PART I.

ITEM 1. BUSINESS

OVERVIEW

Encore Medical Corporation, a Delaware corporation, and its wholly owned subsidiaries (indivudally referred to as "us," "we," "our company," "the Company," or "Encore"), is a diversified orthopedic company that designs, manufactures and distributes a comprehensive range of high quality orthopedic devices, sports medicine equipment and other related products for the orthopedic industry. We sell our products to orthopedic surgeons, physical and occupational therapists and other orthopedic specialists who use our products to treat patients with musculoskeletal conditions resulting from degenerative diseases, deformities, traumatic events and sports related injuries. Our surgical implants are used in reconstructive surgical procedures for the knee, hip, shoulder and spine. Our soft goods and rehabilitation products are used before surgery to offset the progression of an orthopedic condition. After surgery, our rehabilitation and soft goods products are used to assist the patient in recovery and to protect against further injury. As a result, we believe our products address a wide spectrum of the orthopedic continuum of care.

We have marketed and distributed our products through our three operating divisions, our Surgical Division, our Chattanooga Group Division and our Soft Goods Division. Our Surgical Division provides implant products across all three major segments of the orthopedic surgical market, including reconstructive joint products, such as hip, knee and shoulder implants; trauma products; and spinal implants. Our Chattanooga Group Division is a leader in domestic sales of many of the products used for orthopedic rehabilitation. Our Soft Goods Division provides orthopedic soft goods that are used to assist in the repair and rehabilitation of soft tissue and bone, and protect against injury. Total revenue from all three divisions was $108.1 million in 2003 and $95.5 million in 2002. Our income from operations was $9.2 million in 2003 and $7.1 million in 2002. Beginning in 2004 our soft goods products will be marketed and distributed as part of our Chattanooga Group Division to improve operational effectiveness and focus.

Throughout our history, we have strongly emphasized research and development to expand the product line of our Surgical Division. Since our inception, we have developed and obtained regulatory approval for over 100 products and product improvements. We continue to develop internally new products to enhance our organic growth. For example, we commenced the sale of several new products in 2003, including the 3DKnee System, our data-driven design total knee replacement. In addition to a continued focus on product innovation within our Surgical Division, our Chattanooga Group Division will continue its historical pattern of investing in product development. For example, we recently began selling VitalStim, a product used for the treatment of dysphagia, a swallowing disorder, and a new line of world-class electrotherapy equipment.

We have used strategic business acquisitions to broaden our product offering and to increase our customer base. Since July 1, 2001, we have completed two significant acquisitions that have allowed us to expand our business into two new product segments of the orthopedic market — orthopedic soft goods and rehabilitation equipment — both of which complement our Surgical Division. In July 2001, we purchased the orthopedic soft goods, patient safety devices and pressure care product lines of Kimberly-Clark Corporation. In February 2002, we purchased Chattanooga Group, Inc., a provider of orthopedic rehabilitation products, which became our Chattanooga Group Division. These acquisitions provide us access to a wide range of distribution partners and allow us the opportunity to sell our existing products to an expanded customer base. With the completion of these two acquisitions, we provide a comprehensive range of orthopedic devices and related products to orthopedic specialists operating in a variety of treatment settings.

INDUSTRY BACKGROUND

The worldwide orthopedic market was estimated to be approximately $17.1 billion in 2002 with sales in the United States accounting for approximately $10.5 billion. While we participate in the overall orthopedic market, for the twelve months period ended December 31, 2003, we derived approximately 33% of our revenue from sales of our orthopedic implants through our Surgical Division. The worldwide orthopedic implant market is expected to grow from $4.6 billion in 2002 to $7.2 billion in 2009 and the number of procedures is expected to grow from 2.0 million in 2002 to 2.6 million in 2009.

Orthopedic implants include reconstructive joint products such as hip, knee, and shoulder implants, all of which are expected to experience market growth over the next several years. Worldwide hip implant sales are expected to grow at a 6.2% annual growth rate from 2002 to 2009 and average selling prices are expected to increase from $2,173 in 2002 to $2,769 in 2009. Over the same time period, worldwide sales of knee implants are expected to increase by 6.9% annually with the average selling price expected to increase from $2,698 in 2002 to $3,152 in 2009, primarily due to advancements in technology. Though a smaller market opportunity, worldwide shoulder implant sales are expected to experience a 7.9% annual growth rate from $178.7 million in 2002 to $304.5 million in 2009. We participate in each of these markets.

Several factors are driving growth in the orthopedic industry, these factors include:

OUR STRATEGY 

Our objective is to strengthen our position as a provider of a comprehensive range of orthopedic devices, sports medicine equipment and related products to orthopedic surgeons, physical and occupational therapists and other orthopedic specialists operating in a variety of treatment settings. To achieve this objective, we intend to:

OUR PRODUCTS

We design, manufacture, market and distribute orthopedic devices and related products for the orthopedic industry. Our products are used primarily by orthopedic surgeons, physical and occupational therapists and other orthopedic specialists who treat patients with musculoskeletal conditions resulting from degenerative diseases, deformities, traumatic events and sports related injuries. During 2003, our Surgical Division accounted for 32.9% of total sales, our Chattanooga Group Division accounted for 53.2% of total sales and our Soft Goods Division accounted for 13.9% of total sales.

Surgical Division

We currently design, manufacture and market a wide variety of orthopedic reconstructive joint products, trauma products, spinal implant products and instruments used by surgeons to perform orthopedic surgery.

Reconstructive Joint Products.    We offer reconstructive joint products in three general areas: knees, hips and shoulders. In 2003, knee products accounted for 40.2% of our Surgical Division sales, hip products accounted for 33.9% of our Surgical Division sales, and shoulder products accounted for 8.8% of our Surgical Division sales. The following table summarizes our current Surgical Division reconstructive joint product offerings:

Trauma Products.    Our trauma products are designed to address difficult surgical requirements brought about by disease, fracture and deformity. In 2003, trauma products accounted for approximately 5.4% of our total Surgical Division sales. Our trauma products include:

Spinal Implant Products.    Within the United States we distribute spinal implant products designed and manufactured by Medicrea, a French company whose spinal implant products are used in lumbar and cervical fusion. The PASS Poly-Axial Spinal System, designed and manufactured by Medicrea, consists of a lumbar pedicle screw system used to achieve fusion of the spine. In addition, we recently introduced the Cyclone Anterior Cervical Plate used in cervical spine fusion. In 2003, sales of spinal products accounted for approximately 9.4% of our total Surgical Division sales.

Chattanooga Group Division

Our Chattanooga Group Division is a leading provider of rehabilitation products used by a variety of healthcare professionals involved in the field of physical medicine. In 2003, sales of our Chattanooga Group Division were as broken down as follows: patient care products accounted for 46.9% sales; electrotherapy products, including the new dysphagia products accounted for 31.4% of sales; physical therapy tables and traction products accounted for 14.9% of sales; and chiropractic products accounted for 6.8% of sales. The following table summarizes many of our current Chattanooga Group Division product offerings:

Soft Goods Division

Our Soft Goods Division offers orthopedic soft goods, patient safety devices and patient care products, which are used to assist in the repair and rehabilitation of soft tissue and bone, to protect patients from injury and to aid patients in their recovery from orthopedic trauma and surgery. In 2003, sales for our Soft Goods Division were broken down as follows: orthopedic soft goods products accounted for 63.4% of sales, patient safety devices accounted for 29.8% of sales, and pressure care products accounted for 6.8% of sales. The following table summarizes many of our current Soft Goods Division product offerings:

RESEARCH AND DEVELOPMENT

Our research and development programs focus on the development of new products, as well as the enhancement of existing products with the latest technology and updated designs. We are continually seeking to develop new technologies to improve durability, performance and usability of existing products. In addition to our own research and development, we receive new product and invention ideas, especially in procedure-specific areas, from orthopedic surgeons, inventors and other orthopedic specialists. For ideas that we deem promising from a clinical and commercial perspective, we seek to obtain rights to these ideas through entering into either assignment or licensing agreements. We conduct research and development programs at our facilities in Austin, Texas and Chattanooga, Tennessee.

