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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 8-K
CURRENT REPORT
PURSUANT TO SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934
Date of Report (Date of earliest event reported) August 27, 2001
DJ ORTHOPEDICS, LLC
(Exact name of registrant as specified in its charter)
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DELAWARE 333-86835 52-2165554
(State or Other Jurisdiction (Commission File Number) (I.R.S. Employer
of Incorporation) Identification No.)
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DJ ORTHOPEDICS CAPITAL CORPORATION
(Exact name of registrant as specified in its charter)
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DELAWARE 333-86835 52-2157537
(State or Other Jurisdiction (Commission File Number) (I.R.S. Employer
of Incorporation) Identification No.)
</Table>
DONJOY, L.L.C.
(Exact name of registrant as specified in its charter)
<Table>
DELAWARE 333-86835 33-0848317
(State or Other Jurisdiction (Commission File Number) (I.R.S. Employer
of Incorporation) Identification No.)
</Table>
2985 SCOTT STREET
VISTA, CALIFORNIA 92083
(Address of principal executive
offices including Zip Code)
(800) 336-5690
(Registrant's telephone number, including area code)
N.A.
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(Former name or former address, if changed since last report)
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EXPLANATORY NOTE
This integrated Form 8-K is filed pursuant to the Securities Exchange Act of
1934, as amended, for each of DonJoy, L.L.C. ("DonJoy"), a Delaware limited
liability company, dj Orthopedics, LLC ("dj Ortho"), a Delaware limited
liability company and a wholly-owned subsidiary of DonJoy, and DJ Orthopedics
Capital Corporation ("DJ Capital"), a Delaware corporation and a wholly-owned
subsidiary of dj Ortho. DJ Capital was formed solely to act as a co-issuer (and
as a joint and several obligor) with dj Ortho of $100,000,000 aggregate
principal amount at maturity of 12 5/8% Senior Subordinated Notes due 2009. DJ
Capital does not hold any assets or other properties or conduct any business. No
separate financial information for DJ Capital has been provided herein because
management believes such information would not be meaningful because DJ Capital
has no financial or other data to report, and, accordingly, there is no separate
information regarding DJ Capital to report herein. DonJoy is a guarantor of the
Notes and of dj Ortho's bank borrowings and has no material assets or operations
other than its ownership of 100% of dj Ortho's equity interests. dj Ortho
represents substantially all of the revenues and net income of DonJoy. As a
result, the consolidated financial position and results of operations of DonJoy
are substantially the same as dj Ortho's.
ITEM 5. OTHER EVENTS
Historically, DonJoy, L.L.C. reflected allowances and discounts applicable
to the OfficeCare program as selling and marketing expenses. With the growth in
the program, management believes that these charges are more appropriately
presented as adjustments to revenues, rather than as operating expenses. As a
result, DonJoy L.L.C. has reclassified in its historical financial statements
$0.6 million, $1.3 million, $3.9 million and $1.2 million of charges for the
years ended December 31, 1998, 1999 and 2000 and the first six months of 2000,
respectively, which were previously included in selling and marketing expenses,
against revenues related to the OfficeCare program. This reclassification had no
effect in net income (loss) for the foregoing periods. DonJoy, L.L.C.'s
consolidated financial statements as of December 31, 1999 and 2000 and for each
of the three years in the period ended December 31, 2000 and at June 30, 2001
and for the six months ended July 1, 2000 and June 30, 2001 reflecting such
reclassifications are filed under Item 7 of this Report.
Set forth below is the Company's Management's Discussion and Analysis of
Financial Condition and Results of Operations based on such reclassified
financial statements.
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MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
OVERVIEW
DonJoy is a guarantor of the notes and of the credit facility and has no
material assets or operations other than its ownership of all dj Ortho's equity
interests. As a result, the discussion below of the historical consolidated
financial position and results of operations of DonJoy is substantially the same
as dj Ortho's. No financial information of DJ Capital, the co-issuer of the
notes, is included herein because management believes such information would not
be material given that DJ Capital has no assets, liabilities or operations.
RECAPITALIZATION
On June 30 1999, we consummated a $215.3 million recapitalization. In
connection with the recapitalization transactions, we established dj Ortho and
DJ Capital Corporation (DJ Capital), a co-issuer of our senior subordinated
notes with no material assets or operations. DonJoy, L.L.C. sold all of its net
assets to dj Ortho for cash which was funded with the net proceeds of
$100.0 million principal amount of 12 5/8% senior subordinated notes issued by
dj Ortho and DJ Capital, as co-issuers, and the remainder by funds borrowed by
dj Ortho under a senior credit facility. In addition, new investors, including
three members of our senior management, invested new capital of $94.6 million in
equity in DonJoy, L.L.C. The proceeds of the equity investment together with
debt financings were used as follows:
- approximately $199.1 million as consideration paid to redeem a portion of
members' equity from our former parent, and
- approximately $8.8 million to pay costs and fees in connection with the
recapitalization.
As part of the recapitalization agreement, immediately prior to the
recapitalization, our former parent made a capital contribution in an amount
equal to our then existing cash balance. In addition, it canceled current and
deferred liabilities due to our former parent and assumed a then existing
restructuring reserve which resulted in an additional capital contribution in
those amounts. These amounts aggregated $47.9 million and were treated as a
capital contribution by our former parent to our members' equity.
ACQUISITIONS AND OTHER RECENT TRANSACTIONS
In accordance with a unit purchase agreement dated as of June 28, 2000, the
former parent sold its remaining interest in 54,000 common units in DonJoy,
L.L.C. to J.P. Morgan DJ Partners, LLC Partners and certain members of
management for $5.9 million. JPMDJ Partners purchased 52,495 common units for a
total consideration of $5.7 million and the members of management purchased the
remaining 1,505 units for a total consideration of $0.2 million, which they
financed by cash and promissory notes issued to us.
On July 7, 2000, we completed the purchase of specified assets and assumed
specified liabilities related to the rehabilitation business, referred to in
this Report on Form 8-K as Orthotech or the Orthotech business, of DePuy
Orthopedic Technology, Inc., a subsidiary of Johnson & Johnson. We acquired
Orthotech for a purchase price of $46.4 million in cash, exclusive of
transaction fees and expenses. Orthotech developed, manufactured, and marketed
an array of orthopedic products for the orthopedic sports medicine market
including braces, soft goods and specialty products which were similar to the
products offered by us. Orthotech also had an inventory management and billing
program that complemented our OfficeCare program. We purchased primarily
inventory, equipment and certain intellectual property. We were not required to
assume any liabilities existing prior to the closing date. The Orthotech
acquisition has been accounted for using the purchase method of accounting
whereby
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the total purchase price has been allocated to tangible and intangible assets
acquired and liabilities assumed based on their estimated fair market values.
Effective March 5, 2001, we invested in an Australian joint venture, dj
Orthopaedics Pty Ltd (dj Australia) which is 60% owned by dj Ortho. dj Australia
has replaced our Smith & Nephew distributor in Australia and also sells two new
product lines.
On June 1, 2001, we completed the acquisition of substantially all of the
assets and liabilities of Alaron Technologies, L.L.C. for an aggregate purchase
price of $500,000 in cash, payable in four equal installments of $125,000 each,
the first two of which have been paid, with the two remaining payments due on
October 1, 2001 and November 30, 2001. Alaron provided product development,
manufacturing and supply chain management services related to medical and
surgical devices. We purchased primarily equipment and acquired technology. The
Alaron acquisition has been accounted for using the purchase method of
accounting whereby the total purchase price has been allocated to tangible and
intangible assets acquired and liabilities assumed based on their estimated fair
market values. The acquisition also provided order fulfillment and supply chain
management systems and software for our new Alaron Surgical division. These
systems will allow us to better serve the overall sports medicine market by
offering our surgical products in procedure-specific kits. In connection with
the Alaron acquisition, we entered into an employment agreement with Paul K.
Nichols, a principal owner of Alaron Technologies, L.L.C., who serves as a
Senior Vice President and head of the Alaron Surgical division.
PENDING ACQUISITIONS
We have executed letters of intent to acquire two European orthopedic
products manufacturers and distributors. We intend to acquire Ro+Ten SRL, a
manufacturer of soft goods and our current distributor in Italy, and its Swiss
affiliate, Orthoservice AG, which manufactures orthopedic products for Ro+Ten,
for an aggregate purchase price of approximately $9.5 million in cash and an
additional $0.5 million if specified performance targets are met. Consummation
of the acquisitions is subject to completion of our due diligence, execution of
definitive agreements, receipt of necessary financing and the receipt of
necessary regulatory approvals and, accordingly, we cannot assure you that
either of these acquisitions will be consummated. If consummated, we anticipate
that these transactions would close during the first quarter of 2002. Our
acquisition of these companies is part of our strategy to expand our direct
distribution capability in selected international markets where we believe that
there is significant potential to increase sales due to high per capita health
care expenditures.
SEGMENTS
We are a world leading designer, manufacturer and marketer of products for
the orthopedic sports medicine market. Our product lines include rigid knee
braces, soft goods, a portfolio of specialty and other complementary orthopedic
products and our recently introduced line of surgical products. Our rigid knee
braces include ligament braces, which provide durable support for knee ligament
instabilities, post-operative braces, which provide both knee immobilization and
a protected range of motion, and osteoarthritic braces, which provide relief of
knee pain due to osteoarthritis. Our soft goods products, most of which are
fabric or neoprene-based, provide support and/or heat retention and compression
for injuries to the knee, ankle, back and upper extremities, including the
shoulder, elbow, neck and wrist. Our portfolio of specialty and other
complementary orthopedic products, which are designed to facilitate orthopedic
rehabilitation, include lower extremity walkers, upper extremity braces, cold
therapy systems and pain management delivery systems. Our recently introduced
surgical products include fixation devices for soft tissue repair in the knee as
well as to address cartilage damage due to trauma or osteoarthritis. The rigid
knee brace product lines and the soft goods product lines constitute reportable
segments under generally accepted accounting principles. See note 7 of the notes
to our consolidated financial statements. We began selling our Alaron Surgical
products in the third quarter of 2001.
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Set forth below is revenue and gross profit information for our product
lines for the years ended December 31, 1998, 1999 and 2000 and the first six
months of 2000 and 2001. Gross profit information is presented before brand
royalties charged by Smith & Nephew for use of Smith & Nephew trademarks and
trade names for periods prior to the June 1999 recapitalization (which charges
are no longer incurred by us following the recapitalization), certain other cost
of goods sold, primarily manufacturing variances and royalty expenses, which
have not been directly allocated to any of the product lines, and freight
revenue. See note 9 of the notes to our consolidated financial statements.
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<Caption>
YEARS ENDED DECEMBER 31, SIX MONTHS ENDED
------------------------------ -------------------
JULY 1, JUNE 30,
1998 1999 2000 2000 2001
-------- -------- -------- -------- --------
(DOLLARS IN THOUSANDS)
RIGID KNEE BRACING:
Net revenues............................... $52,473 $52,953 $58,115 $27,672 $32,661
Gross profit............................... 36,669 37,994 41,189 19,853 23,281
Gross profit margin........................ 69.9% 71.8% 70.9% 71.7% 71.3%
SOFT GOODS:
Net revenues............................... $32,010 $38,606 $51,412 $20,563 $30,307
Gross profit............................... 15,707 18,723 24,662 9,686 13,225
Gross profit margin........................ 49.1% 48.5% 48.0% 47.1% 43.6%
SPECIALTY AND OTHER COMPLEMENTARY ORTHOPEDIC
PRODUCTS:
Net revenues............................... $15,653 $21,344 $29,647 $12,217 $17,895
Gross profit............................... 7,050 9,447 16,635 6,897 9,649
Gross profit margin........................ 45.0% 44.3% 56.1% 56.5% 53.9%
</Table>
Our total gross profit margin before brand royalties, other cost of goods
sold not allocable to specific product lines and freight revenue was 59.3%,
58.6%, 59.3%, 60.3% and 57.1% for the years ended December 31, 1998, 1999 and
2000 and the first six months of 2000 and 2001, respectively.
Our products are marketed under the DonJoy, ProCare and Alaron Surgical
brand names through several distribution channels. DonJoy brand product sales
represented approximately 75% and 73% of total net revenues, excluding freight
revenue, in 2000 and the first six months of 2001, respectively. Excluding
freight revenue, we marketed substantially all of our rigid knee braces,
approximately 84% of our specialty and other complementary orthopedic products
and approximately 41% of our soft goods products under the DonJoy brand name in
2000. ProCare brand product sales represented approximately 25% and 27% of total
net revenues, excluding freight revenue, in 2000 and the first six months of
2001, respectively. Excluding freight revenue, we sold approximately 59% of our
soft goods products, approximately 16% of our specialty and other complementary
orthopedic products and a nominal percentage of our rigid knee braces under the
ProCare brand name in 2000. Following the Orthotech acquisition, we sold
products under the Orthotech brand; however, in 2000 we integrated Orthotech
products into the DonJoy and ProCare brands. Our recently introduced surgical
products are marketed under the Alaron Surgical brand name.
DOMESTIC SALES
In the United States, DonJoy brand products are marketed to orthopedic
sports medicine surgeons, orthotic and prosthetic centers, hospitals, surgery
centers, physical therapists and athletic trainers. Our surgical products, which
are sold under the Alaron Surgical brand name, are marketed to orthopedic sports
medicine surgeons, hospitals and surgery centers. Both DonJoy and Alaron
Surgical products are sold by 38 commissioned sales agents who employ
approximately 210 sales representatives. After a product order is received by a
sales representative, we generally ship the product directly to the orthopedic
professional and we pay a sales commission to the agent on sales of such
products, which
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commissions are reflected in sales and marketing expense in our consolidated
financial statements. Excluding freight revenue, domestic sales of DonJoy brand
products represented approximately 63% and 64% of total net revenues in 1999 and
2000, respectively, and 63% and 60% of total net revenues in the first six
months of 2000 and 2001, respectively.
Our ProCare products are sold in the United States to third party
distributors, including large, national distributors, regional specialty dealers
and medical products buying groups who generally purchase such products at a
discount from list prices. These distributors then resell ProCare products to
large hospital chains, hospital buying groups, primary care networks and
orthopedic physicians for use by the patients. Excluding freight revenue,
domestic sales of ProCare products represented approximately 22% and 24% of
total net revenues in 1999 and 2000, respectively, and 21% and 28% of total net
revenues in the first six months of 2000 and 2001, respectively.
The change in the mix of domestic sales between the DonJoy and ProCare
brands has been a direct result of the Orthotech acquisition. A majority of the
Orthotech products were soft goods and have been integrated into the ProCare
brands, thus increasing the percent of domestic sales sold under the ProCare
brand while decreasing the percent of domestic sales sold under the DonJoy
brand.
INTERNATIONAL SALES
Excluding freight revenue, international sales accounted for approximately
17%, 16%, 13%, 15% and 12% of our net revenues, in 1998, 1999 and 2000 and the
first six months of 2000 and 2001, respectively. Excluding freight revenue,
total sales in Europe, Germany and Canada accounted for 62%, 31% and 11%,
respectively, of our 2000 international net revenues and 70%, 37% and 12%,
respectively, of our international revenues in the first six months of 2001,
with no other country accounting for 10% or more of our international net
revenues in 2000 or the first six months of 2001. The decrease in international
net revenues as a percentage of total revenues in 2000 and the first six months
of 2001 as compared to prior years is a direct result of the Orthotech business,
which historically consisted primarily of domestic sales.
International sales are currently made primarily through two distinct
channels: independent third party distributors (such as in Germany) and Smith &
Nephew sales organizations within certain major countries (such as Canada). We
distribute our products in Australia through dj Australia. Distributors in these
channels buy and resell the DonJoy and ProCare brand products within their
designated countries. Excluding freight revenue, DonJoy brand products
constituted approximately 90%, 86%, 85%, 84% and 82% of international net
revenues in 1998, 1999, 2000 and the first six months of 2000 and 2001,
respectively. A significant amount of 2000 sales were transferred from Smith &
Nephew sales organizations to independent distributors. International sales made
through Smith & Nephew sales organizations were 55%, 40%, 20% and 10% of our
international sales, exclusive of freight revenue, in 1998, 1999 and 2000 and
the first six months of 2001, respectively. We believe future opportunities for
sales growth within international markets are significant. We intend to
selectively replace our third-party independent distributors with wholly or
partially owned distributors in key countries where we believe the opportunity
for growth is significant due to higher per capita health care spending. We
believe that more direct control of the distribution network in these countries
will allow us to accelerate the launch of new products and product enhancements,
to benefit from the sale of our higher margin products and to capture the
distributor's margin. Our pending acquisitions, if completed, the establishments
of our Australian subsidiary and our recent decision not to renew the
distribution agreement with our existing distributor in Germany and the United
Kingdom effective December 31, 2001 represent our initial steps in pursuing this
strategy.
Since our international sales have historically been made in U.S. dollars,
our results of operations have not been directly impacted by foreign currency
exchange fluctuations. However, as was the case in 2000, the volume and product
mix of international sales has been and may continue to be adversely
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impacted by foreign currency exchange fluctuations as changes in the rate of
exchange between the U.S. dollar and the applicable foreign currency will affect
the cost of our products to our customers and thus may impact the overall level
of customer purchases. International sales in 2000 were adversely impacted by
foreign currency exchange fluctuations as the strengthening of the U.S. dollar
against the Euro effectively increased the cost of our products to our European
customers. In addition, as we begin to directly distribute our products in
selected foreign countries, we expect that future sales of our products in these
markets will be denominated in the applicable foreign currencies which would
cause currency fluctuations to more directly impact our operating results. We
may seek to reduce the potential impact of currency fluctuations on our business
through hedging transactions.
