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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

(Mark One)

Commission file number 1-10670

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

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

        Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2 of the Exchange Act):  Yes  X   No  __

        As of November 8, 2004, 21,578,547 shares of common stock, $.01 par value per share were outstanding.

HANGER ORTHOPEDIC GROUP, INC.

INDEX

HANGER ORTHOPEDIC GROUP, INC.
CONSOLIDATED BALANCE SHEETS
(Dollars in thousands, except share and per share amounts)

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

1

HANGER ORTHOPEDIC GROUP, INC.
CONSOLIDATED BALANCE SHEETS
(Dollars in thousands, except share and per share amounts)

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

2

HANGER ORTHOPEDIC GROUP, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
For the Three and Nine Months Ended September 30,
(Dollars in thousands, except share and per share amounts)

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

3

HANGER ORTHOPEDIC GROUP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
For the Nine Months Ended September 30,
(Dollars in thousands)

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

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HANGER ORTHOPEDIC GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE A – BASIS OF PRESENTATION

The unaudited interim consolidated financial statements as of and for the three and nine months ended September 30, 2004 and 2003 have been prepared by the Company pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”) for interim financial reporting. These consolidated statements are unaudited and, in the opinion of management, include all adjustments (consisting of normal recurring adjustments and accruals) necessary to represent fairly the consolidated balance sheets, consolidated operating results, and consolidated cash flows for the periods presented in accordance with accounting principles generally accepted in the United States of America (“GAAP”). The consolidated balance sheet at December 31, 2003 included herein has been restated to reflect accounting for the correction of an error related to a write-off of uncollectible accounts receivable (See Note C). Certain information and footnote disclosures normally included in annual financial statements prepared in accordance with GAAP have been omitted in accordance with the rules and regulations for interim reporting of the SEC.

Certain prior period amounts have been reclassified to conform to the current period presentation.

These consolidated financial statements should be read in conjunction with the consolidated financial statements of Hanger Orthopedic Group, Inc. (the “Company”) and notes thereto included in the Annual Report on Form 10-K and the Form 10-K/A for the year ended December 31, 2003, filed by the Company with the SEC.

NOTE B – SIGNIFICANT ACCOUNTING PRINCIPLES

Use of Estimates

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Inventories

Inventories, which consist principally of raw materials, work in process and finished goods, are stated at the lower of cost or market using the first-in, first-out method. For its patient-care centers segment, the Company calculates cost of goods sold in accordance with the gross profit method. The Company bases the estimates used in applying the gross profit method on the actual results of the most recently completed fiscal year and other factors affecting cost of goods sold during the current reporting periods, such as a change in the sales mix or changes in the trend of purchases. Estimated cost of goods sold during the period is reconciled and adjusted when the

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NOTE B – SIGNIFICANT ACCOUNTING PRINCIPLES (CONTINUED)

Inventories (continued)

annual physical inventory is taken. The Company treats these adjustments as changes in accounting estimates. For its distribution segment, a perpetual inventory is maintained. Management adjusts the reserve for inventory obsolescence whenever the facts and circumstances indicate that the carrying cost of certain inventory items is in excess of its market price. Shipping and handling activities are reported as part of cost of goods sold.

Goodwill

The Company assesses goodwill for impairment when events or circumstances indicate that the carrying value may not be recoverable, or, at a minimum, annually at October 1. During August 2004, the decline in the fair value of the Company’s stock triggered an interim valuation of goodwill and other intangible assets. The interim evaluation, based on a discounted cash flow model, resulted in an impairment estimate of $45.8 million as of August 31, 2004, which was recognized during the three months ended September 30, 2004. During the fourth quarter, the Company will finalize its estimate in accordance with the provisions of Statement of Financial Accounting Standards 142, Goodwill and Other Intangible Assets, and update the valuation to October 1, 2004, the Company’s annual testing date. The Company will record any changes to its estimate at that time.

Stock-Based Compensation

Restricted Shares of Common Stock

The Company issues restricted shares of common stock to its directors and certain employees. The Company recognizes the fair value of those shares at the date of grant as unearned compensation and amortizes such amount to compensation expense ratably over the vesting period of each grant.

