-care centers and (ii) distribution. The Company completes its annual goodwill impairment analysis in October. The fair value of the Company’s reporting units are primarily determined based on the income approach and considers the market and cost approach.

The activity related to goodwill for the six month period ended June 30, 2008 is as follows:

(In thousands)	Patient-Care Centers		Distribution		Total
Balance at December 31, 2007	$	421,174	$	38,388	$	459,562
Additions due to acquisitions	4,180				4,180
Additions due to earnouts	17				17
Balance at June 30, 2008	$	425,371	$	38,388	$	463,759

NOTE F – INVENTORY

Inventories, which are recorded at the lower of cost or market using the first-in, first-out method, were as follows:

	June 30,		December 31,
(In thousands)	2008		2007
Raw materials	$	30,481	$	30,482
Work-in-process	34,153		32,641
Finished goods	18,909		19,105
	$	83,543	$	82,228

NOTE G – LONG-TERM DEBT

Long-term debt consisted of the following:

	June 30,			December 31,
(In thousands)	2008			2007
Term Loan	$	223,065		$	226,550
10 1/4% Senior Notes due 2014	175,000			175,000
Subordinated seller notes, non-collateralized, net of unamortized discount with principal and interest payable in either monthly, quarterly or annual installments at effective interest rates ranging from 5.0% to 10.8%, maturing through December 2011	8,360			9,342
	406,425			410,892
Less current portion	(4,769		)	(5,691		)
	$	401,656		$	405,201

14

NOTE G – LONG-TERM DEBT (CONTINUED)

Revolving Credit Facility

The $75.0 million Revolving Credit Facility matures on May 26, 2011 and bears interest, at the Company’s option, of LIBOR plus 2.75% or a Base Rate (as defined in the credit agreement) plus 1.75%. The obligations under the Revolving Credit Facility are guaranteed by the Company’s subsidiaries and are secured by a first priority perfected interest in the Company’s subsidiaries’ shares, all of the Company’s assets and all the assets of the Company’s subsidiaries. The Revolving Credit Facility requires compliance with various covenants including but not limited to a maximum total leverage ratio and a maximum annual capital expenditures limit. As of June 30, 2008, the Company has not made draws on the Revolving Credit Facility and has $71.5 million available under that facility. Availability under the Company’s Revolving Credit Facility is net of standby letters of credit of approximately $3.5 million.

Term Loan

The $230.0 million Term Loan matures on May 26, 2013 and requires quarterly payments which commenced on September 30, 2006.  From time to time, mandatory payments may be required as a result of capital stock issuances, additional debt incurrence, asset sales or other events as defined in the credit agreement. The Term Loan bears interest, at the Company’s option, at LIBOR plus 2.00% or a Base Rate (as defined in the credit agreement) plus 1.50%.  At June 30, 2008, the interest rate on the Term Loan was 4.46%. The obligations under the Term Loan are guaranteed by the Company’s subsidiaries and are secured by a first priority perfected interest in the Company’s subsidiaries’ shares, all of the Company’s assets and all the assets of the Company’s subsidiaries. The Term Loan is subject to covenants that mirror those of the Revolving Credit Facility.

10 ¼% Senior Notes

The 10 ¼% Senior Notes mature June 1, 2014, are senior indebtedness and are guaranteed in full and unconditionally, on a senior unsecured basis by all of the Company’s current and future domestic subsidiaries as well as all the assets of the Company. The parent company has no independent assets or operations and all subsidiaries are 100% owned by the Company. Interest is payable semi-annually on June 1 and December 1, and commenced December 1, 2006. On or prior to June 1, 2009, the Company may redeem up to 35% of the aggregate principal amount of the notes at a redemption price of 110.250% of the principal amount thereof, plus accrued and unpaid interest and additional interest, if any, with the net cash proceeds of an equity offering; provided that (i) at least 65% of the aggregate principal amount of the notes remains outstanding immediately after the redemption (excluding notes held by the Company and its subsidiaries); and (ii) the redemption occurs within 90 days of the date of the closing of the equity offering. Except as discussed above, the notes are not redeemable at the Company’s option prior to June 1,2010. On or after June 1, 2010, the Company may redeem all or part of the notes upon not less than 30 days and no more than 60 days’ notice, for the twelve-month period

15

NOTE G – LONG-TERM DEBT (CONTINUED)

10 ¼% Senior Notes (continued)

beginning on June 1 of the following years: at (i) 105.125% during 2010; (ii) 102.563% during 2011; and (iii) 100.0% during 2012 and thereafter.

Debt Covenants

The terms of the Senior Notes and the Revolving Credit Facility limit the Company’s ability to, among other things, incur additional indebtedness, create liens, pay dividends on or redeem capital stock, make certain investments, make restricted payments, make certain dispositions of assets, engage in transactions with affiliates, engage in certain business activities and engage in mergers, consolidations and certain sales of assets. At June 30, 2008, the Company is in compliance with all covenants under these debt agreements.

NOTE H – COMMITMENTS AND CONTINGENT LIABILITIES

Commitments

The Company’s wholly-owned subsidiary, Innovative Neurotronics, Inc. (“IN, Inc.”), is party to a non-binding purchase agreement under which it agrees to purchase assembled WalkAide System kits.  As of June 30, 2008, IN, Inc. had outstanding purchase commitments of approximately $0.5 million.

Contingencies

The Company is subject to legal proceedings and claims which arise in the ordinary course of its business, including additional payments under business purchase agreements.  In the opinion of management, the amount of ultimate liability, if any, with respect to these actions will not have a materially adverse effect on the financial position, liquidity or results of operations of the Company.

On June 15, 2004, the Company announced that an employee at its patient-care center in West Hempstead, New York alleged in a television news story aired on June 14, 2004 that there were instances of billing discrepancies at that facility.

On June 18, 2004, the Company announced that on June 17, 2004, the Audit Committee of the Company’s Board of Directors had engaged a law firm to serve as independent counsel to the Audit Committee and to conduct an independent investigation of the allegations.  The scope of that independent investigation was expanded to cover certain of the Company’s other patient-care centers and included consideration of some of the allegations made in the Amended Complaint filed in the class actions discussed below.  On June 17, 2004, the U.S. Attorney’s Office for the Eastern District of New York subpoenaed records of the Company regarding various

16

NOTE H – COMMITMENTS AND CONTINGENT LIABILITIES (CONTINUED)

Contingencies (continued)

Billing activities and locations.  In addition, the Company also announced on June 18, 2004 that the Securities and Exchange Commission had commenced an informal inquiry into the matter.  The Company is cooperating with the regulatory authorities. The Audit Committee’s investigation will not be complete until all regulatory authorities have indicated that their inquiries are complete.

Management believes that any billing discrepancies are likely to be primarily at the West Hempstead patient-care center.  Furthermore, management does not believe the resolution of the matters raised by the allegations will have a materially adverse effect on the Company’s financial statements.  The West Hempstead facility generated $0.2 million and $0.3 million of net sales during the six months ending June 30, 2008 and 2007, respectively, or less than 0.1% of the Company’s net sales, for each quarter.

It should be noted that additional regulatory inquiries may be raised relating to the Company’s billing activities at other locations.  No assurance can be given that the final results of the regulatory agencies’ inquiries will be consistent with the results to date or that any discrepancies identified during the ongoing regulatory review will not have a material adverse effect on the Company’s financial statements.

Guarantees and Indemnifications

In the ordinary course of its business, the Company may enter into service agreements with service providers in which it agrees to indemnify or limit the service provider against certain losses and liabilities arising from the service provider’s performance of the agreement.  The Company has reviewed its existing contracts containing indemnification or clauses of guarantees and does not believe that its liability under such agreements will result in any material liability.

NOTE I — PREFERRED STOCK

In May 2006, the Company issued 50,000 shares of Series A Convertible Preferred Stock (“Series A Preferred”) with a stated value of $1,000 per share.  The Series A Preferred provides for cumulative dividends at a rate of 3.33% per annum, payable quarterly in arrears.  The Company may elect to defer the payment of dividends. In addition, the initial holders of the Series A Preferred are entitled to have representation on the board of directors of the Company and are entitled to vote on all matters on which the holders of the Company’s common stock are entitled to vote.

The Series A Preferred can be redeemed for cash, at the option of the holder, upon the occurrence of a “Fundamental Transaction”, as defined in the Certificate of Designations.  These events or transactions include (i) acquisition of more than thirty-five percent of voting equity interest of the Company by a legal entity or group; (ii) replacement of more than one-half of the members of the board of directors with members that are not approved by the persons who were directors on May 25, 2006; (iii) a merger or consolidation of the Company or any subsidiary or a sale of all or substantially all of the assets of the Company in one or a series of related transactions, unless following such transaction or series of transactions, the holders of the Company’s securities prior to the first

17

NOTE I — PREFERRED STOCK (CONTINUED)

such transaction continue to hold at least half of the voting rights or voting equity interests of the surviving entity or acquirer of such assets; (iv) a recapitalization, reorganization or other transaction involving the Company or any significant subsidiary that constitutes or results in a transfer of more than one-half of the voting rights or voting equity interests in the Company; (v) consummation of a “Rule 13e-3 transaction” as defined in Rule 13e-3 under the Securities Exchange Act of 1934 with respect to the Company; (vi) any tender offer or exchange offer (whether by the Company or another person) is completed pursuant to which holders of the Company’s common stock are permitted to tender or exchange their shares for other securities, cash or property; (vii) the Company effects any reclassification of its common stock or any compulsory share exchange pursuant to which its common stock is effectively converted into or exchanged for other securities, cash or property; or (viii) the execution by the Company of an agreement directly or indirectly providing for any of the foregoing events. The redemption price per share of Series A Preferred in the event a holder elects redemption following the occurrence of a Fundamental Event, is equal to the stated value per share, plus accrued but unpaid dividends as of the date of the Fundamental Transaction.

The Series A Preferred may be converted into common shares at $7.56 per share at the option of the holders after a required holding period of 61 days, which has since passed, or at the option of the Company upon satisfaction of certain conditions.  In June 2008, the Company’s average closing price of its common stock price exceeded the Company’s forced conversion price of the Series A Convertible Preferred Stock by 200% for a 20-trading day period, triggering an acceleration of the Series A Preferred dividends that were otherwise payable through May 26, 2011. The accelerated dividends were paid in the form of increased stated value of preferred stock, in lieu of cash.  On July 25, 2008, the Company notified the holder of Series A Preferred of its election to force the conversion of the Series A Preferred into 7,308,730 shares of common stock.  The conversion will occur on August 8, 2008.

