ReAble Therapeutics 10-Q 2005 Q2 Quarterly report

FORM 10-Q

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

(Mark One)

þ	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
	For the quarterly period ended July 2, 2005

OR

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

Commission file number: 0-26538

ENCORE MEDICAL CORPORATION

(Exact name of Registrant as specified in its charter)

Delaware	65-0572565
(State or other jurisdiction of	(I.R.S. Employer
incorporation or organization)	Identification No.)
9800 Metric Boulevard
Austin, Texas	78758
(Address of principal executive offices)	(Zip code)

512-832-9500
(Registrant’s telephone number including area code)

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.
Yesþ Noo

Indicate by check mark whether the Registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2).
Yesþ Noo

The number of shares of the registrant’s common stock, par value $0.001, outstanding as of August 1, 2005 was 51,750,492.

ENCORE MEDICAL CORPORATION AND SUBSIDIARIES

Quarterly Report on Form 10-Q
For the period ended July 2, 2005

TABLE OF CONTENTS

	Page
PART I.
Item 1. Financial Statements		3
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		18
Item 3. Quantitative and Qualitative Disclosures About Market Risk		28
Item 4. Controls and Procedures		29
PART II.
Item 1. Legal Proceedings		29
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds		29
Item 3. Defaults Upon Senior Securities		29
Item 4. Submission of Matters to a Vote of Security Holders		29
Item 5. Other Information		30
Item 6. Exhibits		30
Signatures		31
Board of Directors Compensation
Certification Pursuant to Rule 13a-14a by CEO
Certification Pursuant to Rule 13a-14a by CFO
Section 1350 Certification by CEO
Section 1350 Certification by CFO

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Part I. Financial Information

Item 1. Financial Statements

ENCORE MEDICAL CORPORATION AND SUBSIDIARIES

Consolidated Balance Sheets
As of July 2, 2005 and December 31, 2004
(in thousands, except share and per share data)

	July 2,			December 31,
	2005			2004
	(unaudited)
Assets
Current assets:
Cash and cash equivalents		$15,666			$19,889
Accounts receivable, net		53,959			58,588
Inventories, net		56,787			49,129
Current deferred tax asset		9,308			8,831
Prepaid expenses and other current assets		3,653			2,691
Total current assets		139,373			139,128
Property and equipment, net		26,356			26,886
Goodwill		291,154			286,231
Intangible assets, net		86,156			87,697
Other assets		11,459			12,197
Total assets		$554,498			$552,139
Liabilities, Minority Interests and Stockholders’ Equity
Current liabilities:
Current portion of long-term debt		$8,377			$8,346
Accounts payable		12,201			10,850
Accrued expenses		26,223			29,049
Total current liabilities		46,801			48,245
Long-term debt, net of current portion		317,908			307,207
Non-current deferred tax liability		29,424			34,682
Other non-current liabilities		582			867
Total liabilities		394,715			391,001
Minority interests		580			821
Stockholders’ equity:
Common stock, $0.001 par value, 100,000,000 shares authorized; 52,262,000 and 52,204,000 shares issued, respectively		52			52
Additional paid-in capital		155,098			154,894
Notes received for sale of common stock		(846	)		(948	)
Retained earnings		7,609			3,576
Accumulated other comprehensive (loss) income		(1,063	)		4,390
Less cost of repurchased stock, warrants and rights (512,000 shares)		(1,647	)		(1,647	)
Total stockholders’ equity		159,203			160,317
Total liabilities, minority interests and stockholders’ equity		$554,498			$552,139

See accompanying notes to unaudited consolidated financial statements.

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ENCORE MEDICAL CORPORATION AND SUBSIDIARIES

Consolidated Statements of Operations
For the three and six months ended July 2, 2005 and July 3, 2004
(in thousands, except per share amounts)
(unaudited)

	Three Months						Six Months
	Ended						Ended
	July 2,			July 3,			July 2,			July 3,
	2005			2004			2005			2004
Net sales	$	78,007		$	29,296		$	153,363		$	60,340
Cost of sales		31,287			14,237			62,441			29,326
Gross margin		46,720			15,059			90,922			31,014
Operating expenses:
Selling, general and administrative		33,214			10,575			65,221			22,313
Research and development		2,426			1,735			4,919			3,404
Income from operations		11,080			2,749			20,782			5,297
Other income (expense):
Interest income		86			114			171			246
Interest expense		(7,345	)		(176	)		(14,342	)		(365	)
Other income (expense), net		127			(33	)		36			(26	)
Income before income taxes and minority interests		3,948			2,654			6,647			5,152
Provision for income taxes		1,491			996			2,571			1,940
Minority interests		17			—			43			—
Net income		$2,440			$1,658			$4,033			$3,212
Net income per common share:
Basic earnings per share		$0.05			$0.04			$0.08			$0.07
Shares used in computing basic earnings per share		51,744			42,875			51,722			42,847
Diluted earnings per share		$0.05			$0.04			$0.08			$0.07
Shares used in computing diluted earnings per share		52,289			44,261			52,348			44,313

See accompanying notes to unaudited consolidated financial statements.

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ENCORE MEDICAL CORPORATION AND SUBSIDIARIES

Consolidated Statements of Cash Flow
For the six months ended July 2, 2005 and July 3, 2004
(in thousands)
(unaudited)

	Six Months Ended
	July 2,			July 3,
	2005			2004
OPERATING ACTIVITIES:
Net income		$4,033			$3,212
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Depreciation		4,372			1,489
Amortization of intangibles		2,566			388
Amortization of debt issuance costs		1,103			56
Non-cash interest expense		49			—
Stock-based compensation		91			38
Loss on disposal of assets		774			5
Deferred taxes		(1,947	)		9
Accretion of held-to-maturity investments		—			(165	)
Provision for (recoveries of) bad debt expense and sales returns		2,333			(45	)
Inventory reserves		2,303			1,739
Minority interests		43			—
Tax provision associated with stock options		(49	)		—
Changes in operating assets and liabilities, net of acquired assets and liabilities:
Accounts receivable		1,362			(1,821	)
Inventories		(4,717	)		(5,734	)
Prepaid expenses, other assets and liabilities		(1,157	)		(260	)
Accounts payable and accrued expenses		(396	)		(808	)
Net cash provided by (used in) operating activities		10,763			(1,897	)
INVESTING ACTIVITIES:
Acquisition of subsidiaries		(21,065	)		—
Acquisition of technology license		—			(459	)
Purchases of property and equipment		(3,810	)		(2,426	)
Purchases of investments		—			(25,000	)
Maturities of investments		—			35,170
Net cash (used in) provided by investing activities		(24,875	)		7,285
FINANCING ACTIVITIES:
Proceeds from issuance of common stock		181			349
Proceeds from notes receivable for sale of common stock		102			152
Proceeds from short-swing profit		—			288
Proceeds from long-term obligations		14,700			—
Payments on long-term obligations		(4,046	)		(429	)
Payments of debt issuance costs		(226	)		—
Payments of dividend to minority shareholders		(198	)		—
Net cash provided by financing activities		10,513			360
Effect of exchange rate changes on cash and cash equivalents		(624	)		—
Net (decrease) increase in cash and cash equivalents		(4,223	)		5,748
Cash and cash equivalents at beginning of period		19,889			10,074
Cash and cash equivalents at end of period		$15,666			$15,822
Supplemental disclosures of cash flow information:
Cash paid for interest		$12,362			$230
Cash paid for income taxes		$4,894			$1,698
Non-cash investing and financing activities:
Purchase of technology through the issuance of a note payable		$—			$250

See accompanying notes to unaudited consolidated financial statements.

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ENCORE MEDICAL CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements
(unaudited)

1. BASIS OF PRESENTATION AND DESCRIPTION OF BUSINESS

Basis of Presentation

The accompanying unaudited consolidated financial statements include the accounts of Encore Medical Corporation, a Delaware corporation, and its wholly owned subsidiaries and those entities in which we hold a controlling interest (individually and collectively referred to as “us,” “we,” “our company” or “Encore”). Minority interest reflects the 50% separate ownership of Medireha GmbH. All significant intercompany balances and transactions have been eliminated in consolidation. The unaudited consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and notes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three and six-month periods ended July 2, 2005, are not necessarily indicative of the results that may be expected for the year ending December 31, 2005. For further information, refer to the consolidated financial statements and footnotes thereto included in our Form 10-K dated December 31, 2004.

Description of Business

We are a diversified orthopedic company that develops, manufactures, markets and distributes a comprehensive range of high quality orthopedic devices including surgical implants, sports medicine equipment and products for orthopedic rehabilitation, pain management and physical therapy. Our products are used by orthopedic surgeons, physicians, therapists, athletic trainers and other healthcare professionals to treat patients with musculoskeletal conditions resulting from degenerative diseases, deformities, traumatic events and sports-related injuries. Our non-invasive medical devices and related accessories are primarily used by patients for at-home physical therapy.

We currently market and distribute our products through two operating divisions, our Surgical Implant Division and our Orthopedic Rehabilitation Division. Our Surgical Implant Division offers a comprehensive suite of reconstructive joint products and spinal implants. Our Orthopedic Rehabilitation Division offers non-invasive medical products that are used before and after surgery to assist in the repair and rehabilitation of soft tissue and bone, and to protect against further injury; electrotherapy devices and accessories used to treat pain and restore muscle function; iontophoretic devices and accessories used to deliver medication; clinical therapy tables and traction equipment; and orthotics devices used to treat joint and spine conditions.

Our products are subject to regulation by the Food and Drug Administration (“FDA”) with respect to their sale in the United States, and we must, in many cases, obtain FDA authorization to market our products before they can be sold in the United States. Additionally, we are subject to similar regulations in many of the foreign countries in which we sell products.