We spent approximately $5.0 million in 2003, $3.4 million in 2002, and $1.7 million in 2001 for research and development. As of December 31, 2003, our research and development department had 38 employees.

MARKETING AND SALES

Each of our three divisions has developed its own sales and distribution channels. The combination of these three divisions provides us the opportunity to sell our products to a variety of treatment settings across new and potentially complementary distribution networks.

Surgical Division

Our Surgical Division products are currently marketed and sold in the United States to hospitals and orthopedic surgeons through a network of 115 independent commissioned sales representatives who cover territories in all or part of approximately 35 states. We are actively recruiting sales agents and representatives to continue to expand the geographic areas in which we sell. Generally, our sales representatives sell either reconstructive and trauma products or spinal products. However, a few of our sales representatives sell all of these products. Sales agents are generally granted a contract with a term of one to five years. Additional representatives work for these agents. Agents are typically paid a sales commission and are eligible for bonuses if sales exceed certain preset objectives. We assign our sales agents to an exclusive sales territory. Substantially all of our sales agents agree not to sell competitive products. Typically we can terminate our agreements with sales agents prior to the expiration of our agreements only with “cause,” which includes failure to meet specified periodic sales targets. The few sales agents who are permitted to sell competitive products are terminable at will. We provide our agents with product inventories on consignment for their use in marketing our products and for filling customer orders.

Outside the United States, our surgical products are sold through distributors principally in Europe and Japan. While we previously had a distribution arrangement that covered substantially all of Europe, we terminated our relationship with that European distributor in the fourth quarter of 2000 because, based on the decline in European sales by that distributor, we determined that over time we could develop a more effective European distribution network on a country-by-country basis. In Japan, Senko Medical Trading Co. carries our total joint products and most of our trauma products while the rest of our trauma products are sold by Century Medical, Inc. During 2003, we added three new distributors in Germany, Greece, and Venezuela which began carrying our total joint products.

To a significant extent, sales of our surgical products depend on the preference of orthopedic surgeons and other sports medicine professionals. We have developed and maintained close contractual relationships with a number of widely recognized orthopedic surgeons who not only assist us with designing our products, but who also assist us in marketing our products. These orthopedic surgeons may give demonstrations utilizing our products, assist in the development of our marketing materials, participate in symposia addressing both clinical and economic aspects of our products, speak about our products at medical seminars, train other surgeons in the use and implantation of our products, and provide us with feedback on the industry’s acceptance of our products. Surgeons who assist us in designing our products are generally compensated with a royalty. Our consulting surgeons, depending on the particular services provided in support of our products, are paid consulting fees for their services. As a portion of their compensation, these surgeons may also receive stock options under our 1997 Surgeon Advisory Panel Stock Option Plan.

Chattanooga Group Division

Our rehabilitation products are currently marketed and sold through a worldwide network of over 6,000 dealers, which are managed by our internal sales people. These dealers sell Chattanooga Group Division products to a variety of healthcare professionals including physical therapists, athletic trainers, chiropractors and sports medicine physicians. Except for distributors outside of the United States, the Chattanooga Group Division does not maintain formal distribution contracts. In addition, no particular distributor accounts for more than 4.7% of Chattanooga Group Division sales. Distributors purchase products from Chattanooga Group Division at discounts ranging from 30% to 50% off the published list price. We maintain an internal marketing and sales support program to support our dealer network. This network is comprised of a group of individuals who provide dealer and end-user training, develop promotional materials, and attend over 30 trade shows each year.

Soft Goods Division

Our Soft Goods Division products are sold primarily to hospitals through third-party distributors. These distributors include large, national third-party medical/surgical distributors such as Cardinal Health, Owens & Minor, Inc., McKesson, the Henry Schein companies and Physician Sales and Service (PSS), regional medical/surgical distributors such as The Burrows Company and Professional Hospital Supply, and medical product buying groups. These distributors generally resell the products to hospitals, hospital buying groups, integrated delivery networks, primary care networks and orthopedic physicians for use by patients. In addition, we have entered into national or regional contracts to sell our products to large healthcare providers and group purchasing organizations, such as Consorta, Concentra, Broadlane, MedAssets HSCA, Amerinet, and the United States government. Under these contracts, we provide discounted pricing to the buying groups and are designated to the members of the particular buying group as an authorized, and sometimes preferred, source for specific products. Because members of these buying groups are not obligated to purchase our products, we utilize an independent commissioned sales force to market our products directly to the members of these buying groups. Our Soft Goods Division has limited international sales to distributors in Canada, England, Puerto Rico, France, Portugal and several other countries. We leverage the sales and distribution of our Soft Goods Division products to build brand awareness and strengthen our reputation in markets targeted for the sale of higher priced Surgical Division products.

MANUFACTURING

We use both in-house manufacturing capabilities and relationships with third-party vendors to supply our products. Generally, we use third-party vendors that have special manufacturing capabilities. In addition, we use third party vendors when we believe it is appropriate based on certain factors, including our in-house capacity, lead time control, and cost control. We believe there are alternate sources for all our vendors and suppliers and believe that adequate capacity exists at our current suppliers to meet all of our anticipated needs.

Surgical Division

Our in-house capacity for our Surgical Division includes computer controlled machine tools, belting, polishing, cleaning, packaging and quality control. We obtained internationally recognized ISO 9001 qualification and the European Community Medical Device Directive “CE” certification for this division in 1996. Our U.S. manufacturing operations also comply with FDA QSR regulations. The primary raw materials used in the manufacture of our surgical products are cobalt chromium alloy, stainless steel alloys, titanium alloy and ultra high molecular weight polyethylene. All Surgical Division implants and instruments go through in-house quality control, cleaning and packaging operations. Quality control measures begin with an inspection of raw materials and castings prior to use, and pieces are inspected at various intervals in the manufacturing process. As a final step, our products pass through a “clean room” environment designed and maintained to clean our products and reduce product exposure to particulate matter and bio burden.

Chattanooga Group Division

Our Chattanooga Group Division manufactures products which account for a majority of that division’s sales in its manufacturing facilities located in Chattanooga, Tennessee. These facilities are capable of utilizing various manufacturing processes, including metal fabrication, coating, electronic assembly, mechanical assembly, wood working, sewing and a variety of others. The manufacturing facilities for our Chattanooga Group Division are ISO 9001 certified. Our U.S. manufacturing operations for rehabilitation equipment products also comply with FDA QSR regulations. We utilize Asian subcontractors to manufacture a significant amount of our electronic components.

Soft Goods Division

For our Soft Goods Division, we supply all of the raw materials and equipment necessary to make our products to a manufacturing supplier in Mexico. They in turn supply the labor component necessary to assemble and finish our soft goods products. This vendor employs the laborers and manages the assembly process, subject to the supervision of our onsite personnel. We currently have no manufacturing operations in any foreign country other than Mexico. We entered into our agreement with the manufacturer located in Acuna, Mexico, on July 1, 2001. That agreement remains in effect through June 30, 2004, and may be renewed for a term of one to three years by mutual agreement between us and the manufacturer. We pay the manufacturer based on labor hours, and we have promised to purchase from the manufacturer a minimum of $506,250 of labor per year.