NOTE J – NET INCOME PER COMMON SHARE

Basic per common share amounts are computed using the weighted average number of common shares outstanding during the period.  Diluted per common share amounts are computed using the weighted average number of common shares outstanding during the period and dilutive potential common shares.  Dilutive potential common shares consist of stock options, restricted shares, and convertible preferred stock, and are calculated using the treasury stock method.

18

NOTE J – NET INCOME PER COMMON SHARE (CONTINUED)

Net income per share is computed as follows:

	Three Months Ended				Six Months Ended
	June 30,				June 30,
(In thousands, except share and per share data)	2008		2007		2008		2007
Net income	$	8,005	$	5,092	$	11,570	$	6,876
Preferred stock dividends -Series A Convertible Preferred Stock	5,254		416		5,670		833
Net income applicable to common stock	$	2,751	$	4,676	$	5,900	$	6,043
Shares of common stock outstanding used to compute basic per common share amounts	23,017,282		22,399,292		22,949,127		22,295,606
Effect of dilutive restricted stock and options (1)	1,191,349		1,036,686		1,172,707		998,941
Effect of dilutive convertible preferred stock (2)	—		6,613,757		—		6,613,757
Shares used to compute dilutive per common share amounts	24,208,631		30,049,735		24,121,834		29,908,304
Basic income per share applicable to common stock	$	0.12	$	0.21	$	0.26	$	0.27
Diluted income per share applicable to common stock	0.11		0.17		0.24		0.23

(1) For the three and six months ended June 30, 2008 and June 30, 2007, options to purchase 999,060, 1,006,060, 1,401,960 and 1,461,065 shares of common stock, respectively, are not included in the computation of diluted income per share as these options are anti-dilutive because the exercise prices of these options were greater than the average market price of the Company’s stock during the period.

(2) For the three month and six months ended June 30, 2008, excludes the effect of the conversion of Preferred Stock as it is considered anti-dilutive.

NOTE K – SUPPLEMENTAL EXECUTIVE RETIREMENT PLAN

The Company’s unfunded noncontributory defined benefit plan (the “Plan”) covers certain senior executives, is administered by the Company and calls for annual payments upon retirement based on years of service and final average salary. Benefit costs and liabilities balances are calculated based on certain assumptions including benefits earned, discount rates, interest costs, mortality rates and other factors.  Actual results that differ from the assumptions are accumulated and amortized over future periods, affecting the recorded obligation and expense in future periods.

The following assumptions were used in the calculation of the net benefit cost and obligation at June 30, 2008:

Discount rate	6.25	%
Average rate of increase in compensation	3.00	%

We believe the assumptions used are appropriate, however, changes in assumptions or differences in actual experience may affect our benefit obligation and future expenses. The change in the Plan’s net benefit obligation is as follows:

	(In thousands)
Net benefit cost accrued at December 31, 2007	$	8,269
Service cost	1,110
Interest cost	259
Net benefit cost accrued at June 30, 2008	$	9,638

19

NOTE L - STOCK-BASED COMPENSATION

Employee Plans

Under the Company’s 2002 Stock Option Plan, 1.5 million shares of common stock were authorized for issuance.  Options may only be granted at an exercise price that is not less than the fair market value of the common stock on the date of grant and may expire no later than ten years after grant.  Vesting and expiration periods are established by the Compensation Committee of the Board of Directors, generally with vesting of four years following the date of grant and generally with expirations of ten years after grant.  During 2003, the 2002 Stock Option Plan was amended to permit the grant of restricted shares of common stock in addition to stock options and to change the name of the plan to the 2002 Stock Incentive Plan. During May 2006, an additional 2.7 million shares of common stock were authorized for issuance. During May 2007, the Company’s shareholders approved amendments to the 2002 Stock Incentive Plan, most notably the incorporation of the Company’s current annual incentive plan for certain executive officers into the 2002 Stock Incentive Plan.  The amendments resulted in the following changes to the 2002 Stock Incentive Plan: (i) addition of performance-based cash awards (“Incentive Awards”) and renaming the 2002 Stock Incentive Plan to be the 2002 Stock Incentive and Bonus Plan; (ii) limitation on the number of options, shares of restricted stock, annual Incentive Awards and long term Incentive Awards that an individual can receive during any calendar year; (iii) addition of a list of specific performance goals that the Company may use for the provision of awards under the 2002 Stock Incentive and Bonus Plan; (iv) limitation on the total number of shares of stock issued pursuant to the exercise of incentive stock options; and (v) addition of a provision allowing for the Company to institute a compensation recovery policy, which would allow the Compensation Committee, in appropriate circumstances, to seek reimbursement of certain compensation realized under awards granted under the 2002 Stock Incentive and Bonus Plan. In August 2007, 205,000 performance-based restricted shares were granted to certain executives.  These performance-based restricted shares are subject to the same vesting period as the service-based restricted shares for employees.  However, the quantity of restricted shares to be released under this grant is dependent on the diluted EPS for the twelve month period from July 1, 2007 through June 30, 2008.  The target EPS for this period was met, therefore, 100% of the performance-based restricted shares will be released based on the four year vesting period. Note that the agreements which include these performance-based awards are expected to be renewed annually, at which time a new target performance period will be established.

During the six months ended June 30, 2008, no options and 27,500 restricted shares were cancelled under the 2002 Stock Incentive and Bonus Plan. During the six months ended June 30, 2007, no options and 14,250 restricted shares were cancelled under the 2002 Stock Incentive and Bonus Plan. At June 30, 2008, 1,425,169 shares of common stock were available for issuance.

Director Plans

During April and May 2003, the Compensation Committee of the Board of Directors and the shareholders of the Company, respectively, approved the 2003 Non-Employee Directors’ Stock Incentive Plan (“2003 Directors’ Plan”) which replaced the Company’s 1993 Non-Employee Director Stock Option Plan (“Director Plan”).  The 2003 Directors’ Plan authorized 500,000

20

NOTE L - STOCK-BASED COMPENSATION (CONTINUED)

Director Plans (continued)

shares of common stock for grant and permits the issuance of stock options and restricted shares of common stock. The 2003 Directors’ Plan also provides for the automatic annual grant of 8,500 shares of restricted shares of common stock to each director and permits the grant of additional restricted stock in the event the director elects to receive his or her annual director fee in restricted shares of common stock rather than cash.  Options may only be granted at an exercise price that is not less than the fair market value of the common stock on the date of grant and may expire no later than ten years after grant.  Vesting and expiration periods are established by the Compensation Committee of the Board of Directors, generally with vesting of three years following grant and generally with expirations of ten years after grant.  In May 2007, the Company’s shareholders further approved an amendment to the 2003 Directors’ Plan providing for the issuance by the Company of restricted stock units to its non-employee directors, at the option of such director.  The restricted stock units effectively allow the director to elect to defer receipt of the shares of restricted stock which the director would ordinarily receive on an annual basis until (i) the January 15th of the year following the calendar year in which the director terminates service on the Board of Directors, or (ii) the fifth, tenth or fifteenth anniversary of the annual meeting date on the election form for that year.  The director may elect to receive his or her annual grant of restricted stock, including shares to be received in lieu of the annual director fee, in the form of restricted stock units, with such election to take place on or prior to the date of the annual meeting of stockholders for such year.  The restricted stock units are subject to the same vesting period as the shares of restricted stock issued under the 2003 Directors’ Plan. During the three months ended June 30, 2008 and 2007, no restricted shares or options were cancelled under the 2003 Directors’ Plan. At June 30, 2008, 141,623 shares of common stock were available for issuance.

Restricted Shares of Common Stock

A summary of the activity of restricted shares of common stock for the six months ended June 30, 2008 is as follows:

	Employee Plans				Director Plans
	Shares		Weighted Average Grant Date Fair Value		Shares		Weighted Average Grant Date Fair Value
Nonvested at December 31, 2007	1,470,687		$	8.67	122,956		$	9.73
Granted	25,000		12.18		66,742		12.59
Vested	(242,562	)	7.62		(48,362	)	9.40
Forfeited	(27,500	)	8.82		—		—
Nonvested at June 30, 2008	1,225,625		$	8.95	141,336		$	11.19

During the three and six month periods ended June 30, 2008, 227,924 and 290,924 restricted shares of common stock, with an intrinsic value of $1.9 million and $2.3 million, respectively, became fully vested.  As of June 30, 2008, total unrecognized compensation cost related to unvested restricted shares of common stock was approximately $10.6 million and the related

21

NOTE L - STOCK-BASED COMPENSATION (CONTINUED)

Restricted Shares of Common Stock (continued)

weighted-average period over which it is expected to be recognized is approximately 2.7 years.  The aggregate granted shares have vesting dates through June 2012.

Options

The summary of option activity and weighted average exercise prices are as follows:

(In thousands, except per	Employee Plans					Director Plans					Non-Qualified Awards
and weighted average price amounts)	Shares			Weighted Average Price		Shares			Weighted Average Price		Shares		Weighted Average Price
Outstanding at December 31, 2007	1,510,649			$	11.10	153,113			$	11.04	406,000		$	5.95
Granted	—			—		—			—		—		—
Terminated	(88,314		)	6.89		(10,000		)	18.63		—		—
Exercised	(132,006		)	2.40		(5,000		)	1.64		—		—
Outstanding at June 30, 2008	1,290,329			$	12.27	138,113			$	10.23	406,000		$	5.95
Aggregate intrinsic value at June 30, 2008	$	15,843,367				$	1,411,804				$	2,415,000
Weighted average remaining contractual term (years)	3.1					4.8					1.8

The intrinsic value of options exercised during the three and six months ended June 30, 2008 was $0.1 million and $0.3 million, respectively. Options exercisable under the Company’s share-based compensation plans at June 30, 2008 were 1.8 million shares with a weighted average exercise price of $10.73, an average remaining contractual term of 3.0 years, and an aggregate intrinsic value of $19.7 million.  Cash received by the Company related to the exercise of options during the three and six months ended June 30, 2008 amounted to $0.08 million and $0.1 million, respectively. As of June 30, 2008, total unrecognized compensation cost related to stock option awards is immaterial and will be recorded as of the quarter ending September 30, 2008.

