UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-Q

 

(Mark one)
ý		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934
		FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 25, 2004
		OR
o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934

 

FOR THE TRANSITION PERIOD FROM            TO            .

 

Commission File Number 001-16757

 

DJ ORTHOPEDICS, INC.

(Exact name of registrant as specified in its charter)

 

DELAWARE		33-0978270
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification Number)
2985 Scott Street
Vista, California		92081
(Address of principal executive offices)		(Zip Code)
Registrant’s telephone number, including area code: (760) 727-1280

 

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 ý  No o

 

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

 

Yes ý  No o

 

The number of shares of the registrant’s Common Stock outstanding at October 27, 2004 was 21,457,190 shares.

 

 

DJ ORTHOPEDICS, INC.

FORM 10-Q INDEX

 

EXPLANATORY NOTE
PART I.	FINANCIAL INFORMATION
Item 1.	Financial Statements
	Unaudited Consolidated Balance Sheets as of September 25, 2004 and December 31, 2003
	Unaudited Condensed Consolidated Statements of Income for the three and nine months ended September 25, 2004 and September 27, 2003
	Unaudited Condensed Consolidated Statements of Cash Flows for the nine months ended September 25, 2004 and September 27, 2003
	Notes to Unaudited Condensed Consolidated Financial Statements
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3.	Quantitative and Qualitative Disclosures About Market Risk
Item 4.	Controls and Procedures
PART II.	OTHER INFORMATION
Item 1.	Legal Proceedings
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds
Item 3.	Defaults upon Senior Securities
Item 4.	Submission of Matters to a Vote of Security Holders
Item 5.	Other Information
Item 6.	Exhibits
SIGNATURES

 

EXPLANATORY NOTE

 

Unless the context requires otherwise, in this Form 10-Q the terms “we,” “us” and “our” refer to dj Orthopedics, Inc., our wholly-owned operating subsidiary dj Orthopedics, LLC and our other wholly-owned and indirect subsidiaries.  In November 2003, we acquired the bone growth stimulation device business of OrthoLogic Corp. We refer to this business as Regentek and the acquisition as the Regentek acquisition.  In this Form 10-Q, pro forma data for the three and nine months ended September 27, 2003 give effect to the Regentek acquisition as if it had occurred on January 1, 2003.

 

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PART I. FINANCIAL INFORMATION

 

ITEM 1. FINANCIAL STATEMENTS

 

DJ ORTHOPEDICS, INC.

UNAUDITED CONSOLIDATED BALANCE SHEETS

(In thousands, except share and per share data)

 

		September 25, 2004			December 31, 2003
Assets
Current assets:
Cash and cash equivalents		$	22,907		$	19,146
Accounts receivable, net of provisions for contractual allowances and doubtful accounts of $24,819 and $20,717 at September 25, 2004 and December 31, 2003, respectively		46,090			43,876
Inventories, net		17,889			15,534
Deferred tax asset, current portion		11,284			11,283
Other current assets		4,492			6,342
Total current assets		102,662			96,181
Property, plant and equipment, net		15,751			15,556
Goodwill		96,428			96,552
Intangible assets, net		56,772			59,045
Debt issuance costs, net		2,504			5,042
Deferred tax asset		42,586			47,509
Other assets		567			619
Total assets		$	317,270		$	320,504
Liabilities and stockholders’ equity
Current liabilities:
Accounts payable		$	8,958		$	8,325
Accrued compensation		7,024			6,646
Accrued commissions		3,810			4,629
Long-term debt, current portion		5,000			5,000
Accrued interest		760			734
Accrued restructuring costs		2,257			766
Other accrued liabilities		10,122			7,915
Total current liabilities		37,931			34,015
12 5/8% senior subordinated notes		—			74,156
Long-term debt, less current portion		92,500			95,000
Commitments and contingencies
Stockholders’ equity:
Preferred stock, $0.01 par value; 1,000,000 shares authorized, none issued and outstanding at September 25, 2004 and December 31, 2003		—			—
Common stock, $0.01 par value; 39,000,000 shares authorized, 22,113,034 shares and 18,304,269 shares issued and outstanding at September 25, 2004 and December 31, 2003, respectively		221			183
Additional paid-in-capital		130,371			69,545
Notes receivable from employees for stock purchases		(1,749		)	(1,988		)
Accumulated other comprehensive income		785			1,106
Retained earnings		57,211			48,487
Total stockholders’ equity		186,839			117,333
Total liabilities and stockholders’ equity		$	317,270		$	320,504

 

See accompanying Notes.

 

3

 

DJ ORTHOPEDICS, INC.

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(In thousands, except per share data)

 

		Three Months Ended								Nine Months Ended
		September 25, 2004				September 27, 2003				September 25, 2004				September 27, 2003
Net revenues		$	62,471			$	48,850			$	187,898			$	143,324
Costs of goods sold		23,033				20,648				69,345				63,163
Gross profit		39,438				28,202				118,553				80,161
Operating expenses:
Sales and marketing		19,092				14,039				58,056				39,108
General and administrative		7,114				4,236				20,662				16,271
Research and development		1,307				1,139				4,087				3,133
Amortization of acquired intangibles		1,152				—				3,577				—
Restructuring costs		2,085				(497			)	2,085				(497		)
Total operating expenses		30,750				18,917				88,467				58,015
Income from operations		8,688				9,285				30,086				22,146
Interest expense, net of interest income		(1,129			)	(2,972			)	(7,777			)	(9,129		)
Prepayment premium and other costs related to senior subordinated notes redemption		—				—				(7,760			)	—
Other income (expense)		221				(242			)	(28			)	305
Income before income taxes		7,780				6,071				14,521				13,322
Provision for income taxes		(3,112			)	(2,429			)	(5,806			)	(5,332		)
Net income		$		4,668		$		3,642		$		8,715		$	7,990
Net income per share:
Basic		$		0.21		$		0.20		$		0.41		$	0.45
Diluted		$		0.20		$		0.19		$		0.39		$	0.43
Weighted average shares outstanding used to calculate per share information:
Basic		21,962				17,945				21,108				17,916
Diluted		23,114				18,898				22,323				18,408

 

See accompanying Notes.