During the three months ended September 30, 2004 the Company did not grant restricted shares of common stock. During the three months ended September 30, 2003, the Company granted 196,313 restricted shares of common stock. The Company granted 19,725 and 206,593 restricted shares of common stock during the nine months periods ended September 30, 2004 and 2003, respectively. At September 30, 2004 and 2003, a total of 171,475 and 206,593 restricted shares of common stock were outstanding, respectively. These shares had an aggregate market value of $2.5 million and $2.8 million at September 30, 2004 and 2003, respectively, as determined at the date of grant. The shares have vesting dates through April 2008, of which 49,563 shares became fully vested during the three months ended September 30, 2004.

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NOTE B – SIGNIFICANT ACCOUNTING PRINCIPLES (CONTINUED)

Stock-Based Compensation (continued)

Options

The Company has multiple stock-based employee compensation plans and has outstanding non-qualified options held by employees. Stock-based compensation is accounted for using the intrinsic value based method. No stock-based employee compensation expense for stock options is reflected in net income as all options granted under these plans and the non-qualified options granted to employees had an exercise price equal to the market value of the underlying common stock on the date of grant. The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition to stock-based employee compensation for all awards:

The fair value of these options was estimated at the date of grant using a Black-Scholes option pricing model with the following weighted average assumptions:

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NOTE B – SIGNIFICANT ACCOUNTING PRINCIPLES (CONTINUED)

Stock-Based Compensation (continued)

Options (continued)

For the three months ended September 30, 2004 the Company did not grant options to purchase shares of the Company’s common stock. During the three months ended September 30, 2003, the Company granted aggregate options to purchase 159,031 shares of the Company’s common stock. The Company granted aggregate options to purchase 131,865 and 301,503 shares of the Company’s common stock during the nine months periods ended September 30, 2004 and 2003, respectively.

Segment Information

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

NOTE C – CORRECTION OF AN ERROR, RESTATEMENT OF ACCOUNTS RECEIVABLE

The previously issued consolidated balance sheet as of December 31, 2003 and the consolidated statements of operations and cash flows for the three and nine months ended September 30, 2003 have been restated to reflect a correction of an error that led to the overstatement of recorded accounts receivable and an equal understatement of bad debt expense. The error resulted in an understatement of selling, general and administrative expense of $0.3 million and $0.8 million for the three and nine months ended September 30, 2003, respectively.

The correction of the error decreased previously reported income before taxes by $0.3 million and $0.8 million for the three and nine months ended September 30, 2003, respectively. The impact of the correction decreased previously reported net income applicable to common stock by $0.2 million and $0.4 million for the three and nine month periods ended September 30, 2003, respectively. The impact of the correction decreased previously reported basic and diluted net income per share by $0.01 and $0.02 for the three and nine months ended September 30, 2003, respectively.

The discrepancy was discovered during the preparation of the Company’s June 30, 2004 financial statements. By June, the Company had substantially completed the roll-out of its new billing and cash collection system (O/P/S), which aided in the discovery of the discrepancy. The O/P/S system replaced more than 15 different billing and cash collection platforms previously utilized in the Company’s over 600 practices to bill and collect for products and services. The new system provides the Company better visibility over its accounts receivable and improved

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NOTE C – CORRECTION OF AN ERROR, RESTATEMENT OF ACCOUNTS RECEIVABLE (CONTINUED)

controls over its inter-branch cash collection activity. After a successful pilot test, the Company commenced the installation of this system in September 2003 and by the end of June 2004 had installed the system in all practices except the patient-care centers of three recent acquisitions and three central billing offices which require an enhanced multi-user version of the system for which testing has not yet been completed.

The conversion to the O/P/S single billing and cash collection platform permitted reconciliation of inter-branch cash collection activity and the Company determined that certain receivables were uncollectible. The Company, with the concurrence of its independent registered public accounting firm, concluded that this adjustment should be reported as a correction of an error to previously issued financial statements.

NOTE D – SUPPLEMENTAL CASH FLOW FINANCIAL INFORMATION

The following are the supplemental disclosure requirements for the consolidated statements of cash flows:

NOTE E – ACQUISITIONS

During the trailing twelve months ended September 30, 2004, the Company acquired eight orthotics and prosthetics companies that operated a total of 41 patient-care centers. The Company paid an aggregate purchase price of $25.2 million for these acquisitions. None of these acquisitions were material to the Company. As of September 30, 2004, the purchase price allocation of two of the purchased companies has been determined on a preliminary basis due to the lack of final information necessary for measurement.