We are also subject to other risks inherent in international operations
including political and economic conditions, foreign regulatory requirements,
exposure to different legal requirements and standards, potential difficulties
in protecting intellectual property, import and export restrictions, increased
costs of transportation or shipping, difficulties in staffing and managing
international operations, labor disputes, difficulties in collecting accounts
receivable and longer collection periods and potentially adverse tax
consequences. As we continue to expand our international business, our success
will be dependent, in part, on our ability to anticipate and effectively manage
these and other risks. These and other factors may have a material adverse
effect on our international operations or on our business, financial condition
and results of operations.
THIRD PARTY REIMBURSEMENT; HEALTH CARE REFORM; MANAGED CARE
While national health care reform and the advent of managed care has
impacted the orthopedic sports medicine market, its impact has not been as
dramatic as experienced by other sectors of the health care market, such as long
term care, physician practice management and managed care (capitation) programs.
In recent years, efforts to control medical costs within the United States have
been directed towards scrutiny of medical device reimbursement codes, whereby
devices are classified to determine the reimbursement levels including
reimbursement for products packaged with related orthopedic procedures.
Reimbursement codes covering certain of our products have been redefined,
thereby reducing the breadth of products for which reimbursement can be sought
under recognized codes. We expect that reduction in the total dollar value
eligible for reimbursement will occur in the future as the reform process
continues.
In international markets, while the movement toward health care reform and
the development of managed care are generally not as advanced as in the United
States, we have experienced some downward pressure on the pricing of certain of
our products and other effects of health care reform similar to those we have
experienced in the United States. We expect health care reform and managed care
to continue to develop in primary international markets, including Europe and
Japan, which will result in further downward pressure on product pricing.
A further result of managed care and the related pressure on costs has been
the advent of buying groups in the United States which enter into preferred
supplier arrangements with one or more manufacturers of orthopedic or other
medical products in return for volume commitments and price discounts. We have
entered into national contracts with selected buying groups and expect to enter
into additional national contracts in the future. We believe that the high level
of product sales to such groups, to the extent such groups are able to command a
high level of compliance by their members with the preferred supplier
arrangements, and the opportunity for increased market share can offset the
financial impact of the price discounting under such contracts. Accordingly,
although we cannot assure you, we believe that such price discounting will not
have a material adverse effect on our operating results in the future.
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OFFICECARE PROGRAM
In 1996, in response to the needs of our customers, we launched OfficeCare,
an inventory management and insurance billing program for our U.S. orthopedic
sports medicine surgeons. Under the OfficeCare program, we provide the
orthopedic sports medicine surgeon with an inventory of orthopedic products for
immediate disbursement to the patient. We then seek reimbursement directly from
the patient's insurance company or other third party payor or from the patient
where self-pay is applicable. The majority of these billings are performed by an
independent third-party contractor.
Since its inception, the OfficeCare program has been promoted specifically
to provide our orthopedic sports medicine surgeons with a broad array of soft
goods and certain other specialty products for immediate patient use. The
OfficeCare program is also intended to facilitate the introduction of our
products to the orthopedic sports medicine surgeons who had not previously been
our customers.
The OfficeCare program represented approximately 6%, 10%, 10% and 17% of our
net revenues, excluding freight revenue, for 1999 and 2000 and the first six
months of 2000 and 2001, respectively, with sales of soft goods and specialty
and other complementary orthopedic products representing the majority of such
sales. The OfficeCare program involves our lower margin soft goods products, but
is designed to also strengthen our relationship with the customer, and serves to
provide a pull-through effect for both existing and planned sales of our higher
margin products. The OfficeCare program has historically experienced a strong
growth rate, with an increase of sales, of 42% in 1999 over 1998, 99% in 2000
over 1999 and 127% for the first six months of 2001 over the first six months of
2000. The increases in 2000 and the first six months of 2001 are primarily due
to the Orthotech acquisition.
As a result of the growth of the program, our working capital needs have
significantly increased due to higher levels of accounts receivable and
inventories necessary to operate the program. Historically, we reflected
allowances and discounts applicable to the OfficeCare program as selling and
marketing expense. With the growth in the program, management believes that
these charges are more appropriately presented as adjustments to revenues,
rather than as operating expense. As a result, we reclassified $0.6 million,
$1.3 million, $3.9 million and $1.2 million of charges for the years ended
December 31, 1998, 1999 and 2000 and the first six months of 2000, respectively,
which were previously included in selling and marketing expenses, against
revenues related to our OfficeCare program.
SMITH & NEPHEW ALLOCATIONS AND SALES
Prior to December 29, 1998, our business was operated as the Bracing &
Support Systems Division of Smith & Nephew. Effective December 29, 1998,
Smith & Nephew contributed the Division's net assets and shares of a Mexican
subsidiary to us, then a newly formed Delaware limited liability company, the
sole member of which was Smith & Nephew. Accordingly, the contribution has been
accounted for on a predecessor basis for financial reporting purposes.
As a result of formerly being a division of Smith & Nephew, our historical
results of operations prior to the June 1999 recapitalization reflect certain
direct charges from Smith & Nephew as well as certain allocations of Smith &
Nephew's overhead and other expenses. These amounts were charged or allocated to
us on the basis of direct usage where identifiable, with the remainder allocated
to us on the basis of its annual sales or the capital employed by Smith & Nephew
in our business. See note 9 of the notes to our consolidated financial
statements.
The following is a summary of such charges and allocations and their
applicability to us on a stand-alone basis following the recapitalization:
(1) Charges for brand royalties historically included in cost of goods sold
resulting from our use of the Smith & Nephew trademarks and trade name.
These charges were $3.2 million and $1.8 million in 1998 and 1999,
respectively. As a result of the recapitalization on June 30,
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1999, we no longer have the right to use the Smith & Nephew trademarks
and trade names and, accordingly, these charges are no longer incurred by
us.
(2) Foreign sales corporation commissions historically included in general
and administrative expense paid by us on sales to foreign sales
corporations established by Smith & Nephew. The use of sales corporations
was a tax planning strategy for Smith & Nephew. These charges were
$0.4 million in 1998. As of January 1999, we no longer incurred these
charges.
(3) Smith & Nephew allocations for a portion of its corporate managed
accounts and new business expense and corporate management expense
historically were included in general and administrative expense. These
allocations were $1.7 million and $1.0 million in 1998 and 1999,
respectively. These allocations were for a portion of Smith & Nephew's
overhead expenses that we have not incurred or replaced following the
recapitalization.
(4) Smith & Nephew allocations for research and development and for finance
(risk management, treasury, audit and taxes), human resources and
payroll, and legal services historically provided by Smith & Nephew to us
were included in general and administrative expense. These allocations
were $1.7 million and $0.8 million in 1998 and 1999, respectively. These
allocations were for a portion of Smith & Nephew's overhead expenses. On
a stand-alone basis, we have replaced these services provided by Smith &
Nephew following the recapitalization and we have incurred additional
expenses associated with external auditing and periodic filings with the
Securities and Exchange Commission. We estimate that the aggregate annual
cost of replacing these services and such additional expenses was
approximately $0.8 million following the recapitalization.
(5) Other allocations relating to bonuses, pension and insurance
historically included in cost of goods sold, sales and marketing expense
and general and administrative expense, and charges for payroll taxes and
benefits and direct legal expenses incurred by Smith & Nephew on our
behalf were included in general and administrative expense. These costs
and expenses are of a nature we continue to incur on a stand-alone basis
following the recapitalization.
Under a transition services agreement entered into in connection with the
recapitalization, Smith & Nephew continued to provide certain of the
administrative services referred to in paragraph (4) above as required by us
through November 30, 2000. We have replaced the services provided by Smith &
Nephew with internal staff, including the addition of new employees and through
arrangements with third party providers. As noted above, we estimate that the
services described in paragraph (4) above (which are reflected as general and
administrative expense following the recapitalization) have cost us
approximately $0.8 million following the recapitalization.
For the years ended December 31, 1998, 1999 and 2000 and the first six
months of 2000 and 2001, sales to Smith & Nephew and its affiliates (including
Smith & Nephew's sales organizations) were $10.7 million, $8.3 million,
$4.6 million, $2.0 million and $0.9 million, respectively, or 11%, 7%, 2%, 3%
and 1% respectively, of total sales, excluding freight revenue, for these
periods. International sales made through Smith & Nephew sales organizations
were 55%, 40%, 20% 23% and 10% of international sales, excluding freight
revenue, in 1998, 1999 and 2000 and the first six months of 2000 and 2001,
respectively. In connection with the recapitalization, Smith & Nephew and its
sales organizations, which distribute our products internationally entered into
agreements with us regarding the purchase of our products following consummation
of the recapitalization. However, neither Smith & Nephew nor such sales
organizations have any obligation to purchase any specific or minimum quantity
of products pursuant to such agreements.
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MANUFACTURING COST REDUCTION INITIATIVES
Over the past several years, we have undertaken initiatives designed to
further strengthen our overall manufacturing cost structure and improve
operating efficiency. In order to take advantage of the lower labor costs in
Mexico, in 1993 we began manufacturing certain of our labor intensive
operations, principally sewing, final assembly and packaging, in Tijuana,
Mexico. In 1998, we completed the consolidation of our domestic operations into
one location in Vista, California. As a result, we incurred $2.5 million of
restructuring costs in 1998, substantially all of which related to lease
termination costs on the vacated facility. Pursuant to the recapitalization
agreement, the remainder of the restructuring reserve, which amounted to
$0.9 million at June 29, 1999 and consisted of the remaining lease obligations
on the vacated facility, was assumed by Smith & Nephew. In addition, in 1998
general and administrative expense included $0.2 million of costs related to
moving costs resulting from the consolidation of the facilities. Operating
results for the first three quarters of 1998 were adversely affected by the
consolidation and integration of the manufacturing operations of the DonJoy and
ProCare brands which were previously separate and distinct, but returned to
prior levels in the fourth quarter of 1998 and sustained these levels through
the remainder of 1999 and 2000.
In 2000, we completed the consolidation of the Orthotech operations into our
Vista, California location. Operating results for the last two quarters of 2000
were adversely affected by the consolidation and integration of the
manufacturing operations of the Orthotech brands which were previously separate
and distinct.
We have identified additional opportunities to reduce manufacturing costs
and improve operating efficiency. In 2001 we consolidated our two separate
Mexican operations into one campus location and have listed the vacated facility
for sale. We have recently leased additional space in Mexico, directly within
the current campus. Consolidation of these facilities will enable us to continue
to take advantage of the lower labor costs in Mexico and utilize the resulting
additional capacity in our U.S. facilities to manufacture our more
technologically advanced, high value products. We have begun to take advantage
of our operating efficiencies by moving our post operative and walker lines to
Mexico. By upgrading our computer systems to achieve more efficient production,
we expect to achieve material and labor cost reductions as well as economies of
scale across our entire manufacturing operation. We have converted our
manufacturing scheduling to produce finished goods upon customer demand. We will
further convert our procurement process to enable us to replenish our supply of
raw materials upon usage. Both processes will allow us to decrease the level of
inventory necessary to operate the business and reduce the risk of excess and
obsolete inventory. We have also reorganized our manufacturing facility into
product focused groups. The reorganization and streamlining of the manufacturing
facility is expected to reduce the total manufacturing costs, principally
overhead costs. In addition, we intend to further automate our manufacturing
operations in the rigid knee brace product line through the use of more
technologically advanced fabrication and equipment systems. We will continue to
rationalize raw materials used in the production of our existing products,
thereby enabling us to leverage our purchasing power. Finally, in order to
achieve further cost savings, we intend to further reduce the number of stock
keeping units (SKUs) without impacting service or breadth of our product range.
9
<Page>
BASIS OF PRESENTATION; TAXES
Our former parent files a consolidated federal income tax return which
includes all of its eligible subsidiaries and divisions, which included us prior
to the recapitalization. The provision for income taxes has been presented
assuming we filed a separate federal income tax return. The recapitalization had
no impact on the historical basis of our assets and liabilities as reflected in
our consolidated financial statements except for the elimination of the
remaining restructuring reserve and the intercompany accounts. However, as a
result of the recapitalization, for federal income tax purposes, we have
recorded an increase in the tax basis of our fixed and intangible assets in an
amount approximately equal to the taxable gain recognized by Smith & Nephew on
the sale of its interest in us. As a result, after the recapitalization, for tax
purposes we are able to depreciate assets with a higher tax basis than for
financial reporting purposes. The increase in tax basis as of December 31, 1999
was as follows (in thousands):
<Table>
Inventory................................................... $ 3,670
Property, plant & equipment................................. 4,145
Goodwill.................................................... 130,543
--------
$138,358
========
</Table>
The Orthotech acquisition also resulted in an increase in the tax basis due
to the fixed and intangible assets acquired. The increase in tax basis due to
the Orthotech acquisition is equal to the amounts we recorded under purchase
accounting. See note 2 of the notes to our consolidated financial statements.
Prior to the recapitalization, our results of operations were included in
the consolidated federal income tax returns that Smith & Nephew filed in the
United States and the historical financial statements reflect a provision for
income taxes assuming that we had filed a separate federal income tax return. As
limited liability companies, DonJoy, L.L.C. and dj Ortho are not subject to
income taxes following the recapitalization. Instead, DonJoy, L.L.C.'s earnings
following the recapitalization are allocated to its members and included in the
taxable income of the members. The indenture governing our senior subordinated
notes and the credit facility currently permit dj Ortho to make distributions to
DonJoy, L.L.C. in certain amounts to allow DonJoy, L.L.C. to make distributions
to its members to pay income taxes in respect of their allocable share of
taxable income.
RESULTS OF OPERATIONS
We operate our business on a manufacturing calendar, with our fiscal year
always ending on December 31. Each quarter is 13 weeks, consisting of one
five-week and two four-week periods. The first and fourth quarters may have more
or less working days from year to year based on what day of the week holidays
fall on. The first six months of 2001 contained one less business day than the
first six months of 2000, which resulted in approximately $0.7 million less
revenue in the first six months of 2001 as compared to the first six months of
2000.
In the fourth quarter of 2000, we adopted Emerging Issues Task Force (EITF)
Issue 00-10 "Accounting for Shipping and Handling Fees and Costs." As a result,
we have reclassified $3.5 million, $3.5 million, $4.4 million, and $1.9 million
for December 31, 1998, 1999 and 2000 and the first six months of 2000,
respectively, of freight revenue from sales and marketing expenses into net
revenues. We continue to include freight expenses in sales and marketing
expense.
10
<Page>
The following table sets forth our operating results as a percentage of net
revenues:
<Table>
<Caption>
YEARS ENDED
DECEMBER 31, SIX MONTHS ENDED
------------------------------------ ----------------------------
1998 1999 2000 JULY 1, 2000 JUNE 30, 2001
-------- -------- -------- ------------ -------------
Net revenues:
Rigid knee bracing................... 50.6% 45.5% 40.5% 44.4% 39.2%
Soft goods........................... 30.9 33.2 35.8 33.0 36.4
Specialty and other complementary
orthopedic products................ 15.1 18.3 20.6 19.6 21.5
----- ----- ----- ----- -----
Revenues from product lines............ 96.6 97.0 96.9 97.0 97.1
Freight revenue...................... 3.4 3.0 3.1 3.0 2.9
----- ----- ----- ----- -----
Total consolidated net revenues........ 100.0 100.0 100.0 100.0 100.0
Cost of goods sold..................... 44.8 44.4 41.9 40.4 41.6
----- ----- ----- ----- -----
Gross profit........................... 55.2 55.6 58.1 59.6 58.4
Sales and marketing.................. 26.7 24.9 26.9 25.2 28.2
General and administrative........... 15.9 14.4 13.8 14.5 14.5
Research and development............. 2.2 1.8 1.7 1.9 1.6
Merger and integration costs......... -- -- 0.3 -- --
Restructuring costs.................. 2.3 -- -- -- --
----- ----- ----- ----- -----
Income from operations................. 8.1 14.5 15.4 18.0 14.1
Interest expense....................... -- (6.5) (11.8) (12.2) (11.2)
Interest income........................ -- 0.2 0.3 0.4 0.2
Discontinued acquisition costs......... -- -- (0.3) -- --
----- ----- ----- ----- -----
Income before income taxes............. 8.1 8.2 3.6 6.2 3.1
Provision for income taxes............. (3.3) (2.1) -- -- --
----- ----- ----- ----- -----
Net income............................. 4.8% 6.1% 3.6% 6.2% 3.1%
===== ===== ===== ===== =====
</Table>
11
<Page>
The following table summarizes certain of our operating results by quarter
for 1999 and 2000 and the first six months of 2001:
<Table>
<Caption>
YEAR ENDED DECEMBER 31, 1999
----------------------------------------------------
FIRST SECOND THIRD FOURTH TOTAL
QUARTER QUARTER QUARTER QUARTER YEAR
-------- -------- -------- -------- --------
(IN THOUSANDS)
Net revenues.................. $29,030 $26,400 $30,717 $30,271 $116,418
Gross profit.................. 15,517 14,364 17,711 17,082 64,674
Income from operations........ 3,080 2,739 5,637 5,446 16,902
Number of operating days...... 64 61 66 60 251
</Table>
<Table>
<Caption>
YEAR ENDED DECEMBER 31, 2000
----------------------------------------------------
FIRST SECOND THIRD FOURTH TOTAL
QUARTER QUARTER QUARTER QUARTER YEAR
-------- -------- -------- -------- --------
(IN THOUSANDS)
Net revenues.................. $31,881 $30,432 $39,873 $41,400 $143,586
Gross profit.................. 18,997 18,111 22,028 24,272 83,408
Income from operations........ 5,809 5,386 4,583 6,351 22,129
Number of operating days...... 65 63 63 61 252
</Table>
<Table>
<Caption>
SIX MONTHS ENDED
JUNE 30, 2001
-------------------
FIRST SECOND
QUARTER QUARTER
-------- --------
(IN THOUSANDS)
Net revenues.............................................. $40,295 $42,988
Gross profit.............................................. 23,528 25,075
Income from operations.................................... 5,994 5,731
Number of operating days.................................. 64 63
</Table>
SIX MONTHS ENDED JUNE 30, 2001 COMPARED TO SIX MONTHS ENDED JULY 1, 2000
NET REVENUES. Net revenues increased $21.0 million, or 33.7%, to
$83.3 million for the first six months of 2001 from $62.3 million for the first
six months of 2000. Net revenues, excluding freight revenue, for the rigid knee
bracing segment increased $5.0 million over the prior period due to growth in
the domestic sales of the OA and ligament product lines. We introduced the
DonJoy Vista-TM- Rehabilitation System in April 2001, the SE Four Point Brace in
March 2001, and a low cost ACL off-the-shelf brace and a new post-operative
brace line with telescoping bars in February 2001. Soft goods sales, excluding
freight revenue, increased by $9.7 million over the prior period due primarily
to the Orthotech acquisition, growth in the OfficeCare program and increased
sales volumes of wrist splints, ankle braces, knee braces and other general soft
good supports. Specialty and other complementary orthopedic products sales,
excluding freight revenue, increased by $5.7 million over the prior period due
primarily to increased sales of lower extremity walkers, cold therapy units, and
shoulder braces, as well as the growth of the OfficeCare program.