AFFILIATED SURGEONS

A key aspect in our development, marketing and sale of our surgical products is the use of designing and consulting surgeons. Each major product is supported by several designing surgeons who assist us not only with the design of the product, but who also give demonstrations using the product, assist in developing marketing materials and participate at symposia addressing both clinical and economic aspects of the product. These professionals often assist the Company by, speaking about our products at medical seminars, assisting in the training of other professionals in the use and implantation of these products and providing us with feedback on the industry’s acceptance of our products. We also have established relationships with consulting surgeons who perform various consulting services for us. Such services include conducting clinical studies on various products, analysis of economic issues relating to use of the products, establishment of protocols for use of the products and participation at various symposia. The designing surgeons working on a product are compensated with a royalty, which is typically split among the group members. Consulting surgeons are also paid consulting fees for their services to us in support of our products. The designing and consulting surgeons may also receive stock options.

INTELLECTUAL PROPERTY

We hold numerous United States and foreign patents covering a wide range of our products. We own a majority of these patents and have licensed rights to the remainder, either on an exclusive or non-exclusive basis. The quantity of intellectual property we own significantly increased as a result of our acquisition of Chattanooga Group, Inc. and our purchase of our orthopedic soft goods product lines from Kimberly-Clark Corporation. We have over 50 trademarks registered in the United States, a number of which are also registered in countries around the world, such as China, Japan, Australia, Germany, Switzerland, Austria, and/or other countries in the European Community. We also assert ownership of numerous unregistered trademarks, some of which have been submitted for registration in the United States and foreign countries. In the future, we will apply for such additional patents and trademarks as we deem appropriate. However, we cannot guarantee whether our existing or future patents, if any, will afford adequate protection, whether any existing patent applications will result in issued patents, or whether our patents will be circumvented or invalidated.

Additionally, we seek to protect our non-patented know-how, trade secrets, processes and other proprietary confidential information, through a variety of methods, including having our employees and consultants sign invention assignment agreements and confidentiality agreements and having our independent sales agents and distributors sign confidentiality agreements. However, these methods may not provide us with adequate protection. Because many of our products are regulated, proprietary information created during our development of a new or improved product may have to be disclosed to the FDA or another U.S. or foreign regulatory agency in order to have the lawful right to market such product. Our proprietary information may also become known to, or be independently developed by, our competitors, or our proprietary rights in intellectual property may be challenged, any of which could have a material adverse effect on our business, financial condition and results of operations.

We have distribution rights to certain products that are manufactured by others and hold both exclusive and nonexclusive licenses under third party patents and trade secrets that cover some of our existing products and products under development. As of December 31, 2003, sales from these distribution agreements and licenses represent a small portion of our overall sales.

There can be no assurance that the validity of any of the patents or other intellectual property owned by or licensed to us would be upheld if challenged by others in litigation. Due to these and other risks described previously, we do not rely solely on our patents and other intellectual property to maintain our competitive position. We believe that development of new products and improvement of existing ones is and will continue to be more important than having our products covered by patents in maintaining our competitive position.

COMPETITION

The market for orthopedic products is highly competitive and somewhat fragmented. Some of our competitors, either alone or in conjunction with their respective parent corporate groups, have research and development, sales, marketing and manufacturing capabilities that are larger than ours, which could provide those companies with a competitive advantage over our company. Recently, product pricing has become increasingly important as a competitive factor, particularly due to governmental and third-party payors’ adoption of prospective payment systems.

Due to the prior success of our Surgical Division and the market leadership of our Chattanooga Group Division, our history of innovative product development, and the extensive experience of our management team, we believe we are capable of effectively competing in the orthopedic market in the future. Further, the comprehensive range of products we offer enables us to reach a diverse customer base and to utilize multiple distribution channels in an attempt to fuel our growth across the orthopedic market. Further, our recent acquisitions in the rehabilitation area, continue to fuel name recognition of our company and our products.

Surgical Division

The market for orthopedic products similar to those produced by our Surgical Division is dominated by a number of large companies, including Biomet, Inc., DePuy, Inc. (a Johnson & Johnson company), Medtronic, Inc., Smith & Nephew, Stryker Corporation, and Zimmer Holdings, Inc. Our Surgical Division also faces competition from companies in size similar to ours, such as Wright Medical Technology, Inc. and Exactech Inc.

Many of our larger competitors offer a wider range of products than those offered by our Surgical Division, and many of their products have the endorsement of leading orthopedic surgeons. Due to recent advances, new technologies and product concepts have been introduced into the orthopedic market at an increasingly rapid rate. Often, new technologies and product concepts are introduced before the previous technologies and concepts have been fully integrated into the orthopedic market. Due to the increasing costs of research and development related to these recent advances, many of our competitors have entered into various agreements and joint ventures with each other, which may allow them to develop innovative products while sharing the research and development costs. As a result, our competitors who enter into such agreements may have a competitive advantage over our Surgical Division. It is the opinion of our management that this evolution in our industry of high technology products will continue for the foreseeable future.

Chattanooga Group Division

While in many rehabilitation market segments, the Chattanooga Group Division holds a leading market share position, its primary competitors in the rehabilitation marketplace are Dynatronics Corporation, Mettler Electronics Corporation, Richmar Corporation, Ability One Products Corp., (a wholly owned subsidiary of Patterson Dental Company), Enraf-Nonius B.V., and Acorn Engineering Company.

Soft Goods Division

Competitors in the soft good products segment of the orthopedic market include DeRoyal Industries, Inc., dj Orthopedics, Inc., and Zimmer Holdings, Inc. Competition in the patient safety product segment includes DeRoyal Industries, Inc. and the Posey Company.

GOVERNMENT REGULATION

Our products are subject to rigorous government agency regulation in the United States and certain other countries. In the United States, the FDA regulates the testing, labeling, manufacturing and marketing of medical devices to ensure that medical products distributed in the United States are safe and effective for their intended uses. The FDA also regulates the export of medical devices manufactured in the United States to international markets. Most of our medical devices are subject to such FDA regulation.

Under the Food, Drug and Cosmetic Act, as amended, medical devices are classified into one of three classes depending on the degree of risk imparted to patients by the medical device. Class I devices are those for which safety and effectiveness can be assured by adherence to General Controls, which include compliance with Quality System Regulations (“QSRs”), facility and device registrations and listings, reporting of adverse medical events, and appropriate truthful and non-misleading labeling, advertising and promotional materials. Some Class I devices also require pre-market review and clearance by the FDA through the 510(k) Pre-market Notification process described below. Class II devices are subject to General Controls, as well as pre-market demonstration of adherence to certain performance standards or other special controls as specified by the FDA. Pre-market review and clearance by the FDA is accomplished through the 510(k) Pre-market Notification procedure. In the 510(k) Pre-market Notification procedure, the manufacturer submits appropriate information to the FDA in a Pre-market Notification submission. If the FDA determines that the device is “substantially equivalent” to a device that was legally marketed prior to May 28, 1976, the date upon which the Medical Device Amendments of 1976 were enacted, or to another similar commercially available device subsequently cleared through the 510(k) Pre-market Notification process, it will grant clearance to commercially market the device. It generally takes three to six months from the date of submission to obtain clearance of a 510(k) Pre-market Notification submission, but the process may take longer. If the FDA determines that the device, or its “labeled” intended use, is not “substantially equivalent,” the FDA will automatically place the device into Class III.

A Class III product is a product that has a wholly new intended use or is based on advances in technology for which the device’s safety and effectiveness cannot be assured solely by the General Controls, performance standards and special controls applied to Class I and II devices. These devices often require formal clinical investigation studies to assess their safety and effectiveness. A Pre-market Approval (“PMA”) from the FDA is required before the manufacturer of a Class III product can proceed in marketing the product. The PMA process is much more extensive than the 510(k) Pre-market Notification process. In order to obtain a PMA, Class III devices, or a particular intended use of any such device, must generally undergo clinical trials pursuant to an application submitted by the manufacturer for an Investigational Device Exemption (“IDE”). An IDE allows the investigational device to be used in a clinical study in order to collect safety and effectiveness data required to support a PMA application or a 510(k) Pre-market Notification submission to the FDA. Only a small percentage of 510(k)Pre-market Notification submissions require clinical data to support the application. Investigational use also includes clinical evaluation of certain modifications or new intended uses of legally marketed devices. All clinical evaluations of investigational devices, unless exempt, must have an approved IDE before the study is initiated. An approved IDE permits a device to be shipped lawfully for the purpose of conducting investigations of the device without complying with other requirements of the Food, Drug and Cosmetic Act that would apply to devices in commercial distribution.