The Company believes that the purchased entities contributed to a higher market share and allowed the Company to enter new markets. All acquired entities have been profitable and have immediately contributed to the Company’s operating income and earnings per share. These

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NOTE E – ACQUISITIONS (CONTINUED)

acquired entities generated a total of $22.9 million in the trailing twelve months’ net sales as of September 30, 2004 and $7.2 million in net sales for the quarter ended September 30, 2004. The results of operations of the acquired companies are included in the Company’s consolidated results of operations effective as of their respective acquisition dates.

During the first quarter of 2004, the Company recorded a $0.7 million restructuring reserve, included in accrued expenses, related to one of the orthotics and prosthetics companies purchased. The restructuring plan calls for the closure/merger of nine facilities and the payment of severance costs to 20 terminated employees. At September 30, 2004 four of the nine patient-care centers had been closed/merged and approximately $0.1 million in lease costs were paid. As of September 30, 2004, 11 employees had been terminated and $0.1 million of severance payments and benefits are expected to be paid through January 2005. Approximately $0.5 million of lease payments are expected to be paid through April 2008.

Earnouts are defined in the purchase agreement and are accrued based on earnout targets for the following quarter being attained. These estimates are adjusted in the actual quarter the payment is made. The Company made earnout payments of $0.8 million and $0.9 million in the nine months ended September 30, 2004 and 2003, respectively. The Company has accounted for these amounts as additional purchase price, resulting in an increase in excess cost over net assets acquired. The Company estimates that it may pay an additional $2.4 million related to earnout provisions in future periods.

The activity related to goodwill for the nine months ended September 30, 2004 is as follows:

The additions to goodwill during the period will be deductible for tax purposes in future periods.

NOTE F – NET INCOME PER COMMON SHARE

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

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NOTE F – NET INCOME PER COMMON SHARE (CONTINUED)

Income per share is computed as follows:

(a)     For the three and nine months ended September 30, 2004, excludes the effect of the conversion of the Redeemable Convertible Preferred Stock as it is considered anti-dilutive. For the three months and nine months ended September 30, 2003, it became more dilutive to net income per common share to convert the Company’s outstanding Redeemable Convertible Preferred Stock to common stock. Therefore, the preferred stock dividends declared and accretion were not included in the computation of diluted per common share data for those periods.

(b)     For the three months ended September 30, 2004 and 2003, options to purchase 1,863,301and 1,385,529 shares of common stock, respectively, are not included in the computation of diluted income per share as these options are anti-dilutive because the exercise prices of the options were greater than the average market price of the Company’s common stock during the period. Options to purchase 1,591,710 and 1,535,029 shares of common stock were outstanding at September 30, 2004 and 2003, respectively, and are not included in the computation of diluted income per share for the nine month periods ended September 30, 2004 and 2003, respectively, as these options are anti-dilutive.

NOTE G – INVENTORY

Inventories consist of the following:

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NOTE H – LONG TERM DEBT

Long-term debt consists of the following:

(a)     At September 30, 2004 and December 31, 2003, includes $2.2 million and $2.6 million, respectively, of deferred interest rate swap termination income to be recognized as a reduction of interest expense, using the effective interest method, over the remaining life of the Senior Notes.

In September 2004, the Revolving Credit Facility was amended to modify certain covenant calculations. The amended provisions increased the total leverage and the senior secured leverage ratio limitations, reduced the interest coverage and fixed charge coverage ratio limitations and reduced permitted acquisitions and capital expenditures. The Company paid $0.4 million and $1.0 million in debt financing costs during the three and nine months ended September 30, 2004, respectively. At September 30, 2004, the Company had $52.2 million available under the Revolving Credit Facility.

NOTE I – COMMITMENTS AND CONTINGENT LIABILITIES

Commitments

In October 2001, the Company entered into a supply agreement with United States Manufacturing Company (“USMC”), under which it agreed to purchase certain products and components for use solely by the Company’s patient-care centers during a five-year period following the date of the agreement. In connection with the supply agreement, $3.0 million was placed in escrow. The Company satisfied its obligation to purchase from USMC during the first two years following the date of the agreement. Accordingly, the escrow agent released $2.0 million in escrowed funds to the Company for the satisfaction of such purchase obligations, leaving $1.0 million in escrow at September 30, 2004.