GROSS PROFIT. Gross profit increased $11.5 million, or 31.0%, to
$48.6 million for the first six months of 2001 from $37.1 million for the first
six months of 2000. Gross profit margin, exclusive of other cost of goods sold
not allocable to specific product lines and freight revenue, decreased from
60.3% for the first six months of 2000 to 57.1% for the first six months of 2001
primarily as a result of increased soft goods sales which carry a lower gross
profit margin. The decrease in gross profit margin is primarily a result of the
Orthotech acquisition and the related change in mix from rigid knee bracing to
soft goods. Gross profit for the rigid knee bracing segment increased
$3.4 million, with gross profit margins at 71.3% for the first six months of
2001 versus 71.7% for the comparable period in 2000. Gross profit for the soft
goods segment increased $3.5 million, with gross profit margin decreasing to
12
<Page>
43.6% for the first six months of 2001 from 47.1% for the comparable period in
2000. This decrease in gross profit margin is a result of the change in product
mix, primarily related to sales of Orthotech products. Gross profit for the
specialty and other complementary orthopedic products segment increased
$2.8 million, with gross profit margin decreasing to 53.9% for the first six
months of 2001 from 56.5% for the comparable period in 2000. The decrease in the
gross profit margin is a result of the change in product mix, primarily related
to sales of Orthotech products.
SALES AND MARKETING EXPENSES. Sales and marketing expenses increased
$7.8 million, or 49.6%, to $23.5 million for the first six months of 2001 from
$15.7 million for the first six months of 2000. The increase primarily reflects
increased commissions due to higher sales of domestic products, increased
freight expenses, increased processing costs related to OfficeCare volumes and
an increase in salaries and benefits due to increased headcount. Headcount
increased due to the Orthotech acquisition and growth in the OfficeCare program.
In addition, amortization expense related to the intangibles acquired in the
Orthotech acquisition is included in the first six months of 2001. Overall,
sales and marketing expense increased as a percentage of revenues to 28.2% for
the first six months of 2001 from 25.2% for the comparable period in 2000.
GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative expenses
increased $3.0 million, or 33.5%, to $12.0 million for the first six months of
2001 from $9.0 million for the first six months of 2000. The increase was
primarily due to amortization associated with the intangible assets acquired as
part of the Orthotech and Alaron Acquisitions and, to a lesser extent, expenses
related to these acquisitions and the creation of dj Australia and depreciation
associated with our new enterprise software system. Overall, general and
administrative expenses remained constant as a percentage of revenues at 14.5%
for the first six months of 2001 and 2000.
RESEARCH AND DEVELOPMENT EXPENSES. Research and development expenses were
approximately equal over the two periods. During the second quarter of 2001, we
introduced the DonJoy VISTA-TM- Rehabilitation System. In addition, we developed
a low cost ACL off-the-shelf brace, a new post operative brace line with
telescoping bars along with other competitive products, and the SE Brace II.
INTEREST EXPENSE. Interest expense increased approximately $1.7 million, or
22.8% to $9.3 million in the first six months of 2001 from $7.6 million in the
first six months of 2000. The 2001 interest expense reflects the additional
interest expense on the $24.0 million term loan and the $12.6 million borrowing
under the revolving credit facility, both of which were incurred in July 2000 to
partially finance the Orthotech acquisition. There were additional borrowings of
$8.0 million under the revolving credit facility in December 2000 which also
contributed to the increase in interest expense, offset in part by our
$5.0 million repayment under the revolving credit facility in June 2001.
YEAR ENDED DECEMBER 31, 2000 COMPARED TO YEAR ENDED DECEMBER 31, 1999
NET REVENUES. Net revenues increased $27.2 million, or 23.3%, to
$143.6 million in 2000 from $116.4 million in 1999. Net revenues, excluding
freight revenue, for the rigid knee-bracing segment increased $5.2 million over
the prior year due to growth in the domestic sales for the OA and post-operative
product lines including the introduction of the OAdjuster-TM- brace in
March 2000. Soft goods sales, excluding freight revenue, increased by
$12.8 million over the prior year due primarily to the Orthotech acquisition and
increased sales volumes of wrist splints, ankle braces, knee braces and other
general soft good supports. The increases also reflected the growth in the
OfficeCare program. Specialty and other complementary orthopedic product sales,
excluding freight revenue, increased by $8.3 million over the prior year due
primarily to the PainBuster-TM- Pain Management system, cold therapy units,
shoulder bracing and to increased sales of lower extremity walkers, as well as
the growth in the OfficeCare program.
GROSS PROFIT. Gross profit increased $18.7 million, or 29.0%, to
$83.4 million in 2000 from $64.7 million in 1999 primarily as a result of the
Orthotech acquisition. Gross profit margin, exclusive of brand royalties and
other cost of goods sold not allocable to specific product lines and freight
13
<Page>
revenue increased to 59.3% in 2000 from 58.6% in 1999 as a result of increased
walker sales combined with the implementation of efficient manufacturing
techniques in the United States and Mexico. Gross profit, excluding freight
revenue, for the rigid knee bracing segment increased $3.2 million, with gross
profit margin decreasing to 70.9% from 71.7%. The margin decrease reflects the
change in product mix. Gross profit, excluding freight revenue, for the soft
goods segment increased $5.9 million as a result of increased sales volume, with
gross profit decreasing to 48.0% from 48.5% in 1999. Gross profit, excluding
freight revenue, for the specialty and other complementary orthopedic products
segment increased $7.2 million, with gross profit margin increasing to 56.1%
from 44.3%. The increase in gross profit margin reflects lower costs associated
with the production of walkers, which resulted from the production of these
walkers moving to our facilities in Mexico in the first quarter of 2000 to take
advantage of labor cost savings. As a result of the consummation of the
recapitalization on June 30, 1999, we no longer have the right to use the
Smith & Nephew trademarks and trade names and, accordingly, charges for brand
royalties are no longer incurred by us. Other cost of goods sold not allocable
to specific product lines increased $0.3 million from 1999 primarily due to the
step-up in inventory acquired in the Orthotech acquisition to fair market value,
and various facility costs incurred as part of the Orthotech acquisition.
SALES AND MARKETING EXPENSES. Sales and marketing expenses increased
$9.8 million, or 33.7%, to $38.7 million in 2000 from $28.9 million in 1999. The
increase primarily reflected an increase in commissions associated with higher
sales of DonJoy products in the United States and increased costs associated
with the OfficeCare program. In addition, as a result of the Orthotech
acquisition, we incurred higher than anticipated freight expenses along with
amortization expense related to the acquired intangibles.
GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative expenses
increased $3.0 million, or 17.9%, to $19.8 million in 2000 from $16.8 million in
1999. In 2000, we completed the consolidation of the Orthotech operations into
our Vista, California location. As a result, we incurred $0.5 million in
consolidation costs consisting primarily of consulting, information systems,
travel and moving expenses. The increase was also due to increases in salaries
and benefits, an increase in consulting expenses related to the implementation
of a new Enterprise Resource Planning (ERP) System and human resources support
combined with an increase in amortization associated with the intangible assets
acquired as part of the Orthotech acquisition.
RESEARCH AND DEVELOPMENT EXPENSES. Research and development expenses
increased $0.4 million, or 16.5%, to $2.5 million in 2000 from $2.1 million in
1999. The increase was primarily due to investment in clinical trials associated
with new product development, licensed products, as well as continued studies in
core product efficacy.
MERGER AND INTEGRATION COSTS. We incurred $0.4 million in one-time,
non-recurring merger and integration costs associated with the consolidation of
the Orthotech operations into our existing facilities including merger and
integration and information systems consulting. Other integration costs are
included in the operating expenses above.
INTEREST EXPENSE. Interest expense increased $9.4 million, or 124.1% to
$17.0 million in 2000 from $7.6 million in 1999. The recapitalization occurred
in June 1999 and thus 1999 includes only six months of interest expense on the
$100.0 million principal amount of senior subordinated notes and the
$15.5 million term loan borrowed under the credit agreement to partially finance
the recapitalization. Additionally, 2000 includes additional interest expense on
the $24.0 million term loan and the $12.6 million borrowing under the revolving
credit facility, both of which were incurred to partially finance the Orthotech
acquisition.
14
<Page>
YEAR ENDED DECEMBER 31, 1999 COMPARED TO YEAR ENDED DECEMBER 31, 1998
NET REVENUES. Net revenues increased $12.8 million, or 12.3%, to
$116.4 million in 1999 from $103.6 million in 1998. Net revenues, excluding
freight revenue, for the rigid knee bracing segment increased $0.5 million over
the prior year due to increased sales of ligament braces, including the
introduction of the 4TITUDE-TM- brace and post-operative braces in June 1999.
Soft goods sales, excluding freight revenue, increased $6.6 million over the
prior year due primarily to increased sales volumes of neoprene bracing
products, wrist splints, ankle braces and other soft good supports, including
the introduction of the On-Track system. These increases primarily reflect the
effect of national contracts entered into in the second half of 1998 as well as
the growth of the OfficeCare program. Specialty and other complementary
orthopedic products sales, excluding freight revenue, increased by $5.7 million
over the prior year due primarily to the recently introduced PainBuster-TM- Pain
Management Systems, cold therapy units and to increased sales of lower extremity
walkers as well as growth of the OfficeCare program.
GROSS PROFIT. Gross profit increased $7.5 million, or 13.1%, to
$64.7 million in 1999 from $57.2 million in 1998. Gross profit margin, exclusive
of brand royalties and other cost of goods sold not allocable to specific
product lines and freight revenue, decreased to 58.6% in 1999 from 59.3% in
1998. Gross profit, excluding freight revenue, for the rigid knee bracing
segment increased $1.3 million, with gross profit margin increasing to 71.7%
from 69.9%. These increases reflected the improved product mix. Gross profit,
excluding freight revenue, for the soft goods segment increased $3.0 million as
a result of increased sales volume, with gross profit margin decreasing to 48.5%
from 49.1%. Gross profit, excluding freight revenue, for the specialty and other
complementary orthopedic products segment increased $2.4 million, with gross
profit margin decreasing to 44.3% from 45.0%, reflecting increased sales of
lower margin products. As a result of the consummation of the recapitalization
on June 30, 1999, we no longer have the right to use the Smith & Nephew
trademarks and trade names and, accordingly, charges for brand royalties are no
longer incurred by us. Other cost of goods sold not allocable to specific
product lines increased to $3.2 million in 1999 from $2.5 million in 1998. This
increase is primarily due to costs associated with support of the SKU reduction
plan, the OfficeCare program and the amortization of the PainBuster-TM- Pain
Management System distribution rights.
SALES AND MARKETING EXPENSES. Sales and marketing expenses increased
$1.3 million, or 4.6%, to $28.9 million in 1999 from $27.6 million in 1998. The
increase primarily reflected an increase in commissions associated with higher
sales of DonJoy products in the United States and increased costs associated
with the OfficeCare program.
GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative expenses
increased $0.3 million, or 1.6%, to $16.8 million in 1999 from $16.5 million in
1998. The increase was primarily due to an increase in salaries and benefits
offset by a reduction in corporate allocations from Smith & Nephew of
$1.9 million. General and administrative expenses declined as a percentage of
net revenues to 14.2% from 15.8% primarily due to the reduction in Smith &
Nephew allocations.
RESEARCH AND DEVELOPMENT EXPENSES. Research and development expenses were
approximately equal over the two periods. Significant resources within the
department were re-deployed to focus primarily on the development of the DonJoy
Vista-TM- Rehabilitation System as well as the development and release of the
new 4TITUDE-TM- brace in June 1999.
RESTRUCTURING COSTS. In March 1998, we combined our two operating
facilities into one location in Vista, California and accrued $2.5 million in
costs resulting from the restructuring which had no future economic benefit.
These costs related primarily to remaining lease obligations on the vacated
facility, net of projected sublease income, and severance costs associated with
the termination of twelve employees.
15
<Page>
INTEREST EXPENSE. Interest expense in 1999 was $7.6 million. The
recapitalization occurred in June 1999 and thus 1999 includes only six months of
interest expense on the $100.0 million principal amount of senior subordinated
notes and the $15.5 million term loan borrowed under the credit agreement to
partially finance the recapitalization.
LIQUIDITY AND CAPITAL RESOURCES
Our principal liquidity requirements are to service our debt and meet our
working capital and capital expenditure needs. Long-term indebtedness at
June 30, 2001 was $151.7 million.
Net cash provided by operating activities was $3.7 million, $16.1 million,
$1.2 million, $3.6 million and $1.2 million in 1998, 1999, 2000, and the first
six months of 2000 and 2001, respectively. The decrease of $2.4 million in the
first six months of 2001 primarily reflects the increased levels in accounts
receivable in conjunction with the working capital needs associated with the
Orthotech acquisition combined with decreased levels of accounts payable. The
decrease of $14.9 million in 2000 primarily reflects the increased levels in
accounts receivable and inventories during 2000 as compared to 1999, primarily
as a result of the working capital needs associated with the Orthotech
acquisition (which did not include the purchase of the Orthotech historical
accounts receivables).
Cash flows used in investing activities were $4.0 million, $4.8 million,
$57.0 million, $3.1 million and $4.9 million for 1998, 1999, 2000 and the first
six months of 2000 and 2001, respectively. Capital expenditures in the first six
months of 2001 primarily reflected an increase in the capitalization of costs
directly associated with our acquisition and implementation of an enterprise
resource planning system which was completed in March 2001, investments in
manufacturing equipment, and the Alaron Acquisition in June 2001. Included in
investing activities in 2000 is the $46.4 million investment in Orthotech,
exclusive of transaction fees and expenses. Capital expenditures in 2000
primarily reflect an increase in construction in progress related to the
capitalization of costs directly associated with our acquisition and
implementation of an enterprise resource planning system and investments in
manufacturing equipment.
Capital expenditures for the remainder of 2001 are estimated at
$1.6 million, substantially all of which are maintenance capital expenditures.
In addition, if we receive FDA approval of our new bone growth stimulation
product, OrthoPulse-Registered Trademark-, for which we will be the exclusive
North American distributor, we will be required to make a one-time $2.0 million
license payment. We have also committed to purchase 5% of the equity in the
licensor for an aggregate purchase price of $0.5 million within 30 days of our
written acceptance of the first shipment of the product from the licensor.
Cash flows provided by (used in) financing activities were $0.2 million,
$(6.2) million, $54.0 million, $(0.8) million and $3.7 million in 1998, 1999,
and 2000 and the first six months of 2000 and 2001, respectively. The increase
in the first six months of 2001 is the primarily the result of the $9.6 million
in net proceeds from an equity investment in June 2001 net of the $5.0 million
repayment of principal on the revolving credit facility in June 2001. The
changes in 2000 primarily reflect the $24.0 million term loan and $12.6 million
of borrowings under the revolving credit facility during the third quarter of
2000 and the net proceeds from the issuance by DonJoy, L.L.C. of common and
preferred units in the third quarter of 2000, all related to the Orthotech
acquisition. We borrowed an additional $8.0 million at the end of 2000 as a
result of the increase in working capital associated with the Orthotech
acquisition. Prior to the recapitalization, we participated in Smith & Nephew's
central cash management program, wherein all of our cash receipts were remitted
to Smith & Nephew and all cash disbursements were funded by Smith & Nephew.
Following the recapitalization, we no longer participate in Smith & Nephew's
cash management program.
Interest payments on our senior subordinated notes and on borrowings under
the credit facility have significantly increased our liquidity requirements. The
$100.0 million of senior subordinated notes, due 2009, bear interest at 12 5/8%,
payable semi-annually on June 15 and December 15. The credit facility provides
for two term loans totaling $39.5 million, of which $37.7 million was
outstanding at
16
<Page>
June 30, 2001. The first term loan, in the amount of $15.5 million, was borrowed
in connection with the recapitalization and the second term loan, in the amount
of $24.0 million, was borrowed to finance the Orthotech acquisition. We also
have available up to $25.0 million under the revolving credit facility, which is
available for working capital and general corporate purposes, including
financing of acquisitions, investments and strategic alliances. As of June 30,
2001, we had borrowed $15.6 million under that facility, primarily due to the
Orthotech acquisition; however, in July 2001, we repaid $2.0 million. Borrowings
under the term loans and on the revolving credit facility bear interest at
variable rates plus an applicable margin. At June 30, 2001, the effective
interest rate on the term loans and the revolving credit facility was 7.3% and
6.3%, respectively.