Information concerning outstanding and exercisable options as of June 30, 2008 is as follows:

					Options Outstanding				Options Exercisable
					Number of	Weighted Average			Number of	Weighted Average
Range of					Options	Remaining	Exercise		Options	Remaining	Exercise
Exercise Prices					or Awards	Life (Years)	Price		or Awards	Life (Years)	Price
$	1.64	to	$	1.65	253,665	1.0	$	1.64	253,665	1.0	$	1.64
4.63		to	6.02		453,112	2.2	5.87		450,755	2.1	5.87
8.08		to	12.10		124,605	6.2	8.72		124,605	6.2	8.72
12.96		to	18.63		898,060	3.8	14.66		898,060	3.8	14.66
22.13		to	22.50		105,000	0.4	22.31		105,000	0.4	22.31
					1,834,442	3.0	$	10.72	1,832,085	3.0	$	10.73

22

NOTE M – SEGMENT AND RELATED INFORMATION

The Company has identified two reportable segments in which it operates based on the products and services it provides. The Company evaluates segment performance and allocates resources based on the segments’ income from operations.  The reportable segments are:  (i) patient-care centers and (ii) distribution.  The reportable segments are described further below:

Patient-Care Centers – This segment consists of the Company’s owned and operated patient-care centers and fabrication centers of orthotic and prosthetic (“O&P”) devices and components.  The patient-care centers provide services to design and fit O&P devices to patients.  These centers also instruct patients in the use, care and maintenance of the devices.  Fabrication centers are involved in the fabrication of O&P components for both the O&P industry and the Company’s own patient-care centers.

Distribution – This segment distributes O&P products and components to both the O&P industry and the Company’s own patient-care practices.

Other – This segment consists of Hanger Corporate, Innovative Neurotronics, Inc (“IN, Inc.”), and Linkia. IN, Inc. specializes in bringing emerging MyoOrthotics Technologies® to the O&P market. MyoOrthotics Technologies represents the merging of orthotic technologies with electrical stimulation. Linkia is a national managed-care agent for O&P services and a patient referral clearing house.

The accounting policies of the segments are the same as those described in the summary of “Significant Accounting Policies” in Note B to the consolidated financial statements.

Summarized financial information concerning the Company’s reportable segments is shown in the following table.  Intersegment sales mainly include sales of O&P components from the distribution segment to the patient-care centers segment and were made at prices which approximate market values.

23

NOTE M – SEGMENT AND RELATED INFORMATION (CONTINUED)

(In thousands)	Patient-Care Centers			Distribution		Other			Consolidating Adjustments			Total
Three Months Ended June 30, 2008
Net sales
Customers	$	159,557		$	21,072	555			$	—		$	181,184
Intersegments	—			35,066		875			(35,941		)	—
Depreciation and amortization	3,032			182		1,075			—			4,289
Income (loss) from operations	27,494			6,200		(12,814		)	507			21,387
Interest (income) expense	(1,610		)	1,777		7,878			—			8,045
Income (loss) before taxes	29,104			4,423		(20,692		)	507			13,342
Three Months Ended June 30, 2007
Net sales
Customers	$	144,372		$	15,522	$	472		$	—		$	160,366
Intersegments	—			31,735		140			(31,875		)	—
Depreciation and amortization	3,047			86		745			—			3,878
Income (loss) from operations	24,007			4,715		(11,409		)	516			17,829
Interest (income) expense	(1,628		)	1,728		9,025			—			9,125
Income (loss) before taxes	25,635			2,987		(20,434		)	516			8,704
Six Months Ended June 30, 2008
Net sales
Customers	$	297,321		$	40,012	$	1,507		$	—		$	338,840
Intersegments	—			66,665		2,504			(69,169		)	—
Depreciation and amortization	6,035			356		2,079			—			8,470
Income (loss) from operations	46,915			11,423		(23,277		)	525			35,586
Interest (income) expense	(3,242		)	3,555		15,990			—			16,303
Income (loss) before taxes	50,157			7,868		(39,267		)	525			19,283
Total assets	733,709			86,492		(59,723		)	—			760,478
Capital expenditures	4,834			290		2,716			—			7,840
Six Months Ended June 30, 2007
Net sales
Customers	$	274,981		$	28,570	$	666		$	—		$	304,217
Intersegments	—			60,575		567			(61,142		)	—
Depreciation and amortization	6,052			168		1,406			—			7,626
Income (loss) from operations	43,159			8,335		(22,121		)	852			30,225
Interest (income) expense	(3,255		)	3,460		18,260			—			18,465
Income (loss) before taxes	46,414			4,875		(40,381		)	852			11,760
									—
Total assets	661,092			98,674		(34,051		)	—			725,715
Capital expenditures	5,352			377		3,365			—			9,094

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ITEM 2.Management’s Discussion and Analysis of Financial Condition and Results of Operations

Overview

The following is a discussion of our results of operations and financial condition for the periods described below. This discussion should be read in conjunction with the Consolidated Financial Statements included in this report.  Our discussion of our results of operations and financial condition includes various forward-looking statements about our markets, the demand for our products and services and our future results. These statements are based on our current expectations, which are inherently subject to risks and uncertainties. Our actual results and the timing of certain events may differ materially from those indicated in the forward looking statements.

Business Overview

General

We are the largest owner and operator of orthotic and prosthetic (“O&P”) patient-care centers (“patient-care centers”), accounting for approximately 25% of the estimated $2.5 billion O&P patient-care market, in the United States. At June 30, 2008, we operated 661 O&P patient-care centers in 45 states and the District of Columbia and employed in excess of 1,000 revenue-generating O&P practitioners (“practitioners”). In addition, through our wholly-owned subsidiary, Southern Prosthetic Supply, Inc. (“SPS”), we are the largest distributor of branded and private label O&P devices and components in the United States, all of which are manufactured by third parties.  We also create new products, through our wholly-owned subsidiary, Innovative Neurotronics, Inc. (“IN, Inc.”) for patients who have had a loss of mobility due to strokes, multiple sclerosis or other similar conditions.  Another subsidiary, Linkia LLC (“Linkia”), develops programs to manage all aspects of O&P patient care for large private payors.

For the three and six month periods ended June 30, 2008, our net sales were $181.2 million and $338.8 million, respectively, and we recorded net income of $8.0 million and $11.6 million, respectively.

We conduct our operations primarily in two reportable segments – patient-care centers and distribution.  For the three months ended June 30, 2008, net sales attributable to our patient-care services segment and distribution segment were $159.6 million and $21.6 million, respectively. For the six months ended June 30, 2008, net sales attributable to our patient-care services segment and distribution segment were $297.3 million and $40.0 million, respectively. See Note M to our consolidated financial statements contained herein for further information related to our segments.

Patient Care Services

As of June 30, 2008, we provided O&P patient care services through 661 patient-care centers and over 1,000 practitioners in 45 states and the District of Columbia.  Substantially all of our practitioners are certified, or candidates for formal certification, by the O&P industry certifying boards.  One or more practitioners closely manage each of our patient-care centers.  Our patient-care centers also

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employ highly trained technical personnel who assist in the provision of services to patients and who fabricate various O&P devices, as well as office administrators who schedule patient visits, obtain approvals from payors and bill and collect for services rendered.

An attending physician determines a patient’s treatment, writes a prescription and refers the patient to one of our patient-care centers.  Our practitioners then consult with both the referring physician and the patient with a view toward assisting in the formulation of the prescription for, and design of, an orthotic or prosthetic device to meet the patient’s need.

The fitting process often involves several stages in order to successfully achieve desired functional and cosmetic results.  The practitioner creates a cast and takes detailed measurements, frequently using our digital imaging system (Insignia), of the patient to ensure an anatomically correct fit.  Prosthetic devices are custom fabricated by technicians and fit by skilled practitioners.  The majority of the orthotic devices provided by us are custom designed, fabricated and fit; the remainder are prefabricated but custom fit.

Custom devices are fabricated by our skilled technicians using the plaster castings, measurements and designs made by our practitioners as well as utilization of our proprietary Insignia system. The Insignia system replaces plaster casting of a patient’s residual limb with the generation of a computer scanned image.  Insignia provides a very accurate image, faster turnaround for the patient, and a more professional overall experience.  Technicians use advanced materials and technologies to fabricate a custom device under quality assurance guidelines.  Custom designed devices that cannot be fabricated at the patient-care centers are fabricated at one of several central fabrication facilities.  After final adjustments to the device by the practitioner, the patient is instructed in the use, care and maintenance of the device.  Training programs and scheduled follow-up and maintenance visits are used to provide post-fitting treatment, including adjustments or replacements as the patient’s physical condition and lifestyle change.

To provide timely service to our patients, we employ technical personnel and maintain laboratories at many of our patient-care centers.  We have earned a strong reputation within the O&P industry for the development and use of innovative technology in our products, which has increased patient comfort and capability, and can significantly enhance the rehabilitation process.  The quality of our products and the success of our technological advances have generated broad media coverage, building our brand equity among payors, patients and referring physicians.

A substantial portion of our O&P services involves the treatment of a patient in a non-hospital setting, such as our patient-care centers, a physician’s office, an out-patient clinic or other facility.  In addition, O&P services are increasingly rendered to patients in hospitals, long-term care facilities, rehabilitation centers and other alternate-site healthcare facilities.  In a hospital setting, the practitioner works with a physician to provide either orthotic devices or temporary prosthetic devices that are later replaced by permanent prosthetic devices.

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Distribution Services

We distribute O&P components to the O&P market as a whole and to our own patient-care centers through our wholly-owned subsidiary, SPS, which is the nation’s largest O&P distributor. In July 2007, SPS acquired certain assets of SureFit, LLC, a leading manufacturer and distributor of therapeutic footwear for diabetic patients in the podiatric market.  SPS maintains in inventory approximately 21,000 O&P related items, all of which are manufactured by other companies.  SPS maintains distribution facilities in California, Florida, Georgia, Pennsylvania, and Texas, which allows us to deliver products via ground shipment anywhere in the United States within two business days.

Our distribution business enables us to:

·lower our material costs by negotiating purchasing discounts from manufacturers;

·reduce our patient-care center inventory levels and improve inventory turns through centralized purchasing control;

·access prefabricated and finished O&P products quickly;

·perform inventory quality control;

·encourage our patient-care centers to use clinically appropriate products that enhance our profit margins; and

·coordinate new product development efforts with key vendor “partners”.