 

4

 

DJ ORTHOPEDICS, INC.

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

 

		Nine Months Ended
		September 25, 2004			September 27, 2003
Operating activities
Net income		$	8,715		$	7,990
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for contractual allowances and doubtful accounts		22,312			16,379
Provision (credit) for excess and obsolete inventories		(165		)	2,200
Provision (credit) for restructuring costs		2,085			(497		)
Depreciation and amortization		9,581			5,683
Step-up to fair value of inventory charged to costs of goods sold		438			—
Amortization of debt issuance costs and discount on senior subordinated notes		678			1,306
Write-off of debt issuance costs and discount on senior subordinated notes		3,025			—
Liquidation preference on redemption of senior subordinated notes		4,735			—
Changes in current and deferred tax asset, net		4,923			4,592
Changes in operating assets and liabilities, net		(23,321		)	(21,446		)
Net cash provided by operating activities		33,006			16,207
Investing activities
Purchases of property, plant and equipment		(4,580		)	(3,699		)
Purchases of intangible assets		(3,277		)	(3,000		)
Purchases of businesses, net of cash acquired		122			(2,502		)
Purchase of short-term investments		(18,509		)	—
Sale of short-term investments		18,509			—
Changes in other assets, net		67			(266		)
Net cash used in investing activities		(7,668		)	(9,467		)
Financing activities
Repayment of senior subordinated notes		(75,000		)	—
Liquidation preference on redemption of senior subordinated notes		(4,735		)	—
Repayment of long-term debt		(2,500		)	(20,284		)
Debt issuance costs		(313		)	—
Net proceeds from issuance of common stock		60,755			328
Proceeds from repayment of notes receivable issued in connection with sale of common stock		331			—
Net cash used in financing activities		(21,462		)	(19,956		)
Effect of exchange rate changes on cash and cash equivalents		(115		)	(173		)
Net increase (decrease) in cash and cash equivalents		3,761			(13,389		)
Cash and cash equivalents at beginning of period		19,146			32,085
Cash and cash equivalents at end of period		$	22,907		$	18,696
Supplemental disclosure of cash flow information
Interest paid		$	2,690		$	5,525
Income taxes paid		$	423		$	226

 

See accompanying Notes.

 

5

 

DJ ORTHOPEDICS, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(In thousands, except share and per share data)

 

1.  General

 

Business and Organization

 

dj Orthopedics, Inc. (dj Orthopedics), through its subsidiary dj Orthopedics, LLC (dj Ortho) and dj Ortho’s subsidiaries (collectively, the Company) is a global medical device company specializing in rehabilitation and regeneration products for the non-operative orthopedic and spine markets.

 

Basis of Presentation

 

The accompanying unaudited condensed consolidated financial statements as of September 25, 2004 and for the three and nine months ended September 25, 2004 and September 27, 2003 have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information. Accordingly, they do not include all of the information and disclosures required by accounting principles generally accepted in the United States for complete financial statements. These consolidated financial statements should be read in conjunction with the audited consolidated financial statements of dj Orthopedics and the notes thereto included in dj Orthopedics’ Annual Report on Form 10-K for the year ended December 31, 2003. The accompanying unaudited condensed consolidated financial statements as of September 25, 2004 and for the three and nine months ended September 25, 2004 and September 27, 2003 have been prepared on the same basis as the audited consolidated financial statements and include all adjustments (consisting of normal recurring accruals and the adjustments described in Note 4) which, in the opinion of management, are necessary for a fair presentation of the financial position, operating results and cash flows for the interim date and interim periods presented. Results for the interim period ended September 25, 2004 are not necessarily indicative of the results to be achieved for the entire year or future periods.

 

The accompanying unaudited condensed consolidated financial statements present the historical financial position and results of operations of dj Orthopedics and include the accounts of dj Ortho, the accounts of dj Ortho’s wholly-owned subsidiaries, dj Orthopedics Development Corporation (dj Development) and DJ Orthopedics Capital Corporation (dj Capital), as well as the accounts of dj Ortho’s wholly-owned Mexican subsidiary that manufactures a majority of dj Ortho’s products under Mexico’s maquiladora program and the accounts of dj Ortho’s wholly-owned subsidiaries in Canada, Germany, France, the United Kingdom and Denmark (established September 2004).  All intercompany accounts and transactions have been eliminated in consolidation.

 

The preparation of these financial statements requires that the Company make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosure of contingent assets and liabilities. On an ongoing basis, the Company evaluates its estimates, including those related to contractual allowances, doubtful accounts, inventories, rebates, product returns, warranty obligations, income taxes, intangibles and investments.  The Company bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources.  Actual results may differ from these estimates.

 

The Company’s fiscal year ends on December 31. Each quarter consists of one five-week and two four-week periods.