The following table sets forth the principal payments on the term loans for
the last six months of 2001 through their maturity in 2005:
<Table>
<Caption>
PRINCIPAL
YEAR PAYMENT
- ---- ---------
2001........................................................ $ 636
2002........................................................ 1,274
2003........................................................ 1,274
2004........................................................ 17,202
2005........................................................ 17,338
</Table>
In addition, we are required to make annual mandatory prepayments of the
term loans under the credit facility in an amount equal to 50% of excess cash
flow (as defined in the credit facility) (75% if our leverage ratio exceeds a
certain level). We had no excess cash flow at December 31, 2000 or December 31,
1999. In addition, the term loans are subject to mandatory prepayments in an
amount equal to (a) 100% of the net cash proceeds of certain equity and debt
issuances by us, dj Ortho or any of our other subsidiaries and (b) 100% of the
net cash proceeds of certain asset sales or other dispositions of property by
us, dj Ortho or any of our other subsidiaries, in each case subject to certain
exceptions. No mandatory prepayments were required at December 31, 2000 or
December 31, 1999. In June 2001, we obtained a waiver from our bank lenders with
respect to our obligation to prepay the term loans with the proceeds of the
$10.0 million equity investment.
The credit facility and the indenture impose certain restrictions on us,
including restrictions on our ability to incur indebtedness, pay dividends, make
investments, grant liens, sell our assets and engage in certain other
activities. In addition, the credit facility requires us to maintain certain
financial ratios. At June 30, 2001, we were in compliance with all of these
covenants. Indebtedness under the credit facility is secured by substantially
all of our assets, including our real and personal property, inventory, accounts
receivable, intellectual property and other intangibles.
We incurred fees and costs of $8.8 million in connection with the
recapitalization. Approximately $7.4 million, principally relating to financing
fees and expenses, has been capitalized and are being amortized over the terms
of the related debt instruments.
As part of our strategy, we intend to pursue acquisitions, such as the
Orthotech and Alaron Acquisitions, investments and strategic alliances. We may
require new sources of financing to consummate any such transactions, including
additional debt or equity financing. We cannot assure you that such additional
sources of financing will be available on acceptable terms, if at all.
Our ability to satisfy our debt obligations and to pay principal and
interest on our indebtedness, fund working capital requirements and make
anticipated capital expenditures will depend on our future performance, which is
subject to general economic, financial and other factors, some of which are
beyond our control. Management believes that based on current levels of
operations and anticipated growth, cash flow from operations, together with
other available sources of funds including the availability of borrowings under
the revolving credit facility, will be adequate for at least the next twelve
months to make required payments of principal and interest on our indebtedness,
to fund anticipated
17
<Page>
capital expenditures and for working capital requirements. There can be no
assurance, however, that our business will generate sufficient cash flow from
operations or that future borrowings will be available under the revolving
credit facility in an amount sufficient to enable us to service our indebtedness
or to fund our other liquidity needs. In such event, we may need to raise
additional funds through public or private equity or debt financings. We cannot
assure you that any such funds will be available to us on favorable terms or at
all.
MARKET RISK
We are exposed to certain market risks as part of our ongoing business
operations. Primary exposure includes changes in interest rates. We are exposed
to interest rate risk in connection with the term loans and borrowings under the
revolving credit facility which bear interest at floating rates based on London
Inter-Bank Offered Rate (LIBOR) or the prime rate plus an applicable borrowing
margin. 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 market
value but do not impact earnings or cash flows. Conversely, for variable rate
debt, interest rate changes generally do not affect the fair market value but do
impact future earnings and cash flows, assuming other factors are held constant.
As of June 30, 2001, we had $100.0 million principal amount of fixed rate debt
represented by our senior subordinated notes and $53.3 million of variable rate
debt represented by borrowings under the credit facility (at interest rates
ranging from 6.31% to 8.06% at June 30, 2001). Based on our current balance
outstanding under the credit facility, an immediate change of one percentage
point in the applicable interest rate would cause an increase or decrease in
interest expense of approximately $0.5 million on an annual basis. At June 30,
2001, up to $9.4 million of variable rate borrowings was available under the
revolving credit facility. We may use derivative financial instruments, where
appropriate, to manage our interest rate risks. However, as a matter of policy,
we do not enter into derivative or other financial investments for trading or
speculative purposes. As all of our sales have historically been denominated in
U.S. dollars; we have not been subject to foreign currency exchange risk.
However, as we begin to directly distribute our products in selected foreign
markets, we expect that future sales of our products in these markets will be
denominated in the applicable foreign currencies which would cause currency
fluctuations to more directly impact our operating results. We may seek to
reduce the potential impact of currency fluctuations on our business through
hedging transactions.
SEASONALITY
We generally record our highest net revenues in the first and fourth
quarters due to the greater number of orthopedic surgeries and injuries
resulting from increased sports activity, particularly football and skiing. In
addition, during the fourth quarter, a patient has a greater likelihood of
having satisfied his annual insurance deductible than in the first
three-quarters of the year, and thus there is an increase in the number of
elective orthopedic surgeries. Conversely, we generally have lower net revenues
during the second and third quarters as a result of decreased sports activity
and fewer orthopedic surgeries. Our results of operations would be adversely and
disproportionately affected if our sales were substantially lower than those
normally expected during the first and fourth quarters. Increases in our net
revenues beginning in the third quarter of 2000 reflect the Orthotech
acquisition.
RECENT ACCOUNTING PRONOUNCEMENTS
We adopted Statement of Accounting Standards No. 133, "Accounting for
Derivative Instruments and Hedging Activities" (FAS 133), of the Financial
Accounting Standards Board (FASB) in the first quarter of 2001. FAS 133
establishes accounting and reporting standards for derivative instruments and
hedging activities and requires the recognition of all derivatives on our
balance sheet at fair market value. The adoption of FAS 133 on our financial
statements for the first six months of 2001 was not material.
18
<Page>
In July 2001, the FASB issued Statements of Financial Accounting Standards
No. 141, "Business Combinations" (FAS 141) and No. 142, "Goodwill and Other
Intangible Assets" (FAS 142). FAS 141 requires all business combinations
initiated after June 30, 2001 to be accounted for using the purchase method.
Under FAS 142, goodwill and intangible assets with indefinite lives are no
longer amortized but are reviewed annually (or more frequently if impairment
indicators arise) for impairment. Separable intangible assets that are not
deemed to have indefinite lives will continue to be amortized over their useful
lives (but with no maximum life). The amortization provisions of FAS 142 apply
to goodwill and intangible assets acquired after June 30, 2001. With respect to
goodwill and intangible assets acquired prior to July 1, 2001, we are required
to adopt FAS 142 effective October 1, 2002, but we may adopt FAS 142 early in
the first fiscal quarter of 2002. We are currently evaluating the effect that
adoption of the provisions of FAS 142 that are effective October 1, 2002 will
have on our results of operations and financial position.
FORWARD-LOOKING STATEMENT
This Report on Form 8-K includes "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 including, in particular, the statements about
our plans, strategies, and prospects under the heading "Management's Discussion
and Analysis of Financial Condition and Results of Operations." Forward-looking
statements include all statements that are not historical facts and can be
identified by forward-looking words such as "anticipate," "believe," "estimate,"
"expect," "will," "plan," "intend," and similar expressions. Although we believe
that our plans, intentions and expectations reflected in or suggested by such
forward-looking statements are reasonable, we can give no assurance that such
plans, intentions or expectations will be achieved. Important factors that could
cause actual results to differ materially from those expressed or implied by the
forward-looking statements we make in this Report on Form 8-K include, but are
not limited to, (i) our high level of indebtedness; (ii) the restrictions
imposed by the terms of our indebtedness; (iii) the ability to generate cash to
service our debts; (iv) healthcare reform and the emergence of managed care and
buying groups; (v) patents and proprietary know-how; (vi) uncertainty of
domestic and foreign regulatory clearance and approvals; (vii) dependence on
orthopedic professionals, agents and distributors; (viii) our dependence on
certain key personnel; (ix) risks related to competition in our markets; (x)
risks related to changing technology and new product developments; (xi) the
sensitivity of our business to general economic conditions; (xii) uncertainty
relating to third party reimbursement; and (xiii) the other risks referred to
under the caption "Risk Factors" in DonJoy's Annual Report on Form 10-K for the
year ended December 31, 2000. All forward-looking statements attributable to us
or persons acting on our behalf are expressly qualified in their entirety by the
cautionary statements included in this Report on Form 8-K.
19
<Page>
ITEM 7. FINANCIAL STATEMENTS AND EXHIBITS
a) Financial Statements
<Table>
<Caption>
PAGE
----
Report of Ernst & Young LLP, Independent Auditors........... F-2
Consolidated Balance Sheets as of December 31, 1999 and 2000
and June 30, 2001 (unaudited)............................. F-3
Consolidated Statements of Income for the years ended
December 31, 1998, 1999 and 2000 and for the six months
ended July 1, 2000 (unaudited) and June 30, 2001
(unaudited)............................................... F-4
Consolidated Statements of Changes in Members' Equity
(Deficit) for the years ended December 31, 1998, 1999 and
2000 and for the six months ended July 1, 2000 (unaudited)
and June 30, 2001 (unaudited)............................. F-5
Consolidated Statements of Cash Flows for the years ended
December 31, 1998, 1999 and 2000 and for the six months
ended July 1, 2000 (unaudited) and June 30, 2001
(unaudited)............................................... F-6
Notes to Consolidated Financial Statements.................. F-7
</Table>
b) Exhibits
<Table>
23.1 Consent of Ernst & Young LLP
</Table>
F-1
<Page>
REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
To the Board of Managers
DonJoy, L.L.C.
We have audited the accompanying consolidated balance sheets of DonJoy,
L.L.C. as of December 31, 1999 and 2000, and the related consolidated statements
of income, members' equity and cash flows for each of the three years in the
period ended December 31, 2000. These consolidated financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally
accepted in the United States. Those standards require that we plan and perform
the audit to obtain reasonable assurance about whether the financial statements
are free of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements. An
audit also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
In our opinion, the financial statements referred to above present fairly,
in all material respects, the consolidated financial position of DonJoy, L.L.C.
at December 31, 1999 and 2000, and the consolidated results of its operations
and its cash flows for each of the three years in the period ended December 31,
2000, in conformity with accounting principles generally accepted in the United
States.
ERNST & YOUNG, LLP
San Diego, California
February 16, 2001
F-2
<Page>
DONJOY, L.L.C.
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT UNIT INFORMATION)
<Table>
<Caption>
DECEMBER 31,
--------------------- JUNE 30,
1999 2000 2001
--------- --------- -----------
(UNAUDITED)
ASSETS
Current assets:
Cash and cash equivalents................................. $ 5,927 $ 4,106 $ 3,980
Accounts receivable, net of discounts and allowances of
$989, $4,278 and $6,241 at December 31, 1999 and 2000
and June 30, 2001, respectively......................... 21,406 34,498 40,602
Inventories, net.......................................... 13,664 18,510 19,191
Other current assets...................................... 917 3,270 2,585
--------- --------- ---------
Total current assets...................................... 41,914 60,384 66,358
Property, plant and equipment, net.......................... 7,297 12,785 14,627
Intangible assets, net...................................... 33,195 75,419 73,235
Debt issuance costs, net.................................... 6,875 6,549 6,088
Other assets................................................ 135 535 1,080
--------- --------- ---------
Total assets................................................ $ 89,416 $ 155,672 $ 161,388
========= ========= =========
LIABILITIES AND MEMBERS' DEFICIT
Current liabilities:
Accounts payable.......................................... $ 6,411 $ 8,982 $ 8,585
Accrued compensation...................................... 2,443 2,937 2,694
Accrued commissions....................................... 954 1,444 1,201
Long-term debt, current portion........................... 500 1,274 1,274
Accrued interest.......................................... 526 686 632
Other accrued liabilities................................. 3,667 6,366 6,502
--------- --------- ---------
Total current liabilities................................... 14,501 21,689 20,888
12 5/8% Senior Subordinated Notes........................... 98,055 98,260 98,362
Long-term debt, less current portion........................ 14,750 57,688 52,050
Redeemable Preferred Units; 100,000 units authorized,
40,184, 44,405 and 44,405 units issued and outstanding at
December 31, 1999 and 2000 and June 30, 2001 (unaudited),
respectively; liquidation preference $35,368, $43,688 and
$46,229 at December 31, 1999 and 2000 and June 30, 2001
(unaudited), respectively................................. 32,539 41,660 44,895
Minority interest........................................... -- -- 140
Commitments and contingencies (Note 11)
Members' deficit:
Common units; 2,900,000 units authorized, 718,000, 793,890
and 885,633 units issued and outstanding at
December 31, 1999 and 2000 and June 30, 2001,
respectively............................................ 66,521 74,754 84,529
Notes receivable from officers.............................. (1,400) (1,772) (2,071)
Retained deficit............................................ (135,550) (136,607) (137,405)
--------- --------- ---------
Total members' deficit...................................... (70,429) (63,625) (54,947)
--------- --------- ---------
Total liabilities and members' deficit...................... $ 89,416 $ 155,672 $ 161,388
========= ========= =========
</Table>
See accompanying notes.
F-3
<Page>
DONJOY, L.L.C.
CONSOLIDATED STATEMENTS OF INCOME
(IN THOUSANDS)
<Table>
<Caption>
YEARS ENDED SIX MONTHS ENDED
DECEMBER 31, JULY 1, JUNE 30,
1998 1999 2000 2000 2001
-------- -------- -------- ----------- -----------
(UNAUDITED) (UNAUDITED)
Net revenues............................. $103,643 $116,418 $143,586 $62,313 $83,283
Cost of goods sold....................... 46,466 51,744 60,178 25,205 34,680
-------- -------- -------- ------- -------
Gross profit............................. 57,177 64,674 83,408 37,108 48,603
Operating expenses:
Sales and marketing.................... 27,633 28,902 38,653 15,715 23,514
General and administrative............. 16,484 16,755 19,761 9,034 12,064
Research and development............... 2,248 2,115 2,465 1,164 1,300
Merger and integration costs........... -- -- 400 -- --
Restructuring costs.................... 2,467 -- -- -- --
-------- -------- -------- ------- -------
Total operating expenses................. 48,832 47,772 61,279 25,913 36,878
-------- -------- -------- ------- -------
Income from operations................... 8,345 16,902 22,129 11,195 11,725
Interest expense......................... -- (7,568) (16,958) (7,609) (9,344)
Interest income.......................... -- 181 437 253 181
Discontinued acquisition costs........... -- -- (449) -- --
-------- -------- -------- ------- -------
Income before income taxes............... 8,345 9,515 5,159 3,839 2,562
Provision for income taxes............... 3,394 2,387 -- -- --
-------- -------- -------- ------- -------
Net income and comprehensive
net income............................. 4,951 7,128 5,159 3,839 2,562
Less: Preferred unit dividends and
accretion of preferred unit fees....... N/A (2,343) (5,415) (2,480) (3,106)
-------- -------- -------- ------- -------
Net income (loss) available to
members................................ N/A $ 4,785 $ (256) $ 1,359 $ (544)
======== ======== ======== ======= =======
</Table>
See accompanying notes.
F-4
<Page>
DONJOY, L.L.C.
CONSOLIDATED STATEMENTS OF CHANGES IN
MEMBERS' EQUITY (DEFICIT) AND COMPREHENSIVE INCOME
(IN THOUSANDS, EXCEPT UNIT INFORMATION)
<Table>
<Caption>
COMMON UNITS NOTES
--------------------- RECEIVABLE RETAINED TOTAL MEMBERS' COMPREHENSIVE
UNITS AMOUNT FROM OFFICERS EQUITY (DEFICIT) EQUITY (DEFICIT) INCOME
---------- -------- ------------- ---------------- ---------------- -------------
BALANCE AT DECEMBER 31, 1997........ -- $ -- $ -- $ 7,881 $ 7,881
Net income.......................... -- -- -- 4,951 4,951
---------- -------- ------- --------- ---------
BALANCE AT DECEMBER 31, 1998........ -- -- -- 12,832 12,832
Capital contribution by Smith &
Nephew, Inc. in connection with
the Recapitalization.............. 2,054,000 64,117 -- (16,264) 47,853
Issuance of common units at $100 per
unit, net of transaction fees of
$1,563............................ 645,500 62,987 -- -- 62,987
Purchase of common units from
Smith & Nephew, Inc............... (2,000,000) (62,433) -- (136,707) (199,140)
Issuance of common units at $100 per
unit, in exchange for cash and
notes receivable.................. 18,500 1,850 (1,400) -- 450
Preferred unit dividends and
accretion of preferred unit
fees.............................. -- -- -- (2,343) (2,343)
Net income (excluding $196 allocated
to preferred unit holders)........ -- -- -- 6,932 6,932
---------- -------- ------- --------- ---------
BALANCE AT DECEMBER 31, 1999........ 718,000 66,521 (1,400) (135,550) (70,429)
Issuance of common units at $109 per
unit, in exchange for cash and
notes receivable.................. 75,890 8,272 (174) -- 8,098
Note receivable issued to Management
for purchase of common units...... -- -- (124) -- (124)
Transfer of interest receivable to
note receivable................... -- -- (74) -- (74)
Transaction fees in connection with
the Recapitalization.............. -- (39) -- -- (39)
Stock options granted for
services.......................... -- -- -- 36 36
Tax distributions to preferred unit
holders........................... -- -- -- (563) (563)
Preferred unit dividends and
accretion of preferred unit
fees.............................. -- -- -- (5,415) (5,415)
Net income (excluding $274 allocated
to preferred unit holders)........ -- -- -- 4,885 4,885 $4,885
---------- -------- ------- --------- --------- ------
BALANCE AT DECEMBER 31, 2000........ 793,890 74,754 (1,772) (136,607) (63,625) 4,885
======
Issuance of common units at $109 per
unit, in exchange for cash and
notes receivable, net of
transaction fees of $222
(unaudited)....................... 91,743 9,775 (211) -- 9,564
Transfer of interest receivable to
note receivable (unaudited)....... -- -- (88) -- (88)
Stock options granted for services
(unaudited)....................... -- -- -- 208 208
Tax distributions to preferred unit
holders (unaudited)............... -- -- -- (200) (200)
Foreign currency translation
adjustment (unaudited)............ -- -- -- (133) (133) (133)
Preferred unit dividends and
accretion of preferred unit fees
(unaudited)....................... -- -- -- (3,106) (3,106)
Net income (excluding $129 allocated
to preferred unit holders)
(unaudited)....................... -- -- -- 2,433 2,433 2,433
---------- -------- ------- --------- --------- ------
BALANCE AT JUNE 30, 2001
(UNAUDITED)....................... 885,633 $ 84,529 $(2,071) $(137,405) $ (54,947) $2,300
========== ======== ======= ========= ========= ======
</Table>
See accompanying notes.