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NOTE I – COMMITMENTS AND CONTINGENT LIABILITIES (CONTINUED)

Commitments (continued)

The Company executed a Master Amendment with Seattle Systems (as the successor of USMC), dated as of October 2003, pursuant to which the supply agreement and escrow arrangement relating thereto between the Company and USMC/Seattle Systems was amended to reduce the remaining life of the agreement to two years, increase the minimum annual purchase amount, include the Company’s distribution subsidiary’s purchases in the annual purchase threshold, and amend certain shipping and discount terms. In addition, the amendment reflected that $1.0 million remained in escrow and that the Company would receive it in two annual installments of $0.5 million each if it meets the minimum annual purchase amounts. If the Company fails to make such minimum annual purchases for any of the purchase years, then the $0.5 million escrow payment for that purchase year shall be released from escrow to Seattle Systems.

As of October 2004, the Company had met its purchase requirements and USMC has agreed to release an additional $0.5 million which will be received in the fourth quarter of 2004.

Contingencies

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

Matters Relating to Billing Allegations

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

On June 18, 2004, the Company announced that on June 17, 2004, the Audit Committee of the Company’s Board of Directors had engaged the law firm of McDermott, Will & Emery to serve as independent counsel to the committee and to conduct an independent investigation of the allegations. The scope of that independent investigation has been expanded to cover certain of the Company’s other patient-care centers. On June 17, 2004, the U.S. Attorney’s Office for the Eastern District of New York subpoenaed records of the Company regarding various billing activities and locations. In addition, the Company also announced on June 18, 2004 that the Securities and Exchange Commission had commenced an informal inquiry into the matter. The Company is cooperating with the regulatory authorities.

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NOTE I – COMMITMENTS AND CONTINGENT LIABILITIES (CONTINUED)

Matters Relating to Billing Allegations (continued)

Based on the preliminary results of the independent investigation, management believes that any billing discrepancies are likely to be primarily at the West Hempstead patient-care center. Based on the preliminary results of the investigation, management does not believe the resolution of the matters raised by the allegations will have a materially adverse effect on the Company’s financial statements. The net sales of the West Hempstead facility for the nine months ended September 30, 2004 and the year ended December 31, 2003 and were $1.0 million and $1.9 million, respectively, or less than 0.5% of the Company’s net sales for those periods.

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

Class Action Litigation

On June 25, 2004, the Company announced that substantially similar class actions on behalf of certain shareholders of the Company had been filed against the Company and certain of its executive officers and directors in the U.S. District Court for the Eastern District of New York and the U.S. District Court for the Eastern District of Virginia. The complaints in those cases, which repeat the above-referenced employee allegations of misconduct at the West Hempstead, New York patient-care center, are described below. The Company believes that the class action allegations of fraudulent conduct by the Company’s executive directors and officers are without merit and it intends to vigorously defend the suits. The claims have been reported to the Company’s insurance carrier.

A suit captioned Twist Partners vs. Hanger Orthopedic Group, Inc., Thomas F. Kirk, George E. McHenry and Ivan R. Sabel, (Case No. CV 04 2585) was filed on June 22, 2004 in the U.S. District Court for the Eastern District of New York. Mr. Kirk is President and a director of the Company, Mr. McHenry is Chief Financial Officer of the Company and Mr. Sabel is the Chairman of the Board and Chief Executive Officer of the Company. The complaint alleges that throughout the class period (July 29, 2003 through June 14, 2004), the defendants engaged in “an illegal scheme to bill the Medicaid and Medicare programs, the Veterans Administration and private insurers,” and alleges that the improperly booked sales artificially inflated the Company’s reported revenues and earnings. The complaint also alleges that the defendants were motivated to engage in the fraud so that the Company’s insiders could effect sales of their shares of the Company’s common stock at artificially inflated prices, citing the sale of a total of 120,270 shares for total proceeds of $1,931,198. The suit alleges violations of the anti-fraud provision contained in Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder, and asserts violations of Section 20(a) against the individual defendants as controlling persons. The suit seeks an unspecified amount of compensatory damages against all

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NOTE I – COMMITMENTS AND CONTINGENT LIABILITIES (CONTINUED)

Class Action Litigation (continued)

defendants, jointly and severally for all damages sustained, including interest thereon, as well as reasonable costs and expenses incurred, including counsel and expert fees.