2. ACCOUNTS RECEIVABLE

A summary of activity in our accounts receivable allowances for doubtful accounts and sales returns is summarized below (in thousands):

	Three Months Ended						Six Months Ended
	July 2,			July 3,			July 2,			July 3,
	2005			2004			2005			2004
Balance, beginning of period	$	3,947			$617		$	2,790		$	663
Provision for bad debt expense and sales returns		1,192			(105	)		2,333			(45	)
Write-off charges and recoveries		(777	)		25			(761	)		(81	)
Balance, end of period	$	4,362			$537		$	4,362		$	537

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3. INVENTORIES

Inventories consist of the following (in thousands):

	July 2,			December 31,
	2005			2004
Components and raw materials	$	14,581		$	13,639
Work in process		4,249			3,145
Finished goods		31,578			25,054
Inventory held on consignment		13,654			12,725
		64,062			54,563
Less-inventory reserves		(7,275	)		(5,434	)
	$	56,787		$	49,129

The increased inventories at July 2, 2005, principally resulted from inventory related to new product introductions and increased sales representatives in our Surgical Implant Division, coupled with the inventory we acquired pursuant to our acquisition of Osteoimplant Technology, Inc. (“OTI”) during the first quarter of 2005.

A summary of the activity in our inventory reserves for slow moving, excess, product obsolescence and valuation is presented below (in thousands):

	Three Months Ended						Six Months Ended
	July 2,			July 3,			July 2,			July 3,
	2005			2004			2005			2004
Balance, beginning of period	$	6,515		$	2,730		$	5,434		$	2,203
Provision charged to cost of sales		855			1,045			2,303			1,739
Write-offs charged to the reserve		(95	)		(133	)		(462	)		(300	)
Balance, end of period	$	7,275		$	3,642		$	7,275		$	3,642

The write-offs to the reserve principally relate to the disposition of fully reserved inventory. Additionally, the reserve has increased over similar periods in prior years due to our October 2004 acquisition of Empi, Inc. (“Empi”) and the additional inventory obsolescence expense related to trauma product line inventory in the fourth quarter of 2004.

4. GOODWILL AND INTANGIBLE ASSETS

A summary of the activity in goodwill is presented below (in thousands):

	July 2,			July 3,
	2005			2004
Balance, beginning of period	$	286,231		$	18,146
Adjustment related to resolution of contingencies associated with the acquisition of Empi		5,958			—
Goodwill associated with the acquisition of OTI		5,816			—
Foreign currency translation		(6,851	)		—
Balance, end of period	$	291,154		$	18,146

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Intangibles consisted of the following as of July 2, 2005 (in thousands):

	Gross Carrying		Accumulated			Intangibles,
	Amount		Amortization			Net
Amortizable intangible assets:
Technology-based	$	11,186	$	(1,853	)		$9,333
Marketing-based		898		(187	)		711
Customer-based		49,974		(5,016	)		44,958
	$	62,058	$	(7,056	)		55,002
Unamortizable intangible assets:
Trademarks							31,768
Foreign currency translation							(614	)
Total intangible assets						$	86,156

Intangibles consisted of the following as of December 31, 2004 (in thousands):

	Gross Carrying		Accumulated			Intangibles,
	Amount		Amortization			Net
Amortizable intangible assets:
Technology-based	$	11,032	$	(1,604	)		$9,428
Marketing-based		898		(163	)		735
Customer-based		47,143		(3,203	)		43,940
	$	59,073	$	(4,970	)		54,103
Unamortizable intangible assets:
Trademarks							31,768
Foreign currency translation							1,826
Total intangible assets						$	87,697

During the six months ended July 2, 2005, we acquired $4,094,000 of intangible assets and disposed of an intangible asset with a net book value of $629,000 relating to the termination of a technology license. Amortization expense for the six months ended July 2, 2005 and July 3, 2004 was $2,566,000 and $388,000, respectively.

We will continue to amortize our amortizable assets over their remaining useful lives ranging from 1 to 38 years on a straight-line basis.

Our estimated amortization expense for the six months ended December 31, 2005 and the next five years is as follows (in thousands):

For six months ended December 31, 2005	$	2,657
For year ended December 31, 2006		5,020
For year ended December 31, 2007		4,679
For year ended December 31, 2008		4,389
For year ended December 31, 2009		4,112
For year ended December 31, 2010		3,435

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5. LONG-TERM DEBT

Our long-term debt (including capital lease obligations) consists of the following:

	July 2,			December 31,
	2005			2004
	(in thousands)
$180 million senior credit facility to a syndicate of financial institutions; composed of a $150 million six-year term loan and a five-year $30 million revolving credit facility; collateralized by all domestic assets of Encore and pledge of 66% of equity in foreign subsidiaries of Encore; interest rate at Bank of America’s base rate or the London Interbank Offered Rate (LIBOR), plus an applicable margin determined by, among other things, the ratio of total debt to earnings before interest, taxes, depreciation and amortization (EBITDA); term loan subject to quarterly principal installments; payments beginning March 30, 2005 of (a) $1.9 million each of the first 12 quarters, (b) $3.8 million each of the next 8 quarters, and (c) $24.4 million each of the last 4 quarters with the last payment due October 2010; interest rate of 6.47% at July 2, 2005 and 5.35% at December 31, 2004.	$	160,950		$	150,000
$165 million senior subordinated notes payable to institutional investors issued at 99.314% of principal amount; less unamortized discount of $1,059,000 and $1,108,000 at July 2, 2005 and December 31, 2004, respectively; interest at 9.75%; interest payable semi-annually on April 1 and October 1 of each year through October 1, 2012; junior and subordinated to senior credit facility.		163,941			163,892
4% note payable to a corporation in connection with the acquisition of a technology license in 2004, payable in varying quarterly installments through March 2009.		226			250
Note payable to a corporation in connection with the acquisition of Rehab Med+Equip by Empi in 2002; 50% payable in each of July 2005 and July 2008; interest at higher of 5% or prime; interest rate of 6.25% at July 2, 2005.		938			938
European bank loans to finance European working capital; monthly payments through March 2006, variable interest at 5.25% at July 2, 2005.		46			93
8.9% unsecured note payable to individuals in connection with the acquisition of Biodynamic Technologies, Inc. in 1999, payable in varying quarterly installments through March 2005.		—			208
Capital lease obligations, collateralized by related equipment.		184			172
		326,285			315,553
Less — current portion		(8,377	)		(8,346	)
	$	317,908		$	307,207

The debt agreements related to our $180 million senior credit facility and our $165 million senior subordinated notes payable contain warranties and covenants and require maintenance of certain financial ratios. Default on any warranty or covenant could affect our ability to borrow under the agreements and, if not waived or corrected, could accelerate the maturity of any borrowings outstanding under the applicable agreements. As of the date of this report, we are in compliance with all debt covenants and warranties. In addition, these debt agreements restrict our ability to (i) incur additional indebtedness; (ii) issue redeemable equity interests and preferred equity interests; (iii) pay dividends or make distributions, repurchase equity interests or make other restricted payments; (iv) make capital expenditures; (v) create liens; (vi) enter into transactions with our affiliates; (vii) make investments; (viii) sell assets; or (ix) enter into mergers or consolidations.

6. STOCK-BASED COMPENSATION

We have adopted the disclosure-only provisions of SFAS No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosures” (“SFAS 148”) as well as those outlined in SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”). As permitted by SFAS 148 and SFAS 123, we continue to apply the provisions of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” and related interpretations in accounting for our plans. Accordingly, compensation cost for stock options is measured as the excess, if any, of the quoted market price of our stock at the date of the grant, over the amount an employee must pay to acquire the stock. We account for stock based awards for non-employees under the provisions of SFAS No. 123 and Emerging Issues Task Force Consensus 96-18.

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In December 2004, the FASB issued SFAS No. 123 (Revised 2004), “Share-Based Payment”, which revises SFAS No. 123, “Accounting for Stock-Based Compensation” and supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees”. SFAS No. 123(R) amends SFAS 123 to require all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Compensation expense is to be charged during the vesting period. Pro forma disclosure will no longer be an alternative. On April 14, 2005, the Securities and Exchange Commission delayed the effective date for SFAS 123(R) to the first fiscal year beginning after June 15, 2005. Therefore, this Statement will become effective for us in the first quarter of 2006. We are currently evaluating the impact of the adoption of SFAS 123(R) and the impact it will have on our financial position and results of operations.

Had compensation cost for all stock option grants been determined based on their fair value at the grant dates, consistent with the method prescribed by SFAS 148 and SFAS 123, our net income and earnings per share would have been adjusted to the pro forma amounts indicated below (in thousands except per share data):

		Three Months Ended						Six Months Ended
		July 2,			July 3,			July 2,			July 3,
		2005			2004			2005			2004
Net income	As reported	$	2,440		$	1,658		$	4,033		$	3,212
Deduct: Total stock-based employee compensation expense determined under fair value-based method for all awards, net of related tax effects			(457	)		(459	)		(830	)		(610	)
Net income	Pro forma	$	1,983		$	1,199		$	3,203		$	2,602
Earnings per share
Basic:	As reported		$0.05			$0.04			$0.08			$0.07
	Pro forma		$0.04			$0.03			$0.06			$0.06
Diluted:	As reported		$0.05			$0.04			$0.08			$0.07
	Pro forma		$0.04			$0.03			$0.06			$0.06

We estimate the fair value of each option grant on the date of grant using the Black-Scholes option pricing model. We used the following weighted average assumptions for grants during the first six months of 2005 and 2004:

	July 2,			July 3,
	2005			2004
Dividend yield		0.0	%		0.0	%
Expected volatility		81.0	%		92.8	%
Risk-free interest rate		3.9	%		2.4	%
Expected life	4.1 years			4.4 years

7. SEGMENT AND GEOGRAPHIC INFORMATION

We have two reportable segments as defined by SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information.” Our reportable segments are business units that offer different products that are managed separately because each business requires different manufacturing and marketing strategies. The Surgical Implant Division sells reconstructive products including knee, hip, shoulder and spinal implants. The Orthopedic Rehabilitation Division offers non-invasive medical products that are used before and after surgery to assist in the repair and rehabilitation of soft tissue and bone, and to protect against further injury; electrotherapy devices and accessories used to treat pain and restore muscle function; iontophoretic devices and accessories used to deliver medication; clinical therapy tables and traction equipment; and orthotics devices used to treat joint and spine conditions.