F-5
<Page>
DONJOY, L.L.C.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
<Table>
<Caption>
YEARS ENDED
DECEMBER 31, SIX MONTHS ENDED
---------------------------------- -------------------------
JULY 1, JUNE 30,
1998 1999 2000 2000 2001
-------- ------------ -------- ----------- -----------
(UNAUDITED) (UNAUDITED)
Operating activities
Net income................................................ $ 4,951 $ 7,128 $ 5,159 $ 3,839 $ 2,562
Adjustments to reconcile net income to net cash provided
by operating activities:
Depreciation and amortization............................. 4,853 4,952 6,365 2,554 4,638
Amortization of debt issuance costs and discount on Senior
Subordinated Notes...................................... -- 510 1,082 516 563
Step-up to fair value of acquired inventory............... -- -- 268 -- --
Stock options granted for services........................ -- -- 36 -- 208
Restructuring costs....................................... 2,467 -- -- -- --
Merger and integration costs.............................. -- -- 400 -- --
Minority interest......................................... -- -- -- -- 140
Changes in operating assets and liabilities:
Accounts receivable..................................... (3,816) (1,564) (13,092) (1,156) (6,104)
Inventories............................................. (2,760) 704 (2,576) (1,334) (681)
Other current assets.................................... (97) (106) (2,427) (118) 597
Accounts payable........................................ 495 (893) 2,571 (1,148) (397)
Accrued interest........................................ -- 526 160 117 (54)
Accrued compensation.................................... (174) 1,057 494 (66) (243)
Accrued commissions..................................... (377) (237) 490 53 (243)
Income taxes............................................ (744) 2,516 -- -- --
Restructuring reserve................................... (1,197) (339) -- -- --
Other accrued liabilities............................... 147 1,811 2,299 373 196
------- --------- -------- ------- -------
Net cash provided by operating activities................. 3,748 16,065 1,229 3,630 1,182
Investing activities
Purchases of property, plant and equipment................ (3,189) (2,502) (6,522) (2,720) (3,481)
Proceeds from assets held for sale........................ -- -- 126 -- --
Purchase of intangible assets............................. (960) (2,204) (1,200) -- (750)
Investment in Orthotech................................... -- -- (49,019) -- --
Investment in Alaron...................................... -- -- -- -- (125)
Other assets.............................................. 100 (70) (400) (423) (545)
------- --------- -------- ------- -------
Net cash used in investing activities..................... (4,049) (4,776) (57,015) (3,143) (4,901)
Financing activities
Net proceeds from Senior Subordinated Notes............... -- 97,953 -- -- --
Proceeds from long-term debt.............................. -- 15,500 44,600 -- --
Repayment of long-term debt............................... -- (250) (888) (250) (5,638)
Transaction fees in connection with recapitalization...... -- -- -- (39) --
Distributions to preferred unit holders................... -- -- (563) (236) (200)
Debt issuance costs....................................... -- (7,283) (551) (162) --
Purchase of common units from Smith & Nephew (the "Former
Parent")................................................ -- (199,140) -- -- --
Net proceeds from issuance of common units................ -- 63,437 8,059 -- 9,564
Net proceeds from issuance of preferred units............. -- 30,000 3,432 -- --
Note receivable issued for purchase of common units....... -- -- (124) (124) --
Intercompany obligations.................................. 200 (6,388) -- -- --
------- --------- -------- ------- -------
Net cash (used in) provided by financing activities....... 200 (6,171) 53,965 (811) 3,726
------- --------- -------- ------- -------
Effect of exchange rate changes on cash..................... -- -- -- -- (133)
------- --------- -------- ------- -------
Net increase (decrease) in cash............................. (101) 5,118 (1,821) (324) (126)
Cash at beginning of period................................. 910 809 5,927 5,927 4,106
------- --------- -------- ------- -------
Cash at end of period....................................... $ 809 $ 5,927 $ 4,106 $ 5,603 $ 3,980
======= ========= ======== ======= =======
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Interest paid............................................. $ 6,530 $ 15,716 $ 6,976 $ 8,836
========= ======== ======= =======
SUPPLEMENTAL DISCLOSURE OF NON-CASH TRANSACTIONS:
Capital contribution in connection with the
Recapitalization........................................ $ 47,853
=========
Dividends and accretion of preferred unit fees related to
redeemable preferred units.............................. $ 2,343 $ 5,415 $ 2,480 $ 3,106
========= ======== ======= =======
Common units issued in exchange for notes receivable and
transfer of interest receivable to notes receivable..... $ 1,400 $ 248 $ 299
========= ======== =======
</Table>
See accompanying notes.
F-6
<Page>
DONJOY, L.L.C.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(INFORMATION AS OF JUNE 30, 2001 AND FOR THE SIX MONTHS
ENDED JULY 1, 2000 AND JUNE 30, 2001 IS UNAUDITED)
1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
DonJoy, L.L.C. ("DonJoy"), through its subsidiary dj Orthopedics, LLC ("dj
Ortho") and dj Ortho's subsidiaries (collectively the "Company"), designs,
manufactures and markets various lines of recovery products and accessories and
is the successor to a corporation established in December 1982 as DonJoy, Inc.
DonJoy, Inc. was acquired by Smith & Nephew, Inc. (formerly Smith & Nephew
Consolidated, Inc., the "Former Parent") effective September 18, 1987 through a
purchase of all the then outstanding shares of stock. Smith & Nephew, Inc. is a
wholly-owned subsidiary of Smith & Nephew plc., a United Kingdom company. In
November 1996, DonJoy, Inc. was merged into Smith & Nephew, Inc. and began to
operate as a division. Effective December 29, 1998, the Former Parent
contributed the division's net assets and shares of a Mexican subsidiary into
DonJoy, L.L.C., a newly formed Delaware limited liability company, and became
the sole member of the new entity.
DonJoy, L.L.C. will be dissolved on December 31, 2030, unless prior to that
date certain events occur as defined in the Third Amended and Restated Operating
Agreement dated as of July 7, 2000. The debts, obligations and liabilities of
the Company, whether arising in contract, tort or otherwise, shall be solely
debts, obligations and liabilities of the Company, and no member or manager of
DonJoy, L.L.C. shall be obligated personally for any such debt, obligation or
liability of the Company solely by reason of being a member or manager.
RECAPITALIZATION
On June 30, 1999, DonJoy consummated a $215.3 million recapitalization (the
"Recapitalization"). In the Recapitalization, new investors, including J.P.
Morgan DJ Partners, L.L.C. (formerly Chase DJ Partners, L.L.C.) ("JPMDJ
Partners") and affiliates of JPMDJ Partners, invested new capital of
$94.6 million in DonJoy. In addition, certain members of management invested net
equity of $0.4 million, by purchasing $1.8 million in equity which was financed
in part by $1.4 million in interest-bearing, full recourse loans from DonJoy.
The Former Parent retained 54,000 common units, which represented approximately
7.1% of total units in DonJoy then outstanding. In connection with the
recapitalization transactions, DonJoy established dj Ortho and DJ Orthopedics
Capital Corporation ("DJ Capital"). DonJoy sold all of its net assets including
its shares of its wholly-owned Mexican subsidiary to dj Ortho for cash, which
was funded with the net proceeds of $100.0 million of 12 5/8% Senior
Subordinated Notes (the "Notes") issued by dj Ortho and DJ Capital, as
co-issuers, and the remainder by funds borrowed by dj Ortho under a senior
credit facility. The Notes are fully and unconditionally guaranteed by DonJoy.
dj Ortho is a wholly-owned subsidiary of DonJoy and represents substantially all
of the revenues and net income of DonJoy. DJ Capital is a wholly-owned
subsidiary of dj Ortho, has no significant assets or operations and was formed
solely for the purpose of being a co-issuer of the Notes (see Note 8).
The proceeds of the equity investment together with $113.5 million of net
proceeds from debt financing were used for approximately $199.1 million of
consideration paid to redeem 92.9% of members' equity from the Former Parent,
and approximately $8.8 million of costs and fees paid in association with the
Recapitalization.
F-7
<Page>
DONJOY, L.L.C.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(INFORMATION AS OF JUNE 30, 2001 AND FOR THE SIX MONTHS
ENDED JULY 1, 2000 AND JUNE 30, 2001 IS UNAUDITED)
1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
TRANSACTIONS WITH THE FORMER PARENT, SMITH & NEPHEW, INC.
In accordance with a unit purchase agreement dated as of June 28, 2000, the
Former Parent sold its remaining interest of 54,000 common units in DonJoy to
JPMDJ Partners and certain members of management for $5.9 million. JPMDJ
Partners purchased 52,495 common units for a total consideration of
$5.7 million and the members of management purchased the remaining 1,505 units
for a total consideration of $0.2 million, substantially all of which was
financed by DonJoy and evidenced by full recourse promissory notes. As a result
of this transaction, Smith and Nephew, Inc. is no longer a related party;
accordingly, the Company no longer reflects its transactions with Smith &
Nephew, Inc. separately as transactions with an affiliate in its consolidated
financial statements.
ORTHOTECH ACQUISITION
On July 7, 2000, the Company completed the purchase of certain assets and
assumed certain liabilities ("the Orthotech Acquisition") of DePuy Orthopaedic
Technology, Inc. ("DePuy Orthotech"), a subsidiary of Johnson & Johnson, related
to DePuy Orthotech's bracing and soft goods business ("Orthotech"). Orthotech
developed, manufactured, and marketed an array of orthopedic products for the
sports medicine market, including braces, soft goods and specialty products
which were similar to the products offered by the Company.
The asset purchase agreement provided for the purchase of certain assets and
the assumption of certain liabilities of Orthotech, comprising the Orthotech
business, for a purchase price of $46.4 million in cash. We purchased primarily
inventory, equipment and certain intellectual property. We were not required to
assume any liabilities existing prior to the closing date. The Orthotech
acquisition has been accounted for using the purchase method of accounting
whereby the total purchase price has been allocated to tangible and intangible
assets acquired and liabilities assumed based on their estimated fair market
value.
AUSTRALIAN JOINT VENTURE
Effective March 5, 2001, the Company invested in an Australian joint
venture, dj Orthopaedics Pty Ltd ("dj Australia") which is 60% owned by dj
Ortho. dj Australia has replaced the Smith & Nephew distributor in Australia and
also sells two new product lines.
ALARON ACQUISITION
On June 1, 2001, the Company acquired Alaron Technologies, L.L.C. ("Alaron")
under an asset purchase agreement (the "Alaron Acquisition"). Alaron provided
product development, manufacturing and supply chain management services related
to medical and surgical devices.
The asset purchase agreement provided for the purchase of certain assets and
the assumption of certain liabilities of Alaron, comprising the Alaron business,
for a purchase price of $0.5 million in cash payable in four equal installments
on closing, July 31, 2001, October 1, 2001 and November 30, 2001. The Company
purchased primarily equipment and acquired technology. The Alaron Acquisition
has been accounted for using the purchase method of accounting whereby the total
purchase price has been allocated to tangible and intangible assets acquired and
liabilities based on their estimated fair values.
F-8
<Page>
DONJOY, L.L.C.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(INFORMATION AS OF JUNE 30, 2001 AND FOR THE SIX MONTHS
ENDED JULY 1, 2000 AND JUNE 30, 2001 IS UNAUDITED)
1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
EQUITY INVESTMENT
In connection with an equity investment in June 2001, DonJoy sold in a
private placement 89,186 common units to JPMDJ Partners for gross proceeds of
$9.7 million and 2,557 common units to certain members of management for gross
proceeds of $0.3 million (of which $0.2 million was paid for through the
issuance of full recourse promissory notes to DonJoy).
BASIS OF PRESENTATION
The accompanying consolidated financial statements present the historical
consolidated financial position and results of operations of the Company and
include the accounts of dj Ortho and the accounts of its wholly-owned Mexican
subsidiary that manufactures a portion of dj Ortho's products under Mexico's
maquiladora program. The maquiladora program allows foreign manufacturers to
take advantage of Mexico's lower cost production sharing capabilities. All
intercompany accounts and transactions have been eliminated in consolidation.
USE OF ESTIMATES IN THE PREPARATION OF FINANCIAL STATEMENTS
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting periods. Actual results could differ from those estimates.
INTERIM FINANCIAL DATA
The financial statements for the six months ended July 1, 2000 and June 30,
2001 are unaudited. The unaudited financial statements have been prepared on the
same basis as the audited financial statements and, in the opinion of
management, include all adjustments, consisting only of normal recurring
adjustments, necessary to state fairly the financial information set forth
therein, in accordance with generally accepted accounting principles. The
results of operations for the interim period ended June 30, 2001 are not
necessarily indicative of the results which may be reported for any other
interim period or for the year ending December 31, 2001.
DonJoy's fiscal year ends on December 31. Each quarter consists of one
five-week and two four-week periods. The first and fourth quarters may have more
or less working days from year to year based on what day of the week holidays
fall on. The six-month period ended June 30, 2001 contained one less business
day than the six months ended July 1, 2000, resulting in the Company recognizing
approximately $0.7 million less in revenues in the six months ended June 30,
2001 as compared to the same period in 2000.
CASH EQUIVALENTS
Cash equivalents are short-term, highly liquid investments and consist of
investments in money market funds and commercial paper purchased with average
maturities of three months or less.
F-9
<Page>
DONJOY, L.L.C.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(INFORMATION AS OF JUNE 30, 2001 AND FOR THE SIX MONTHS
ENDED JULY 1, 2000 AND JUNE 30, 2001 IS UNAUDITED)
1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
FAIR VALUE OF FINANCIAL INSTRUMENTS
In accordance with requirements of Statement of Financial Accounting
Standards ("SFAS") No. 107, Disclosures about Fair Value of Financial
Instruments, the following methods and assumptions were used in estimating the
fair value disclosures:
- CASH AND CASH EQUIVALENTS AND ACCOUNTS RECEIVABLES. The carrying amounts
approximate fair values because of short maturities of these instruments
and the reserves for doubtful accounts which, in the opinion of
management, are adequate to state accounts receivable at their fair value.
- LONG-TERM DEBT. Based on the borrowing rates currently available to dj
Ortho for loans with similar terms and average maturities, management
believes the fair value of long-term debt approximates its carrying value
at December 31, 2000.
LONG-LIVED ASSETS
Property, plant and equipment and intangible assets are recorded at cost.
The Company provides for depreciation on property, plant and equipment and
intangible assets using the straight-line method over the estimated useful lives
of the assets, which range from three to five years. Leasehold improvements are
amortized over the lesser of their estimated useful life or the term of the
related lease.
The Company periodically reviews its long-lived assets, including
intangibles, for indicators of impairment. If indicators exist, an analysis of
future undiscounted cash flows would be performed. If such future undiscounted
cash flows are less than the net book value of the assets, the carrying value
would be reduced to estimated fair value.
COMPUTER SOFTWARE COSTS
In 1999, the Company adopted the American Institute of Certified Public
Accountants Statement of Position 98-1 "Accounting for Costs of Computer
Software Developed or Obtained for Internal Use". This standard requires
companies to capitalize qualifying computer software costs, which are incurred
during the application development stage and amortize them over the software's
estimated useful life. During 1999 and 2000, the Company capitalized
$1.1 million and $3.9 million, respectively, related to the acquisition and
implementation of its new enterprise resource planning system. Once the system
is fully implemented, the company will amortize the costs over three years.
INVENTORIES
Inventories are stated at the lower of cost or market, with cost determined
on a first-in, first-out (FIFO) basis. In connection with the recapitalization
transactions described in Note 1, the Company changed its method of valuing its
inventory from the last-in, first-out method (LIFO) to the FIFO method because
management believes the FIFO method is more representative of the Company's
operations. This change was implemented during 1998, retroactively for all
periods presented. The effect of the change was an increase in net income of
$346,000 in 1998.
F-10
<Page>
DONJOY, L.L.C.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(INFORMATION AS OF JUNE 30, 2001 AND FOR THE SIX MONTHS
ENDED JULY 1, 2000 AND JUNE 30, 2001 IS UNAUDITED)
1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
REVENUE RECOGNITION
The Company recognizes revenue pursuant to Staff Accounting Bulletin
No. 101 "Revenue Recognition in Financial Statements." Accordingly, revenue is
recognized when all four of the following criteria are met: (i) persuasive
evidence that an arrangement exists; (ii) shipment of goods and passage of
title; (iii) the selling price is fixed or determinable; and
(iv) collectibility is reasonably assured. Revenues from third-party payors are
recorded net of contractual allowances. Estimated returns are accrued in the
period sales are recognized in accordance with the provisions of SFAS No. 48,
"Revenue Recognition When Right of Return Exists". Some products have a limited
warranty and estimated warranty costs are accrued in the period sales are
recognized.