When a manufacturer believes that sufficient pre-clinical and clinical data have been generated to substantiate the safety and efficacy of the new device or new intended use, it may submit a PMA application to the FDA. An FDA review of a PMA application generally takes one to two years from the date the PMA application is accepted for filing, but the process may take significantly longer. In approving a PMA application, the FDA may also require some form of post-market surveillance whereby the manufacturer follows certain patient groups for a number of years, making periodic reports to the FDA on the clinical status of those patients. This helps to ensure that the long-term safety and effectiveness of the device are adequately monitored for adverse events. Most pre-amendment devices (those marketed prior to the enactment of the Medical Device Amendment of 1976) are, in general, exempt from such PMA requirements, as are Class I and Class II devices.

Our products include both pre-amendment and post-amendment Class I, II and III medical devices. All currently marketed devices hold the relevant exemptions or pre-market clearances or approvals, as appropriate, required under federal medical device law.

Our manufacturing processes are also required to comply with QSR regulations that cover the methods and documentation of the design, testing, production, control, quality assurance, labeling, packaging and shipping of our products. Further, our facilities, records and manufacturing processes are subject to periodic unscheduled inspections by the FDA or other agencies. Failure to comply with applicable U.S. medical device regulatory requirements could result in, among other things, warning letters, fines, injunctions, civil penalties, repairs, replacements, refunds, recalls or seizures of products, total or partial suspensions of production, refusal of the FDA to grant future pre-market clearances or approvals, withdrawals or suspensions of current clearances or approvals and criminal prosecution. Currently, we have no adverse regulatory compliance issues or actions pending with the FDA, and no FDA QSR audits conducted at our facilities have resulted in any adverse compliance enforcement actions.

We must obtain export certificates from the FDA before we can export certain of our products and are subject to regulations in many of the foreign countries in which we sell our products. These include product standards, packaging requirements, labeling requirements, import restrictions, tariff regulations, duties and tax requirements. Many of the regulations applicable to our devices and products in such countries are similar to those of the FDA. The national health or social security organizations of certain countries require our products to be qualified before they can be marketed in those countries. To date, we have not experienced any difficulty in complying with these regulations.

We have implemented policies and procedures allowing us to position ourselves for the changing international regulatory environment. The ISO 9001 and ISO 13485 standards have been developed as internationally recognized guidelines that are aimed at ensuring the design and manufacture of quality products. A company that passes an ISO audit and obtains ISO certification becomes internationally recognized as operating under a competent quality system. A “CE” mark is a European system of adherence to the European Medical Device Directive. The European Community promulgaged rules requiring medical products to receive a CE Mark by mid 1998. The Surgical Division and the Chattanooga Group Division have received ISO 9001 and ISO 13485 certification and thereby are allowed to place a “CE” mark on our products.

Certain provisions of the Social Security Act, commonly known as the “Medicare Fraud and Abuse Statute,” prohibit entities, such as ours, from offering, paying, soliciting or receiving any form of remuneration in return for the referral of Medicare or state health program patients or patient care opportunities, or in return for the recommendation, arrangement, purchase, lease or order of items or services that are covered by Medicare or state health programs. Violation of this statute is a felony, punishable by fines of up to $25,000 per violation and imprisonment of up to five years. In addition, the U.S. Department of Health and Human Services may impose civil penalties excluding violators from participation in Medicare or state health programs. Many states have adopted similar prohibitions against payments intended to induce referrals of Medicaid and other third-party payor patients.

Subject to certain exemptions, federal physician self-referral legislation prohibits a physician or a member of his immediate family from referring Medicare or Medicaid patients to an entity providing “designated health services” in which the physician has an ownership or investment interest, or with which the physician has entered into a compensation arrangement. Penalties for violations include a prohibition on payment by these government programs and civil penalties of as much as $15,000 for each referral in violation of the statute and $100,000 for participation in a “circumvention scheme.”

EMPLOYEES

As of December 31, 2003, we had approximately 450 employees. Our workforce is not unionized. We have not experienced any strikes or work stoppages and our management considers our relationship with our employees to be good.

RISK FACTORS

You should carefully consider the following risk factors, in addition to the other information contained in this annual report. Investing in our common stock involves a high degree of risk and you may lose part or all of your investment in our shares. Please read the section on “Forward Looking Statements.”

We have a history of net losses and may not be profitable in the future.

We have had a history of net losses. For the year ended December 31, 2003, we incurred a net loss of approximately $2.5 million, which included approximately $7.7 million ($5.5 million after tax) in prepayment penalties and unamortized warrant and debt issuances costs associated with prepayment of our outstanding debt. For the year ended December 31, 2002 our net income was $6,000. Our net income for the year ended December 31, 2001 was $548,000, excluding a $3.7 million charge resulting from the issuance of 132,353 shares of our Series A Preferred Stock on June 12, 2001. We incurred a net loss of $3.2 million attributable to our common stock for the year ended December 31, 2001. We cannot assure you that we will not continue to incur net losses for the foreseeable future, which could cause our stock price to decline and adversely affect our ability to finance our business in the future. For additional information, you should read the discussion under “Item 7: Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

If we fail to compete successfully against our competitors, our sales and operating results may be negatively affected and we may not achieve future growth.

The markets for our products are highly competitive. The market for our Surgical Division products is dominated by a small number of large companies. In each of our other divisions, there are both large and small companies with which we compete. We may not be able to meet the prices offered by our competitors or offer products similar to or more desirable than those offered by our competitors. Many of our competitors have:

The factors set forth above may be material to our ability to develop and sell our products. Our failure to compete effectively in developing and selling our products would have an adverse effect on our results of operations.

Our future success requires the continued development or licensing of new products and the enhancement of existing products.

The market for orthopedic devices and related products is characterized by new product development and corresponding obsolescence of existing products. Our competitors may develop new medical procedures, technology or products that are more effective than our current technology or products or that render our technology or products obsolete or uncompetitive, which could have a material adverse effect on us. We may not be able to develop successful new products or enhance existing products, obtain regulatory clearances and approval of such products, market such products in a commercially viable manner or gain market acceptance for such products. The failure to develop or license and market new products and product enhancements could materially and adversely affect our competitive position, which could cause a significant decline in our sales and profitability.

We rely on independent sales agents and third-party distributors to market and sell most of our products. If we fail to establish new sales and distribution relationships or maintain our existing relationships, or if our independent sales agents and third-party distributors fail to commit sufficient resources or are otherwise ineffective in selling our products, our results of operations and future growth will be adversely impacted.

Our success depends largely upon marketing arrangements with our independent sales agents and distributors. These persons may terminate their relationships with us or devote insufficient sales efforts to our products. We do not control the efforts these persons make to sell our products. Our failure to attract and retain skilled independent sales agents and distributors would have an adverse effect on our results of operations.

We anticipate that a significant portion of the growth in our Surgical Division will require affiliating with additional sales agents. We will face significant challenges and risks in training, managing and retaining additional qualified sales and marketing agents. We may not be able to retain a sufficient number of additional qualified personnel to create increased demand for our products. If we are unable to grow effectively our sales and marketing team to sell our orthopedic devices and related products, our growth may be negatively affected.

Our quarterly operating results are subject to substantial fluctuations, and you should not rely on them as an indication of our future results.