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Information regarding business segments is as follows (in thousands):

	Three Months Ended				Six Months Ended
	July 2,		July 3,		July 2,		July 3,
	2005		2004		2005		2004
Net sales:
Surgical Implant Division	$	13,658	$	10,268		$25,949	$	21,047
Orthopedic Rehabilitation Division		64,349		19,028		127,414		39,293
Consolidated net sales	$	78,007	$	29,296	$	153,363	$	60,340
Gross margin:
Surgical Implant Division	$	10,572		$7,351		$20,389	$	15,027
Orthopedic Rehabilitation Division		36,148		7,708		70,533		15,987
Consolidated gross margin	$	46,720	$	15,059		$90,922	$	31,014

We allocate resources and evaluate the performance of our segments based on gross margin and therefore have not disclosed certain other items, such as interest, depreciation and income taxes as permitted by SFAS 131. We do not allocate assets to reportable segments because certain of our property and equipment are shared by all of our segments.

Geographic Area

We added a European-based operation in 2004 through our acquisition of Empi on October 4, 2004.

Following are our net sales by geographic area (in thousands):

	Three Months Ended				Six Months Ended
	July 2,		July 3,		July 2,		July 3,
	2005		2004		2005		2004
Net sales:
United States	$	61,634	$	25,879	$	120,225	$	52,998
Germany		7,461		191		17,091		594
Other Europe, Middle East & Africa		5,189		1,239		9,736		2,748
Asia Pacific		2,475		1,017		3,820		2,001
Other		1,248		970		2,491		1,999
	$	78,007	$	29,296	$	153,363	$	60,340

Our property and equipment and depreciation expense by geographic area are as follows (in thousands):

	Property and Equipment, Net				Depreciation Expense				Depreciation Expense
	As of				Three Months Ended				Six Months Ended
	July 2,		December 31,		July 2,		July 3,		July 2,		July 3,
	2005		2004		2005		2004		2005		2004
North America	$	22,293	$	19,162	$	1,716	$	759	$	3,340	$	1,489
Europe		4,063		7,724		507		—		1,032		—
	$	26,356	$	26,886	$	2,223	$	759	$	4,372	$	1,489

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8. EARNINGS PER SHARE

Following is a reconciliation of the basic and diluted per share computations (in thousands except per share data):

	Three Months Ended				Six Months Ended
	July 2,		July 3,		July 2,		July 3,
	2005		2004		2005		2004
Net income		$2,440		$1,658		$4,033		$3,212
Shares used in computing basic earnings per share		51,744		42,875		51,722		42,847
Common stock equivalents		545		1,386		626		1,466
Shares used in computing diluted earnings per share		52,289		44,261		52,348		44,313
Earnings per share:
Basic		$0.05		$0.04		$0.08		$0.07
Diluted		$0.05		$0.04		$0.08		$0.07

For the quarters ended July 2, 2005 and July 3, 2004, we did not include the effect of 1,700,000 and 935,000 common stock equivalents, respectively, in the computation of diluted earnings per share because the inclusion of such would be anti-dilutive. The total number of common stock equivalents excluded from the calculations of diluted earnings per common share was 1,495,000 for the first six months of 2005 and 336,000 for the first six months of 2004.

9. ACQUISITION OF EMPI

On October 4, 2004, we acquired Empi, a privately held Minnesota corporation. We believe with this acquisition, we have created the first orthopedic product company that provides a comprehensive continuum of products for the needs of orthopedic surgical and rehabilitative patients. The total purchase price of approximately $369.8 million was comprised of approximately $172.8 million payable to the Empi common stockholders and option holders in cash, along with eight million shares of our common stock, plus the repayment of approximately $154.9 million of outstanding Empi debt and $7.0 million in purchase costs.

During the first six months of 2005, this purchase price was adjusted to reflect the resolution of two contingencies. The first contingency related to an anticipated closing tax benefit generated by the completion of the Empi acquisition, which resulted in a $6.0 million payment to Empi’s former stockholders and option holders. The second contingency related to completion of the audit of Empi’s closing date balance sheet that resulted in a return to us of $291,000 of the original acquisition consideration. In addition, we incurred an additional $249,000 in purchase costs.

As a result of these transactions, the total purchase price for the Empi acquisition has been adjusted to $375.7 million. There have been no changes to the estimated fair value of acquired tangible and identifiable intangible assets or the assumed liabilities of Empi. Therefore, the net additional acquisition consideration of $5.9 million has been reflected as an addition to the goodwill acquired in this business combination.

10. ACQUISITION OF OTI

On February 22, 2005, we acquired substantially all of the assets of OTI, which included a line of spinal implant products and several total knee and hip implant designs. The total purchase price for the OTI assets of approximately $15.1 million was comprised of approximately $14.5 million payable in cash to the OTI stockholders and $583,000 in purchase costs. We borrowed $14.7 million from our existing line of credit to finance this acquisition.

The acquisition consideration is subject to adjustment based upon the final balance sheet as of the closing date. In addition, there are up to $1.5 million in future milestone payments that could be earned by OTI based on the sales results of the OTI products we have acquired during the first twelve months after the closing of the transaction.

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Under the purchase method of accounting, the total purchase price for the OTI assets was allocated to the acquired tangible and identifiable intangible assets and the assumed liabilities of OTI based upon their estimated fair values as of the closing date. The following represents the allocation of the aggregate purchase price for the OTI assets as of February 22, 2005. The fair value for certain assets acquired was determined based upon independent third party appraisals (inventory, fixed assets, intangible assets). For the remaining assets and liabilities, book value was deemed to approximate fair value due to the nature of the assets and liabilities. The following valuations were determined (in thousands):

Current assets		$4,101
Tangible and other noncurrent assets		1,297
Liabilities assumed		(201	)
Intangible assets		4,094
Goodwill		5,816
	$	15,107

The tangible assets we acquired from OTI are being depreciated over their useful lives of two to five years and the acquired intangible assets consist of the following, and are being amortized over their estimated economic life, where applicable, using the straight-line method:

Asset class	Fair value		Wtd. Avg. Useful life
	(in thousands)
Technology-based	$	1,263	6 years
Customer-based		2,831	7 years
Goodwill		5,816
	$	9,910

The results of OTI have been included within the consolidated statement of operations since the date of acquisition, February 22, 2005.

11. GUARANTOR / NON-GUARANTOR COMPANIES OF THE 9³/4% SENIOR SUBORDINATED NOTES DUE 2012

Under the terms of our 9³/4% senior subordinated notes due 2012, Encore Medical Corporation and our domestic (U.S.) subsidiaries guarantee the notes. Our foreign subsidiaries do not guarantee the notes. The subsidiary issuer and each subsidiary guarantor are 100% owned by the parent company. All guarantees are full and unconditional, and are also joint and several among the guarantor companies. The indenture related to our notes imposes certain restrictions including, among other things, limits on our ability and that of our subsidiaries to:

• incur or guarantee additional indebtedness or issue preferred stock;

• pay dividends or make other distributions;

• repurchase our stock;

• make investments;

• sell or otherwise dispose of our assets, including capital stock of our subsidiaries;

• create liens;

• prepay, redeem or repurchase debt;

• enter into agreements restricting our subsidiaries’ ability to pay dividends;

• enter into transactions with affiliates; and

• consolidate, merge or sell all of our assets.

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The following condensed consolidating schedules present condensed financial information of our guarantors and our subsidiaries that are non-guarantors as of and for the periods presented below.

ENCORE MEDICAL CORPORATION AND SUBSIDIARIES

Condensed Consolidating Balance Sheet
As of July 2, 2005
(in thousands)
(unaudited)

	Encore			Encore
	Medical			Medical			Other		Non-			Elim-
	Corporation			IHC, Inc.			Guarantors		guarantors			inations			Consolidated
Assets
Current assets:
Cash and cash equivalents		$71			$—			$9,959		$5,636			$—			$15,666
Accounts receivable, net		—			—			47,607		6,352			—			53,959
Inventories, net		—			—			55,007		2,337			(557	)		56,787
Current deferred tax asset		—			—			7,642		797			869			9,308
Prepaid expenses and other current assets		—			—			3,157		496			—			3,653
Total current assets		71			—			123,372		15,618			312			139,373
Property and equipment, net		—			—			22,294		6,229			(2,167	)		26,356
Goodwill		—			—			238,098		53,056			—			291,154
Intangible assets, net		—			—			69,881		16,275			—			86,156
Investment in subsidiaries		47,388			128,138			30,764		—			(206,290	)		—
Other assets		—			10,938			521		—			—			11,459
Total assets		$47,459			$139,076		$	484,930	$	91,178		$	(208,145	)	$	554,498
Liabilities, Minority Interests and Stockholders’ Equity
Current liabilities:
Current portion of long-term debt		$—			$7,500			$841		$36			$—			$8,377
Accounts payable		—			—			11,573		628			—			12,201
Accrued expenses		—			5,380			16,358		4,485			—			26,223
Total current liabilities		—			12,880			28,772		5,149			—			46,801
Long-term debt, net of current portion		—			317,390			507		11			—			317,908
Non-current deferred tax liability		—			—			23,052		6,372			—			29,424
Intercompany payable		(111,744	)		(238,582	)		272,872		79,309			(1,855	)		—
Other non-current liabilities		—			—			582		—			—			582
Total liabilities		(111,744	)		91,688			325,785		90,841			(1,855	)		394,715
Minority interests		—			—			—		580			—			580
Stockholders’ equity		159,203			47,388			159,145		(243	)		(206,290	)		159,203
Total liabilities, minority interests and stockholders’ equity		$47,459			$139,076		$	484,930	$	91,178		$	(208,145	)	$	554,498

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ENCORE MEDICAL CORPORATION AND SUBSIDIARIES

Condensed Consolidating Statement of Operations
Three Months Ended July 2, 2005
(in thousands)
(unaudited)