Three substantially identical suits, captioned Robert Imperato vs. Hanger Orthopedic Group, Inc., Ivan R. Sabel, Thomas Kirk, and George E. McHenry (Civil Action No. CV 04 2736), Kenneth Walters vs. Hanger Orthopedic Group, Inc., Thomas F. Kirk, George E. McHenry, and Ivan R. Sabel (Civil Action No. CV 04 2826), and Adam Shapiro vs. Hanger Orthopedic Group, Inc., Ivan R. Sabel and George E. McHenry (Case CV 04 2681) were filed on June 29, 2004, July 6, 2004 and June 28, 2004, respectively, in the U.S. District Court for the Eastern District of New York. A suit captioned Curt Browne vs. Hanger Orthopedic Group, Inc., Ronald N. May, Thomas P. Cooper, Jason P. Owen, Ivan R. Sabel, Richard J. Taylor, George E. McHenry, Glenn M. Lohrmann and Risa J. Lavizzo-Mourey (Case No. 1:04 cv 715) was filed in the U.S. District Court for the Eastern District of Virginia on June 23, 2004. Mr. May is the President of Southern Prosthetic Supply (the Company’s distribution division), Mr. Cooper is a director of the Company, Mr. Owen is Treasurer of the Company, Mr. Taylor is Executive Vice President of the Company, Mr. Lohrmann is Vice President and Secretary of the Company and Ms. Lavizzo-Mourey is a former director of the Company. The complaint’s allegations are substantially similar to those set forth in the above-referenced action and specifies a class period of February 26, 2003 through June 14, 2004. The complaint alleges sales by the individual defendants of a total of 167,270 shares for total proceeds of $2.4 million. The complaint seeks damages in an unspecified amount, including interest, and reasonable costs, including attorneys’ fees.

Guarantees and Indemnifications

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

NOTE J – REDEEMABLE CONVERTIBLE PREFERRED STOCK

The Certificate of Designations associated with the issuance of the Redeemable Convertible Preferred Stock calls for an increase in the stock’s dividend rate in the event the Company does not declare or pay cash dividends on the fifth anniversary of issuance. Accordingly, the dividend rate on the Redeemable Convertible Preferred Stock increased from 7% to 10% effective July 1, 2004. The Company continues to accrue dividends ratably over the life of the Redeemable Convertible Preferred Stock.

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NOTE K – SEGMENT AND RELATED INFORMATION

The Company has identified two reportable segments based on the products and services it provides. The Company evaluates segment performance and allocates resources based on the segment’s EBITDA. EBITDA is defined as income from operations plus depreciation and amortization and other charges, if any. Other charges may include extinguishments of debt and goodwill impairment. Other EBITDA not directly attributable to reportable segments is primarily related to corporate general and administrative expenses.

The two reportable segments are: (i) patient-care centers and (ii) distribution. The reportable segments are described further below:

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

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

The accounting principles of the segments are the same as those described in Note B, “Significant Accounting Principles-Segment Information.”

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

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NOTE K – SEGMENT AND RELATED INFORMATION (CONTINUED)

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NOTE K – SEGMENT AND RELATED INFORMATION (CONTINUED)

The following tables reconcile EBITDA to consolidated net income:

NOTE L – CONSOLIDATING FINANCIAL INFORMATION

The Company’s Revolving Credit Facility, Senior Notes, Senior Subordinated Notes, and Term Loan are guaranteed fully, jointly and severally, and unconditionally by all of the Company’s current and future domestic subsidiaries. The following is summarized condensed consolidating financial information, as of September 30, 2004 and December 31, 2003, and for the three and nine month periods ended September 30, 2004 and 2003 of the Company, segregating the parent company (Hanger Orthopedic Group, Inc.) and its guarantor subsidiaries, as each of the Company’s subsidiaries is wholly-owned.

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NOTE L – CONSOLIDATING FINANCIAL INFORMATION (CONTINUED)

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NOTE L – CONSOLIDATING FINANCIAL INFORMATION (CONTINUED)