Our quarterly operating results may vary significantly due to a combination of factors, many of which are beyond our control. These factors include:

Our quarterly sales and operating results have varied significantly in the past three years primarily as a result of our July 2001 acquisition of the assets which now comprise our Soft Goods Division and our acquisition of Chattanooga Group, Inc. in February 2002. We believe that quarterly sales and operating results may vary significantly in the future. Period-to-period comparisons of our results of operations are not necessarily meaningful and should not be relied upon as indications of future performance. We cannot assure you that our sales will increase or be sustained in future periods or that we will be profitable in any future period. Any shortfalls in sales or earnings in any given period from levels expected by securities or industry analysts could have an immediate and significant adverse effect on the trading price of our common stock, and any other of our securities which we may issue in the future.

If our designing and consulting surgeons do not continue their affiliation with us, we may be unable to develop, design and test new medical devices or enhance our existing medical devices.

We have existing designing and consulting arrangements with surgeons who are well recognized by other surgeons and orthopedic specialists. We have developed and maintain close relationships with these surgeons. These professionals often assist the Company by speaking about our products at medical seminars, assisting in the training of other professionals in the use and/or fitting of our products and providing us with feedback on the industry’s acceptance of our new products. If these arrangements terminate or are not renewed, our ability to develop, design and test new medical devices or enhancements to our existing medical devices, and our ability to operate successfully, could be materially and adversely affected. We cannot assure you that we will be successful in maintaining or renewing our designing and consulting arrangements with our current surgeons.

If surgeons do not recommend our surgical products, our sales may decline or we may be unable to increase our sales or generate profits.

An important factor in the overall demand for our surgical products is the recommendation by surgeons of these products to hospitals, patients and other surgeons. We may not obtain the necessary recommendations from surgeons. Acceptance of our surgical products depends on educating the medical community as to the distinctive characteristics, perceived benefits, clinical efficacy and cost-effectiveness of our surgical products compared to the products offered by our competitors and on training surgeons in the proper application of our surgical products.

If product liability lawsuits are brought against us and we do not have adequate insurance, our business may be harmed.

The manufacture and sale of medical devices exposes us to significant risk of product liability claims, lawsuits and product recalls. In the past, as well as currently, we have been and are the subject of a number of product liability claims and lawsuits relating to our products. In the future, we may be subject to additional product liability claims, which could be costly and divert attention of management. We currently maintain product liability insurance with coverage limits of $20 million per occurrence and an annual aggregate maximum of $20 million. Insurance is expensive, continues to increase in cost, and in the future may not be available on acceptable terms, if at all. Our existing product liability insurance coverage may be inadequate to protect us from any liabilities we might incur, and we are exposed to the risk that our claims may be excluded and that our insurers may become insolvent. If a product liability claim or series of claims is brought against us for uninsured liabilities or in excess of our insurance coverage, our business could suffer materially and cause our stock price to fall. In addition, as a result of a product liability claim, we may have to recall some of our products, which could result in significant costs to us and cause our stock price to fall.

Efforts to acquire other companies or product lines could adversely affect our operations and financial results.

While we have no commitments or agreements to acquire other companies or product lines, we may pursue acquisitions of other companies or additional product lines. Our ability to grow through acquisitions depends upon our ability to identify, negotiate, complete and integrate suitable acquisitions and to obtain any necessary financing, all of which can present difficulties. There can be no assurance that we will be able to identify and make acquisitions on acceptable terms or that we will be able to obtain financing for such acquisitions on acceptable terms. Even if we complete acquisitions, we may experience:

In addition, an acquisition could materially impair our operating results by causing us to incur debt or requiring us to amortize acquired assets. We cannot assure you that we will be able to identify and consummate any future acquisitions or that any acquisition we consummate will be successful.

We have succeeded to contingent obligations as a result of the Chattanooga Group acquisition and may have to use our cash to satisfy such obligations.

Chattanooga Group, Inc. is the subject of a Department of Commerce investigation of its export practices with respect to unlawfully trading with an embargoed country, and unlawfully preparing export documentation. The stock purchase agreement for the Chattanooga Group, Inc. provides that the former owners shall pay us out of escrowed proceeds from their sale of stock for reasonable expenses and fines we actually incur in defending the investigation where such reasonable expenses and fines are greater than the amount that was accrued on the financial statements of Chattanooga Group, Inc. as of the date we acquired the company. To the extent we incur monetary fines, costs, and legal expenses related to the Department of Commerce investigation the sellers from whom we purchased the capital stock of Chattanooga Group Inc have agreed to indemnify us and to pay all reasonable costs, expenses, settlements, and fines in excess of the $167,000, which as of December 31, 2003, was the remaining amount of what was accrued as a liability on Chattanooga Group Inc.’s financial statements as of the date of the acquisition up to a maximum of $5 million. With respect to the legal expenses, the sellers are only obligated to indemnify and reimburse us for the legal expenses of the law firm currently handling the investigation or any other law firm of their choice. If upon final determination or settlement of the Department of Commerce investigation we ultimately incur total expenses or fines in an amount less than the approximately $167,000 accrual, we shall owe the sellers the remainder of the accrual. When we acquired Chattanooga Group, Inc., $2.5 million of the sellers' sale proceeds were placed in escrow to satisfy the sellers' indemnity obligations to us, and currently in accordance with the terms of the purchase agreement $600,000 remains in escrow through February 8, 2005 for such purpose. Therefore, we will not be entitled to any such payment from escrowed proceeds until we have incurred additional expenses related to the investigation in an approximate amount of $167,000. When we acquired Chattanooga Group, Inc., proceeds of up to a maximum of $2.5 million from the former owners’ sale of stock to us were placed in escrow to satisfy their indemnity obligations to us. There currently remains approximately $600,000 in escrow for such purpose. We cannot assure you, however, that any fines or expenses incurred by the Chattanooga Group as a result of this investigation will be less than the amount placed in escrow by the former owners of Chattanooga Group, Inc. to satisfy their indemnity obligations to us, nor can we assure you that the remaining amounts in escrow will continue to be available as a possible source of indemnification. Furthermore, we do not appear to have the right to seek indemnification from the former owners of Chattanooga Group, Inc. for fines and expenses of the Department of Commerce investigation beyond fines and expenses paid from the escrowed proceeds.

Our debt agreements impose restrictions on us which may limit or prohibit us from engaging in certain transactions. If a default were to occur, our lenders could accelerate the amounts of debt outstanding, and holders of our secured indebtedness could force us to sell our assets to satisfy all or part of what is owed.

Covenants relating to our $25 million Bank of America senior credit facility and our $24 million senior subordinated notes credit facility (of which $5 million currently is outstanding as of December 31, 2003) held by CapitalSource Finance LLC restrict our ability to pay dividends, restrict our ability to engage in various operational matters, and require us to maintain specified financial ratios and satisfy specified financial tests. Our ability to meet these financial ratios and tests may be affected by events beyond our control. These covenants and restrictions could limit our ability to obtain future financing, make needed capital expenditures or other investments, repurchase our outstanding debt or equity, withstand a future downturn in our business or in the economy, dispose of operations, engage in strategic acquisitions or mergers or otherwise conduct necessary corporate activities. Various transactions that we may view as important opportunities, such as possible acquisitions, are also subject to the consent of lenders under the senior credit facility and under the senior subordinated notes which consent may be withheld or granted subject to conditions specified at the time that may affect the attractiveness or viability of the transaction.

We amended and restated our agreements with both of our lenders effective as of September 26, 2003 upon repayment of the original debt. These amendments improved our cost of borrowing and modified our financial covenants in a manner which generally increases the likelihood of our compliance. There can be no assurance that we will remain in compliance with these cash flow and other financial covenants or be able to obtain a waiver of default or amendments to our credit agreements in the future.