	Encore Medical		Encore Medical IHC,			Other		Non-			Elim-
	Corporation		Inc.			Guarantors		guarantors			inations			Consolidated
Net sales		$—		$—		$	68,492	$	10,234			$(719	)	$	78,007
Cost of sales		—		—			27,249		4,622			(584	)		31,287
Gross margin		—		—			41,243		5,612			(135	)		46,720
Operating expenses:
Selling, general and administrative		—		—			29,258		3,956			—			33,214
Research and development		—		—			2,098		328			—			2,426
Income from operations		—		—			9,887		1,328			(135	)		11,080
Other income (expense):
Interest income		—		—			39		47			—			86
Interest expense		—		(7,397	)		73		(21	)		—			(7,345	)
Other income (expense), net		2,455		9,852			132		(5	)		(12,307	)		127
Income before income taxes and minority interests		2,455		2,455			10,131		1,349			(12,442	)		3,948
Provision for income taxes		—		—			1,102		440			(51	)		1,491
Minority interests		—		—			—		17			—			17
Net income	$	2,455		$2,455			$9,029		$892		$	(12,391	)		$2,440

ENCORE MEDICAL CORPORATION AND SUBSIDIARIES

Condensed Consolidating Statement of Operations
Six Months Ended July 2, 2005
(in thousands)
(unaudited)

	Encore Medical		Encore Medical IHC,			Other		Non-			Elim-
	Corporation		Inc.			Guarantors		guarantors			Inations			Consolidated
Net sales		$—		$—		$	133,884	$	21,281			$(1,802	)	$	153,363
Cost of sales		—		—			54,353		9,746			(1,658	)		62,441
Gross margin		—		—			79,531		11,535			(144	)		90,922
Operating expenses:
Selling, general and administrative		—		—			57,148		8,073			—			65,221
Research and development		—		—			4,234		685			—			4,919
Income from operations		—		—			18,149		2,777			(144	)		20,782
Other income (expense):
Interest income		2		—			122		47			—			171
Interest expense		—		(14,372	)		30		—			—			(14,342	)
Other income (expense), net		4,174		18,545			196		(160	)		(22,719	)		36
Income before income taxes and minority interests		4,176		4,173			18,497		2,664			(22,863	)		6,647
Provision for income taxes		—		—			1,543		1,082			(54	)		2,571
Minority interests		—		—			—		43			—			43
Net income	$	4,176		$4,173			$16,954		$1,539		$	(22,809	)		$4,033

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ENCORE MEDICAL CORPORATION AND SUBSIDIARIES

Condensed Consolidating Statement of Cash Flows
Six Months Ended July 2, 2005
(in thousands)
(unaudited)

	Encore Medical			Encore Medical IHC,			Other			Non-			Elim-
	Corporation			Inc.			Guarantors			guarantors			inations			Consolidated
Cash flows from operating activities:
Net income		$4,176			$4,173			$16,954			$1,539		$	(22,809	)		$4,033
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Depreciation		—			—			2,907			1,465			—			4,372
Amortization of intangibles		—			—			1,709			857			—			2,566
Amortization of debt issuance costs		—			1,103			—			—			—			1,103
Non-cash interest expense		—			49			—			—			—			49
Stock-based compensation		30			—			61			—			—			91
Loss on disposal of assets		—			—			289			485			—			774
Deferred taxes		—			—			(12,359	)		10,412			—			(1,947	)
Provision for (recoveries of) bad debt expense and sales returns		—			—			2,298			35			—			2,333
Inventory reserves		—			—			2,296			7			—			2,303
Minority interests		—			—			—			43			—			43
Tax provision associated with stock options		(49	)		—			—			—			—			(49	)
Changes in operating assets and liabilities, net of acquired assets and liabilities:
Accounts receivable		—			—			(2,274	)		3,636			—			1,362
Inventories		—			—			(6,233	)		1,372			144			(4,717	)
Prepaid expenses, other assets and liabilities		7			(557	)		(524	)		(83	)		—			(1,157	)
Accounts payable and accrued expenses		—			895			972			(2,209	)		(54	)		(396	)
Net cash provided by (used in) operating activities		4,164			5,663			6,096			17,559			(22,719	)		10,763
Cash flows from investing activities:
Acquisition of subsidiaries		—			—			(21,065	)		—			—			(21,065	)
Investment in subsidiaries		(4,571	)		(18,942	)		794			—			22,719			—
Purchases of property and equipment		—			—			(2,436	)		(1,374	)		—			(3,810	)
Net cash used in investing activities		(4,571	)		(18,942	)		(22,707	)		(1,374	)		22,719			(24,875	)
Cash flows from financing activities:
Proceeds from issuance of common stock		181			—			—			—			—			181
Proceeds from notes receivable for sale of common stock		102			—			—			—			—			102
Intercompany		(544	)		2,556			11,582			(13,594	)		—			—
Proceeds from long-term obligations		—			14,700			—			—			—			14,700
Payments on long-term obligations		—			(3,751	)		(259	)		(36	)		—			(4,046	)
Payment of debt issuance costs		—			(226	)		—			—			—			(226	)
Dividend to minority shareholders		—			—			—			(198	)		—			(198	)
Net cash provided by (used in) financing activities		(261	)		13,279			11,323			(13,828	)		—			10,513
Effect of exchange rate changes on cash and cash equivalents		—			—			24			(648	)		—			(624	)
Net increase (decrease) in cash and cash equivalents		(668	)		—			(5,264	)		1,709			—			(4,223	)
Cash and cash equivalents at beginning of year		739			—			15,223			3,927			—			19,889
Cash and cash equivalents at end of period		$71			$—			$9,959			$5,636			$—			$15,666

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ENCORE MEDICAL CORPORATION AND SUBSIDIARIES

Condensed Consolidating Balance Sheet
As of December 31, 2004
(in thousands)

	Encore Medical		Encore Medical IHC,		Other		Non-		Elim-
	Corporation		Inc.		Guarantors		guarantors		inations			Consolidated
Assets
Current assets:
Cash and cash equivalents		$739		$—		$15,223		$3,927		$—			$19,889
Accounts receivable, net		—		—		51,550		7,038		—			58,588
Inventories, net		—		—		46,742		2,573		(186	)		49,129
Current deferred tax asset		—		—		8,831		—		—			8,831
Prepaid expenses and other current assets		7		—		2,232		452		—			2,691
Total current assets		746		—		124,578		13,990		(186	)		139,128
Property and equipment, net		—		—		19,162		7,724		—			26,886
Goodwill		—		—		225,637		60,594		—			286,231
Intangible assets, net		—		—		67,720		19,977		—			87,697
Investment in subsidiaries		49,299		393,096		73,292		—		(515,687	)		—
Intercompany receivable		111,300		—		—		—		(111,300	)		—
Other assets		—		11,527		557		113		—			12,197
Total assets	$	161,345	$	404,623	$	510,946	$	102,398	$	(627,173	)	$	552,139
Liabilities, Minority Interests and Stockholders’ Equity
Current liabilities:
Current portion of long-term debt		$—		$7,500		$805		$41		$—			$8,346
Accounts payable		—		—		9,110		1,740		—			10,850
Accrued expenses		—		4,484		18,279		6,356		(70	)		29,049
Total current liabilities		—		11,984		28,194		8,137		(70	)		48,245
Long-term debt, net of current portion		—		306,392		763		52		—			307,207
Non-current deferred tax liability		—		—		33,044		1,638		—			34,682
Intercompany payable		—		39,200		58,951		13,149		(111,300	)		—
Other non-current liabilities		—		269		598		—		—			867
Total liabilities		—		357,845		121,550		22,976		(111,370	)		391,001
Minority interests		—		—		—		821		—			821
Stockholders’ equity		161,345		46,778		389,396		78,601		(515,803	)		160,317
Total liabilities, minority interests and stockholders’ equity	$	161,345	$	404,623	$	510,946	$	102,398	$	(627,173	)	$	552,139

Consolidating financial statements prior to October 4, 2004 do not provide additional meaningful information to that presented in the consolidated financial statements, as the issuer (Encore Medical IHC, Inc.) did not exist and the non-guarantor companies were not owned by Encore prior to that date. As a result, we have omitted this information.

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12. SUBSEQUENT EVENT

On August 9, 2005, we completed the sale of certain assets of our soft goods product line for cash consideration of $10.0 million net of customary closing adjustments. The assets sold consist of inventory, fixed assets and intangible assets with a net book value of approximately $5 million. The proceeds will be used to reduce indebtedness under our senior credit facility.

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

Introduction

     This management’s discussion and analysis of financial condition and results of operations is intended to provide an understanding of our results of operations, financial condition and where appropriate, factors that may affect future performance. We will discuss and provide our analysis of the following:

• Overview of Business and Second Quarter Results

• Results of Operations

• Critical Accounting Policies and Estimates

• Recent Accounting Pronouncements

• Liquidity and Capital Resources

     The following discussion should be read in conjunction with the Consolidated Financial Statements and related notes for those financial statements as well as the other financial data included elsewhere in this Form 10-Q.

Overview of Business and Second Quarter Results

     We are a diversified orthopedic company that develops, manufactures, markets and distributes a comprehensive range of high quality orthopedic devices including surgical implants, sports medicine equipment and products for orthopedic rehabilitation, pain management and physical therapy. Our products are used by orthopedic surgeons, physicians, therapists, athletic trainers, and other healthcare professionals to treat patients with musculoskeletal conditions resulting from degenerative diseases, deformities, traumatic events and sports-related injuries. Our non-invasive medical devices and related accessories are primarily used by patients for at-home physical therapy. We currently market and distribute our products through two operating divisions, as follows:

• Surgical Implant Division.Our Surgical Implant Division offers a comprehensive suite of reconstructive joint products and spinal implants.

• Orthopedic Rehabilitation Division.Our Orthopedic Rehabilitation Division offers non-invasive medical products that are used before and after surgery to assist in the repair and rehabilitation of soft tissue and bone, and to protect against further injury; electrotherapy devices and accessories used to treat pain and restore muscle function; iontophoretic devices and accessories used to deliver medication; clinical therapy tables and traction equipment; and orthotics devices used to treat joint and spine conditions.

     Our two divisions enable us to reach a diverse customer base through multiple distribution channels and give us the opportunity to provide a comprehensive range of orthopedic devices and related products to orthopedic specialists operating in a variety of treatment settings for their patients.

     Our products are subject to regulation by the Food and Drug Administration (“FDA”) with respect to their sale in the United States, and we must, in many cases, obtain FDA authorization to market our products before they can be sold in the United States. Additionally, we are subject to similar regulations in many of the foreign countries in which we sell products.