SHIPPING AND HANDLING COSTS
During 2000, the Emerging Issues Task Force ("EITF") reached a consensus on
Issue 00-10, "Accounting for Shipping and Handling Fees and Costs." The issue
concluded that all amounts billed to a customer in a sale transaction represent
the fees earned for the goods provided and, accordingly, should be included with
revenues in the statement of income. The Company has implemented Issue 00-10 in
the fourth quarter of 2000. As a result, revenues in the years ended 1998, 1999
and 2000 and the six months ended July 1, 2000 and June 30, 2001 have been
increased by the amounts billed to customers for freight of $3.5 million,
$3.5 million, $4.4 million and $1.9 million and $2.4 million, respectively,
which was previously offset against shipping and handling costs which are part
of sales and marketing expenses. Shipping and handling costs included as part of
sales and marketing expenses were $5.6 million, $5.6 million and $7.6 million
for December 31, 1998, 1999 and 2000 and $2.7 million and $3.2 million for
July 1, 2000 and June 30, 2001, respectively.
ADVERTISING EXPENSE
The cost of advertising is expensed as incurred. The Company incurred
$122,000, $152,000 and $252,000 in advertising costs for the years ended
December 31, 1998, 1999 and 2000 and $115,000 and $117,000 in advertising costs
for the six months ended July 1, 2000 and June 30, 2001.
FOREIGN CURRENCY TRANSLATION
The financial statements of the Company's international operations where the
local currency is the functional currency are translated into U.S. dollars using
period-end exchange rates for assets and liabilities and average exchange rates
during the period for revenues and expenses. Cumulative translation gains and
losses are excluded from results of operations and recorded as a separate
component of the consolidated statements of changes in members' equity
(deficit).
CONCENTRATION OF CREDIT RISK
dj Ortho sells the majority of its products in the United States through 38
commissioned sale organizations (referred to as agents). Products which are
generic are sold through large distributors, specialty dealers and buying
groups. Excluding freight revenue, international sales comprised 17%, 16% and
13% of the Company's net revenues for the years ended December 31, 1998, 1999
and 2000 and 15% and 12% for the six months ended July 1, 2000 and June 30,
2001, respectively, and are primarily
F-11
<Page>
DONJOY, L.L.C.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(INFORMATION AS OF JUNE 30, 2001 AND FOR THE SIX MONTHS
ENDED JULY 1, 2000 AND JUNE 30, 2001 IS UNAUDITED)
1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
sold through independent distributors. Credit is extended based on an evaluation
of the customer's financial condition and generally collateral is not required.
The Company also provides a reserve for estimated sales returns. Both credit
losses and returns have been within management's estimates.
During the three years ended December 31, 2000 and for the six months ended
July 1, 2000 and June 30, 2001, the Company had no individual customer or
distributor which accounted for 10% or more of total annual revenues.
STOCK-BASED COMPENSATION
As permitted under Financial Accounting Standards Board Statement No. 123,
"Accounting for Stock-Based Compensation" ("FAS No. 123"), the Company has
elected to follow Accounting Principles Board ("APB") Opinion No. 25,
"Accounting for Stock Issued to Employees", in accounting for outstanding stock
options and warrants issued to employees. Under APB Opinion No. 25, compensation
expense relating to employee stock options is determined based on the excess of
the market price of the stock over the exercise price on the date of grant and
does not require the recognition of compensation expense for stock issued under
plans defined as non-compensatory. Adoption of FAS No. 123 for options issued to
employees would require recognition of employee compensation expense based on
their computed "fair value" on the date of grant. In accordance with FAS
No. 123 and EITF 96-18, stock options and warrants issued to consultants and
other non-employees as compensation for services provided to the Company are
accounted for based upon the fair value of the services provided or the
estimated fair market value of the option or warrant, whichever can be more
clearly determined. The Company recognizes this expense over the period the
services are provided.
INCOME TAXES
The Former Parent files a consolidated federal income tax return which
includes all of its eligible subsidiaries and divisions, which prior to the
Recapitalization in June 1999 included the Company. The provision for income
taxes has been presented assuming the Company filed a separate federal income
tax return. The Recapitalization had no impact on the historical basis of the
Company's assets and liabilities as reflected in its consolidated financial
statements except for the elimination of the restructuring reserve and
intercompany accounts. However, as a result of the Recapitalization, for federal
income tax purposes, the Company recorded an increase in the tax basis of its
inventory, fixed and intangible assets in an amount approximately equal to the
taxable gain recognized by Smith & Nephew on the sale of its interest in DonJoy
and, for tax purposes, the Company is able to depreciate assets with a higher
tax basis than for financial reporting purposes. The increase in tax basis as of
December 31, 1999 was as follows (in thousands):
<Table>
Inventory................................................... $ 3,670
Property, plant and equipment............................... 4,145
Goodwill.................................................... 130,543
--------
$138,358
========
</Table>
F-12
<Page>
DONJOY, L.L.C.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(INFORMATION AS OF JUNE 30, 2001 AND FOR THE SIX MONTHS
ENDED JULY 1, 2000 AND JUNE 30, 2001 IS UNAUDITED)
1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
The Orthotech Acquisition also resulted in an increase in the tax basis due
to the fixed and intangible assets acquired. The increase in tax basis due to
the Orthotech Acquisition is equal to the amounts recorded by the Company under
purchase accounting (see Note 2).
Prior to the Recapitalization, the Company's results of operations included
a provision for income taxes assuming that the Company had filed a separate
federal income tax return. As a limited liability company, neither DonJoy nor dj
Ortho is subject to income taxes. Instead, DonJoy's earnings will be allocated
to its members and included in the taxable income of its members. The indenture
and the credit facility permit dj Ortho to make distributions to DonJoy in
certain amounts to allow DonJoy to make distributions to its members to pay
income taxes in respect of their allocable share of taxable income of DonJoy and
its subsidiaries, including dj Ortho.
COMPREHENSIVE INCOME
The Company has adopted SFAS No. 130, Reporting Comprehensive Income, which
requires that all components of comprehensive income, including net income, be
reported in the financial statements in the period in which they are recognized.
Comprehensive income is defined as the change in equity during a period from
transactions and other events and circumstances from non-owner sources. Net
income and other comprehensive income, including foreign currency translation
adjustments, and unrealized gains and losses on investments, shall be reported,
net of their related tax effect, to arrive at comprehensive income.
Comprehensive income for the years ended December 31, 1998, 1999 and 2000 and
the six months ended July 1, 2000 and June 30, 2001 did not differ materially
from reported net income.
RECENTLY ISSUED ACCOUNTING STANDARDS
In June 1998, the Financial Accounting Standards Board ("FASB") issued SFAS
No. 133, "Accounting for Derivative Instruments and Hedging Activities",
("FAS 133") which establishes accounting and reporting standards for derivative
instruments and hedging activities. The statement will require the recognition
of all derivatives on the Company's balance sheet at fair value.
In July 1999, the FASB issued SFAS No. 137, "Accounting for Derivative
Instruments and Hedging Activities--Deferral of the Effective Date of FASB
Statement No. 133" which deferred the adoption requirement to the first quarter
of 2001. The impact of adoption on the Company's financial statements was not
material.
In July 2001, the FASB issued Statements of Financial Accounting Standards
No. 141, "Business Combinations" (FAS 141) and No. 142, "Goodwill and Other
Intangible Assets" (FAS 142). FAS 141 requires all business combinations
initiated after June 30, 2001 to be accounted for using the purchase method.
Under FAS 142, goodwill and intangible assets with indefinite lives are no
longer amortized but are reviewed annually (or more frequently if impairment
indicators arise) for impairment. Separable intangible assets that are not
deemed to have indefinite lives will continue to be amortized over their useful
lives (but with no maximum life). The amortization provisions of FAS 142 apply
to goodwill and intangible assets acquired after June 30, 2001. With respect to
goodwill and intangible assets acquired prior to July 1, 2001, we are required
to adopt FAS 142 effective October 1, 2002, but we may adopt FAS 142 early in
the first fiscal quarter of 2002. The Company is currently evaluating the effect
that adoption of the provisions of FAS 142 that are effective on October 1, 2002
will have on our results of operations and financial position.
F-13
<Page>
DONJOY, L.L.C.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(INFORMATION AS OF JUNE 30, 2001 AND FOR THE SIX MONTHS
ENDED JULY 1, 2000 AND JUNE 30, 2001 IS UNAUDITED)
1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
RECLASSIFICATIONS
To be consistent with the current period's presentation, the Company
reclassified $0.6 million, $1.3 million, $3.9 million and $1.2 million of
charges for the years ended December 31, 1998, 1999 and 2000 and the first six
months of 2000, respectively, which were previously included in selling and
marketing expenses, against revenues related to the Company's OfficeCare
program. Based on the nature of the charges, management believes that the
charges are more appropriately presented as adjustments to revenue than as
operating expenses. This reclassification had no effect on net income (loss) for
the foregoing periods.
2. ACQUISITION
On July 7, 2000, the Company completed the Orthotech Acquisition.
Approximately $49.4 million in cash was required to finance the Orthotech
Acquisition, including approximately $3.0 million for transaction fees and
expenses ($0.4 million of which relates to debt issuance costs). The sources of
funds for the Orthotech Acquisition consisted of:
- The sale of common units to JPMDJ Partners and certain members of
management for $8.3 million, of which $0.2 million was for management
notes receivable.
- The sale of Redeemable Preferred Units for net proceeds of $3.4 million
(excluding preferred unit fees of $0.2 million) to existing holders of the
Redeemable Preferred Units,
- Borrowing under our amended credit agreement of approximately
$36.6 million, and
- $1.3 million from available cash.
The sources and uses of funds for the Orthotech Acquisition are presented in
the following table (dollars in millions):
<Table>
<Caption>
AMOUNT
--------
SOURCES
Cash........................................................ $ 1.3
Revolving credit facility................................... 12.6
Term loan................................................... 24.0
Redeemable Preferred Units.................................. 3.4
Common unit investment by JPMDJ Partners.................... 8.1
Common unit investment by Management........................ 0.2
-----
$49.6
=====
USES
Cash to DePuy Orthopedic.................................... $46.4
Debt issuance costs......................................... 0.4
Transaction fees and costs.................................. 2.6
Management promissory notes................................. 0.2
-----
$49.6
=====
</Table>
F-14
<Page>
DONJOY, L.L.C.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(INFORMATION AS OF JUNE 30, 2001 AND FOR THE SIX MONTHS
ENDED JULY 1, 2000 AND JUNE 30, 2001 IS UNAUDITED)
2. ACQUISITION (CONTINUED)
The Orthotech Acquisition has been accounted for using the purchase method
of accounting whereby the purchase price has been allocated to the acquired
tangible and intangible assets based on their estimated fair market values as
follows (in thousands):
<Table>
Inventories............................................... $ 2,538
Equipment and furniture................................... 1,295
Other assets held for sale................................ 126
Intangibles:
Goodwill.................................................. $36,623
Customer list........................................... 8,400
Assembled workforce..................................... 37 45,060
------- -------
Net assets acquired....................................... $49,019
=======
</Table>
The net assets acquired have been reduced by the $0.4 million relating to
debt issuance costs incurred.
As a result of the Orthotech Acquisition, the Company incurred $0.4 million
in post-closing merger and integration costs. These costs relate primarily to
consulting and information systems expenses that did not qualify for
capitalizations under EITF 95-3, "Recognition of Liabilities in Connection with
a Purchase Business Combination."
The accompanying consolidated statements of income reflect the operating
results of Orthotech since the date of acquisition. Assuming the purchase of
Orthotech had occurred on January 1 of the respective years, the pro forma
unaudited results of operations would have been as follows (in thousands):
<Table>
<Caption>
DECEMBER 31,
-------------------
1999 2000
-------- --------
Net revenues............................................ $161,159 $165,858
Net income.............................................. $ 6,770 $ 5,386
</Table>
3. FINANCIAL STATEMENT INFORMATION
INVENTORIES
Inventories consist of the following (in thousands):
<Table>
<Caption>
DECEMBER 31,
------------------- JUNE 30,
1999 2000 2001
-------- -------- -----------
(UNAUDITED)
Raw materials.................................. $ 6,392 $ 9,074 $ 8,472
Work-in-progress 1,446 1,572 1,558
Finished goods................................. 6,817 11,638 13,192
------- ------- -------
14,655 22,284 23,222
Less reserve for excess and obsolete........... (991) (3,774) (4,031)
------- ------- -------
$13,664 $18,510 $19,191
======= ======= =======
</Table>
F-15
<Page>
DONJOY, L.L.C.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(INFORMATION AS OF JUNE 30, 2001 AND FOR THE SIX MONTHS
ENDED JULY 1, 2000 AND JUNE 30, 2001 IS UNAUDITED)
3. FINANCIAL STATEMENT INFORMATION (CONTINUED)
The reserve for excess and obsolete inventory as of December 31, 2000 and
June 30, 2001 includes $2.2 million and $2.0 million, respectively, relating to
the inventory acquired in the Orthotech Acquisition. The reserve recorded upon
the acquisition totaled $5.1 million of which $2.9 million and $0.2 million was
utilized in the year ended December 31, 2000 and the six months ended June 30,
2001, respectively.
PROPERTY, PLANT AND EQUIPMENT
Property, plant and equipment consists of the following (in thousands):
<Table>
<Caption>
DECEMBER 31,
------------------- JUNE 30,
1999 2000 2001
-------- -------- -----------
(UNAUDITED)
Buildings and leasehold improvements......... $ 3,577 $ 3,676 $ 4,047
Office furniture, fixtures, equipment and
other...................................... 15,817 19,025 25,935
Construction in progress..................... 1,297 5,804 2,081
-------- -------- --------
20,691 28,505 32,063
Less accumulated depreciation and
amortization............................... (13,394) (15,720) (17,436)
-------- -------- --------
$ 7,297 $ 12,785 $ 14,627
======== ======== ========
</Table>
INTANGIBLE ASSETS
Intangible assets arose primarily from the initial acquisition of DonJoy in
1987 by the Former Parent, the Company's acquisition of Professional Care
Products, Inc. in 1995, the Company's acquisition of Orthotech in 2000 and the
Company's acquisition of Alaron in 2001. The Company acquired a license in 1999
related to the distribution of the PainBuster-TM- products. In addition, the
Company re-acquired distribution rights in 2000. Intangible assets consist of
the following (in thousands):
<Table>
<Caption>
DECEMBER 31,
USEFUL LIFE ------------------- JUNE 30,
(IN YEARS) 1999 2000 2001
----------- -------- -------- -----------
(UNAUDITED)
Goodwill........................... 20 $ 24,742 $ 61,365 $ 60,930
Patented technology................ 5-20 14,437 14,437 15,549
Customer base...................... 15-20 11,600 20,000 20,000
Licensing agreements............... 5 2,000 2,000 2,000
Other.............................. 3-20 649 1,886 1,936
-------- -------- --------
53,428 99,688 100,415
Less: accumulated amortization..... (20,233) (24,269) (27,180)
-------- -------- --------
$ 33,195 $ 75,419 $ 73,235
======== ======== ========
</Table>
F-16
<Page>
DONJOY, L.L.C.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(INFORMATION AS OF JUNE 30, 2001 AND FOR THE SIX MONTHS
ENDED JULY 1, 2000 AND JUNE 30, 2001 IS UNAUDITED)
3. FINANCIAL STATEMENT INFORMATION (CONTINUED)
OTHER ACCRUED LIABILITIES
Other accrued liabilities consist of (in thousands):
<Table>
<Caption>
DECEMBER 31,
------------------- JUNE 30,
1999 2000 2001
-------- -------- -----------
(UNAUDITED)
Accrued cost of distribution rights.............. $ -- $1,050 $ 613
Accrued returns.................................. 397 618 587
Accrued rebate expense........................... 356 541 588
Accrued warranty expense......................... 259 305 331
Other accruals................................... 2,655 3,852 4,383
------ ------ ------
$3,667 $6,366 $6,502
====== ====== ======
</Table>
4. FINANCING ARRANGEMENTS
Principal balances under dj Ortho's long-term financing arrangements consist
of the following (in thousands):
<Table>
<Caption>
DECEMBER 31,
------------------- JUNE 30,
1999 2000 2001
-------- -------- -----------
(UNAUDITED)
12 5/8% Senior Subordinated Notes due 2009,
net of $1,740 and $1,638 of unamortized
discount at December 31, 2000 and June 30,
2001, respectively......................... $ 98,055 $ 98,260 $ 98,362
Senior Credit Facility:
Term loans due 2005, interest rates ranging
from 9.18% to 9.81% at December 31, 2000
and 6.81% to 8.06% at June 30, 2001........ 15,250 38,362 37,724
Revolving credit facility, interest rates
ranging from 8.88% to 9.00% at
December 31, 2000 and 6.31% to 6.44% at
June 30, 2001.............................. -- 20,600 15,600
-------- -------- --------
113,305 157,222 151,686
Current portion of long-term debt............ (500) (1,274) (1,274)
-------- -------- --------
112,805 155,948 150,412
Less: Senior Subordinated Notes (see
above)..................................... (98,055) (98,260) (98,362)
-------- -------- --------
Long-term debt net of current portion........ $ 14,750 $ 57,688 $ 52,050
======== ======== ========
</Table>
12 5/8% SENIOR SUBORDINATED NOTES DUE 2009
On June 30, 1999, dj Ortho issued $100.0 million of 12 5/8% Senior
Subordinated Notes due 2009 (the "Notes") to various investors in connection
with the financing of the Recapitalization. The Notes were issued at a discount
of $2.0 million which is being accreted to the Notes balance and amortized to
interest expense over the life of the Notes. The Notes are general unsecured
obligations of dj Ortho, subordinated in right of payment to all existing and
future senior indebtedness of dj Ortho, pari passu in right of payment to all
senior subordinated indebtedness of dj Ortho and senior in right of payment to
all subordinated indebtedness.