This is accomplished at competitive prices as a result of our direct purchases from manufacturers.  Marketing of our distribution services is conducted on a national basis through a dedicated sales force, print and e-commerce catalogues and exhibits at industry and medical meetings and conventions.  We direct specialized catalogues to segments of the healthcare industry, such as orthopedic surgeons, physical and occupational therapists, and podiatrists.

Product Development

In 2004, we formed a new subsidiary, IN, Inc. Specializing in the field of functional electrical stimulation, IN, Inc. identifies emerging MyoOrthotics Technologies® developed at research centers and universities throughout the world that use neuromuscular stimulation to improve the functionality of an impaired limb. MyoOrthotics Technologies® represents the merging of orthotic technologies with electrical stimulation. Working with the inventors under licensing and consulting agreements, IN, Inc. advances the design and manufacturing and regulatory and clinical aspects of the technology, and then introduces the devices to the marketplace through a variety of distribution channels. IN, Inc’s. first product, the WalkAide System (“WalkAide”), has received FDA approval, achieved ISO 13485:2004 and ISO 9001:2000 certification, as well as the European CE Mark, which are widely accepted quality management standards for medical devices and related services.  In addition, in September 2007 the WalkAide earned the esteemed da Vinci Award for Adaptive Technologies from the National Multiple Sclerosis Society.  In the spirit of the 15th century artist and visionary

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Leonardo da Vinci, the da Vinci Awards honor outstanding engineering achievements in adaptive and assistive technology that provide solutions to accessibility issues for people with disabilities.  The WalkAide is sold in the United States through the Company’s patient care centers and SPS. IN, Inc is also marketing the WalkAide internationally through licensed distributors. In July 2007, IN, Inc. announced an agreement granting Teijin Pharma Limited exclusive rights to develop and commercialize the WalkAide in Japan.

Provider Network Management

Linkia is the first provider network management service company dedicated solely to serving the O&P market. Linkia was created by us during 2003 and is dedicated to managing the O&P services of national insurance companies. Linkia partners with healthcare insurance companies by securing national and regional contracts to manage their O&P networks, of which our patient care centers represent the majority of the participating providers. In 2004, Linkia entered into its first contract, and in September 2005, Linkia signed an agreement with CIGNA HealthCare which presently covers approximately nine million beneficiaries. We will continue to invest in and develop Linkia’s networks and capabilities, as well as market Linkia’s services to other national payors.

Industry Overview

We estimate that the O&P patient care market in the United States is approximately $2.5 billion, of which we account for approximately 25%.  The O&P patient care services market is highly fragmented and is characterized by local, independent O&P businesses, with the majority generally having a single facility with annual revenues of less than $1.0 million.  We do not believe that any of our patient care competitors account for a market share of more than 2% of the country’s total estimated O&P patient care services revenue.

The care of O&P patients is part of a continuum of rehabilitation services including diagnosis, treatment and prevention of future injury.  This continuum involves the integration of several medical disciplines that begins with the attending physician’s diagnosis.  A patient’s course of treatment is generally determined by an orthopedic surgeon, vascular surgeon or physiatrist, who writes a prescription and refers the patient to an O&P patient care services provider for treatment.  A practitioner then, using the prescription, consults with both the referring physician and the patient to formulate the design of an orthotic or prosthetic device to meet the patient’s needs.

The O&P industry is characterized by stable, recurring revenues, primarily resulting from the need for periodic replacement and modification of O&P devices.  Based on our experience, the average replacement time for orthotic devices is one to three years, while the average replacement time for prosthetic devices is three to five years.  There is also an attendant need for continuing O&P patient care services.  In addition to the inherent need for periodic replacement and modification of O&P devices and continuing care, we expect the demand for O&P services will continue to grow as a result of several key trends, including:

Aging U.S. Population.  The growth rate of the over-65 age group is nearly triple that of the under-65 age group.  There is a direct correlation between age and the onset of diabetes and vascular disease, which are the leading causes of amputations.  With broader

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medical insurance coverage, increasing disposable income, longer life expectancy, greater mobility expectations and improved technology of O&P devices, we believe the elderly will increasingly seek orthopedic rehabilitation services and products.

Growing Physical Health Consciousness.  The emphasis on physical fitness, leisure sports and conditioning, such as running and aerobics, is growing, which has led to increased injuries requiring orthopedic rehabilitative services and products.  These trends are evidenced by the increasing demand for new devices that provide support for injuries, prevent further or new injuries or enhance physical performance.

Increased Efforts to Reduce Healthcare Costs.  O&P services and devices have enabled patients to become ambulatory more quickly after receiving medical treatment in the hospital.  We believe that significant cost savings can be achieved through the early use of O&P services and products.  The provision of O&P services and products in many cases reduces the need for more expensive treatments, thus representing a cost savings to third-party payors.

Advancing Technology.  The range and effectiveness of treatment options for patients requiring O&P services have increased in connection with the technological sophistication of O&P devices.  Advances in design technology and lighter, stronger and more cosmetically acceptable materials have enabled patients to replace older O&P devices with new O&P products that provide greater comfort, protection and patient acceptability.  As a result, treatment can be more effective or of shorter duration, giving the patient greater mobility and a more active lifestyle.  Advancing technology has also increased the prevalence and visibility of O&P devices in many sports, including skiing, running and tennis.

Competitive Strengths

The combination of the following competitive strengths will help us in growing our business through an increase in our net sales, net income and market share:

·Leading market position, with an approximate 25% share of total industry revenues and operations in 45 states and the District of Columbia, in an otherwise fragmented industry;

·National scale of operations, which has better enabled us to:

·establish our brand name and generate economies of scale;

·implement best practices throughout the Company;

·utilize shared fabrication facilities;

·contract with national and regional managed care entities;

·identify, test and deploy emerging technology; and

·increase our influence on, and input into, regulatory trends;

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·Distribution of, and purchasing power for, O&P components and finished O&P products, which enables us to:

·negotiate greater purchasing discounts from manufacturers and freight providers;

·reduce patient-care center inventory levels and improve inventory turns through centralized purchasing control;

·quickly access prefabricated and finished O&P products;

·promote the usage by our patient-care centers of clinically appropriate products that also enhance our profit margins;

·engage in co-marketing and O&P product development programs with suppliers; and

·expand the non-Hanger client base of our distribution segment;

·Development of leading-edge technology to be brought to market through our patient practices and licensed distributors worldwide;

·Full O&P product offering, with a balanced mix between orthotics services and products and prosthetics services and products;

·Practitioner compensation plans that financially reward practitioners for their efficient management of accounts receivable collections, labor, materials, and other costs, and encourage cooperation among our practitioners within the same local market area;

·Proven ability to rapidly incorporate technological advances in the fitting and fabrication of O&P devices;

·History of successful integration of small and medium-sized O&P business acquisitions, including 65 O&P businesses since 1997,  representing over 168 patient-care centers;

·Highly trained practitioners, whom we provide with the highest level of continuing education and training through programs designed to inform them of the latest technological developments in the O&P industry, and our certification program located at the University of Connecticut;

·Experienced and committed management team; and

·Successful Government Relations efforts including:

·Supported our patients’ efforts to pass “The Prosthetic Parity Act” in 11 states;

·Increased Medicaid reimbursement levels in several states; and

·Created the Hanger Orthopedic Political Action Committee (The Hanger PAC).

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Business Strategy

Our goal is to continue to provide superior patient care and to be the most cost-efficient, full service, national O&P operator.  The key elements of our strategy to achieve this goal are to:

·Improve our performance by:

·developing and deploying new processes to improve the productivity of our practitioners;

·continuing periodic patient evaluations to gauge patients’ device and service satisfaction;

·improving the utilization and efficiency of administrative and corporate support services;

·enhancing margins through continued consolidation of vendors and product offering; and

·leveraging our market share to increase sales and enter into more competitive payor contracts;

·Increase our market share and net sales by:

·continued marketing of Linkia to regional and national providers and contracting with national and regional managed care providers who we believe select us as a preferred O&P provider because of our reputation, national reach, density of our patient-care centers in certain markets and our ability to monitor quality and outcomes as well as reducing administrative expenses;

·increasing our volume of business through enhanced comprehensive marketing programs aimed at referring physicians and patients, such as our Patient Evaluation Clinics program, which reminds patients to have their devices serviced or replaced and informs them of technological improvements of which they can take advantage; and our “People in Motion” program which introduces potential patients to the latest O&P technology;

·expanding the breadth of products being offered out of our patient-care centers; and

·increasing the number of practitioners through our residency program;

·Develop businesses that provide services and products to the broader rehabilitation and post-surgical healthcare areas;

·Continue to create, license or patent and market devices based on new cutting edge technology.  We anticipate bringing new technology to the market through our IN, Inc. product line;

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·Selectively acquire small and medium-sized O&P patient care service businesses and open satellite patient-care centers primarily to expand our presence within an existing market and secondarily to enter into new markets; and

·Provide our practitioners with:

·the training necessary to utilize existing technology for different patient service facets, such as the use of our Insignia scanning system for burns and cranial helmets;

·career development and increased compensation opportunities;

·a wide array of O&P products from which to choose;

·administrative and corporate support services that enable them to focus their time on providing superior patient care; and

·selective application of new technology to improve patient care.

·lobbying of government officials at both the state and federal level on issues important to Hanger, our patients, and the O&P industry.

Results

Net sales for the three months ended June 30, 2008 increased by $20.8 million, or 13.0%, to $181.2 million from $160.4 million in the prior year’s second quarter. The sales growth was the result of a $12.7 million, or 8.9%, increase in same-center sales in our patient care business, a $3.2 million, or 20.6%, increase in sales of the Company’s distribution segment, and a $4.9 million increase related to acquired entities. Income from operations increased by $3.6 million for the three months ended June 30, 2008, to $21.4 million, or 11.8% of net sales, from $17.8 million, or 11.2% of net sales, in the same period in 2007.  Income from operations increased due principally to the increase in sales volume allowing us to leverage our relatively fixed labor costs. Net income for the three months ended June 30, 2008 increased $2.9 million to $8.0 million, compared to net income of $5.1 million in the same period of the prior year.  The current period benefited from sales growth and lower interest costs.