 

Acquisitions and Purchases of Intangible Assets

 

In September 2004, the Company acquired the outstanding stock of KD Innovation A/S (KDI), its independent distributor in Denmark. The acquired company, renamed dj Orthopedics Nordic ApS, has direct responsibility for sales, marketing and distribution of dj Orthopedics’ products in Denmark, Finland, Norway and Sweden.  The stock purchase agreement provided for the purchase of all of the outstanding capital stock for KDI for an initial cash purchase price of $0.7 million, paid in October 2004, plus amounts aggregating up to an additional $0.5 million through 2006 if certain net operating income targets are met.  The acquisition was accounted for using the purchase method of accounting whereby a total purchase price of approximately $1.0 million, including the portion of the contingent future payments that are deemed by management to be probable, was allocated to tangible and intangible assets acquired and liabilities assumed based on their estimated fair market values as of the acquisition date. The assets acquired included cash of approximately $0.1.

 

6

 

During the three months ended September 25, 2004, the Company purchased rights to certain distributor territories, for amounts aggregating $1.5 million, in connection with a reorganization of the distribution activities within such territories.  The reorganization is intended to achieve several objectives, including improvement of sales results within the affected territories and also reduces the Company’s distribution costs within such territories for a defined period of time.  The purchase price for each transaction was capitalized as an intangible asset and will be amortized over the period of cost reduction.

 

During the three months ended September 25, 2004, the Company also acquired a patent license for $0.8 million. This amount was recorded as an intangible asset and will be amortized over the remaining life of the patent, through June 2010.

 

In November 2003, the Company acquired the bone growth stimulation device business from OrthoLogic Corp., which now operates as the Company’s Regentek™ division, for approximately $93.0 million in cash plus certain assumed liabilities aggregating approximately $0.9 million and transaction costs amounting to approximately $0.9 million at closing. The Regentek acquisition was accounted for using the purchase method of accounting whereby the total purchase price was allocated to tangible and intangible assets acquired and liabilities assumed based on their estimated fair market values as of the acquisition date.  Pro forma data in this report gives effect to the Regentek acquisition as if it had occurred on January 1, 2003.

 

Issuances of Common Stock

 

In February 2004, the Company completed a public offering of 8,625,000 shares of its common stock.  The offering consisted of 3,162,500 shares of common stock sold by the Company at $19.00 per share for net proceeds, after underwriters’ commissions and other costs, of $56.4 million and 5,462,500 shares sold by certain of the Company’s stockholders.

 

In June 2004, the Company completed a public offering of 3,072,379 shares of its common stock.  All of these shares were sold by certain of the Company’s stockholders and the Company did not receive any of the net proceeds.  The Company incurred costs of $275,000 related to this offering, which were recorded as a reduction in the Company’s additional paid-in capital.

 

During the nine months ended September 25, 2004, the Company issued 413,170 common shares as a result of stock option exercises at an average exercise price of $8.56 per share.  Additionally, during this period, the Company issued 233,095 shares of common stock for purchases under the Company’s Employee Stock Purchase Plan at an average purchase price of $4.54 per share.

 

Per Share Information

 

Earnings per share are computed in accordance with the Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards (SFAS) No. 128, Earnings Per Share. Basic earnings per share are computed using the weighted average number of common shares outstanding during each period. Diluted earnings per share include the dilutive effect of weighted average common share equivalents potentially issuable upon the exercise of stock options. For purposes of computing diluted earnings per share, weighted average common share equivalents (computed using the treasury stock method) do not include stock options with an exercise price that exceeds the average fair market value of the Company’s common stock during the periods presented. The weighted average shares outstanding used to calculate basic and diluted share information consist of the following (in thousands):

 

		Three months ended				Nine months ended
		September 25, 2004		September 27, 2003		September 25, 2004		September 27, 2003
Shares used in computations of basic net income per share – weighted average shares outstanding		21,962		17,945		21,108		17,916
Net effect of dilutive common share equivalents based on treasury stock method		1,152		953		1,215		492
Shares used in computations of diluted net income per share		23,114		18,898		22,323		18,408

 

Stock-Based Compensation

 

The Company accounts for its employee stock option plans and employee stock purchase plan using the recognition and measurement principles of Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees and its related interpretations, and has adopted the disclosure only provisions of SFAS No. 123, Accounting for Stock-Based Compensation and its related interpretations. Accordingly, no compensation expense has been recognized for the Company’s fixed stock option plans or its employee stock purchase plan. The following table illustrates the effect on net income and earnings per share as if the Company

 

7

 

had applied the fair value recognition provisions of SFAS No. 123, using the Black-Scholes method, to stock-based employee compensation (in thousands, except per share amounts):

 

		Three months ended						Nine months ended
		September 25, 2004			September 27, 2003			September 25, 2004			September 27, 2003
Net income, as reported		$	4,668		$	3,642		$	8,715		$	7,990
Total stock-based employee compensation expense determined under fair value method for all option plans and stock purchase plan, net of related tax effects		(1,414		)	(397		)	(4,002		)	(1,228		)
Pro forma net income		$	3,254		$	3,245		$	4,713		$	6,762
Basic net income per share:
As reported		$	0.22		$	0.20		$	0.42		$	0.45
Pro forma		$	0.15		$	0.18		$	0.23		$	0.38
Diluted net income per share:
As reported		$	0.21		$	0.19		$	0.40		$	0.43
Pro forma		$	0.14		$	0.17		$	0.21		$	0.37

 

Foreign Currency Translation

 

The financial statements of the Company’s international operations for which the local currency is the functional currency are translated into U.S. dollars using period-end exchange rates for assets and liabilities and average exchange rates during the period for revenues and expenses. Cumulative translation gains and losses are excluded from results of operations and recorded as a separate component of consolidated stockholders’ equity.  Gains and losses resulting from foreign currency transactions (transactions denominated in a currency other than the entity’s local currency) are included in the consolidated statements of income as either a component of costs of goods sold or other income or expense.