F-17
<Page>
DONJOY, L.L.C.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(INFORMATION AS OF JUNE 30, 2001 AND FOR THE SIX MONTHS
ENDED JULY 1, 2000 AND JUNE 30, 2001 IS UNAUDITED)
4. FINANCING ARRANGEMENTS (CONTINUED)
Interest on the Notes is payable in cash semi-annually on each June 15 and
December 15, commencing on December 15, 1999. The aggregate principal amount of
the Notes matures on June 15, 2009.
COVENANTS. The Notes contain covenants restricting the ability of dj Ortho
and its subsidiaries to (i) incur additional indebtedness; (ii) prepay, redeem
or repurchase debt; (iii) make loans and investments; (iv) incur liens and
engage in sale lease-back transactions; (v) enter into transactions with
affiliates; (vi) engage in mergers, acquisitions and asset sales; (vii) make
optional payments on or modify the terms of the subordinated debt;
(viii) restrict preferred and capital stock of subsidiaries; (ix) declare
dividends or redeem or repurchase capital stock; and (x) engage in other lines
of businesses. As of December 31, 2000 and June 30, 2001, the Company was in
compliance with all covenants.
GUARANTEES; CO-ISSUERS. The Notes are guaranteed by DonJoy and co-issued by
dj Ortho and DJ Capital, but are not guaranteed by dj Orthopedics, LLC de Mexico
de S.A. de C.V., dj Orthopaedics Pty Ltd or dj Ortho Canada, Inc., dj Ortho's
only existing subsidiaries (other than DJ Capital).
OPTIONAL REDEMPTION. On or after June 15, 2004, the Notes may be redeemed,
in whole or in part, at the following redemption prices (expressed as
percentages of principal amount), plus accrued and unpaid interest and
liquidated damages thereon, if any, to the redemption date if redeemed during
the 12-month period commencing on June 15 of the years set forth below:
<Table>
<Caption>
REDEMPTION
YEAR PRICE
- ---- ----------
2004........................................................ 106.313%
2005........................................................ 104.208%
2006........................................................ 102.104%
2007 and thereafter......................................... 100.000%
</Table>
AMENDED CREDIT FACILITY
In connection with the Recapitalization, dj Ortho entered into a Credit
Agreement with First Union National Bank ("First Union") and the Chase Manhattan
Bank ("Chase") and other lenders. In connection with the Orthotech Acquisition,
the Credit Agreement was amended ("Amended Credit Agreement"). Under the Amended
Credit Agreement, dj Ortho may borrow up to $64.5 million consisting of a
revolving credit facility of up to $25.0 million (the "revolving credit
facility") and term loans in a principal amount of $39.5 million (the "term
loans"). The first term loan, in the amount of $15.5 million, was borrowed in
connection with the Recapitalization and the second term loan, in the amount of
$24.0 million, was borrowed to finance the Orthotech Acquisition. As of
June 30, 2001, dj Ortho has borrowed $15.6 million under the revolving credit
facility, primarily to consummate and fund working capital needs of the
Orthotech Acquisition. The revolving credit facility includes options by dj
Ortho to enter into revolving loans of up to $25.0 million, to enter into
swingline loans and to obtain letters of credit from time to time. The revolving
credit facility provides for letters of credit in an aggregate stated amount at
any time outstanding not in excess of the lesser of $5.0 million and the
difference between $25.0 million and the sum of the outstanding principal amount
of dj Ortho revolving loans, letter of credit exposure and swingline exposure at
such time. Borrowings under the Amended Credit Agreement bear interest at the
rate per annum equal to the greatest of (a) the Prime
F-18
<Page>
DONJOY, L.L.C.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(INFORMATION AS OF JUNE 30, 2001 AND FOR THE SIX MONTHS
ENDED JULY 1, 2000 AND JUNE 30, 2001 IS UNAUDITED)
4. FINANCING ARRANGEMENTS (CONTINUED)
Rate in effect on such day, (b) the Base Certificate of Deposit Rate in effect
on such day plus 1% and (c) the Federal Funds Effective Rate in effect on such
day plus 1/2 of 1%. Borrowings under the revolving credit facility and term
loans bear interest at variable rates plus an applicable margin (ranging from
8.875% to 9.813% as of December 31, 2000 and 6.313% to 8.063% as of June 30,
2001).
In addition to paying interest on outstanding principal under the Amended
Credit Agreement, dj Ortho is required to pay a commitment fee to the lenders
under the revolving credit facility in respect of the unutilized commitments
thereunder at a rate equal to 0.5% per annum.
REPAYMENT. The term loans will mature on June 30, 2005 and are subject to
mandatory repayments and reductions as defined in the Amended Credit Agreement.
The following table sets forth the principal payments on the term loans for the
years 2001 through its maturity in 2005 (in thousands):
<Table>
2001........................................................ $ 1,274
2002........................................................ 1,274
2003........................................................ 1,274
2004........................................................ 17,202
2005........................................................ 17,338
-------
Total....................................................... $38,362
=======
</Table>
In addition, dj Ortho is required to make annual mandatory prepayments of
the term loan under the amended credit facility in an amount equal to 50% of
excess cash flow (as defined in the Amended Credit Agreement) (75% if dj Ortho's
leverage ratio exceeds a certain level). dj Ortho had no excess cash flow at
December 31, 1999 or 2000. In addition, the term loan is subject to mandatory
prepayments in an amount equal to (a) 100% of the net cash proceeds of certain
equity and debt issuances by DonJoy, dj Ortho or any of its subsidiaries and
(b) 100% of the net cash proceeds of certain asset sales or other dispositions
of property by DonJoy, dj Ortho or any of its subsidiaries, in each case subject
to certain exceptions. No mandatory prepayments were required by dj Ortho at
December 31, 1999, December 31, 2000 or June 30, 2001.
SECURITY; GUARANTEES. The obligations of dj Ortho under the Amended Credit
Agreement are irrevocably guaranteed, jointly and severally, by DonJoy, DJ
Capital and future subsidiaries. In addition, the Amended Credit Agreement and
the guarantees thereunder are secured by substantially all the assets of the
Company.
COVENANTS. The Amended Credit Agreement contains a number of covenants
that, among other things, restrict the ability of dj Ortho and its subsidiaries
to (i) dispose of assets; (ii) incur additional indebtedness; (iii) incur or
guarantee obligations; (iv) prepay other indebtedness or amend other debt
instruments; (v) pay dividends or make other distributions (except for certain
tax distributions); (vi) redeem or repurchase membership interests or capital
stock, create liens on assets, make investments, loans or advances, make
acquisitions; (vii) engage in mergers or consolidations; (viii) change the
business conducted by dj Ortho and its subsidiaries; (ix) make capital
expenditures; (x) or engage in certain transactions with affiliates and
otherwise engage in certain activities. In addition, the Amended Credit
Agreement requires dj Ortho and its subsidiaries to comply with specified
financial ratios and tests, including a maximum consolidated leverage ratio test
and a
F-19
<Page>
DONJOY, L.L.C.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(INFORMATION AS OF JUNE 30, 2001 AND FOR THE SIX MONTHS
ENDED JULY 1, 2000 AND JUNE 30, 2001 IS UNAUDITED)
4. FINANCING ARRANGEMENTS (CONTINUED)
minimum consolidated interest coverage ratio test. The Amended Credit Agreement
also contains provisions that prohibit any modifications of the Notes in any
manner adverse to the lenders under the Amended Credit Agreement and that limit
the dj Ortho's ability to refinance or otherwise prepay the Notes without the
consent of such lenders. dj Ortho was in compliance with the covenants at
December 31, 2000 and June 30, 2001.
5. COMMON AND PREFERRED UNITS
DonJoy is authorized to issue up to 2,900,000 common units and up to 100,000
preferred units. As of December 31, 2000 and June 30, 2001, 793,890 and 885,633
common units, respectively, and 44,405 and 44,405 preferred units, respectively,
were issued and outstanding.
In accordance with a unit purchase agreement dated as of June 28, 2000, the
Former Parent sold its remaining interest of 54,000 common units in DonJoy to
CDP and certain members of management for $5.9 million. JPMDJ Partners purchased
52,495 common units for a total consideration of $5.7 million and the members of
management purchased the remaining 1,505 units for a total consideration of
$0.2 million, substantially all of which was financed by loans from DonJoy,
evidenced by full recourse promissory notes with market interest rates. As a
result of this transaction, dj Ortho no longer reflects any intercompany
transactions in its consolidated financial statements. The related party
revenues were $10.7 million in 1998, $8.3 million in 1999 and $4.6 million in
2000.
In connection with the unit purchase agreement, DonJoy agreed to amend and
restate the promissory notes originally issued by the certain members of
management in connection with the Recapitalization. The principal amount of each
amended and restated note was equal to the sum of outstanding principal on the
original notes and any accrued and unpaid interest on the notes. In addition to
increasing the rate of interest payable on the notes from 5.30% to 6.62% per
annum, the amended and restated notes permit the certain members of management
to increase the principal amount due under the note by the amount of a scheduled
interest payment (the "PIK Option"). If a certain member of management elects
the PIK Option, the principal amount of his note is increased by the amount of
the scheduled interest payment and interest then accrues on the principal amount
of the note as so increased. The amended and restated notes mature in 2007.
In connection with the Orthotech Acquisition, gross proceeds of
$8.3 million from the sale of common units were received through the issuance of
73,775 common units to JPMDJ Partners for gross proceeds of $8.0 million and the
issuance of 2,115 common units to certain members of management for gross
proceeds of $231,000 (of which $174,000 was paid for through the issuance of
full recourse promissory notes by the management members). Gross proceeds of
$3.6 million from the sale of 4,221 units of Redeemable Preferred Units were
received from existing Redeemable Preferred Unit holders of which the net
proceeds totaled $3.4 million (excluding preferred unit fees).
The Redeemable Preferred Units accrue a cumulative quarterly preferred
return at a fixed rate of 14.0% per annum, subject to increase to 16.0% per
annum upon the occurrence of certain events of non-compliance. Total dividends
for the year ended December 31, 2000 were $5.3 million. Payment of the preferred
dividends is made at the discretion of the Board of Managers. The proceeds
received from the sale of the Redeemable Preferred Units are net of
$1.8 million of preferred unit fees paid to J.P. Morgan Partners (23A SBIC), LLC
(formerly CB Capital Investors, LLC), First Union Capital Partners, LLC and DJ
Investment, LLC (formerly First Union Investors, Inc.). These Redeemable
F-20
<Page>
DONJOY, L.L.C.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(INFORMATION AS OF JUNE 30, 2001 AND FOR THE SIX MONTHS
ENDED JULY 1, 2000 AND JUNE 30, 2001 IS UNAUDITED)
5. COMMON AND PREFERRED UNITS (CONTINUED)
Preferred Unit fees are being accreted over a period of 114 months, beginning
July 1, 1999 and ending on December 31, 2008. The accretion of these Redeemable
Preferred Units for the year ended December 31, 2000 was $0.2 million and are
included in dividends. In addition to the rights with respect to the preferred
return (including related tax distributions and distributions to the holders of
preferred units of their original capital investment), the Redeemable Preferred
Units will share ratably with the common units in any distributions (including
tax distributions and upon liquidation) made by DonJoy in respect of common
units (the Redeemable Preferred Units Participating Interest).
The Redeemable Preferred Units are subject to mandatory redemption on
December 31, 2009 and may be redeemed at DonJoy's option at any time. Upon a
change of control, holders of Redeemable Preferred Units will have the right,
subject to certain conditions, to require DonJoy to redeem their Redeemable
Preferred Units (including the Redeemable Preferred Units Participating
Interest). In addition, at any time after June 30, 2005 holders will have the
right, subject to certain conditions, to require DonJoy to redeem their
Redeemable Preferred Units Participating Interest. Unless equity proceeds or
other funds are available to DonJoy for the purpose, the ability of DonJoy to
make any of the foregoing payments will be subject to receipt of distributions
from dj Ortho in amounts sufficient to make such payments and such distributions
will be subject to the restrictions contained in the Amended Credit Agreement
and the Indenture.
Upon the occurrence of any Liquidation Event (as defined in the Third
Amended and Restated Operating Agreement of DonJoy, L.L.C. dated July 7, 2000),
the holders of Redeemable Preferred Units are entitled to receive payment,
before any payments shall be made to the holders of common units, equal to the
original costs of such Redeemable Preferred Unit plus any unpaid cumulative
dividends. In addition, DonJoy has the option to redeem the Redeemable Preferred
Units prior to the redemption date based upon the following percents which would
be applied to the total of the original costs of such Redeemable Preferred Unit
plus any unpaid cumulative dividends:
<Table>
Prior to the first anniversary of original issuance date.... 105%
On or after the first anniversary and prior to the second
anniversary of original issuance date..................... 104%
On or after the second anniversary and prior to the third
anniversary of original issuance date..................... 103%
On or after the third anniversary and prior to the fourth
anniversary of original issuance date..................... 102%
On or after the fourth anniversary and prior to the fifth
anniversary of original issuance date..................... 101%
On or after the fifth anniversary of original issuance
date...................................................... 100%
</Table>
VOTING. Except as otherwise required by applicable law or as set forth in
the operating agreement or the members' agreement, holders of common units and
Redeemable Preferred Units shall vote together as a single class on all matters
to be voted on by the members, with each unit being entitled to one vote.
TAX DISTRIBUTIONS. The indenture and the credit facility permit dj Ortho to
make distributions to DonJoy in certain amounts to allow DonJoy to make
distributions to its members to pay income taxes in respect of their allocable
share of the taxable income of DonJoy and its subsidiaries including dj Ortho.
F-21
<Page>
DONJOY, L.L.C.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(INFORMATION AS OF JUNE 30, 2001 AND FOR THE SIX MONTHS
ENDED JULY 1, 2000 AND JUNE 30, 2001 IS UNAUDITED)
5. COMMON AND PREFERRED UNITS (CONTINUED)
UNIT OPTIONS.
Under DonJoy, L.L.C.'s Second Amended and Restated 1999 Option Plan, 166,799
common units are reserved for issuance upon exercise of options granted or to be
granted under the plan as of December 31, 2000. In February 2001, the Company
amended the 1999 Option Plan and, as of June 30, 2001, 178,799 common units are
reserved for issuance upon exercise of options granted or to be granted under
the Plan, as amended. The plan is administered by the Compensation Committee
appointed from time to time by the Board of Managers and allows for the issuance
of common unit options to officers, directors, employees, independent
consultants and advisors of the Company. The plan expires on June 30, 2014
unless earlier terminated by the Board of Managers. The plan provides for the
grant of nonqualified options to officers, directors, and employees of, and
independent consultants and advisors to, the Company.
Options will be granted in amounts to be agreed upon by the Compensation
Committee. Options will generally vest either:
- 25% beginning on June 30, 2000 and thereafter ratably over a 3 year period
for those options granted on June 30, 2000 (Tier I), or
- 25% at the end of 1 year from the date of the grant and the balance
vesting ratably thereafter for all options granted after June 30, 2000
(Tier I), or
- Tier II and III options which cliff vest on December 31, 2007; however,
accelerated vesting can be achieved upon completion of certain events, or
- Time-vested based upon achievement of certain sales targets.
As of December 31, 2000 and June 30, 2001, 14,140 and 29,278 units,
respectively, issued under this plan were exercisable and 17,959 and 16,729
units, respectively, were available for future grant under the option plan. The
following table summarizes option activity through June 30, 2001:
<Table>
<Caption>
WEIGHTED
AVERAGE
EXERCISE
OPTIONS OPTION PRICE PRICE
-------- ------------ --------
Outstanding as of December 31, 1998......................... -- $-- $ --
Granted................................................... 120,512 $100 $100
Exercised................................................. -- -- --
Cancelled................................................. -- -- --
-------
Outstanding as of December 31, 1999 120,512 $100 $100
Granted................................................... 28,328 $100 to $109 $104
Exercised................................................. -- -- --
Cancelled................................................. -- -- --
-------
Outstanding at December 31, 2000 148,840 $100 to $109 $101
Granted (unaudited)....................................... 28,860 $100 to $147 $147
Exercised (unaudited)..................................... -- -- --
Cancelled (unaudited)..................................... (15,630) $100 to $109 $102
-------
Outstanding at June 30, 2001 (unaudited).................... 162,070 $100 to $147 $109
=======
</Table>
F-22
<Page>
DONJOY, L.L.C.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(INFORMATION AS OF JUNE 30, 2001 AND FOR THE SIX MONTHS
ENDED JULY 1, 2000 AND JUNE 30, 2001 IS UNAUDITED)
5. COMMON AND PREFERRED UNITS (CONTINUED)
The following table summarizes information concerning currently outstanding
and exercisable options:
<Table>
<Caption>
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
--------------------------------------- -------------------------
NUMBER NUMBER
OUTSTANDING WEIGHTED WEIGHTED EXERCISABLE AS WEIGHTED
RANGE OF AS OF AVERAGE AVERAGE OF AVERAGE
EXERCISE DECEMBER 31, REMAINING EXERCISE DECEMBER 31, EXERCISE
PRICES 2000 LIFE IN YEARS PRICE 2000 PRICE
- --------------------- ------------ ------------- -------- -------------- --------
100.....$.... 136,540 13.60 $ 100 14,040 $100
109.....$.... 12,300 14.60 $ 109 -- $109
</Table>
Pro forma information regarding net income is required by SFAS 123 and has
been determined as if the Company had accounted for its employee options under
the fair value method of SFAS 123. The fair value of these options was estimated
at the date of grant using the minimum value model for option pricing with the
following assumptions for 1999 and 2000: a risk-free interest rate of 6.25%; a
dividend yield of zero; and a weighted average life of the option of 4 years for
Tier I options and 8.5 years for Tier II and Tier III options.