Net sales for the six months ended June 30, 2008 increased by $34.6 million, or 11.4%, to $338.8 million from $304.2 million for the same period in the prior year.  The sales growth was principally the result of an $18.2 million, or 6.7%, increase in same-center sales in our patient care business, a $6.7 million, or 23.5%, increase in sales of the Company’s distribution segment, and a $9.1 million increase related to acquired entities. Income from operations increased by $5.4 million for the six months ended June 30, 2008, to $35.6 million, or 10.5% of net sales, from $30.2 million, or 9.9% of net sales, in the same period in 2007.  Income from operations increased due principally to the increase in sales volume allowing us to leverage our relatively fixed labor costs.  Net income for the six months ended June 30, 2008 increased $4.7 million to $11.6 million, compared to net income of $6.9 million in the same period of the prior year.  The current period benefited from the sales volume increase, improved bad debt and lower interest costs.

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Critical Accounting Policies and Estimates

Our analysis and discussion of our financial condition and results of operations are based upon our consolidated financial statements. The unaudited interim consolidated financial statements as of and for the three and six months ended June 30, 2008 and 2007 have been prepared by the Hanger Orthopedic Group, Inc. (the “Company”) pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”) for interim financial reporting.  These consolidated statements are unaudited and, in the opinion of management, include all adjustments (consisting of normal recurring adjustments and accruals) necessary for a fair statement for the periods presented.  The year-end consolidated data was derived from audited financial statements but does not include all disclosures required by accounting principles generally accepted in the United States of America (“GAAP”).

These consolidated financial statements should be read in conjunction with the consolidated financial statements of the Company and notes thereto included in the Annual Report on Form 10-K for the year ended December 31, 2007, filed by the Company with the SEC. We believe the following accounting policies are critical to understanding the results of operations and affect the more significant judgments and estimates used in the preparation of the Consolidated Financial Statements.

·Revenue Recognition:  Revenues from the sale of orthotic and prosthetic devices and associated services to patients are recorded when the device is accepted by the patient, provided that (i) delivery has occurred or services have been rendered; (ii) persuasive evidence of an arrangement exists; (iii) the sales price is fixed or determinable; and (iv) collectability is reasonably assured.  Revenues from the sale of orthotic and prosthetic devices to customers by our distribution segment are recorded upon the shipment of products, in accordance with the terms of the invoice, net of merchandise returns received and the amount established for anticipated returns.  Discounted sales are recorded at net realizable value.  Deferred revenue represents prepaid tuition and fees received from students enrolled in our practitioner education program.

Revenue at our patient-care centers segment is recorded net of all governmental adjustments, contractual adjustments and discounts.  We employ a systematic process to ensure that our sales are recorded at net realizable value and that any required adjustments are recorded on a timely basis.  The contracting module of our centralized, computerized billing system is designed to record revenue at net realizable value based on our contract with the patient’s insurance company.  Updated billing information is received periodically from payors and is uploaded into our centralized contract module and then disseminated to all patient-care centers electronically.

The following represents the composition of our patient-care segment’s accounts receivable balance by payor:

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June 30, 2008
(In thousands)	0-60 days		61-120 days		Over 120 days		Total
Commercial and other	$	41,230	$	7,999	$	5,490	$	54,719
Private pay	3,608		1,493		998		6,099
Medicaid	10,263		2,471		1,823		14,557
Medicare	21,458		1,681		1,416		24,555
VA	1,289		185		37		1,511
	$	77,848	$	13,829	$	9,764	$	101,441

December 31, 2007
(In thousands)	0-60 days		61-120 days		Over 120 days		Total
Commercial and other	$	41,806	$	9,561	$	6,836	$	58,203
Private pay	3,124		1,326		1,266		5,716
Medicaid	8,506		2,320		2,084		12,910
Medicare	20,557		2,622		1,603		24,782
VA	1,140		196		135		1,471
	$	75,133	$	16,025	$	11,924	$	103,082

Disallowed sales generally relate to billings to payors with whom we do not have a formal contract.  In these situations, we record the sale at usual and customary rates and simultaneously record an estimate to reduce the sale to net realizable value, based on our historical experience with the payor in question.  Disallowed sales may also result if the payor rejects or adjusts certain billing codes.  Billing codes are frequently updated within our industry.  As soon as updates are received, we reflect the change in our centralized billing system.

As part of our preauthorization process with payors, we validate our ability to bill the payor for the service we are providing before we deliver the device.  Subsequent to billing for our devices and services, there may be problems with pre-authorization or with other insurance coverage issues with payors.  If there has been a lapse in coverage, the patient is financially responsible for the charges related to the devices and services received.  If we do not collect from the patient, we record bad debt expense.  Occasionally, a portion of a bill is rejected by a payor due to a coding error on our part and we are prevented from pursuing payment from the patient due to the terms of our contract with the insurance company.  We appeal these types of decisions and are generally successful.  This activity is factored into our methodology to determine the estimate for the allowance for doubtful accounts.  We immediately record, as a reduction of sales, a disallowed sale for any claims that we know we will not recover and adjust our future estimates accordingly.

Certain accounts receivable may be uncollectible, even if properly pre-authorized and billed.  Regardless of the balance, accounts receivable amounts are periodically evaluated to assess collectability.  In addition to the actual bad debt expense recognized during collection activities, we estimate the amount of potential bad debt expense that may occur in the future.  This estimate is based upon our historical experience as well as a review of our receivable balances.  On a quarterly basis, we evaluate cash collections, accounts receivable balances and write-off activity to assess the adequacy of our allowance for doubtful accounts.  Additionally, a company-wide evaluation of collectability of receivable balances older than 180 days is performed at least semi-annually, the results of which are used in the next allowance analysis.  In these detailed reviews,

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the account’s net realizable value is estimated after considering the customer’s payment history, past efforts to collect on the balance and the outstanding balance, and a specific reserve is recorded if needed.  From time to time, the Company may outsource the collection of such accounts to outsourced agencies after internal collection efforts are exhausted.  In the cases when valid accounts receivable cannot be collected, the uncollectible account is written off to bad debt expense.

·Fair Value:  Effective January 1, 2008, the Company adopted Statement of Financial Accounting Standard No. 157, Fair Value Measurements, or SFAS 157, which establishes a framework for measuring fair value and requires enhanced disclosures about fair value measurements.  SFAS 157 requires disclosure about how fair value is determined for assets and liabilities and establishes a hierarchy for which these assets and liabilities must be grouped, based on significant levels of inputs as follows:

Level 1quoted prices in active markets for identical assets or liabilities;

Level 2quoted prices in active markets for similar assets and liabilities and inputs that are observable for the asset or liability;

Level 3unobservable inputs, such as discounted cash flow models and valuations.

The determination of where assets and liabilities fall within this hierarchy is based upon the lowest level of input that is significant to the fair value measurement. The following is a listing of our assets and liabilities required to be measured at fair value on a recurring basis and where they are classified within the hierarchy as of June 30, 2008:

(in thousands)	Level 1		Level 2		Level 3		Total
Assets
Auction rate securities	—		—		6,902		6,902
Interest rate swaps	—		1,955		—		1,955
	$	—	$	1,955	$	6,902	$	8,857
	Level 1		Level 2		Level 3		Total
Liabilities
Interest rate swaps	—		487		—		487
	$	—	$	487	$	—	$	487

Auction rate securities: The fair values of our ARSs were estimated through discounted cash flow models.  These models consider, among other things, the timing of expected future successful auctions, collateralization of underlying security investments and the credit worthiness of the issuer. Since these inputs were not observable, they are classified as

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level 3 inputs.  The auctions for all of the ARSs then held by us were unsuccessful as of June 30, 2008, resulting in our continuing to hold them beyond their typical auction reset dates and causing the level of inputs used to determine their fair values to be unobservable (level 3 inputs). As a result of the lack of liquidity in the ARS market and not as a result of the quality of the underlying collateral, for the three and six months ended June 30, 2008, we recorded an unrealized losses on our ARSs of $0.1 million and $0.6 million, respectively, which is reflected in accumulated other comprehensive income in our consolidated balance sheet.

Interest rate swaps: In May 2008, the Company entered into two interest rate swap agreements under which $150.0 million of the Company’s variable rate Term Loans were converted to a fixed rate of 5.4%.  The agreements, which expire April 2011, qualify as cash flow hedges in accordance with Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities, or SFAS 133. The fair value of the interest rate swaps is an estimate of the present value of expected future cash flows the Company is to receive under the interest rate swap agreement. The valuation models used to determine the fair value of the interest rate swap are based upon forward yield curve of one month LIBOR (level 2 inputs), the hedged interest rate.  There was no ineffectiveness relating to the interest rate swaps for the three and six months ended June 30, 2008, with all of the unrealized gains of $1.5 million reported in accumulated other comprehensive income, a component of shareholders’ equity. The interest rate swap asset of $2.0 million is reported in other long-term assets, while the interest rate liability of $0.5 million is reported in accrued expenses on the Company’s balance sheet as of June 30, 2008.

·Inventories:  Inventories, which consist principally of raw materials, work in process and finished goods, are stated at the lower of cost or market using the first-in, first-out method.  At our patient-care centers segment, we calculate cost of goods sold in accordance with the gross profit method for all reporting periods.  We base the estimates used in applying the gross profit method on the actual results of the most recently completed physical inventory and other factors, such as sales mix and purchasing trends among other factors, affecting cost of goods sold during the interim reporting periods.  Cost of goods sold during the period is adjusted when the annual physical inventory is taken.  We treat these inventory adjustments as changes in accounting estimates.  At our distribution segment, a perpetual inventory is maintained.  Management adjusts our reserve for inventory obsolescence whenever the facts and circumstances indicate that the carrying cost of certain inventory items is in excess of its market price.  Shipping and handling costs are included in cost of goods sold.

·Property, Plant and Equipment:  We record property, plant and equipment at cost.  Equipment acquired under capital leases is recorded at the lower of fair market value or the present value of the future lease payments.  The cost and related accumulated depreciation of assets sold, retired or otherwise disposed of are removed from the respective accounts, and any resulting gains or losses are included in the Consolidated Statements of Operations.  Depreciation is computed for financial reporting purposes using the straight-line method over the estimated useful lives of the related assets as follows:

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Furniture and fixtures	5 years
Machinery and equipment	5 years
Computers and software	5 years
Buildings	10 to 40 years
Assets under capital leases	Shorter of asset life or term of lease
Leasehold improvements	Shorter of asset life or term of lease

We capitalize internally developed computer software costs incurred during the development stage of the software in accordance with Statement of Position 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use.