     In recent years, our growth has been driven both by the introduction of products facilitated by our research and development efforts and selected acquisitions of businesses or products in the orthopedic industry. Our February 2005 acquisition of OTI added the Advanced Spine^TM spinal implant product line and several total knee and hip implant designs to our existing product offerings within our Surgical Implant Division. In addition, in prior years we completed three other acquisitions that expanded our presence in the orthopedic market to include electrotherapy products, rehabilitation equipment and orthopedic soft goods. These products form our Orthopedic Rehabilitation Division. The

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October 2004 acquisition of Empi added non-invasive medical devices and accessories that are primarily used by patients for at-home therapy to the existing product offering in this division.

     We have financed our recent acquisitions through the sale of equity securities and the issuance of additional debt. We borrowed funds from our existing line of credit to finance our cash purchase of the OTI assets. We financed the Empi acquisition through a combination of the issuance of new equity and the issuance of both senior secured and senior subordinated unsecured debt, which was obtained from financial institutions and institutional investors. We expect that we will continue to utilize some combination of both debt and equity funding to finance acquisitions in the future.

     The nature of our business requires significant investment in inventory, capital equipment and new product development. Our customers expect us to maintain sufficient inventory on hand at all times to meet their needs. Many of our domestic customers require consignment product to be placed at or near their respective locations. Our remaining customers across all product lines demand short delivery schedules for their orders. Additionally, we are subject to significant requirements for investment in manufacturing equipment and facilities and for the instrument sets required by our Surgical Implant Division customers. Additionally, we have placed an emphasis on our research and development efforts for new products.

     Our net sales increased 166.3% in the second quarter of 2005 to $78.0 million compared to $29.3 million in the quarter ended July 3, 2004. Similarly, year to date sales increased 154.2% to $153.4 million compared to $60.3 million in the same period of 2004. This improvement was driven by revenue growth in both our Surgical Implant and Orthopedic Rehabilitation Divisions, and by revenues resulting from products we acquired in the Empi acquisition, which was completed in October 2004. Gross margin as a percentage of our net sales increased to 59.9% in the second quarter of 2005 from 51.4% in the second quarter of 2004 and to 59.3% for the first six months of 2005 from 51.4% in the first six months of 2004. Gross margin in both of our divisions improved due to increasing sales of higher margin product lines and for our Orthopedic Rehabilitation Division from the impact of revenue from sales of Empi products, which are sold via a direct sales force at a higher margin than our other Orthopedic Rehabilitation Division product lines, which are sold through an extensive dealer network. Our operating income improved significantly to $11.1 million for the second quarter of 2005 compared to $2.7 million in the same period of 2004 primarily due to continued growth in both our Surgical Implant and Orthopedic Rehabilitation Divisions. Operating income for the six month period ended July 2, 2005 increased to $20.8 million from $5.3 million in the comparable prior year period. Finally, we achieved net income of $2.4 million, or $0.05 of diluted earnings per share, in the second quarter of 2005 compared to net income of $1.7 million, or $0.04 of diluted earnings per share, in the second quarter of 2004 and net income of $4.0 million, or $0.08 of diluted earnings per share, for the first half of 2005 compared to net income of $3.2 million, or $0.07 of diluted earnings per share, for the first half of 2004.

     Our results in the second quarter of 2005 were principally driven by improved net sales and gross margin percentages in both of our divisions. We continued to invest in expanding our United States sales force for reconstruction and spinal products in our Surgical Implant Division and in new product development across both our divisions. As a result, operating activities provided $10.8 million of cash in the six months ended July 2, 2005, which represents an improvement of $12.7 million from the six month period ended July 3, 2004 when operating activities used $1.9 million of cash.

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Results of Operations

     The following table sets forth our statements of operations as a percentage of net sales for the periods indicated:

	Three Months Ended						Six Months Ended
	July 2,			July 3,			July 2,			July 3,
	2005			2004			2005			2004
Net sales		100.0	%		100.0	%		100.0	%		100.0	%
Cost of sales		40.1			48.6			40.7			48.6
Gross margin		59.9			51.4			59.3			51.4
Operating expenses:
Selling, general and administrative		42.6			36.1			42.5			37.0
Research and development		3.1			5.9			3.2			5.6
Income from operations		14.2			9.4			13.6			8.8
Interest income		0.1			0.4			0.1			0.3
Interest expense		(9.4	)		(0.6	)		(9.4	)		(0.6	)
Other income (expense), net		0.2			(0.1	)		0.0			0.0
Income before income taxes and minority interests		5.1			9.1			4.3			8.5
Provision for income taxes		2.0			3.4			1.7			3.2
Minority interests		0.0			0.0			0.0			0.0
Net income		3.1			5.7			2.6			5.3

Three Months Ended July 2, 2005, as compared to the Three Months Ended July 3, 2004

     Net sales.Our net sales for the quarter ended July 2, 2005 were $78.0 million, representing an increase of 166.3% over net sales of $29.3 million in the quarter ended July 3, 2004, driven by continued growth in both our Surgical Implant and Orthopedic Rehabilitation Divisions. Sales generated from products we acquired in our October 2004 acquisition of Empi had a significant impact on comparative growth in net sales. Our domestic net sales increased 138.2% to $61.6 million in the second quarter of 2005 from $25.9 million in the second quarter of 2004. Our foreign net sales increased 379.2%, to $16.4 million for the second quarter of 2005 from $3.4 million for the same period in 2004.

     The following table sets forth the geographic mix of our net sales for the second quarter of 2005 compared to the second quarter of 2004 (in thousands):

	Domestic							International							Total
	July 2,		July 3,		%			July 2,		July 3,		%			July 2,		July 3,		%
	2005		2004		Growth			2005		2004		Growth			2005		2004		Growth
Surgical
Implant
Division	$	11,456		$9,341		22.6	%		$2,202		$927		137.5	%	$	13,658	$	10,268		33.0	%
Orthopedic
Rehabilitation
Division		50,178		16,538		203.4	%		14,171		2,490		469.1	%		64,349		19,028		238.2	%
Total	$	61,634	$	25,879		138.2	%	$	16,373	$	3,417		379.2	%	$	78,007	$	29,296		166.3	%

     In the Surgical Implant Division, we had net sales of $13.7 million during the second quarter of 2005 compared to $10.3 million in the second quarter of 2004, an increase of 33.0%. The increase in sales was driven principally by sales growth in the division’s knee and hip product lines, along with sales of the Advanced Spine^TM spinal and other total joint products from our February 2005 acquisition of the assets of OTI. Domestic Surgical Implant Division sales for the second quarter of 2005 grew 22.6% to $11.5 million compared to $9.3 million in the second quarter of 2004 as we continue to increase our market penetration in domestic surgical implant sales. International Surgical Implant Division sales of $2.2 million in the second quarter of 2005 grew 137.5% over the prior year’s second quarter international sales of $927,000 primarily due to timing associated with orders from stocking distributors.

     Our Orthopedic Rehabilitation Division achieved net sales of $64.3 million during the second quarter of 2005 compared to $19.0 million in the second quarter of 2004, representing an increase of 238.2%. This division achieved continued growth in its clinical and home electrotherapy product lines, which continue to be positively impacted by the

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introduction of new models of its Vectra Genisys®, Intelect XT® and Intelect Advanced® electrotherapy, ultrasound and laser products.

     In the second quarter of 2005, sales of new products, which are products that have been on the market less than one year, accounted for $3.1 million compared to last year’s second quarter 2004 new product sales, which accounted for $1.8 million.

     Gross margin.Our overall gross margin as a percentage of net sales increased to 59.9% in the second quarter 2005 from 51.4% in the second quarter of 2004. Both of our divisions experienced improvement in gross margin as a percentage of net sales in the second quarter of 2005. Our Surgical Implant Division gross margin increased to 77.4% in the second quarter of 2005 from 71.6% in the second quarter of 2004 and our Orthopedic Rehabilitation Division gross margin increased to 56.2% in the second quarter of 2005 from 40.5% in the second quarter of 2004. The improvement in our Surgical Implant Division’s gross margin as a percentage of net sales was driven by continued growth of higher margin hip, knee and shoulder product sales and a lower comparative obsolescence reserve expense. Similarly, our Orthopedic Rehabilitation Division’s improvement in gross margin as a percentage of net sales was impacted by continued growth in our higher margin electrotherapy product lines. In addition, this division benefited from the impact of revenue from sales of Empi products, which are sold through a direct sales force at a higher margin than our other Orthopedic Rehabilitation Division product lines, which are sold on a wholesale basis through an extensive dealer network.

     Selling, General and Administrative Expenses.Our selling, general, and administrative expenses increased to $33.2 million in the second quarter of 2005 from $10.6 million in the second quarter of 2004. As a percentage of net sales, selling, general, and administrative expenses increased to 42.6% from 36.1% in the prior year second quarter. The majority of this increase is a result of additional selling, general and administrative expenses related to the acquisition of Empi. We also incurred higher commission expenses resulting from higher sales in our Surgical Implant and Orthopedic Rehabilitation Divisions and our amortization expense increased $1.2 million primarily due to the additional amortization related to the intangible assets acquired when we purchased Empi.

     Research and Development Expenses. Our research and development expenses increased 39.8% to $2.4 million for the second quarter of 2005 from $1.7 million for the second quarter of 2004. There was an increase of $700,000 in research and development expenditures, which was largely due to the acquisition of Empi. As a percentage of net sales, research and development costs were only 3.1% for the second quarter of 2005 compared to 5.9% for the second quarter of 2004. Empi has historically spent fewer dollars on research and development activities. As a result, the inclusion of Empi’s results has offset our increased expenditures in 2005 to develop new product designs. We expect to expand our new product design initiatives related to our new products acquired in the Empi acquisition as we move forward.

     Operating Income.Our operating income increased $8.3 million to $11.1 million in the second quarter of 2005 from $2.7 million in the second quarter of 2004. This increase is primarily due to continued sales and gross margin improvements in both our Surgical Implant Division and our Orthopedic Rehabilitation Division, which also benefited from the impact of the acquisition of Empi. Additionally, operating income as a percentage of sales increased to 14.2% in the second quarter of 2005 from 9.4% in the second quarter of 2004.