If a default under our Bank of America credit facility were to occur, the lenders under the credit facility could accelerate the amounts outstanding under the credit facility and our other lenders, principally CapitalSource Finance LLC as holder of the senior subordinated notes, could declare immediately due and payable all amounts borrowed under other instruments such as the senior subordinated notes that could contain certain provisions for cross-acceleration or cross-default. Similarly, a default under the senior subordinated notes could permit CapitalSource Finance LLC, as holder, to accelerate amounts outstanding and our lenders, principally the lenders under the Bank of America senior credit facility, could declare immediately due and payable all amounts borrowed under the Bank of America senior credit facility because of cross-acceleration and cross-default rights of those lenders. In addition, the lenders under these agreements could terminate their commitments to lend to us. If the lenders under these agreements accelerate the repayment of borrowings, we may not have sufficient liquid assets at that time to repay the amounts then outstanding under our indebtedness or be able to find additional alternative financing. Even if we could obtain additional alternative financing, the terms of the financing may not be favorable or acceptable to us.

The existing indebtedness under our senior credit facility and our senior subordinated notes is secured by substantially all of our assets. Should a default or acceleration of this indebtedness occur, the holders of this indebtedness could sell the assets to satisfy all or a part of what is owed. Our Bank of America senior credit facility also contains provisions prohibiting the modification of our outstanding senior subordinated notes held by CapitalSource Finance LLC, as well as limiting the ability to refinance these notes.

If we lose one of our key suppliers or one of our contract manufacturers stops making our products, we may be unable to meet customer orders for our products in a timely manner or within our budget.

We rely on a limited number of foreign and domestic suppliers for the raw materials and components used in our products. One or more of our suppliers may decide for reasons beyond our control to cease supplying us with raw materials and components. FDA regulations may require additional testing of any raw materials or components from new suppliers prior to our use of these materials or components and in the case of a device with a pre-market approval, we may be required to obtain prior FDA permission, either of which could delay or prevent our access or use of such raw materials or components. If we are unable to obtain materials we need from our suppliers and we cannot obtain these materials from other sources, we may be unable to manufacture our products for a period of time or within our manufacturing budget, which could negatively impact our results of operations.

The products sold by our Soft Goods Division are primarily manufactured by a company located in Acuna, Mexico, which provides the required labor to us on a contract basis. If our agreement with the Mexican company terminated and we were otherwise unable to find suitable contract labor, it could have a material adverse effect on our business, financial condition and results of operations.

Our Soft Goods Division’s reliance on our contract manufacturing facility in Mexico exposes us to related risks and uncertainties, including difficulties in staffing and managing international operations; controlling quality of manufacture; political, social, and economic instability; interruptions and limitations in telecommunication services; product and/or material transportation delays or disruption; trade restrictions and changes in tariffs; import and export license requirements and restrictions; fluctuations in currency exchange rates; and potential adverse tax consequences. If any of these risks materialize, our international manufacturing operations and results from our Soft Goods Division, as well as our operating results, may be harmed.

If we cannot retain our key personnel, many of whom have been with us for less than four years, we may not be able to manage and operate successfully and we may not be able to meet our strategic objectives.

Our continued success depends, in part, upon key managerial, scientific, sales and technical personnel, as well as our ability to continue to attract and retain additional highly qualified personnel. We compete for such personnel with other companies, academic institutions, government entities and other organizations. We cannot assure you that we will be successful in retaining our current personnel or in hiring or retaining qualified personnel in the future.

Many of our existing management personnel have been employed by us for four years or less, including Kenneth W. Davidson, our Chief Executive Officer, who joined us in October 2000, Paul Chapman, our President and Chief Operating Officer, who joined us when we acquired Chattanooga Group, Inc. in February 2002 and became our President on May 20, 2003, Jack Cahill, our Executive Vice President, President-Surgical Division, who joined us in January 2001, and Scott Klosterman, our Executive Vice President, President-Chattanooga Group who joined us in February 2002. These executives have substantial experience and expertise in our business. Our future success depends to a significant extent on the ability of our executive officers and other members of our management team to operate effectively, both individually and as a group. We cannot be certain that we will be able to efficiently allocate responsibilities or that the new members of our executive team will succeed in their roles.

Issuances of our securities are subject to federal and state securities laws, and certain holders of common stock issued by us in prior offerings may be entitled to rescind their purchases.

From January 1997 through June 2003, certain participants in our 401(k) Profit Sharing Plan purchased shares of our common stock for inclusion in their respective 401(k) plan accounts. By failing to register properly our 401(k) plan or the shares purchased thereunder, we may not have complied with various requirements of applicable federal securities laws. In such situations a number of remedies may be available to regulatory authorities and the participants for whose accounts the trustee of the 401(k) plan purchased shares of our common stock, including, without limitation, a right of rescission, civil penalties, a restraining order or injunction, and a court order to pay restitution and costs. As a result, we agreed with the underwriters of our public offering which closed August 11, 2003, that in the event that the daily per share closing price of our common stock (as quoted on the Nasdaq National Market or any national securities exchange on which shares of our common stock are listed or admitted for trading) falls below $4.00 at any time on or prior to May 31, 2004 we would commence a rescission offer with respect to shares of our common stock sold to participants under our 401(k) plan within the time period covered by the rescission offer.

Substantially all of the shares that were purchased by 401(k) plan participants within the time period which would be covered by the rescission offer were purchased at a price of less than $4.00 per share. Even assuming the closing price of our stock were to decline to $3.70 per share prior to May 31, 2004 (thus triggering our obligation to make the rescission offer), we would be required to make an aggregate payment of less than $5,000, and the resulting recorded charge to our earnings would be less than $500, if all offerees whose shares were purchased for their 401(k) plan account at a price in excess of $3.70 per share (approximately 1,200 shares) were to accept the offer. If, at the time we are required to conduct the rescission offer, and the closing price of our common stock were to be less than $3.70 per share, the amount we would be required to pay and the corresponding charge to our earnings would increase.

As of the date hereof, no claims for rescission have been made against us. We cannot assure you, however, that we will not otherwise be subject to possible claims, litigation, penalties or fines relating to such sales. Any claims, litigation, penalties or fines which could be asserted against us relating to these sales could have a material adverse effect on our liquidity and results of operations.

We derive a portion of our sales from operations in international markets, which may be subject to political, economic and social instability.

Approximately 13% of our sales for the year ended December 31, 2003 was derived from our international operations. One component of our growth strategy is to expand our international sales efforts. However, to the extent we are successful in expanding our international sales and operations, this will increasingly expose us to risks inherent in operating in foreign jurisdictions, including:

If our patents and other intellectual property rights do not adequately protect our products, we may lose market share to our competitors and be unable to operate our business profitably.

We rely on a combination of patents, trade secrets, copyrights, trademarks, license agreements and contractual provisions to establish and protect our intellectual property rights in our products and the processes for the development, manufacture and marketing of our products. These legal means, however, afford only limited protection and may not adequately protect our rights. In addition, we cannot assure you that any of our pending patent or trademark applications will issue. The U.S. Patent and Trademark Office may deny or require significant narrowing of claims in our pending patent applications, and patents issuing from the pending patent applications, if any, may not provide us with significant commercial protection. We could incur substantial costs in proceedings before the U.S. Patent and Trademark Office. These proceedings could result in adverse decisions as to the priority of our inventions and the narrowing or invalidation of claims in issued patents. In addition, the laws of some of the countries in which our products are or may be sold may not protect our products and intellectual property to the same extent as U.S. laws, if at all. We may be unable to protect our rights in trade secrets and unpatented proprietary technology in these countries.

In addition, we hold patent and other intellectual property licenses from third parties for some of our products and on technologies that are necessary in the designing and manufacturing of some of our products. The loss of such licenses would prevent us from manufacturing, marketing and selling these products, which could harm our business.

Other parties may have filed applications for or been issued patents and in the future may obtain additional patents and intellectual property rights related to products that compete with or are similar to our products. We may not be aware of all patents potentially adverse to our interests that may have been issued to others, and there can be no assurance that such patents do not exist or have not been filed or issued. If patents have been or are issued to others containing preclusive or conflicting claims and such claims are ultimately determined to be valid, we may be required to obtain licenses thereto or to develop or acquire alternate technology, which would have a material adverse affect on us.