·Goodwill and Other Intangible Assets:  Excess cost over net assets acquired (“Goodwill”) represents the excess of purchase price over the value assigned to net identifiable assets of purchased businesses.  We assess goodwill for impairment annually on October 1, or when events or circumstances indicate that the carrying value of the reporting units may not be recoverable.  Any impairment would be recognized by a charge to operating results and a reduction in the carrying value of the intangible asset.  Our annual impairment test for goodwill primarily utilizes the income approach and considers the market approach and the cost approach in determining the value of our reporting units.

Non-compete agreements are recorded based on agreements entered into by us and are amortized, using the straight-line method, over their terms ranging from five to seven years.  Other definite-lived intangible assets are recorded at cost and are amortized, using the straight-line method, over their estimated useful lives of up to 16 years.  Whenever the facts and circumstances indicate that the carrying amounts of these intangibles may not be recoverable, management reviews and assesses the future cash flows expected to be generated from the related intangible for possible impairment.  Any impairment would be recognized as a charge to operating results and a reduction in the carrying value of the intangible asset.

·Income Taxes:  We adopted the provisions of Financial Accounting Standards Board Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”), on January 1, 2007.  As a result of adoption, we recognized a decrease of approximately $0.2 million in the January 1, 2007 retained earnings balance. We recognize interest accrued and penalties related to unrecognized tax benefits as a component of income tax expense.

We recognize deferred income tax liabilities and assets for the expected future tax consequences of events that have been included in the financial statements or tax returns.  Deferred income tax liabilities and assets are determined based on the difference between the financial statement and the tax basis of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse.  We recognize a valuation allowance on the deferred tax assets if it is more likely than not that the assets will not be realized in future years.

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New Accounting Guidance

In December 2007, the FASB issued SFAS 141(R), Business Combinations (“SFAS 141(R)”). SFAS 141(R) provides revised guidance to improve the relevance, representational faithfulness, and comparability of the information that a reporting entity provides in its financial reports about a business combination and its effects. SFAS 141(R) revises the accounting literature previously issued under SFAS 141, Business Combinations.  SFAS 141(R) is effective for fiscal years beginning after December 15, 2008. The Company is currently evaluating the impact that adopting SFAS 141(R) will have on our financial statements.

In December 2007, the FASB issued SFAS 160, Noncontrolling Interest in Consolidated Financial Statements (“SFAS 160”). SFAS 160 revises ARB 51 accounting for non-controlling interests in subsidiaries. SFAS 160 is effective for fiscal years beginning after December 15, 2008. SFAS 160 will not have a material impact on the Company’s financial statements.

In February 2008, the FASB issued FSP No. FAS 157-2, Effective Date of FASB Statement No. 157 (“SFAS 157-2”).  SFAS 157-2 delays the application of SFAS 157 for all non-financial assets and liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis, to fiscal years beginning after November 15, 2008. SFAS 157 provides guidance on the application of fair value measurement objectives required in existing GAAP literature to ensure consistency and comparability.  Additionally, SFAS 157 requires additional disclosures on the fair value measurements used.  The Company is currently evaluating the impact that adopting SFAS 157 will have on non-financial assets or liabilities disclosed in the Company’s financial statements.

In March 2008, the FASB issued SFAS 161, Disclosures about Derivative Instruments and Hedging Activities (“SFAS 161”), an amendment of FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities. SFAS 161 is intended to enhance the current disclosure framework in SFAS 133.  SFAS 161 requires that objectives for using derivative instruments be disclosed in terms of underlying risk and accounting designation.  SFAS 161 is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008, with early application encouraged.  The Company is currently evaluating the impact that adopting SFAS 161 will have on our financial statements.

In April 2008, the FASB issued FSP No. FAS 142-3, Determination of the Useful Life of Intangible Assets (“SFAS 142-3”).  SFAS 142-3 amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset under FASB Statement No. 142, Goodwill and Other Intangible Assets. The intent of SFAS 142-3 is to improve the consistency between the useful life of a recognized intangible asset under Statement 142 and the period of expected cash flows used to measure the fair value of the asset under SFAS 141(R), and other U.S. generally accepted accounting principles (GAAP).  SFAS 142-3 is effective for financial statements issued for fiscal years and interim periods beginning after December 15, 2008.  The Company is currently evaluating the impact that adopting SFAS 142-3 will have on our financial statements.

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In May 2008, the FASB issued SFAS 162, The Hierarchy of Generally Accepted Accounting Principles (“SFAS 162”). SFAS 162 identifies the sources of accounting principles and the framework for selecting the principles used in the preparation of financial statements of nongovernmental entities that are presented in conformity with generally accepted accounting principles (GAAP) in the United States (the GAAP hierarchy). This Statement shall be effective 60 days following the SEC’s approval of the Public Company Accounting Oversight Board (PCAOB) amendments to AU Section 411, The Meaning of Present Fairly in Conformity With Generally Accepted Accounting Principles. SFAS 162 will not have a material impact on the Company’s the financial statements.

In May 2008, the FASB issued SFAS 163, Accounting for Financial Guarantee Insurance Contracts, an interpretation of FASB Statement No. 60 (“SFAS 163”). SFAS 163 clarifies how Statement 60 applies to financial guarantee insurance contracts, including the recognition and measurement of premium revenue and claim liabilities. SFAS 163 also requires expanded disclosures about financial guarantee insurance contracts.  This Statement shall be effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years.  SFAS 163 will not have a material impact on the Company’s the financial statements.

Results of Operations

The following table sets forth for the periods indicated certain items from our Consolidated Statements of Operations as a percentage of our net sales:

		Three Months Ended				Six Months Ended
		June 30,				June 30,
		2008		2007		2008		2007
Net sales		100.0	%	100.0	%	100.0	%	100.0	%
Cost of goods sold	��	48.7		49.2		49.4		49.8
Selling, general and administrative		37.1		37.2		37.6		37.8
Depreciation and amortization		2.4		2.4		2.5		2.5
Income from operations		11.8		11.2		10.5		9.9
Interest expense		4.4		5.7		4.8		6.1
Income before taxes		7.4		5.5		5.7		3.8
Provision for income taxes		3.0		2.3		2.3		1.6
Net income		4.4		3.2		3.4		2.2

Three Months Ended June 30, 2008 Compared to the Three Months Ended June 30, 2007

Net Sales.  Net sales for the three months ended June 30, 2008 increased by $20.8 million, or 13.0%, to $181.2 million from $160.4 million in the prior year’s second quarter. The sales growth was the result of a $12.7 million, or 8.9%, increase in same-center sales in our patient care business, a $3.2 million, or 20.6%, increase in sales of the Company’s distribution segment, and a $4.9 million increase related to acquired entities.

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Cost of Goods Sold.  Cost of goods sold for the three months ended June 30, 2008 was $88.2 million, an increase of $9.3 million, over $78.9 million for the same period in the prior year.  The increase was the result of growth in sales.  Cost of goods sold as a percentage of net sales improved 0.5% to 48.7% for the three months ended June 30, 2008.  The improvement is due to improved leverage of labor cost over greater sales, offset by increased material costs.

Selling, General and Administrative.  Selling, general and administrative expenses for the three months ended June 30, 2008 increased by $7.6 million to $67.3 million from $59.7 million, for the three months ended June 30, 2008.  The increase was principally due to: (i) a $2.6 million increase in variable compensation accruals; (ii) a $2.6 million increase in personnel cost, which is primarily employee benefits and merit salary increases; (iii) a $1.4 million increase related to acquisitions; (iv) a $1.0 million increase in professional fees and other expenses; (v) $0.6 million of additional investment in growth initiatives; and (vi)  a $0.6 million decrease in bad debt expense. Selling, general, and administrative expenses as a percentage of net sales improved 0.1% from 37.2% for the three months ended June 30, 2007 to 37.1% for the three months ended June 30, 2008.  The improvement is attributable to increased sales volumes but relatively fixed labor costs and a reduction of bad debt expense as a percentage of net sales, offset by increases in personnel cost and incentive compensation as a percentage of net sales.

Depreciation and Amortization. Depreciation and amortization for the three months ended June 30, 2008 was $4.3 million versus $3.9 million for the three months ended June 30, 2007.  The increase is a result of investments in infrastructure improvements and leasehold improvements as well as amortization of acquired intangible assets.

Income from Operations.  The increase in net sales resulted in income from operations increasing $3.6 million to $21.4 million for the three months ended June 30, 2008.  Income from operations, as a percentage of net sales, improved to 11.8% for the three months ended June 30, 2008 versus 11.2% for the prior year’s comparable period.  Income from operations as a percentage of net revenues improved due to increased sales volumes but relatively fixed labor costs.

Interest Expense.  Interest expense in the three months ended June 30, 2008 decreased $1.1 million to $8.0 million from $9.1 million in the three months ended June 30, 2007 due to a decrease in variable interest rates.

Income Taxes.  An income tax provision of $5.3 million was recognized for the three months ended June 30, 2008 compared to a provision of $3.6 million for the same period of the prior year.  The change in the income tax provision was primarily the result of higher income from operations.  The effective tax rate for the three months ended June 30, 2008 was 40.0% compared to 41.5% for the three months ended June 30, 2007.  The effective tax rate for the three month periods ended June 30, 2008 and 2007 consists principally of the federal statutory tax rate of 35.0% and state income taxes.

Net Income.  As a result of the above, we recorded net income of $8.0 million for the three months ended June 30, 2008, compared to $5.1 million for the same period in the prior year.

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Six Months Ended June 30, 2008 Compared to the Six Months Ended June 30, 2007

Net Sales.  Net sales for the six months ended June 30, 2008 increased by $34.6 million, or 11.4%, to $338.8 million from $304.2 million for the six months ended June 30, 2007. The sales growth was principally the result of an $18.2 million, or 6.7%, increase in same-center sales in our patient care business, a $6.7 million, or 23.5%, increase in sales of the Company’s distribution segment, and a $9.1 million increase related to acquired entities.