     Interest Expense.Our interest expense increased $7.2 million to $7.3 million in the second quarter of 2005 from $176,000 in the second quarter of 2004. The primary reasons for the increase in interest expense are borrowings of $328.6 million we incurred to finance the Empi and OTI acquisitions, along with $550,000 of amortization of deferred financing fees associated with the Empi acquisition.

     Net Income.We achieved net income for the second quarter of 2005 of $2.4 million, or $0.05 of diluted earnings per share, compared to net income of $1.7 million, or $0.04 of diluted earnings per share, in the second quarter of 2004 based on the factors discussed above.

Six Months Ended July 2, 2005, as compared to the Six Months Ended July 3, 2004

     Net sales.Our net sales for the six months ended July 2, 2005 were $153.4 million, representing an increase of 154.2% over net sales of $60.3 million in the six months ended July 3, 2004, driven by continued growth in both our Surgical Implant and Orthopedic Rehabilitation Divisions. Sales generated from products we acquired in our October 2004 acquisition of Empi had a significant impact on comparative growth in net sales. Our domestic net sales increased 126.8% to $120.2 million in the first six months of 2005 from $53.0 million in the first six months of 2004. Our foreign

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net sales increased 351.3%, to $33.1 million for the first six months of 2005 from $7.3 million for the same period in 2004.

     The following table sets forth the geographic mix of our net sales for the first six months of 2005 compared to the first six months of 2004 (in thousands):

	Domestic							International							Total
	July 2,		July 3,		%			July 2,		July 3,		%			July 2,		July 3,		%
	2005		2004		Growth			2005		2004		Growth			2005		2004		Growth
Surgical
Implant
Division		$22,263	$	18,996		17.2	%		$3,686	$	2,051		79.7	%		$25,949	$	21,047		23.3	%
Orthopedic
Rehabilitation
Division		97,962		34,002		188.1	%		29,452		5,291		456.6	%		127,414		39,293		224.3	%
Total	$	120,225	$	52,998		126.8	%	$	33,138	$	7,342		351.3	%	$	153,363	$	60,340		154.2	%

     In the Surgical Implant Division, we had net sales of $25.9 million during the first six months of 2005 compared to $21.0 million in the first six months of 2004, an increase of 23.3%. Domestic Surgical Implant Division sales for the first six months of 2005 grew 17.2% to $22.3 million compared to $19.0 million in the first six months of 2004. International Surgical Implant Division sales of $3.7 million in the first six months of 2005 grew 79.7% over the prior year’s first six months international sales of $2.1 million. Our core knee and hip product lines were the primary drivers of our Surgical Implant Division growth for the year to date period, along with sales of Advanced Spine™ spinal and other total joint products from our February 2005 acquisition of the assets of OTI.

     In the Orthopedic Rehabilitation Division, we had net sales of $127.4 million during the first six months of 2005 compared to $39.3 million in the first six months of 2004, representing an increase of 224.3%. This Division achieved significant growth, principally driven by revenues associated with the Empi acquisition and increased sales in its clinical and home electrotherapy product lines.

     For the six month period ended July 2, 2005, sales of new products, which are products that have been on the market less than one year, accounted for $5.7 million compared to last year’s six month period ended July 3, 2004, where new product sales accounted for $2.9 million.

     Gross margin.Our overall gross margin as a percentage of net sales increased to 59.3% for the first six months of 2005 from 51.4% in the first six months of 2004. Both of our divisions experienced improvement in gross margin as a percentage of net sales. Our Surgical Implant Division gross margin increased to 78.6% in the first six months of 2005 from 71.4% in the first six months of 2004 and our Orthopedic Rehabilitation Division gross margin increased to 55.4% in the first six months of 2005 from 40.7% in the first six months of 2004. The improvement in our Surgical Implant Division’s gross margin as a percentage of net sales was driven by continued growth of higher margin knee and hip product sales. Similarly, our Orthopedic Rehabilitation Division’s improvement in gross margin as a percentage of net sales was impacted by continued growth in our higher margin electrotherapy and dysphagia product lines. In addition, this division benefited from the impact of revenue from sales of Empi products, which are sold through a direct sales force at a higher margin than our other Orthopedic Rehabilitation Division product lines, which are sold on a wholesale basis through an extensive dealer network.

     Selling, General and Administrative Expenses.Our selling, general, and administrative expenses increased to $65.2 million in the first six months of 2005 from $22.3 million in the first six months of 2004. As a percentage of net sales, selling, general, and administrative expenses increased to 42.5% from 37.0% in the first six months of the prior year. The majority of this increase is a result of additional selling, general and administrative expenses related to the acquisition of Empi. We also incurred $820,000 of severance charges for certain former executive officers of Empi and our amortization expense increased $2.2 million primarily due to the additional amortization related to the intangible assets acquired from Empi. Finally, our commission expenses increased as a result of higher sales in both our Surgical Implant and Orthopedic Rehabilitation Divisions.

     Research and Development Expenses. Our research and development expenses increased 44.5% to $4.9 million for the first six months of 2005 from $3.4 million for the first six months of 2004 representing an increase of $1.5 million in research and development expenditures, which was largely due to the acquisition of Empi. However, as a percentage of net sales, research and development costs were 3.2% for the first six months of 2005 compared to 5.6%

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for the first six months of 2004. Empi has historically spent fewer dollars on research and development activities. As a result, the inclusion of Empi’s results has offset, on a percentage basis, our increased expenditures in 2005 to develop new product designs.

     Operating Income.Our operating income increased $15.5 million to $20.8 million in the first six months of 2005 from $5.3 million in the first six months of 2004. This increase is primarily due to continued revenue growth and gross margin improvement in both our Surgical Implant and Orthopedic Rehabilitation Divisions. Additionally, operating income as a percentage of sales increased to 13.6% in the first six months of 2005 from 8.8% in the first six months of 2004.

     Interest Expense.Our interest expense increased $14.0 million to $14.3 million in the first six months of 2005 from $365,000 in the first six months of 2004. The primary reasons for the increase in interest expense are borrowings of $328.6 million we incurred to finance the Empi and OTI acquisitions, along with $1.1 million of amortization of deferred financing fees associated with the Empi acquisition.

     Net Income.We achieved net income for the first six months of 2005 of $4.0 million, or $0.08 of diluted earnings per share compared to net income of $3.2 million, or $0.07 of diluted earnings per share in the first six months of 2004 based on the factors discussed above.

Critical Accounting Policies and Estimates

     Management’s discussion and analysis of financial condition and results of operations is based upon our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, management evaluates estimates, including those related to inventory, revenue recognition, deferred taxes, goodwill and intangible assets. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. To the extent that actual events differ from our estimates and assumptions, there could be a material impact to our financial statements.

Inventory Reserves

     The nature of our business requires us to maintain sufficient inventory on hand at all times to meet the requirements of our customers. We record inventory at the lower of cost or market, with cost based upon average actual cost. We maintain inventory reserves for such issues as slow moving or excess inventory, product obsolescence and declines in valuation. In each division we use a specific identification methodology, which can occur whenever there is a change in strategy. In addition, we review sales performance on at least a quarterly basis to determine the amounts that we should add to the existing reserve. We monitor reserves on a quarterly basis and make changes as determined by the processes referred to above. To determine the adequacy of our reserves at each reporting date we analyze the following, among other factors:

• Current inventory quantities on hand;

• Product acceptance in the marketplace;

• Customer demand;

• Historical sales;

• Forecasted sales;

• Product obsolescence; and

• Technological innovations.

     If there is a material change due to the factors listed above, the current level of the reserve for inventory may not be adequate and would result in our increasing the reserve level. Any modifications to our estimates of our reserves are reflected in cost of sales within the statement of operations, during the period in which such modifications are determined necessary by management.

     Our Surgical Implant Division products are sold in the United States at the time the product is used in a surgical procedure. As such, we must maintain sufficient quantities of our products at many locations throughout the country. The Orthopedic Rehabilitation Division also consigns a portion of its inventory to clinics and other healthcare provider locations to allow its products to be immediately dispensed to patients. This requires a large amount of inventory to be on hand for the products we sell on consignment. It also increases the sensitivity of this line of business to obsolescence

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reserve estimates. Because this inventory is not in our possession, we reserve for these products based on the results of periodic inventory counts and historical trends.

Revenue Recognition

     We sell our Surgical Implant Division products through a network of independent sales representatives in the United States, as well as distributors outside the United States. We record revenues from sales made by sales representatives, who are paid commissions upon the ultimate sale of the products, at the time the product is used in a surgical procedure (implanted in a patient) and a purchase order is received from the hospital. We record revenues from sales to customers outside the United States at the time the product is shipped to the distributor. Our international distributors, who sell the products to their customers, take title to the products, have no rights of return and assume the risk for credit and obsolescence. Distributors are obligated to pay us within specified terms, regardless of when they sell the products. In addition, there is no price protection available to distributors.

     We sell our Orthopedic Rehabilitation Division products through a variety of distribution channels. We sell our clinical rehabilitation products to dealers. We sell our soft goods products to distributors, retail outlets and various medical and sports establishments. For both of these distribution channels, we record sales at the time the product is shipped to the customer. Customers take title to the products, assume credit and product obsolescence risks, must pay within specified periods regardless of when they sell or use the products and have no price protection except for distributors who participate in our rebate program. For our home therapy products, we recognize wholesale revenue when we ship our products to our wholesale customers. We recognize retail revenue, both rental and purchase, when our product has been dispensed to the patient and the patient’s insurance has been verified. For retail products that are sold from our inventories consigned at clinic locations, we recognize revenue when we receive notice that the device has been prescribed and dispensed to the patient and the insurance has been verified or preauthorization from the insurance company has been obtained, when required.

     Reserves for Sales Allowances, Product Returns, Rebates and Rental Credits.We have established reserves to account for sales allowances, rebates, product returns and rental credits. Significant management judgment must be used and estimates made in connection with establishing the sales returns, rebates and other allowances in any accounting period.

     Our reserves for sales allowances and rebates account for sales of our products below the invoice price. These sales generally result from agreements that we enter into with certain customers that permit them to pay us for our products in amounts that are below the invoice price of the product. We estimate the amount of the reduction based on historical experience and invoices generated in the period in question, and we consider the impact of new contract terms or modifications of existing arrangements with our customers. We provide for these reserves by reducing our gross revenue.