Option valuation models require the input of highly subjective assumptions.
Because the Company's employee options have characteristics significantly
different from those of traded options, and because changes in the subjective
input assumptions can materially affect the fair value estimate, in management's
opinion, the existing models do not necessarily provide a reliable single
measure of the fair value of its employee options.
For purposes of adjusted pro forma disclosures the estimated fair value of
the options is amortized to expense over the vesting period. The Company's pro
forma information is as follows for the years ended December 31 (in thousands):
<Table>
<Caption>
1999 2000
-------- --------
Pro forma net income........................................ $6,569 $3,979
</Table>
The pro forma effect on net income is not necessarily indicative of
potential pro forma effects on results for future years.
6. RECAPITALIZATION COSTS AND FEES
In connection with the Recapitalization, the Company incurred costs and fees
of $8.8 million, $5.9 million for the Notes, $1.4 million for the credit
agreement and $1.5 million for transaction fees and expenses related to equity.
Of the $8.8 million, $7.4 million ($6.5 million net of accumulated amortization)
has been capitalized in the accompanying balance sheet as of December 31, 2000.
The remaining $1.5 million has been recorded as a reduction to members' equity
(deficit) transaction fees and expenses as of December 31,1999. The capitalized
debt fees are being amortized over the term of the related debt.
F-23
<Page>
DONJOY, L.L.C.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(INFORMATION AS OF JUNE 30, 2001 AND FOR THE SIX MONTHS
ENDED JULY 1, 2000 AND JUNE 30, 2001 IS UNAUDITED)
7. SEGMENTS AND RELATED INFORMATION
dj Ortho has two reportable segments as defined by Financial Accounting
Standards Board SFAS No. 131, DISCLOSURES ABOUT SEGMENTS OF AN ENTERPRISE AND
RELATED INFORMATION. dj Ortho's reportable segments are business units that
offer different products that are managed separately because each business
requires different technology and marketing strategies. The rigid knee bracing
segment designs, manufactures and sells rigid framed ligament and osteoarthritis
knee braces and post-operative splints. The soft goods segment designs,
manufactures and sells fabric, neoprene and Drytex based products for the knee,
ankle, shoulder, back and wrist. dj Ortho's other operating segments are
included in specialty and other complementary orthopedic products. None of the
other segments met any of the quantitative thresholds for determining reportable
segments. In 2001, dj Ortho determined that certain products within the soft
goods segment and specialty and other complementary orthopedic products were
more appropriately classified in the rigid knee bracing segment. In addition,
certain products within specialty and other complementary orthopedic products
were more appropriately classified in the soft goods segment. To be consistent
with the current period presentation, prior periods have been reclassified.
Information regarding industry segments is as follows (in thousands):
<Table>
<Caption>
YEARS ENDED DECEMBER 31, SIX MONTHS SIX MONTHS
------------------------------ ENDED JULY 1, ENDED JUNE 30,
1998 1999 2000 2000 2001
-------- -------- -------- ------------- --------------
(UNAUDITED) (UNAUDITED)
Net revenues:........................
Rigid knee bracing................. $ 52,473 $ 52,953 $ 58,115 $27,672 $32,661
Soft goods......................... 32,010 38,606 51,412 20,563 30,307
-------- -------- -------- ------- -------
Net revenues for reportable
segments......................... 84,483 91,559 109,527 48,235 62,968
Specialty and other complementary
orthopedic products.............. 15,653 21,344 29,647 12,217 17,895
Freight revenue.................... 3,507 3,515 4,412 1,861 2,420
-------- -------- -------- ------- -------
Total consolidated net revenues...... $103,643 $116,418 $143,586 $62,313 $83,283
======== ======== ======== ======= =======
Gross profit:
Rigid knee bracing................. $ 36,669 $ 37,994 $ 41,189 $19,853 $23,281
Soft goods......................... 15,707 18,723 24,662 9,686 13,225
-------- -------- -------- ------- -------
Gross profit for reportable
segments......................... 52,376 56,717 65,851 29,539 36,506
Specialty and other complementary
orthopedic products.............. 7,050 9,447 16,635 6,897 9,649
Freight revenue.................... 3,507 3,515 4,412 1,861 2,420
Brand royalties.................... (3,249) (1,817) -- -- --
Other cost of goods sold........... (2,507) (3,188) (3,490) (1,189) 28
-------- -------- -------- ------- -------
Total consolidated gross profit...... $ 57,177 $ 64,674 $ 83,408 $37,108 $48,603
======== ======== ======== ======= =======
</Table>
The accounting policies of the reportable segments are the same as those
described in the basis of presentation. dj Ortho allocates resources and
evaluates the performance of segments based on gross profit. Intersegment sales
were not significant for any period.
F-24
<Page>
DONJOY, L.L.C.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(INFORMATION AS OF JUNE 30, 2001 AND FOR THE SIX MONTHS
ENDED JULY 1, 2000 AND JUNE 30, 2001 IS UNAUDITED)
7. SEGMENTS AND RELATED INFORMATION (CONTINUED)
For the periods ended December 31, 1999 and 2000 and June 30, 2001, dj Ortho
had no individual customer or distributor within a segment which accounted for
more than 10% or more of total revenues.
Assets allocated in foreign countries were not significant. Net revenues to
customers, attributed to countries based on the location of the customer, were
as follows (in thousands):
<Table>
<Caption>
SIX MONTHS ENDED
YEARS ENDED DECEMBER 31, -------------------------
------------------------------ JULY 1, JUNE 30,
1998 1999 2000 2000 2001
-------- -------- -------- ----------- -----------
(UNAUDITED) (UNAUDITED)
United States............................ $ 82,898 $ 95,022 $121,125 $51,475 $71,527
Europe................................... 11,050 11,473 11,124 6,186 6,570
Other countries.......................... 6,188 6,408 6,925 2,791 2,766
Freight revenue.......................... 3,507 3,515 4,412 1,861 2,420
-------- -------- -------- ------- -------
Total consolidated net revenues.......... $103,643 $116,418 $143,586 $62,313 $83,283
======== ======== ======== ======= =======
</Table>
dj Ortho does not allocate assets to reportable segments because all
property and equipment are shared by all segments of dj Ortho.
8. CONDENSED CONSOLIDATING FINANCIAL INFORMATION
As discussed in Notes 1 and 4 above, dj Ortho's obligations under the Notes
are guaranteed by its parent, DonJoy L.L.C. This guarantee and any guarantee by
a future wholly-owned subsidiary guarantor, is full and unconditional. dj Ortho
and DJ Capital comprise all the direct and indirect subsidiaries of DonJoy
(other than inconsequential subsidiaries). We have concluded separate financial
statements of DonJoy, dj Ortho and DJ Capital are not required to be filed as
separate reports under the Securities Exchange Act of 1934. The Notes and the
Amended Credit Agreement contain certain covenants restricting the ability of dj
Ortho and DJ Capital to, among other things, pay dividends or make other
distributions (other than certain tax distributions) or loans or advances to
DonJoy unless certain financial tests are satisfied in the case of the indenture
or the consent of the lenders is obtained in the case of the credit facility.
The indenture and the credit facility permit dj Ortho to make distributions to
DonJoy in certain amounts to allow DonJoy to make distributions to its members
to pay income taxes in respect of their allocable share of taxable income of
DonJoy and its subsidiaries, including dj Ortho. At December 31, 2000, under
these requirements, neither dj Ortho nor DJ Capital would be permitted to make
dividends, distributions, loans or advances to DonJoy except for the permitted
tax distributions.
9. TRANSACTIONS WITH SMITH & NEPHEW
Prior to the Recapitalization, the Company was a wholly owned subsidiary of
Smith & Nephew, Inc. On June 30, 1999 the Company consummated the
Recapitalization. On June 28, 2000, the Former Parent sold its remaining
interest in DonJoy to JPMDJ Partners and certain members of management (see
Note 1). As a result of this transaction, the Company no longer reflects any
F-25
<Page>
DONJOY, L.L.C.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(INFORMATION AS OF JUNE 30, 2001 AND FOR THE SIX MONTHS
ENDED JULY 1, 2000 AND JUNE 30, 2001 IS UNAUDITED)
9. TRANSACTIONS WITH SMITH & NEPHEW (CONTINUED)
intercompany transactions on the consolidated balance sheets, statements of
income and statements of cash flows.
Under the control of its Former Parent, the Company had numerous
transactions with its Former Parent and its affiliates. The intercompany
obligations represent a net balance as the result of various transactions. There
were no terms of settlement or interest charges associated with the account
balance. The balance results from the Company's former participation in the
Former Parent's central cash management program, wherein all the Company's cash
receipts were remitted to the Former Parent and all cash disbursements were
funded by the Former Parent. An analysis of intercompany transactions follows
(in thousands):
<Table>
<Caption>
YEARS ENDED DECEMBER 31,
-------------------------
1998 1999
----------- -----------
Net cash remitted to Former Parent.................. $(18,256) $(17,743)
Net intercompany sales.............................. (4,822) (112)
Share of Former Parent's current income taxes....... 4,287 (134)
Corporate management expense allocations............ 5,664 3,159
Cash owed to Former Parent.......................... -- 1,002
I-Flow licensing agreement.......................... -- 800
Capital contribution................................ -- (38,865)
Direct charges:
Brand royalties................................... 3,249 1,817
Payroll taxes and benefits........................ 8,635 4,651
Direct legal expenses............................. 324 67
Foreign Sales Corporation (FSC) commission........ 439 --
Miscellaneous other administrative expenses......... 680 131
</Table>
Prior to the Recapitalization, the Former Parent and Smith & Nephew, plc
provided certain management, financial, administrative and legal services to the
Company. These expenses and all other central operating costs, were charged on
the basis of direct usage when identifiable, with the remainder allocated among
the Former Parent's subsidiaries and divisions on the basis of their respective
annual sales or percentage of capital employed.
F-26
<Page>
DONJOY, L.L.C.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(INFORMATION AS OF JUNE 30, 2001 AND FOR THE SIX MONTHS
ENDED JULY 1, 2000 AND JUNE 30, 2001 IS UNAUDITED)
9. TRANSACTIONS WITH SMITH & NEPHEW (CONTINUED)
Former Parent allocations consist of the following (in thousands):
<Table>
<Caption>
YEARS ENDED
DECEMBER 31,
-------------------
1998 1999
-------- --------
Corporate managed accounts and new business................. $ 394 $ 195
Finance (risk management, treasury, audit, and taxes)....... 310 177
Human resources and payroll................................. 291 147
Legal....................................................... 223 128
Research and development.................................... 854 380
Corporate management expense................................ 1,332 784
Bonus....................................................... 503 467
Pension..................................................... 514 267
Insurance................................................... 1,243 614
------ ------
$5,664 $3,159
====== ======
Amounts included in:
Cost of goods sold........................................ $ 991 $ 495
Sales and marketing....................................... 179 94
General and administrative................................ 4,439 2,553
Research and development.................................. 55 17
------ ------
$5,664 $3,159
====== ======
</Table>
Also prior to the Recapitalization, the Company participated in the Former
Parent's corporate insurance programs for workers' compensation, product and
general liability. These charges were settled with the Former Parent, and thus,
accruals for related liabilities, if any, were maintained by the Former Parent
and are not reflected in the accompanying consolidated balance sheets.
10. RESTRUCTURING
In March 1998, dj Ortho combined its two operating facilities into one
location in Vista, California and accrued $2.5 million in costs resulting from
the restructuring which had no future economic benefit. These costs relate
primarily to remaining lease obligations on the vacated facility, net of
projected sublease income, and severance costs associated with the termination
of twelve employees. Included in general and administrative costs for 1998 are
$0.2 million of costs also related to the combination of the facilities.
Pursuant to the Recapitalization agreement, the restructuring reserve, which
amounted to $0.9 million at June 29, 1999 and consisted of the remaining lease
obligations on the vacated facility, was assumed by Smith & Nephew.
11. COMMITMENTS AND CONTINGENCIES
The Company is obligated under various noncancellable operating leases for
land, buildings, equipment, vehicles and office space through February 2008.
Certain of the leases provide that dj
F-27
<Page>
DONJOY, L.L.C.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(INFORMATION AS OF JUNE 30, 2001 AND FOR THE SIX MONTHS
ENDED JULY 1, 2000 AND JUNE 30, 2001 IS UNAUDITED)
11. COMMITMENTS AND CONTINGENCIES (CONTINUED)
Ortho pay all or a portion of taxes, maintenance, insurance and other operating
expenses, and certain of the rents are subject to adjustment for changes as
determined by certain consumer price indices and exchange rates. In connection
with the Recapitalization, the Company entered into a subleasing agreement with
Smith & Nephew for its Vista facility. DonJoy has guaranteed the payment of rent
and other amounts owed under the sublease by the Company.
Minimum annual lease commitments for noncancellable operating leases as of
December 31, 2000 are as follows (in thousands):
<Table>
2001........................................................ $ 2,458
2002........................................................ 2,263
2003........................................................ 2,202
2004........................................................ 1,880
2005........................................................ 1,852
2006 and thereafter......................................... 4,013
-------
$14,668
=======
</Table>
Aggregate rent expense was approximately $3.2 million, $2.7 million and
$3.2 million for the years ended December 31, 1998, 1999 and 2000 and
$1.4 million and $1.7 million for the six months ended July 1, 2000 and
June 30, 2001, respectively.
LICENSE AGREEMENTS
In August of 1998, the Company entered into an exclusive license agreement
with IZEX Technologies, Incorporated ("IZEX") to acquire the intellectual
property rights and to retain IZEX to consult on the design and development of
an advanced rehabilitation bracing system. Under the license, the Company also
has the worldwide exclusive rights to manufacture, use and sell developed
products. At December 31, 2000, $1.0 million is included in intangible assets
(patented technology) in the accompanying balance sheet. Under an amended
agreement, the Company is obligated to make an additional payment of
$0.8 million.
In 1999, the Company entered into an agreement, which was subsequently
amended, with I-Flow Corporation ("I-Flow") for the exclusive North American
distribution rights for the PainBuster-TM- Pain Management Systems manufactured
by I-Flow for use after orthopedic surgical procedures. The license payment has
been capitalized during 1999 and is being amortized over 5 years. In addition,
the Company purchased $2.8 million in I-Flow product during 2000 and is required
to purchase $2.5 million in I-Flow product in 2001.
CONTINGENCIES
The Company is subject to legal proceedings and claims that arise in the
normal course of business. While the outcome of the proceedings and claims
cannot be predicted with certainty, management does not believe that the outcome
of any of these matters will have a material adverse effect on the Company's
consolidated financial position or results of operations.
F-28
<Page>
DONJOY, L.L.C.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(INFORMATION AS OF JUNE 30, 2001 AND FOR THE SIX MONTHS
ENDED JULY 1, 2000 AND JUNE 30, 2001 IS UNAUDITED)
12. RETIREMENT PLANS
Prior to the Recapitalization, substantially all of the Company's employees
participated in a defined benefit pension plan sponsored by the Former Parent.
Benefits related to this plan were computed using formulas, which were generally
based on age and years of service. Aggregate pension prepayments and liabilities
related to this plan are recorded by the Former Parent. Pension expense
allocated (based on relative participation) to the Company related to this plan
was as follows (in thousands):
<Table>
<Caption>
YEARS ENDED DECEMBER 31,
-------------------------
1998 1999
----------- -----------
Service costs........................................ $466 $242
Interest costs....................................... 48 25
---- ----
Total pension expense allocated...................... $514 $267
==== ====
</Table>
DonJoy has a qualified 401(k) profit-sharing plan covering substantially all
of its U.S. employees, which is substantially the same as the plan previously
provided by Smith & Nephew. The assets funding the Smith & Nephew plan were
transferred to the DonJoy 401(k) Plan. The Company matches dollar for dollar the
first $500, then matches at a 30 percent rate, employee contributions up to
6 percent of total compensation. The Company's matching contributions related to
this plan were $0.3 million, $0.3 million and $0.4 million for the years ended
December 31, 1998, 1999 and 2000, respectively. The plan also provides for
discretionary Company contributions (employee profit sharing) which began on
June 30, 1999 as approved by the Board of Managers. There were no contributions
for the year ended December 31, 2000. The Company's discretionary 401(k)
contributions for the year ended December 31, 1999 were $228,000. DonJoy's
401(k) plan is administered by Fidelity Investments Institutional Services
Company, Inc.
13. TERMINATED ACQUISITION
In October 2000, the Company decided to discontinue its pursuit of a
potential acquisition. Absent the resumption of negotiations which is not
currently anticipated, costs incurred related to this potential acquisition have
been expensed during the fourth quarter of 2000 in the amount of $0.4 million.
F-29
<Page>
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, as
amended, the registrant has duly caused this report to be signed on its behalf
by the undersigned hereunto duly authorized.
<Table>
DJ ORTHOPEDICS, LLC
DJ ORTHOPEDICS CAPITAL CORPORATION
DONJOY, L.L.C.
(Registrant)
Dated August 27, 2001 By: /s/ LESLIE H. CROSS
-----------------------------------------
Leslie H. Cross
President and Chief Executive Officer
(Principal Executive Officer)
Dated August 27, 2001 By: /s/ CYRIL TALBOT III
-----------------------------------------
Cyril Talbot III
Senior Vice President, Chief Finacial
Officer and Secretary (Principal Financial
Officer)
</Table>
II-1
<Page>
EXHIBIT INDEX
<Table>
<Caption>
EXHIBIT NO. DESCRIPTION PAGE
- ----------- ----------- --------
23.1 Consent of Ernst & Young LLP
</Table>