 

2.  Financial Statement Information

 

Inventories consist of the following (in thousands):

 

		September 25, 2004			December 31, 2003
Raw materials		$	7,013		$	7,074
Work-in-progress		1,089			1,565
Finished goods		13,325			13,264
		21,427			21,903
Less reserves, primarily for excess and obsolete inventories		(3,538		)	(6,369		)
Inventories, net		$	17,889		$	15,534

 

3.  Comprehensive Income

 

Comprehensive income consists of the following components (in thousands):

 

		Three months ended						Nine months ended
		September 25, 2004			September 27, 2003			September 25, 2004			September 27, 2003
Net income, as reported		$	4,668		$	3,642		$	8,715		$	7,990
Foreign currency translation adjustment		(112		)	(722		)	(321		)	(173		)
Comprehensive income		$	4,556		$	2,920		$	8,394		$	7,817

 

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4.  Restructuring Costs

 

In August 2004, the Company began the integration of its Regentek sales organization into its DonJoy sales organization and most of its remaining Regentek operations in Tempe, Arizona into its corporate facility in Vista, California.  The objectives of the Regentek integration are to strengthen the distribution activities of the Regentek business and to reduce both costs of goods sold and operating expenses as a percentage of net revenues in future periods, after the related costs of the integration have been incurred.  There can be no assurance the integration will be successful or achieve the desired goals.  In addition, in August 2004, the Company completed construction of a new leased 200,000 square foot manufacturing facility in Tijuana, Mexico to replace three separate facilities it operated in the same area. As of early October 2004, all of the Company’s existing Mexico facilities have been moved to this new facility.  In the fourth quarter of 2004, the Company expects to initiate the relocation of the manufacturing of its cold therapy products and machine shop activities from Vista, California to the new Mexico plant. The relocation to Mexico of these California-based activities is expected to result in reduced manufacturing costs beginning in 2005.  The Regentek integration and the move of the U.S. manufacturing operations are expected to result in the elimination of approximately 140 positions, including temporary employees, by the end of 2004.  Approximately 110 new positions will be added in Vista and Mexico in the aggregate to accommodate the operations moved to each of those locations. The Company anticipates that the Regentek integration and manufacturing move will be substantially completed by the end of 2004.

 

The Company accounts for restructuring costs in accordance with SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities, which addresses financial accounting and reporting for costs associated with exit or disposal activities.  SFAS 146 requires that costs associated with an exit or disposal activity be recorded as an expense and a liability when incurred.  The results for the third quarter of 2004 include charges totaling $2.1 million ($1.3 million net of tax, with an effect of $0.05 on diluted net income per share) related to the Company’s Regentek integration and manufacturing move.  The Company expects to incur additional restructuring costs of approximately $3 million during the fourth quarter of 2004.

 

Total restructuring costs in the accompanying consolidated statement of income for the three and nine months ended September 25, 2004, are as follows (in thousands):

 

		Total costs incurred			Cash payments			Accrued liability at September 25, 2004
Employee severance and retention costs		$	1,305		$	(59	)	$	1,246
Other		780			(278		)	502
Total		$	2,085		$	(337	)	$	1,748

 

In the three months ended September 27, 2003, the Company recorded a credit of $0.5 million to restructuring costs as a reversal of an accrual recorded in 2002 related to future rent to be paid for vacated facilities, as the Company decided to retain the vacant space for future expansion and discontinued subleasing efforts.  Accrued restructuring costs in the accompanying consolidated balance sheet at September 25, 2004 also includes approximately $0.5 million related to certain other lease termination and exit costs accrued in 2002.

 

5.  Long-Term Debt

 

Credit Agreement Amendments

 

On September 28, 2004, the Company completed a second amendment to its credit agreement permitting the Company to implement a stock repurchase program (see Note 8).

 

In July 2004, the Company completed an amendment of its credit agreement providing for a reduction in the interest rate applicable to its outstanding term loan from LIBOR plus 2.75% to LIBOR plus 2.25%, reducing the Company’s effective borrowing rate.  In connection with the amendment, the Company incurred fees and expenses of approximately $0.3 million, which are being amortized over the remaining term of the loan.

 

Redemption of Senior Subordinated Notes

 

In June 2004, the Company redeemed all of its outstanding senior subordinated notes for $79.7 million, including a redemption premium of $4.7 million.  The redemption was funded by the net proceeds from the Company’s February 2004 sale of common stock

 

9

 

and from existing cash.  As a result of the redemption, the Company recorded a charge of $7.8 million, including the redemption premium and unamortized debt issuance costs and original issue discounts.  Prior to the redemption, the Company had received the consents necessary under its credit agreement to use the proceeds from the sale of shares by the Company and cash on hand to redeem the notes.