     Our reserve for product returns accounts for customer returns of our products after purchase. These returns are mainly attributable to a third-party payor’s refusal to provide a patient release or reimbursement for the product or the inability of the product to adequately address the patient’s condition. We provide for this reserve by reducing gross revenue by an amount based on our historical rate of returns.

     Our reserve for rental credit recognizes a timing difference between billing of a purchase and processing of a rental credit associated with some of our electrotherapy devices. Many insurance providers require patients to rent our rehabilitation devices for a period of one to three months prior to purchase. If the patient has a long-term need for the device, these insurance companies may authorize purchase of the device after such time period. When the device is purchased, most providers require that rental payments previously made on the device be credited toward the purchase price. These credits are processed at the time the payment is received for the purchase of the device, which creates a time lag between billing of the purchase and processing of the rental credit. Our rental credit reserve accounts for unprocessed rental credits based on the number of devices converted to purchase. The reserve is calculated by first assessing the number of our products being rented during the relevant period and our historical conversion rate of rentals to sales, and then reducing our revenue by the applicable amount. The cost to refurbish rented products is expensed as incurred as part of cost of sales.

     Reserve for Uncollectible Accounts Receivable.In addition to the reserves for sales allowances, rebates, returns and rental credits, we have also established a reserve for uncollectible accounts receivable. These uncollectible accounts are a result of nonpayment from our customers and patients. The reserve is based on historical trends and current relationships with our customers and providers. Additions to this reserve are reflected in selling, general, and administrative expense.

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Deferred Tax Asset Valuation Allowance

     In assessing the potential realization of deferred tax assets, we consider whether it is more likely than not that some portion or all of the deferred tax assets will be realized. The ultimate realization of deferred tax assets is dependent upon whether we attain future taxable income during the periods in which those temporary differences become deductible. Based upon our projections of future taxable income, and the periods and manner in which our deferred tax assets will be available, we estimate that it is more likely than not that all of our deferred tax assets will be available to offset future taxable income. As such, no valuation allowance has been provided against the deferred tax asset balance.

     Our gross deferred tax asset balance is approximately $13.0 million at July 2, 2005 and primarily relates to inventory and other reserves, accrued compensation and a net operating loss carry forward. Based on our current projections, we estimate that we will utilize these deferred tax items in future years before expiration.

Goodwill and Intangible Assets

     We must make estimates related to the initial recognition and measurement of intangible assets acquired in connection with a business combination or asset acquisition, as well as the ongoing measurement of the useful life and value of intangible assets and goodwill. With respect to valuations of intangible assets acquired in connection with a business combination or asset acquisition, we use external third party evaluations in determining the respective fair values and relative allocations of acquisition cost to the assets acquired and liabilities assumed. We periodically evaluate whether events and circumstances have occurred which may affect the estimated useful life, or the recoverability of the remaining balances of our goodwill and other intangible assets. If such events or circumstances were to indicate that the carrying amount of those assets would not be recoverable, we would estimate the future cash flows expected to result from the use of the assets and their eventual disposition. The process of evaluating the potential impairment is subjective and requires us to exercise judgment in making assumptions related to future cash flows and discount rates. If the sum of the expected future cash flows (undiscounted and without interest charges) were less than the carrying amount of goodwill and other long-lived assets, we would recognize an impairment loss.

     Any impairment of an intangible asset or goodwill would require a reduction in the value of the asset on our consolidated balance sheet and a charge to operating income on our consolidated statement of operations. The nature of the charge to operating income would be determined based upon the nature of the intangible asset or goodwill requiring the adjustment.

     As of July 2, 2005, we have goodwill and intangible assets as follows (in thousands):

	Goodwill		Intangibles, net
Surgical Implant Division		$5,816		$3,889
Orthopedic Rehabilitation Division		285,338		82,267
Total	$	291,154	$	86,156

Recent Accounting Pronouncements

     In June 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections”, which replaces APB Opinion No. 20, “Accounting Changes”, and FASB SFAS No. 3, “Reporting Accounting Changes in Interim Financial Statements”. The Statement changes the accounting for, and reporting of, a change in accounting principle. Statement 154 applies to all voluntary changes in accounting principles and changes required by an accounting standard when the standard does not include specific transition provisions. Statement 154 is effective for accounting changes and corrections of errors in fiscal years beginning after December 15, 2005. Earlier application is permitted for accounting changes and corrections of errors during fiscal years beginning after June 1, 2005. We do not expect the adoption of SFAS No. 154 to have a material impact on our financial condition, results of operations or cash flows.

     In December 2004, the FASB issued SFAS No. 123 (Revised 2004), “Share-Based Payment”, which revises SFAS No. 123, “Accounting for Stock-Based Compensation” and supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees”. SFAS No. 123(R) amends SFAS No. 123 to require all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Compensation expense is to be charged during the vesting period. Pro forma disclosure will no longer be an alternative. On April 14, 2005, the Securities and Exchange Commission delayed the effective date for SFAS No. 123(R) to the first fiscal year beginning after June 15, 2005. Therefore, this Statement will become effective for us in the first quarter of 2006. We are currently evaluating the impact of the adoption of SFAS No. 123(R) and the impact it will have on our financial position and results of operations.

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     In November 2004, the FASB issued SFAS No. 151, “Inventory Costs”. This Statement amends the guidance in ARB No. 43 Chapter 4 “Inventory Pricing”, to require items such as idle facility costs, excessive spoilage, double freight and rehandling costs to be expensed in the current period, regardless of whether they are abnormal amounts or not. This Statement will become effective for us in the first quarter of 2006. We do not expect the adoption of SFAS No. 151 to have a material impact on our financial condition, results of operations or cash flows.

Liquidity and Capital Resources

     During the six months ended July 2, 2005, our operating activities provided $10.8 million of cash and cash equivalents as compared to the six months ended July 3, 2004 when our operating activities used cash of $1.9 million resulting in an improvement of $12.7 million. Our net income adjusted for non-cash items provided $15.7 million in operating cash flow during the first six months of 2005, an increase of $8.9 million, compared to the $6.7 million provided during the first six months of 2004. Our gross accounts receivable provided $1.4 million during the first six months of 2005 while in the same period in the prior year our gross accounts receivable used $1.8 million, a net increase in cash of $3.2 million. Our gross inventory used $4.7 million during the first six months of 2005 and $5.7 million during the first six months of 2004, resulting in a net decrease in cash usage of $1.0 million during the first six months of 2005. Additionally, our prepaid expenses and other assets and liabilities used $1.2 million of cash primarily for inventory purchase advances and sales meeting expenditures as compared to the first six months of 2004 when these assets used $260,000 of operating cash resulting in a decline in operating cash flow of $940,000 during the first six months of 2005. Finally, our outstanding balances of accounts payable and accrued liabilities decreased $396,000 compared to the first six months of 2004 when payables and accrued liabilities used cash of $808,000.

     Investing activities used $24.9 million of cash in the first six months of 2005 compared to $7.3 million provided in the first six months of 2004. This increased use of cash is primarily due to the purchase of OTI during the first quarter of 2005, which utilized $15.1 million of cash, and the settlement of Empi acquisition contingencies, which utilized $6.0 million of cash. Capital expenditures used $3.8 million of cash during the first six months of 2005 compared to $2.4 million during the first six months of 2004, which was an increase of $1.4 million over 2004. We continue to invest in the instrument sets required by our Surgical Implant Division to support sales force expansion, in the machine tools necessary to increase our manufacturing capacity and in the hardware and software required to improve our information systems.

     Cash provided by financing activities in the six month period ended July 2, 2005 increased to $10.5 million when compared to the same period in the prior year, when cash provided by financing activities was $360,000. This $10.2 million increase is primarily the result of capital raising activities to support our acquisition strategy. Proceeds from the issuance of our long-term debt were $14.7 million in the first six months of 2005, which represents borrowings under our revolving credit facility to fund the OTI acquisition. Payments on long-term obligations used $4.0 million during the first six months of 2005 compared to $429,000 during the first six months of 2004.

     Since our inception, we have financed our operations through the sale of equity securities, borrowings and cash flow from operations. We believe there is sufficient liquidity to fund current operations and contingencies. On October 4, 2004, we entered into a new senior credit facility with a syndicate of banks, financial institutions and other institutional lenders led by Bank of America, N.A., that provides for aggregate borrowings of up to $180 million, comprised of a five-year $30 million revolving credit facility, and a six-year $150 million term loan facility (the “Credit Facility”). Proceeds from the term loan facility were used to finance the cash portion of our purchase of Empi. In February 2005, we borrowed $14.7 million from our existing line of credit to finance the purchase of OTI. The remaining $15.3 million revolving credit facility is available to be used by us for general corporate purposes, subject to certain limitations. We executed various security documents, and we pledged to the lenders all of our domestic assets and 66% of the equity holdings of our foreign subsidiaries to secure the financing under the Credit Facility. The interest rate under the Credit Facility is dependent upon, among other things, our total debt to EBITDA (earnings before interest, taxes, depreciation and amortization) ratio. Based on that ratio as of July 2, 2005, our interest rate is equal to Bank of America’s base rate plus 0.5%, or the London Interbank Offered Rate (LIBOR) plus 3.00%.

     Beginning March 30, 2005, our term loan facility is payable in quarterly installments of principal of (a) $1.875 million, for each of the first twelve quarterly periods, (b) $3.75 million, for each of the next eight quarterly periods, and (c) $24.375 million, for each of the last four quarterly periods, with the last payment due in October 2010.

     Additionally, on October 4, 2004, we sold to investors $165 million in aggregate principal amount of 9³/4% senior subordinated notes due 2012 (the “notes”) at a purchase price of 99.314% of the principal amount of the notes.

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Interest on the notes accrues at the rate of 9³/4% per annum and is payable semi-annually on April 1 and October 1, beginning on April 1, 2005. The lenders’ rights under the notes are junior and subordinate to the rights of the various lenders and the security interests created by the security documents executed pursuant to the Credit Facility.