There can be no assurance that the validity of any of the patents or other intellectual property owned by or licensed to us would be upheld if challenged by others in litigation or that our products, even if covered by our patents or other intellectual property, would not infringe patents owned by others.

We seek to protect our trade secrets, know-how and other unpatented proprietary technology, in part, with confidentiality agreements and invention assignment with our employees, our designing and consulting surgeons and our other consultants. Our agreements with independent sales agents and distributors also contain confidentiality agreements. We cannot assure you, however, that:

Also, our competitors may allege that our products infringe their patents leading to voluntary or involuntary loss of sales from those products. In addition, the cost to prosecute infringements of our patents or the cost to defend our products against patent infringement actions by others could be substantial.

If we lose any future intellectual property lawsuits, a court could require us to pay significant damages or prevent us from selling our products.

Litigation involving patents and other intellectual property rights is common in the orthopedic industry, and companies in this industry have used intellectual property litigation in an attempt to gain a competitive advantage. In the future, we may become a party to lawsuits involving patents or other intellectual property. If we lose one of these proceedings, a court, or a similar foreign governing body, could require us to pay significant damages to third parties, require us to seek licenses from third parties and pay ongoing royalties, require us to redesign our products, or prevent us from manufacturing, using or selling our products. In addition to being costly, protracted litigation to defend or prosecute our intellectual property rights could seriously detract from the time our management would otherwise devote to running our business. Intellectual property litigation relating to our products could cause our customers or potential customers to defer or limit their purchase or use of the affected products until resolution of the litigation.

We may be liable for contamination or other harm caused by hazardous materials that we use.

Our research and development and manufacturing processes involve the use of hazardous materials. We are subject to federal, state and local regulation governing the use, manufacture, handling, storage and disposal of hazardous materials. We cannot completely eliminate the risk of contamination or injury resulting from hazardous materials, and we may incur liability as a result of any contamination or injury. In addition, under some environmental laws and regulations, we could also be held responsible for all of the costs relating to any contamination at our past or present facilities and at third-party waste disposal sites. We may incur significant expenses in the future relating to any failure to comply with environmental laws. Any such future expenses or liability could have a significant negative impact on our financial condition.

If a natural or man-made disaster strikes our manufacturing facilities, we may be unable to manufacture our products for a substantial amount of time, which could cause our sales to decline.

We principally rely on our manufacturing facilities in Austin, Texas and Chattanooga, Tennessee, as well as a contract manufacturer located in Acuna, Mexico. These facilities and the manufacturing equipment we use to produce our products would be difficult to replace and could require substantial lead-time to repair or replace. Our facilities may be affected by natural or man-made disasters. In the event one of our facilities was affected by a disaster, we would be forced to rely on third-party manufacturers or shift production to our other manufacturing facilities. We currently carry insurance to protect us against disasters. However, such insurance may not be sufficient to cover all of our potential losses or may become unavailable on acceptable terms, if available at all.

To remain competitive we may have to move more of our manufacturing operations to foreign countries.

We currently have no manufacturing operations in any foreign country other than Mexico. The cost of transporting some of our products to foreign countries is currently borne by our customers, who are usually required to pay foreign import duties on the products. As a result, the cost of these products to customers who use or distribute them outside the United States is often greater than the cost of products manufactured in that country. In addition, foreign manufacturers of competitive products often receive various local tax concessions, which lower their overall manufacturing costs. In order to compete successfully in the event we are successful in expanding our international sales and operations, we may be required to open or acquire manufacturing operations abroad, which would be costly to implement and would increase our exposure to the risks of doing business in international countries. If we were to do this, we may not be able to operate successfully our foreign manufacturing operations, which could have a material adverse effect on our international operations and on our overall business, financial condition, results of operations and future prospects.

Our business plan relies on certain assumptions about the market for our products, which, if incorrect, may adversely affect our profitability.

Our ability to achieve our business objectives is subject to a variety of factors, many of which are beyond our control. For example, we believe that the relative increase in the aging of the general population and increasingly active lifestyles will continue and that these trends will increase the need for our orthopedic implant products. The projected demand for our products could materially differ from actual demand if our assumptions regarding these trends and acceptance of our products by the medical community prove to be incorrect or do not materialize or if non-surgical treatments gain more widespread acceptance as a viable alternative to orthopedic implants.

We are subject to substantial government regulation that could have a material adverse effect on our business.

Government regulation in the United States and other countries is a significant factor affecting the research, development, manufacture and marketing of our products. In the United States, the FDA has broad authority to regulate the development, manufacture, marketing and sale of medical devices. Overseas, these activities are subject to foreign governmental regulation, which is in many respects similar to regulation in the United States but which vary from country to country. U.S. and foreign regulation continues to evolve, which could result in additional burdens on our operations. Failure to comply with applicable regulations can, among other things, result in fines, suspension or withdrawal of regulatory approvals, product recalls, operating restrictions, and criminal prosecution. Additionally, the cost of maintaining personnel and systems necessary to comply with applicable regulations is substantial.

Many of our products required or will require regulatory approval prior to being marketed. The process of obtaining these approvals can be lengthy and expensive. We may not be able to obtain or maintain necessary approvals for testing or marketing our products. Moreover, regulatory approvals, if granted, may include significant limitations on the indicated uses for which our products may be marketed or other restrictions or requirements that reduce the value to us of the products. Regulatory authorities may also withdraw product approvals if we fail to comply with regulatory standards or if any problems related to our products develop following initial marketing. We are also subject to strict regulation with respect to our manufacturing operations. This regulation includes testing, control and documentation requirements, and compliance with the current good manufacturing practice is monitored through inspections by regulatory authorities. Delays in the receipt of, or failure to receive necessary approvals, the loss of previously obtained approvals, or failure to comply with existing or future regulatory requirements could have a significant negative effect on our financial condition and results of operations.

Certain federal laws regarding Medicare, Medicaid and physician self-referrals are far-reaching and we may be required to alter one or more of our practices to be in compliance with these laws. Health care fraud and abuse regulations are complex and even minor, inadvertent irregularities in submissions can potentially give rise to claims that the statute has been violated. Any violations of these laws could result in a material adverse effect on our business, financial condition and results of operations. If there is a change in law, regulation or administrative or judicial interpretations, we may have to change our business practices or our existing business practices could be challenged as unlawful, which could have a material adverse effect on our business, financial condition and results of operations.

Modifications to our marketed devices may require FDA regulatory clearances or approvals and may require us to cease marketing or recall the modified devices until such clearances or approvals are obtained.

When required, the products we market in the United States have obtained pre-market notification under Section 510(k) of the Federal Food Drug & Cosmetics Act or were exempt from the 510(k) Pre-market Notification process. We have modified some of our products and product labeling since obtaining 510(k) clearance, but we do not believe these modifications require us to submit new 510(k) Pre-market Notifications. However, if the FDA disagrees with us and requires us to submit a new 510(k) Pre-market Notification for modifications to our existing products, we may be the subject of enforcement actions by the FDA and be required to stop marketing the products while the FDA reviews the 510(k) Pre-market Notification. If the FDA requires us to go through a lengthier, more rigorous examination than we expect, our product introductions or modifications could be delayed or canceled, which could cause our sales to decline. In addition, the FDA may determine that future products will require the more costly, lengthy and uncertain Pre-market Approval(PMA), process. Products that are approved through the PMA process generally need FDA approval before they may be modified.

Our products may be subject to product recalls even after receiving clearance or approval, which would harm our reputation and our business.

The FDA and foreign regulatory authorities have the authority to request and, in some cases, require the recall of products in the event of material deficiencies, design defects or manufacturing defects. A government mandated or voluntary recall by us could occur as a result of component failures, manufacturing errors, design defects, or any other incidents related to our medical devices, including, but not limited to, adverse event recalls, cease and desist communications and any other product liability issues related to our medical devices. Any product recall would divert managerial and financial resources and harm our reputation with customers and our business.