 

6.  Segment and Related Information

 

The Company’s reportable segments, which, except for Regentek, reflect its primary distribution channels, are as follows:

 

•            DonJoy®, is the Company’s largest sales channel, comprised of the sale of rigid knee braces, pain management products and certain soft goods.  Approximately 40 independent sales agents who employ approximately 300 independent commissioned sales representatives sell the Company’s DonJoy products to orthopedic surgeons, podiatrists, orthopedic and prosthetic centers, hospitals, athletic trainers and other healthcare professionals. The representatives are technical specialists responsible for educating patients on device usage. After a product order is received by a sales representative, the Company generally ships the product directly to the orthopedic professional and pays a sales commission to the agent based on sales of such products. These commissions are reflected in sales and marketing expense in the Company’s consolidated statements of income;

 

•            ProCare®, in which products are sold by approximately 30 direct and independent representatives that manage over 320 dealers focused on primary and acute facilities. Products are sold primarily to national third-party distributors, other regional medical supply dealers and medical product buying groups, generally at a discount from list prices. The majority of these products are soft goods and pain management products requiring little or no patient education. The distributors resell these products to large hospital chains, hospital buying groups, primary care networks and orthopedic physicians for use by their patients;

 

•            Regentek^TM, in which the Company’s Regentek products are sold through a combination of the Company’s DonJoy segment sales representatives, direct sales representatives and certain independent regional sales agents, with respect to OL1000, and by Johnson & Johnson’s DePuy Spine under an exclusive sales agreement, with respect to SpinaLogic.  These products are sold either directly to the patient or to independent distributors.  The Company arranges billing to third-party payors or patients, for products sold directly to the patient;

 

•            OfficeCare®, in which the Company maintains an inventory of products (primarily soft goods) on hand at orthopedic practices for immediate distribution to the patient. For these products, the Company arranges billing to the patient or third-party payor after the product is provided to the patient. The Company outsources certain OfficeCare billing and collections activities to an independent third-party contractor. As of September 25, 2004, the OfficeCare program was located at over 600 physician offices throughout the United States.  The Company has contracts with over 330 third-party payors for its OfficeCare products; and

 

•            International, in which the Company’s products (primarily rigid knee braces and soft goods) are sold in foreign countries through wholly-owned subsidiaries or independent distributors.  The Company sells its products in over 40 foreign countries, primarily in Europe, Canada, Australia and Japan.

 

Set forth below is revenue, gross profit and operating income information for the Company’s reporting segments for the three and nine months ended September 25, 2004 and September 27, 2003 (in thousands, except number of operating days).  This information excludes the impact of certain expenses not allocated to segments, which are comprised of general corporate expenses and certain restructuring costs that apply to multiple segments.  Restructuring costs related to the Regentek integration have been reported within the Regentek segment.

 

10

 

		Three months ended									Nine months ended
		September 25, 2004			September 27, 2003			Pro Forma September 27, 2003 (1)			September 25, 2004			September 27, 2003			Pro Forma September 27, 2003 (1)
Net revenues:
DonJoy		$	24,407		$	24,240		$	24,240		$	72,939		$	70,286		$	70,286
ProCare		12,939			12,382			12,382			36,812			35,308			35,308
Regentek (1)		11,547			—			12,453			36,458			—			34,391
OfficeCare		6,942			6,637			6,637			20,248			18,464			18,464
International		6,636			5,591			5,591			21,441			19,266			19,266
Consolidated net revenues		62,471			48,850			61,303			187,898			143,324			177,715
Gross profit:
DonJoy		14,410			13,864			13,864			42,805			39,490			39,490
ProCare		5,152			5,428			5,428			14,353			14,767			14,767
Regentek (1)		10,076			—			10,375			31,384			—			28,656
OfficeCare		5,703			5,345			5,345			16,510			14,322			14,322
International		4,097			3,565			3,565			13,501			11,582			11,582
Consolidated gross profit		39,438			28,202			38,577			118,553			80,161			108,817
Income from operations:
DonJoy		5,737			5,868			5,868			16,163			16,201			16,201
ProCare		2,979			2,873			2,873			7,321			7,652			7,652
Regentek (1)		718			—			2,876			5,695			—			5,944
OfficeCare		888			506			506			3,009			896			896
International		1,293			1,539			1,539			5,083			5,254			5,254
Income from operations of reportable segments		11,615			10,786			13,662			37,271			30,003			35,947
Expenses not allocated to segments		(2,927		)	(1,501		)	(1,501		)	(7,185		)	(7,857		)	(7,857		)
Consolidated income from operations		$	8,688		$	9,285		$	12,161		$	30,086		$	22,146		$	28,090
Number of operating days		63			63			63			188			189			189

 

(1)                The Regentek operations were acquired on November 26, 2003. Pro forma data for the three and nine months ended September 27, 2003, gives effect to the Regentek acquisition as if it had occurred on January 1, 2003.  For the three and nine months ended September 25, 2004, Regentek income from operations has been reduced by amortization of acquired intangible assets amounting to $1.2 million and $3.6 million, respectively.  For both the three and nine months ended September 25, 2004, Regentek income from operations has also been reduced by restructuring charges of approximately $2.0 million related to the integration of the business.

 

The accounting policies of the reportable segments are the same as the accounting policies of the Company. The Company allocates resources and evaluates the performance of segments based on income from operations and therefore has not disclosed certain other items, such as interest, depreciation and amortization by segment. The Company does not allocate assets to reportable segments because a significant portion of assets are shared by the segments.

 

For the three and nine months ended September 25, 2004 and September 27, 2003, the Company had no individual customer or distributor that accounted for 10% or more of total revenues.