Cost of Goods Sold.  Cost of goods sold for the six months ended June 30, 2008 was $167.3 million, an increase of $15.8 million, or 10.4%, over $151.5 million for the same period in the prior year.  The increase was the result of growth in sales.  Cost of goods sold as a percentage of net sales improved to 49.4% in 2008 from 49.8% in 2007. The improvement is a result of leveraging the labor portion of cost of goods sold over a larger sales volume, offset by increased material costs.

Selling, General and Administrative.  Selling, general and administrative expenses for the six months ended June 30, 2008 increased by $12.6 million to $127.5 million from $114.9 million, for the six months ended June 30, 2008. The increase was principally due to: (i) a $4.4 million increase in personnel cost which is primarily employee benefits and merit salary increases ; (ii) a $2.8 million increase in variable compensation expense; (iii) a $2.9 million increase related to acquisitions; (iv) $2.0 million of additional investment in growth initiatives; (v) $1.4 million of other overhead increases; and (vi) a $1.1 million decrease in bad debt expense. Selling, general, and administrative costs as a percentage of net sales improved 0.2% from 37.8% for the six months ended June 30, 2007 to 37.6% for the six months ended June 30, 2008.  The improvement is attributable to increased sales volumes but relatively fixed labor costs and a reduction of bad debt expense as a percentage of net sales, offset by increases in personnel cost and incentive compensation as a percentage of net sales.

Depreciation and Amortization. Depreciation and amortization for the six months ended June 30, 2008 was $8.5 million versus $7.6 million for the six months ended June 30, 2007.  The increase is a result of investment in infrastructure improvements and leasehold improvements as well as amortization of acquired intangible assets.

Income from Operations.  Principally due to the increase in net sales, income from operations increased $5.4 million to $35.6 million for the six months ended June 30, 2008.  Income from operations, as a percentage of net sales, improved to 10.5% for the six months ended June 30, 2008 versus 9.9% for the prior year’s comparable period.  Income from operations as a percentage of net revenues improved due increased sales volumes but relatively fixed labor costs.

Interest Expense.  Interest expense in the six months ended June 30, 2008 decreased to $16.3 million compared to $18.5 million in the six months ended June 30, 2007 due to a decrease in variable interest rates.

Income Taxes.  An income tax provision of $7.7 million was recognized for the six months ended June 30, 2008 compared to a provision of $4.9 million for the same period of the prior year.  The change in the income tax provision was primarily the result of higher income from operations.  The effective tax rate for the six months ended June 30, 2008 was 40.0% compared to 41.5% for the six months ended June 30, 2007.  The effective tax rate for the six month periods ended June 30, 2008 and 2007 consists principally

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of the federal statutory tax rate of 35.0% and state income taxes.

Net Income.  As a result of the above, we recorded net income of $11.6 million for the six months ended June 30, 2008, compared to $6.9 million for the same period in the prior year.

Financial Condition, Liquidity, and Capital Resources

Cash Flows

Our working capital at June 30, 2008 was $176.1 million compared to $165.8 million at December 31, 2007.  Working capital increased principally as a result increases in operating income and continued strong cash collections.  Cash flows provided by operations of $12.6 million for the six months ended June 30, 2008 compared unfavorably to $20.1 million of cash provided by operations in the prior year, primarily due to the timing of $8.8 million of incentive compensation payments.  Days sales outstanding (“DSO”), which is the number of days between the billing for our O&P services and the date of our receipt of payment thereof, for the six months ended June 30, 2008, decreased to 52 days, compared to 57 days for the same period last year.  The decrease in DSO is due to a continued effort at our patient-care centers to target collections.

Net cash used in investing activities was $10.0 million for the six months ended June 30, 2008, versus $10.4 million for the same period in the prior year.  Cash used in investing activities in the current period included $7.8 million related to the purchase of computer related assets, machinery and equipment and leasehold improvements and $2.2 million related to acquisitions of patient-care centers.  In conjunction with the acquisitions completed during the six months ended June 30, 2008, the Company recorded approximately $4.2 million of goodwill.

Net cash used in financing activities was $5.5 million for the six months ended June 30, 2008, compared to $2.8 million for the six months ended June 30, 2007.  The increase in cash used by financing activities was primarily due to repayments made to our term loan.

In June 2008, the Company’s average closing price of its common stock price exceeded the Company’s forced conversion price of the Series A Convertible Preferred Stock by 200% for a 20-trading day period, triggering an acceleration of the Series A Preferred dividends that were otherwise payable through May 26, 2011. The accelerated dividends were paid in the form of increased stated value of preferred stock, in lieu of cash.  On July 25, 2008, the Company notified the holder of Series A Preferred of its election to force the conversion of the Series A Preferred into 7,308,730 shares of common stock.  The conversion will occur on August 8, 2008.

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Long-term debt consisted of the following:

	June 30,			December 31,
(In thousands)	2008			2007
Term Loan	$	223,065		$	226,550
10 1/4% Senior Notes due 2014	175,000			175,000
Subordinated seller notes, non-collateralized, net of unamortized discount with principal and interest payable in either monthly, quarterly or annual installments at effective interest rates ranging from 5.0% to 10.8%, maturing through December 2011	8,360			9,342
	406,425			410,892
Less current portion	(4,769		)	(5,691		)
	$	401,656		$	405,201

Revolving Credit Facility

The $75.0 million Revolving Credit Facility matures on May 26, 2011 and bears interest, at the Company’s option, of LIBOR plus 2.75% or a Base Rate (as defined in the credit agreement) plus 1.75%. The obligations under the Revolving Credit Facility are guaranteed by the Company’s subsidiaries and are secured by a first priority perfected interest in the Company’s subsidiaries’ shares, all of the Company’s assets and all the assets of the Company’s subsidiaries. The Revolving Credit Facility requires compliance with various covenants including but not limited to a maximum total leverage ratio and a maximum annual capital expenditures limit. As of June 30, 2008, the Company has not made draws on the Revolving Credit Facility and has $71.5 million available under that facility. Availability under the Company’s Revolving Credit Facility is net of standby letters of credit of approximately $3.5 million.

Term Loan

The $230.0 million Term Loan matures on May 26, 2013 and requires quarterly payments which commenced on September 30, 2006. From time to time, mandatory payments may be required as a result of capital stock issuances, additional debt incurrence, asset sales or other events as defined in the credit agreement. The Term Loan bears interest, at the Company’s option, at LIBOR plus 2.00% or a Base Rate (as defined in the credit agreement) plus 1.50%. At June 30, 2008, the interest rate on the Term Loan was 4.46%. The obligations under the Term Loan are guaranteed by the Company’s subsidiaries and are secured by a first priority perfected interest in the Company’s subsidiaries’ shares, all of the Company’s assets and all the assets of the Company’s subsidiaries. The Term Loan is subject to covenants that mirror those of the Revolving Credit Facility.

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10 1/4 % Senior Notes

The 10 1/4 % Senior Notes mature June 1, 2014, are senior indebtedness and are guaranteed in full and unconditionally, on a senior unsecured basis by all of the Company’s current and future domestic subsidiaries as well as all the assets of the Company. The parent company has no independent assets or operations and all subsidiaries are 100% owned by the Company. Interest is payable semi-annually on June 1 and December 1, and commenced on December 1, 2006. On or prior to June 1, 2009, the Company may redeem up to 35% of the aggregate principal amount of the notes at a redemption price of 110.250% of the principal amount thereof, plus accrued and unpaid interest and additional interest, if any, with the net cash proceeds of an equity offering; provided that (i) at least 65% of the aggregate principal amount of the notes remains outstanding immediately after the redemption (excluding notes held by the Company and its subsidiaries); and (ii) the redemption occurs within 90 days of the date of the closing of the equity offering. Except as discussed above, the notes are not redeemable at the Company’s option prior to June 1, 2010. On or after June 1, 2010, the Company may redeem all or part of the notes upon not less than 30 days and no more than 60 days’ notice, for the twelve-month period beginning on June 1 of the following years: at (i) 105.125% during 2010; (ii) 102.563% during 2011; and (iii) 100.0% during 2012 and thereafter.

Debt Covenants

The terms of the Senior Notes and the Revolving Credit Facility limit the Company’s ability to, among other things, incur additional indebtedness, create liens, pay dividends on or redeem capital stock, make certain investments, make restricted payments, make certain dispositions of assets, engage in transactions with affiliates, engage in certain business activities and engage in mergers, consolidations and certain sales of assets. At June 30, 2008, the Company is in compliance with all covenants under these debt agreements.

Obligations and Commercial Commitments

The following table sets forth our contractual obligations and commercial commitments as of June 30, 2008:

	Payments Due by Period
(In thousands)	2008		2009		2010		2011		2012		Thereafter		Total
Long-term debt	$	2,694	$	4,442	$	3,880	$	3,868	$	3,772	$	387,769	$	406,425
Interest payments on long-term debt	14,540		28,115		26,736		27,236		27,578		29,214		153,419
Operating leases	16,123		27,420		19,584		14,161		9,065		8,243		94,596
Capital leases and other long-term obligations (1)	4,157		1,476		1,166		1,364		1,514		7,997		17,674
Total contractual cash obligations	$	37,514	$	61,453	$	51,366	$	46,629	$	41,929	$	433,223	$	672,114

(1) Other long-term obligations consist primarily of amounts related to our Supplemental Executive Retirement Plan, earnout payments and payments under the restructuring plans.

In addition to the table above, the Company has certain other tax liabilities as of June 30, 2008 comprised of $3.4 million of unrecognized tax benefits, of which $1.5 million is expected to be settled in the fiscal year 2008, with the remainder expected to be settled thereafter.

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Off-Balance Sheet Arrangements

The Company’s wholly-owned subsidiary, Innovative Neurotronics, Inc. (“IN, Inc.”), is party to a non-binding purchase agreement under which it agrees to purchase assembled WalkAide System kits. As of June 30, 2008, IN, Inc. had outstanding purchase commitments of approximately $0.5 million.

Market Risk

We are exposed to the market risk that is associated with changes in interest rates.  At June 30, 2008, all our outstanding debt, with the exception of the Revolving Credit Facility and $73.0 million of the Term Loan, is subject to a fixed interest rate. (See Item 3, Quantitative and Qualitative Disclosures about Market Risk, below.)