     These debt arrangements contain operating and financial agreements and restrictions, which may restrict our business and financing activities. These debt agreements restrict our ability to (i) incur additional indebtedness; (ii) issue redeemable equity interests and preferred equity interests; (iii) pay dividends or make distributions, repurchase equity interests or make other restricted payments; (iv) make capital expenditures; (v) create liens; (vi) enter into transactions with our affiliates; (vii) make investments; (viii) sell assets; or (ix) enter into mergers or consolidations. The debt agreements also require us to meet certain financial tests. As of the date of this report, we are in compliance with all debt covenants and warranties.

     We believe that our existing cash, plus the amounts we expect to generate from operations and amounts available through our remaining revolving credit facility, will be sufficient to meet our operating needs for the next twelve months, including working capital requirements, capital expenditures, debt repayment obligations and potentially smaller product acquisitions.

     While we currently believe that we will be able to meet all of our financial covenants imposed by our credit agreements, there is no assurance that we will in fact be able to do so or that, if we do not, we will be able to obtain from our lenders waivers of default or amendments to our credit agreements in the future.

     We continue to expand our business through selected acquisitions of businesses or products in the orthopedic industry. We have completed four acquisitions since 2000 that have allowed us to extend our business in the orthopedic market to include rehabilitation equipment and to expand our Surgical Implant Division product offerings. We have a history of raising capital through a combination of debt and equity offerings to finance these acquisitions. As additional financing needs arise, we will consider sources of financing to include a combination of debt or equity. We may issue debt or equity in anticipation of future financing needs, to position our capital structure towards a certain debt-to-equity range or to replace existing borrowing agreements.

     In addition to the current restrictions and requirements contained in our current loan and credit agreements, the maximum amounts allowable to borrow under our current credit facilities could limit our flexibility in obtaining additional financing and in pursuing other business opportunities. This potential high degree of leverage could have negative consequences for us, including the following: (i) our ability to obtain additional financing, if necessary, for working capital, capital expenditures, acquisitions or other purposes may be impaired or financing may not be available to us on favorable terms; (ii) we would need a substantial portion of our cash flow to pay the principal and interest on our indebtedness, including indebtedness that we may incur in the future; (iii) payments on our indebtedness would reduce the funds that would otherwise be available for operations and future business opportunities; (iv) a substantial decrease in net operating cash flows could make it difficult for us to meet our debt service requirements and force us to modify our operations; (v) our debt level could make us more vulnerable than our competitors to a downturn in either our business or the economy generally; and (vi) because some of our debt has a variable rate of interest, it would expose us to the risk of increased interest rates.

Related Party Transaction

     During the first quarter of 2004, in accordance with Section 16(b) of the Securities Exchange Act of 1934 (the “Exchange Act”), we received $288,000 from a greater than 10% stockholder and its affiliates, which represented a “short-swing profit” under Section 16 of the Exchange Act. The funds were earned when shares of our stock were sold by this stockholder and its affiliates in our December 2003 public offering, which was within six months of the date the stockholders received warrants to acquire shares of our stock. The amounts received were recorded as an increase to additional paid-in capital.

     During the first quarter of 2005, a portion of the total consideration paid for the acquisition of OTI was used to repay a $96,000 note payable due from OTI to Windy City, Inc. (“Windy City”). Joel Kanter, a member of our board of directors, is an officer and director of Windy City. In connection with the acquisition, a finder’s fee obligation of OTI to Mr. Kanter in the amount of $60,000 was also paid to Mr. Kanter at the closing of the OTI acquisition.

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Forward Looking Statements

     The foregoing management’s discussion and analysis contains various “forward looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 that represent our expectations or beliefs concerning future events, including, but not limited to, statements regarding growth in sales of our products, profit margins and the sufficiency of our cash flow for future liquidity and capital resource needs. These forward-looking statements are further qualified by important factors that could cause actual results to differ materially from those in the forward-looking statements. These factors include, without limitation, the effect of competitive pricing, our dependence on the ability of our third-party manufacturers to produce components on a basis that is cost-effective to us, market acceptance of our products, the ability to attract and retain competent employees, technological obsolescence of one or more products, changes in product strategies, the ability to locate acceptable acquisition candidates and then finance and integrate those acquisitions and effects of government regulation. Results actually achieved may differ materially from expected results included in these statements as a result of these or other factors.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

     We are exposed to certain market risks as part of our ongoing business operations, primarily risks from changing interest rates, foreign currency exchange rates or weak economic conditions that could impact our financial condition, results of operations, and cash flows. Our primary exposure is to changing interest rates. We are exposed to interest rate risk in connection with our Credit Facility, which bears interest at floating rates based on the London Interbank Offering Rate (LIBOR) or the prime rate plus an applicable borrowing margin. Our outstanding balance under this agreement was $161.0 million as of July 2, 2005.

     We manage our interest rate risk by balancing the amount of fixed and variable debt. For fixed rate debt, interest rate changes affect the fair value, but do not impact earnings or cash flow. Conversely, for variable rate debt, interest rate changes generally do not affect the fair value, but do impact future earnings and cash flow, assuming other factors are held constant. Our $180 million credit facility is based on variable interest rates. As of July 2, 2005, utilizing a hedging strategy, we have swapped variable rates for fixed rates on $50 million of the borrowing under the Credit Facility thereby locking in a fixed rate on this portion of the principal. A hypothetical 1% increase in variable interest rates for the Credit Facility would have impacted our earnings and cash flow as of July 2, 2005 by approximately $1 million. All of our other debt is fixed rate debt. We may use additional derivative financial instruments where appropriate to manage our interest rate risk. However, as a matter of policy, we do not enter into derivative or other financial investments for trading or speculative purposes.

     Some of our Orthopedic Rehabilitation Division products are sold in European markets and are denominated in Euros. During the first six months of 2005, our average monthly Euro sales were $3.9 million compared to $200,000 during the first six months of 2004. This increase in average monthly sales is due to the inclusion of sales related to the Empi acquisition. As a result, currency fluctuations could have a greater impact on our operating results. For example, in periods in which the Euro strengthens against the U.S. dollar, our international net revenues increase because our Euro denominated net revenues will translate into a greater number of U.S. dollars. Conversely, in periods in which the Euro weakens against the U.S. dollar, our international revenues decrease because our Euro denominated net revenues will translate into fewer U.S. dollars. We manufacture our products in the United States, Mexico and Germany and incur the costs to manufacture in US dollars in both the United States and Mexico, and Euros in our Germany facility.

     Our U.S. operations are subject to risk associated with international currency exchange rates on purchases of inventory from a small number of suppliers. Our German subsidiary, whose functional currency is Euros, is billed for certain inventory in U.S. dollars. From time to time, our German subsidiary utilizes international currency derivatives to limit its risk to currency fluctuations. These derivatives are used to manage currency fluctuation on purchases of inventory that are denominated in U.S. dollars. At July 2, 2005 there were no international currency derivatives outstanding and we have not used international currency derivatives to hedge against our investment in our German subsidiary or its operating results, which are converted into U.S. dollars at period-end and average rates, respectively.

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ITEM 4. CONTROLS AND PROCEDURES

     We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to management, including our Chief Executive Officer and our Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.

     As indicated in the certifications in Exhibit 32 of this report, our Chief Executive Officer and our Chief Financial Officer, with the assistance of other members of our management, have evaluated our disclosure controls and procedures (as defined in the Securities Exchange Act of 1934 Rules 13a-15(e) and 15d-15(e)). Based upon the evaluation of our disclosure controls and procedures required by Securities Exchange Act Rules 13a-15(b) or 15d-15(b), our Chief Executive Officer and Chief Financial Officer have concluded that as of the end of the period covered by this report, our disclosure controls and procedures were effective for the purpose of ensuring that material information required to be in this quarterly report is made known to them by others on a timely basis.

     Our management is responsible for establishing and maintaining adequate internal control over financial reporting. Our internal control system was designed to provide reasonable assurance to the company’s management and board of directors regarding the preparation and fair presentation of published financial statements.

     All internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation.

Changes in Internal Control Over Financial Reporting

     We are involved in ongoing evaluations of internal controls. In anticipation of the filing of this Form 10-Q, our Chief Executive Officer and Chief Financial Officer, with the assistance of other members of our management, reviewed our internal controls and have determined, based on such review, that there have been no changes in internal control over financial reporting during the quarter ended July 2, 2005 that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

Part II. Other Information

Item 1.Legal Proceedings

     None.

Item 2.Unregistered Sales Of Equity Securities And Use of Proceeds

     None.

Item 3.Defaults Upon Senior Securities

     None.

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

     The annual meeting of our stockholders was held on May 18, 2005. At the meeting, our stockholders acted on the following matter:

Election of three Class B directors for a term of three years each and until his or her successor is duly elected and qualified.

Name	Voted For		Voted Against		Votes Withheld
Class B Directors
Kenneth W. Davidson		47,247,142		0		108,285
Karen R. Osar		46,935,121		0		420,306
Bruce F. Wesson		46,966,698		0		388,729

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Item 5.Other Information

     Also, as provided in our proxy statement filed with the Securities and Exchange Commission on April 14, 2005, our Board of Directors approved an increase in non-employee director compensation by including a cash component of $12,000 per year for each non-employee board member plus $2,000 per each quarterly meeting that each non-employee director attends in person.

Item 6.Exhibits

a)Exhibits.

10.1	Board of Directors Compensation
31.1	Certification (pursuant to Securities Exchange Act Rule 13a-14a) by Chief Executive Officer.
31.2	Certification (pursuant to Securities Exchange Act Rule 13a-14a) by Chief Financial Officer.
32.1	Section 1350 — Certification (pursuant to Section 906 of the Sarbanes-Oxley Act of 2002) by Chief Executive Officer.
32.2	Section 1350 — Certification (pursuant to Section 906 of the Sarbanes-Oxley Act of 2002) by Chief Financial Officer.

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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.

August 10, 2005	By:	/s/ Kenneth W. Davidson
Date		Kenneth W. Davidson, Chairman of the Board and Chief Executive Officer
August 10, 2005	By:	/s/ William W. Burke
Date		William W. Burke, Executive Vice President and Chief Financial Officer

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