 

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Net revenues, attributed to countries based on the location of the customer, were as follows (in thousands):

 

		Three months ended						Nine months ended
		September 25, 2004			September 27, 2003			September 25, 2004			September 27, 2003
United States		$	55,835		$	43,259		$	166,457		$	124,058
Europe		4,573			3,746			15,153			13,264
Other countries		2,063			1,845			6,288			6,002
Total consolidated net revenues		$	62,471		$	48,850		$	187,898		$	143,324

 

Total assets by region were as follows (in thousands):

 

		September 25, 2004			December 31, 2003
United States		$	307,067		$	313,857
International		10,203			6,647
Total consolidated assets		$	317,270		$	320,504

 

7.  Commitments and Contingencies

 

In early 2004, the Company reached a settlement with the parties to a class action complaint resulting from the Company’s initial public offering in November 2001.  The settlement was within the coverage limits of the Company’s directors’ and officers’ liability insurance policies and became final with court approval in June 2004.

 

From time to time, the Company has been involved in lawsuits arising in the ordinary course of business. This includes patent and other intellectual property disputes between its various competitors and the Company.  With respect to these matters, management believes that it has adequate legal defense, insurance and/or has provided adequate accruals for related costs. Management of the Company is not aware of any pending lawsuits that could have a material adverse effect on its business, financial condition or results of operations.  During the three months ended September 25, 2004, the Company settled a contract dispute for approximately $0.3 million, which is included in operating expenses in the accompanying consolidated statement of income.

 

8.  Subsequent Events

 

On September 27, 2004, the Company’s board of directors authorized a program to repurchase up to $20 million of our common stock. The shares may be repurchased at times and prices as determined by management and may be completed through open market or privately negotiated transactions. The repurchase program provides that repurchases will be made in accordance with applicable state and federal law and in accordance with the terms and subject to the restrictions of Rule 10b-18 under the Securities Exchange Act of 1934, as amended. Shares will be retired and cancelled upon repurchase. The Company obtained an amendment to its credit agreement permitting the stock repurchase program.  Through October 27, 2004, the Company has repurchased approximately 0.7 million shares of its common stock at an average price of 17.77 per share, for an aggregate total cost of approximately $12.2 million.

 

On September 28, 2004, the Company entered into a new lease agreement providing for the construction of a 110,000 square foot corporate headquarters facility for the Company on vacant land currently leased to the Company in Vista, California.  Once completed, the Company will occupy the facility under a 15-year lease with two five-year options to extend the term and will move out of its existing facilities in Vista.  Initial annual rent for the new facility will be equal to 9.5% of total costs incurred for the construction of the facility and is not expected to exceed the rent currently paid by the Company for its existing Vista facilities.  The new lease is contingent on the new landlord closing a transaction to purchase the existing facilities leased by the Company in Vista, California, as well as the real property underlying the new lease.  Once the new landlord’s purchase is complete, the Company’s lease for the vacant land will be terminated, and when the new headquarters facility is completed and occupied, the Company’s leases for its existing Vista facilities will be terminated.  Those leases would otherwise have continued until February 2008.  Upon occupancy of the new facility, expected to occur in mid-2006, the Company will make a lump sum payment, currently estimated to be approximately $1.6 million, equal to 40% of the rent that would have been due under the existing facilities leases from the termination date of the existing leases through the original expiration date. If the new landlord is able to lease the Company’s former Vista

 

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facilities during what would have remained of the term of Company’s existing leases, a portion of that sum may be refunded to Company.  The lump sum payment will be charged to operations in the period the Company vacates the existing facilities.

 

ITEM 2.      MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

The following discussion should be read in conjunction with our historical consolidated financial statements and the related notes thereto and the other financial data included in this Form 10-Q and in our Annual Report on Form 10-K for the year ended December 31, 2003.

 

Overview

 

We are a global medical device company specializing in rehabilitation and regeneration products for the non-operative orthopedic and spine markets.  Our broad range of over 600 rehabilitation products, including rigid knee braces, soft goods, and pain management products, are used to prevent injury, to treat chronic conditions and to aid in recovery after surgery or injury. Our regeneration products consist of bone growth stimulation devices that are used to treat nonunion fractures and as an adjunct therapy after spinal fusion surgery.  Our rigid knee braces, soft goods, pain management and regeneration products represented 31.8%, 42.6%, 7.2% and 18.5%, respectively, of our consolidated net revenues for the first nine months of 2004.

 

According to Frost & Sullivan, the segment of the non-operative orthopedic and spine markets we target is estimated to generate sales of approximately $1.6 billion in 2004 and is expected to grow at approximately 5.4% per annum until 2008. We believe that the growth of the markets we target is being driven by the following factors:

 

•                  Growing elderly populations with broad medical coverage, increased disposable income and longer life expectancy.  People over 65 years old currently represent about 13% of the U.S. population, yet are estimated to account for nearly 40% of healthcare expenditures.  This population segment is expected to increase as a result of aging “baby boomers” (people born between 1946 and 1965) and longer life expectancies;

 

•                  Growing emphasis on physical fitness, leisure sports and conditioning, which has led to increased injuries, especially among women.  A U.S. Consumer Product Safety Commission survey determined that from 1990 to 1996 there was an 18% increase in the number of sports-related injuries among the population segment that is 25 to 64 years old.  From 1991-1998, “baby boomers” likewise experienced significant increases in sports-related injuries: 64% for those who lift weights, 240% for golfers and more than four times for those that engage in general exercise and running.  In addition, according to industry studies, female athletes are six to eight times more likely than their male counterparts to suffer anterior cruciate ligament (ACL) injuries; and

 

•                  Increasing awareness and use of non-invasive devices for prevention, treatment and rehabilitation purposes.  The growing awareness and clinical acceptance by patients and healthcare professionals of the benefits of non-invasive solutions continues to drive demand for non-operative rehabilitation and regeneration products.