If adequate levels of reimbursement from third-party payors for our products are not obtained, surgeons and patients may be reluctant to use our products, and our sales may decline.

Our sales depend largely on government health care programs such as Medicare and Medicaid and private health insurers reimbursing patients’ medical expenses. Surgeons, hospitals and other health care providers may not purchase our products if they do not receive satisfactory reimbursement from these third-party payors for the cost of the procedures using our products. Consequently, we may be unable to sell our products on a profitable basis if third-party payors deny coverage or reduce their current levels of reimbursement.

Payors continue to review their coverage policies carefully for existing and new therapies and can, without notice, deny coverage for treatments that include the use of our products. Health care providers may attempt to control costs by (i) authorizing fewer elective surgical procedures, including joint reconstructive surgeries, (ii) by requiring the use of the least expensive implant available, or (iii) reducing the reimbursement for or limiting the number of authorized visits for rehabilitation procedures.

Outside of the United States, reimbursement systems vary significantly by country. Many foreign markets have government-managed health care systems that govern reimbursement for new devices and procedures. Canada and some European countries, in particular France, have tightened reimbursement rates. If adequate levels of reimbursement from third-party payors outside of the United States are not obtained, international sales of our products may decline.

If a significant number of shares of our common stock are sold into the market, the market price of our common stock could significantly decline, even if our business is doing well.

Our stockholders may sell their common stock, and our employees, directors, officers, sales representatives and distributors may exercise their stock options in order to sell the common stock underlying their options in the market under a registration statement we have filed with the Securities and Exchange Commission. Sales of a substantial number of shares of our common stock in the public market or the perception that such sales may occur could depress the market price of our common stock and impair our ability to raise additional capital through the sale of our equity securities. As of December 31, 2003, Galen Partners beneficially owned approximately 23.6% of our outstanding shares of common stock. Officers, directors and our principal stockholders owning an aggregate of approximately 14,942,404 shares of our common stock have agreed that they will not, without the prior written consent of the underwriters in our public offering, directly or indirectly sell any of these restricted shares, or any of the 1,306,641 shares of our common stock that we may issue upon the exercise of outstanding options or warrants held by such officers, directors, and principal stockholders, for 180 days after the closing of our public offering of common stock on December 17, 2003.

Our certificate of incorporation, our bylaws and Delaware law contain provisions that could discourage, delay, or prevent a takeover attempt.

Provisions of our certificate of incorporation, our bylaws and Delaware law may discourage, delay or prevent another company from merging with us or from acquiring us, even if our stockholders were to consider such merger or acquisition to be favorable.

ITEM 2. PROPERTIES

 We own two pieces of real property in Chattanooga, Tennessee. These include a 160,000 square foot facility which houses the headquarters and principal manufacturing operations of the Chattanooga Group Division, as well as a 60,000 square foot building that houses additional manufacturing operations for the Chattanooga Group Division. We lease an approximately 70,000 square foot facility in Austin, Texas for our corporate headquarters, manufacturing facilities and warehouse for our Surgical Division and Soft Goods Division business operations.

The lease term, which commenced on April 1, 1997, is for a period of ten years, and we have an option to renew the lease for an additional term of five years. Our monthly lease payments are approximately $41,000 for an annual lease payment of approximately $492,000, exclusive of our share of applicable common area maintenance, property taxes and public utility charges, which collectively are approximately $10,000 per month.

ITEM 3. LEGAL PROCEEDINGS

From time to time, we are plaintiffs or defendants in various litigation matters in the ordinary course of business, some of which involve claims for damages that are substantial in amount. We believe that the disposition of claims currently pending will not have a material adverse effect on our financial position or results of operations. With respect to the matters discussed below, although we are currently unable to predict the outcome, we do not believe the disposition of these matters will have a material adverse effect on our financial position or results of operations.

Akthea S.A.R.L. Matter

In the fall of 2001, we began a number of legal proceedings against Akthea S.A.R.L. (“Akthea”), our former Surgical Division product distributor in France. The nature of the claims revolve around monies that were not paid to us by Akthea in connection with the distribution agreement and lease agreement that were entered into by the parties. We filed a complaint in the United States District Court in Texas related to the lease agreement issues. We also filed a request for arbitration with the International Chamber of Commerce Court of Arbitration in Paris related to the distribution agreement issues. On February 25, 2002, we were awarded a default judgment against Akthea in the United States District Court in the amount of $377,000. With respect to the distribution agreement issues, our request for arbitration sought monies owed under the distribution agreement and an injunction prohibiting Akthea from initiating additional actions similar to those described in the paragraph below. The arbitration panel issued a preliminary ruling granting us damages for Akthea’s breach of the payment provisions of the distribution agreement. On July 21, 2003, the arbitration panel issued its final ruling granting our claim for other costs as well as injunctive relief.

While Akthea interposed no counterclaims in the actions described in the preceding paragraph, in 2002, Akthea initiated two civil proceedings in Nanterre, France against us and others. The two civil cases have been stayed in favor of the arbitration already commenced between the parties, and we have been awarded costs in obtaining these stays. Akthea has appealed the imposition of the stays of the two French civil cases, which appeal has been denied. Additionally, Akthea requested that the responsible French regulatory authority institute criminal proceedings against us based on Akthea’s claims that our implant products are combined with other products and such combination does not comply with the French public health codes. The French authorities declined to act on Akthea’s request to pursue a criminal investigation.

Department of Commerce Investigation of Chattanooga Group, Inc.

We are the subject of a Department of Commerce investigation of Chattanooga Group, Inc.‘s export practices with respect to unlawfully trading with an embargoed country, and unlawfully preparing export documentation. The Department of Commerce investigation commenced prior to our February 2002 acquisition of Chattanooga Group, Inc. To the extent we incur monetary fines, costs and legal expenses related to the Department of Commerce investigation, the sellers from whom we purchased the capital stock of Chattanooga Group, Inc. have agreed to indemnify us and to pay all reasonable costs, expenses, settlements and fines in excess of the $167,000, which, as of December 31, 2003, was the remaining amount of what was accrued as a liability on Chattanooga Group Inc.‘s financial statements as of the date of the acquisition up to a maximum of $5.0 million. With respect to the legal expenses, the sellers are only obligated to indemnify and reimburse us for the legal expenses of the law firm currently handling the investigation or any other law firm of their choice. If upon final determination or settlement of the Department of Commerce investigation we ultimately incur total expenses or fines in an amount less than the approximately $167,000 accrual, we shall owe the sellers the remainder of the accrual. When we acquired Chattanooga Group, Inc., $2.5 million of the sellers’ sale proceeds were placed in escrow to satisfy the sellers’ indemnity obligations to us, and currently in accordance with the terms of the purchase agreement $600,000 remains in escrow through February 8, 2005 for such purpose. In addition, we, as a successor in interest to Chattanooga Group, Inc., and our officers and employees might be subject to any criminal charges which could be commenced as a result of this investigation. The Department of Commerce also may revoke our export licenses or otherwise restrict our ability to export our products.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

On December 4, 2003, a special meeting of our stockholders was held to vote on two proposals. The first proposal was to amend our certificate of incorporation to increase the number of authorized shares of our common stock. A total number of 32,844,952 votes were cast for this proposal, 1,248,090 votes were cast against this proposal, and no votes were withheld. There were 6,733 abstentions and no broker non-votes with regard to this proposal. The second proposal was to amend our 1997 Distributor Advisory Panel Stock Option Plan to increase the number of shares of our common stock authorized for issuance under such plan. A total of 26,857,006 votes were cast for this proposal, 2,666,000 votes were cast against this proposal, and no votes were withheld. There were 22,401 abstentions and 4,554,368 broker non-votes with regard to this proposal.