Forward Looking Statements

This report contains forward-looking statements setting forth our beliefs or expectations relating to future revenues, contracts and operations, as well as the results of an internal investigation and certain legal proceedings.  Actual results may differ materially from projected or expected results due to changes in the demand for our O&P products and services, uncertainties relating to the results of operations or recently acquired O&P patient-care centers, our ability to enter into and derive benefits from managed-care contracts, our ability to successfully attract and retain qualified O&P practitioners, federal laws governing the health-care industry, uncertainties inherent in incomplete investigations and legal proceedings, governmental policies affecting O&P operations and other risks and uncertainties generally affecting the health-care industry.  Please see Part II, Item 1A of this report and Part I, Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2007 for additional information relating to important risks that could materially adversely affect our business, financial condition, or results of operations. Readers are cautioned not to put undue reliance on forward-looking statements.  We disclaim any intent or obligation to publicly update these forward-looking statements, whether as a result of new information, future events or otherwise.

ITEM 3.Quantitative and Qualitative Disclosures about Market Risk

We have existing obligations relating to our 10 1/4 % Senior Notes, Term Loan, Subordinated Seller Notes, and Series A Convertible Preferred Stock.  As of June 30, 2008, we have cash flow exposure to the changing interest rate on the Term Loan and Revolving Credit Facility.  The other obligations have fixed interest or dividend rates.

We have a $75.0 million revolving credit facility, with no outstanding balance at June 30, 2008, as discussed in Note G of the Notes to Consolidated Financial Statements included in this report.  The rates at which interest accrues under the entire outstanding balance are variable.

In addition, in the normal course of business, we are exposed to fluctuations in interest rates.  From time to time, we execute LIBOR

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contracts to fix interest rate exposure for specific periods of time.  At June 30, 2008, we had one contract outstanding which fixed LIBOR at 4.46% and expired on July 30, 2008.

In May 2008, the Company entered into two interest rate swap agreements under which $150.0 million of the Company’s variable rate Term Loans were converted to a fixed rate of 5.4%.  The agreements expire in April 2011.

Presented below is an analysis as of June 30, 2008 of our financial instruments that are sensitive to changes in interest rates.  The table demonstrates the change in estimated annual cash flow related to the outstanding balance under the Interest Rate Swap, Term Loan, and the Revolving Credit Facility (the Revolving Credit Facility did not have an outstanding balance at June 30, 2008), calculated for an instantaneous parallel shift in interest rates, plus or minus 50 basis points (“BPS”), 100 BPS, and 150 BPS.

Cash Flow Risk	Annual Interest Expense Given an Interest Rate Decrease of X Basis Points								No Change in		Annual Interest Expense Given an Interest Rate Increase of X Basis Points
(In thousands)	(150 BPS)			(100 BPS)			(50 BPS)		Interest Rates		50 BPS		100 BPS		150 BPS
Interest Rate Swap	$	(1,350	)	$	(600	)	$	150	$	900	$	1,650	$	2,400	$	3,150
Term Loan	6,603			7,718			8,833		9,949		11,064		12,179		13,295
Revolving Credit Facility	—			—			—		—		—		—		—
	$	5,253		$	7,118		$	8,983	$	10,849	$	12,714	$	14,579	$	16,445

ITEM 4.Controls and Procedures

Disclosure Controls and Procedures

The Company’s disclosure controls and procedures are designed to provide reasonable assurance that information required to be disclosed by it in its periodic reports filed with the Securities and Exchange Commission is recorded, processed, summarized and reported, within the time periods specified in the Commission’s rules and forms.  Based on an evaluation of the Company’s disclosure controls and procedures conducted by the Company’s Chief Executive Officer and Chief Financial Officer, such officers concluded that the Company’s disclosure controls and procedures were effective as of June 30, 2008 to ensure that information required to be disclosed in the reports filed under the Exchange Act was accumulated and communicated to management, including the Company’s Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosures.

Change in Internal Control Over Financial Reporting

In accordance with Rule 13a-15(d) under the Securities Exchange Act of 1934, management, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, determined that there was no change in the Company’s internal control over financial reporting that occurred during the quarter ended June 30, 2008, that has materially effected, or is reasonably likely to materially effect, the Company’s internal control over financial reporting.

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Part II.  Other Information

ITEM 1A.  RISK FACTORS.

Item 1A (“Risk Factors”) of the Company’s Annual Report on Form 10-K for the year ended December 31, 2007 sets forth information relating to important risks and uncertainties that could materially adversely affect the Company’s business, financial condition or operating results.  Those risk factors continue to be relevant to an understanding of the Company’s business, financial condition and operating results.  Certain of those risk factors have been updated in this Form 10-Q to provide updated information, as set forth below.  References to “we,” “our” and “us” in these risk factors refer to the Company.

Changes in government reimbursement levels could adversely affect our net sales, cash flows and profitability.

We derived 39.8% and 41.1% of our net sales for the three months ended June 30, 2008 and 2007, respectively, from reimbursements for O&P services and products from programs administered by Medicare, Medicaid and the U.S. Veterans Affairs. For the six months ended June 30, 2008 and 2007, we derived 39.7% and 40.7%, respectively, in reimbursements from the programs administered by Medicare, Medicaid, and the U.S. Veterans Affairs. Each of these programs sets maximum reimbursement levels for O&P services and products. If these agencies reduce reimbursement levels for O&P services and products in the future, our net sales could substantially decline. In addition, the percentage of our net sales derived from these sources may increase as the portion of the U.S. population over age 65 continues to grow, making us more vulnerable to maximum reimbursement level reductions by these organizations. Reduced government reimbursement levels could result in reduced private payor reimbursement levels because fee schedules of certain third-party payors are indexed to Medicare.  Furthermore, the healthcare industry is experiencing a trend towards cost containment as government and other third-party payors seek to impose lower reimbursement rates and negotiate reduced contract rates with service providers.  This trend could adversely affect our net sales. Medicare provides for reimbursement for O&P products and services based on prices set forth in fee schedules for ten regional service areas.  If the U.S. Congress were to legislate additional modifications to the Medicare fee schedules, our net sales from Medicare and other payors could be adversely and materially affected.  We cannot predict whether any such modifications to the fee schedules will be enacted or what the final form of any modifications might be.  In addition, the WalkAide is not currently covered by Medicare and no assurances can be given as to whether or to what extent coverage will be granted by the Centers for Medicare & Medicaid Services.

On April 24, 2006, the Centers for Medicare & Medicaid Services announced a proposed rule that would call for a competitive bidding program for certain covered prosthetic and orthotic equipment as required by the Medicare Modernization Act of 2003.  The rule became effective on June 11, 2007 following its adoption by the Centers for Medicare & Medicaid Services.  We cannot now identify the impact of such adapted rule on us.

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Funds associated with certain of our auction rate securities are not currently accessible and our auction rate securities may experience an other than temporary decline in value, which would adversely affect our income.

Our short-term investments are comprised two auction rate securities (“ARS”) reported at an aggregate fair value of $6.9 million and an aggregate cost of $7.5 million, as of June 30, 2008.  ARS are securities that are structured with short-term interest rate reset dates which generally occur every 28 days, but with contractual maturities that can be well in excess of ten years.  At the end of each reset period, investors can sell or continue to hold the securities at par.  The auctions for all of the ARS held by us were unsuccessful as of June 30, 2008.  Therefore, based on an analysis of other-than-temporary impairment factors, we recorded an unrealized loss within accumulated other comprehensive income, a component of shareholders’ equity, of approximately $0.6 million at June 30, 2008 related to these auction rate securities.  Although we believe that the decline in the fair market value of these securities is temporary, if the decline in value were ultimately deemed to be other than temporary, it would result in a loss being recognized in our statement of operations, which could be material.  The funds associated with these will not be accessible until a successful auction occurs, a buyer is found outside of the auction process or the underlying securities have matured.

ITEM 4.Submission of Matters to a Vote of Security Holders

The Company’s Annual Meeting of Shareholders was held on May 8, 2008.

The first proposal at the annual meeting was the election of directors.  The following persons were nominated and elected to serve as members of the Board of Directors for one year, or until their successors are elected and qualified, by the votes indicated:  Bennett Rosenthal (18,986,047 shares for and 673,958 shares withheld), Edmond E. Charrette, M.D. (18,599,307 shares for and 1,060,698 shares withheld), Thomas P. Cooper, M.D. (18,600,657 shares for and 1,059,348 shares withheld), Cynthia L. Feldmann (18,844,747 shares for and 815,258 shares withheld), Eric A. Green (18,598,457 shares for and 1,061,548 shares withheld), Isaac Kaufman (18,164,113 shares for and 1,495,892 shares withheld), Thomas F. Kirk (18,597,757 shares for and 1,062,248 shares withheld), Ivan R. Sabel (18,596,957 shares for and 1,063,048 shares withheld), and H.E. Thranhardt (18,561,924 shares for and 1,098,081 shares withheld).

The second proposal at the annual meeting was a proposed ratification of the Board of Directors’ adoption on August 9, 2007 of an amendment to the By-Laws of the Company providing that the Company’s common stock be eligible for the Direct Registration System operated by the Depository Trust Company.  The proposal was approved by the holders of more than the required majority of the shares of Common Stock voting at the meeting.  The proposal was approved by a vote of 19,584,019 shares of Common Stock for (representing approximately 99.61% of the shares voting), 39,197 shares of Common Stock against, with 36,790 shares of Common Stock abstaining.

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ITEM 6.	Exhibits
	(a)	Exhibits. The following exhibits are filed herewith:

Exhibit No.		Document
31.1	Written Statement of the Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley
Act of 2002.
31.2	Written Statement of the Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley
Act of 2002.
32	Written Statement of the Chief Executive Officer and Chief Financial Officer Pursuant to 18
U.S.C. Section 1350, As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

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SIGNATURES

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

	HANGER ORTHOPEDIC GROUP, INC.
Dated: August 11, 2008	/s/ Thomas F. Kirk
	Thomas F. Kirk
	President and Chief Executive Officer
	(Principal Executive Officer)
Dated: August 11, 2008	/s/ George E. McHenry
	George E. McHenry
	Executive Vice President and
	Chief Financial Officer
	(Principal Financial Officer)
Dated: August 11, 2008	/s/ Thomas C. Hofmeister
	Thomas C. Hofmeister
	Vice President of Finance
	(Chief Accounting Officer)

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