 

We conduct our business through five segments, which, except for Regentek, reflect our primary distribution channels:

 

•                  DonJoy, our largest sales channel, comprised of the sale of rigid knee braces, pain management products and certain soft goods.  Approximately 40 independent sales agents who employ approximately 300 independent commissioned sales representatives sell our DonJoy products to orthopedic surgeons, podiatrists, orthopedic and prosthetic centers, hospitals, athletic trainers and other healthcare professionals. The representatives are technical specialists responsible for educating patients on device usage. After a product order is received by a sales representative, we generally ship the product directly to the orthopedic professional and pay a sales commission to the agent based on sales of such products. These commissions are reflected in sales and marketing expense in our consolidated statements of income.  DonJoy revenues comprised 39% and 49% of total consolidated net revenues in the first nine months of fiscal 2004 and 2003, respectively, and 40% of pro forma consolidated net revenues for the first nine months of 2003;

 

•                  ProCare, in which products are sold by approximately 30 direct and independent representatives that manage over 320 dealers focused on primary and acute facilities. Products are sold primarily to national third-party distributors, other regional medical supply dealers and medical product buying groups, generally at a discount from list prices. The majority of these products are

 

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soft goods and pain management products requiring little or no patient education. The distributors resell these products to large hospital chains, hospital buying groups, primary care networks and orthopedic physicians for use by their patients.  ProCare revenues comprised 20% and 25% of total consolidated net revenues in the first nine months of fiscal 2004 and 2003, respectively, and 20% of pro forma consolidated net revenues for the first nine months of 2003;

 

•                  Regentek, in which our Regentek products are sold through a combination of our DonJoy segment sales representatives, direct sales representatives and certain independent regional sales agents, with respect to OL1000, and by DePuy Spine under an exclusive sales agreement, with respect to SpinaLogic.  These products are sold either directly to the patient or to independent distributors.  We arrange billing to third-party payors or patients, for products sold directly to the patient.  Regentek revenues comprised 19% of total consolidated net revenues in the first nine months of fiscal 2004 and 19% of pro forma consolidated net revenue for the first nine months of 2003;

 

•                  OfficeCare, in which we maintain an inventory of product (primarily soft goods) on hand at orthopedic practices for immediate disbursement to the patient. For these products, we arrange billing to the patient or third-party payor after the product is provided to the patient. We outsource certain OfficeCare billing and collection activities to an independent third-party contractor. As of September 25, 2004, the OfficeCare program was located at over 600 physician offices throughout the United States. We have contracts with over 330 third-party payors for our OfficeCare products.  OfficeCare revenues comprised 11% and 13% of total consolidated net revenues in the first nine months of fiscal 2004 and 2003 respectively, and 10% of pro forma consolidated net revenues for the first nine months of 2003; and

 

•                  International, in which our products (primarily rigid knee braces and soft goods) sold in foreign countries through wholly-owned subsidiaries or independent distributors.  We sell our products in over 40 foreign countries, primarily in Europe, Canada, Australia and Japan.  International revenues comprised 11% and 13% of total consolidated net revenues in the first nine months of fiscal 2004 and 2003, respectively, and 11% of pro forma consolidated net revenues for the first nine months of 2003.

 

Our Strategy

 

Our strategy is to increase revenue and profitability and enhance cash flow by strengthening our market leadership position.  Our key initiatives to implement this strategy include:

 

•                  Regentek Integration. In August 2004, we began the integration of our Regentek sales organization into our DonJoy sales organization and most of our remaining Regentek operations in Tempe, Arizona into our corporate facility in Vista, California.  The objectives of the Regentek integration are to strengthen the distribution activities of the Regentek business and to reduce both costs of goods sold and operating expenses as a percentage of net revenues in future periods, after the related costs of the integration have been incurred.  We estimate the costs of the integration, primarily severance, recruiting and training, will be approximately $5 million, and will result in annualized pre-tax savings of approximately $3 million beginning in 2005.  The accompanying consolidated statements of income for both the three and nine months ended September 25, 2004 include charges totaling approximately $2.0 million ($1.2 million net of tax), with an effect of $0.05 on diluted net income per share related to the Regentek integration. We anticipate that the remaining integration costs will be substantially incurred in the fourth quarter of 2004.

 

•                  Further Penetrate Our Existing Customer Base.  We are focused on increasing the number and variety of products sold to our existing customers.  We believe that our OfficeCare program provides us with a strong platform for selling additional products to our existing customers because of the amount of contact our sales representatives have with the orthopedic practices who participate in the program.  We also believe that the addition of the bone growth stimulation products to our existing product line will further this goal by providing significant cross-selling opportunities.  We believe the Regentek acquisition and the integration of the sales activities of the Regentek segment will provide us the opportunity to further penetrate our customer base by providing additional products to satisfy our customers’ orthopedic needs;

 

•                  Continue to Introduce New Products and Product Enhancements.  We have a history of developing and introducing innovative products into the marketplace, and are committed to continuing that tradition by introducing new products across our product platform.  In the nine months ended September 25, 2004, we launched 18 new products.  We believe that product innovation through effective and focused research and development will provide a sustainable competitive advantage.  We are currently a technology leader in several product categories and we intend to continue to develop next generation technologies;

 

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•                  Expand Our OfficeCare Channel.  Our OfficeCare channel currently includes over 600 physician offices encompassing over 2,500 physicians.  We estimate that there are approximately 10,000 orthopedic physicians in the United States practicing in offices with three or more physicians.  We believe that our OfficeCare channel serves a growing need among orthopedic practices to have a number of products readily available for immediate distribution to patients and represents an opportunity for significant sales growth.  We intend to expand our OfficeCare channel into more “high-volume” orthopedic offices, thereby increasing the number of potential customers to whom we sell our products.  In the three and nine months ended September 25, 2004, we added 17 and 71, respectively, net new offices to our OfficeCare channel;

 

•                  Maximize Existing and Secure Additional National Accounts.  We plan to capitalize on the growing practice in healthcare in which hospitals and other large healthcare providers seek to consolidate their purchasing activities to national buying groups.   Contracts with these national accounts represent a significant opportunity for sales growth. We believe that our broad range of products are well suited to the goals of these buying groups and intend to aggressively pursue these contracts;

 

•                  Expand Product Offerings for the Spine.  SpinaLogic is our first product that targets the spine.  According to Frost & Sullivan, back pain is the number one cause of healthcare expenditure in the United States.  The spine segment of the orthopedics market is estimated to grow in excess of 18% from 2001 to 2005.  As a result, we believe that expanding our product offerings in this market represents a significant growth opportunity.  We recently launched a new compression back brace to address the spine market;

 

•                  Pursue Selective Strategic Acquisitions. We believe that strategic acquisitions represent an attractive and efficient means to broaden our product lines. The products acquired in the Regentek acquisition, for example, which generated revenues of $11.5 million and $36.5 million during the three and nine months ended September 25, 2004, respectively, enabled us to enter the regeneration market, which is predicted to grow faster than the rehabilitation market. We intend to pursue additional acquisition opportunities that enhance sales growth, are accretive to earnings, increase customer penetration and/or provide geographic diversity;

 

•                  Expand International Sales. International sales have historically represented less than 15% of our net revenues. Although our presence outside the United States has been limited, we have successfully established direct distribution capabilities in major international markets.  In September 2004, we acquired the outstanding stock of KD Innovation A/S, our independent distributor in Denmark. The acquired company, renamed dj Orthopedics Nordic ApS, has direct responsibility for sales, marketing and distribution of dj Orthopedics’ products in Denmark, Finland, Norway and Sweden.  We believe that sales to foreign markets continue to represent a significant growth opportunity and we intend to continue to develop direct distribution capabilities in selected foreign markets; and

 

•                  Expand Low Cost Manufacturing Capabilities. We plan to continue to expand our low cost manufacturing capabilities in Mexico to reduce our costs of goods sold and improve our gross margins. At the end of 2002 we moved the manufacturing of our off-the-shelf rigid knee braces and the remaining manufacturing of our soft goods products from Vista, California to Tijuana, Mexico, resulting in a significant reduction in our costs of goods sold. This improved our gross margins beginning in 2003. In August 2004, we completed construction of a new 200,000 square foot leased facility in Tijuana, Mexico, to replace three separate facilities we operated in the same area and to provide further opportunities to expand our Mexico manufacturing operations.  As of early October 2004, all of our existing Mexico facilities had been moved to this new facility.  In the fourth quarter of 2004, we expect to initiate the relocation of the manufacturing of our cold therapy products and machine shop activities from Vista, California to the new Mexico plant.  The relocation to Mexico of these California-based activities is expected to be completed in the fourth quarter of 2004 and is expected to result in an annual reduction in pre-tax manufacturing costs of approximately $1 million, beginning in 2005.  The results of the third quarter of 2004 include restructuring charges totaling $0.1 million related to the manufacturing move.  We also intend to use our expanded Mexico capabilities in the future to vertically integrate the manufacturing of certain components we purchase, further reducing our costs of goods sold.

 

Critical Accounting Policies and Estimates

 

Our discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States.  The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities.  On an on-going basis, we evaluate our

 

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estimates, including those related to contractual allowances, doubtful accounts, inventories, rebates, product returns, warranty obligations, income taxes, intangibles and investments.  We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources.  Actual results may differ from these estimates under different assumptions or conditions.

 

We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements and this discussion and analysis of our financial condition and results of operations:

 

Provision for Contractual Allowances and Doubtful Accounts. We maintain provisions for contractual allowances for reimbursement amounts from our third-party payor customers based on negotiated contracts and historical experience for non-contracted payors. We also maintain provisions for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. We have contracts with certain third-party payors for our third-party reimbursement billings, which call for specified reductions in reimbursement of billed amounts based upon contractual reimbursement rates.  In 2003, we recorded contractual allowances related to our third-party payor revenues of 24% to 36% of gross billed charges to third-party payors.  Our contractual allowances percentages increased in mid-2003 following increases in our current gross price levels.  In the first nine months of 2004, we have recorded contractual allowances of approximately 29% to 39% of gross billed charges, increasing from the prior year due partly to additional increases in our gross billed charges and partly to the impact of a new reduced reimbursement code for certain of our fracture boot products.  For sales of our Regentek products that are subject to third party reimbursement, we record revenue net of actual contractual allowances and discounts from our gross prices, which are determined on a specific identification basis and amount to approximately 21% to 24% of our gross prices.

 

Our reserve for doubtful accounts is based upon estimated losses from customers who are billed directly and the portion of third-party reimbursement billings that ultimately become the financial responsibility of the end user patients. Direct-billed customers represented approximately 57% and 56% of our net accounts receivable at September 25, 2004 and December 31, 2003, respectively, and we have historically experienced write-offs of less than 2% of these accounts receivable. Our third-party reimbursement customers include all of the customers of our OfficeCare business segment, the majority of customers of our Regentek business segment and certain customers of our DonJoy business segment, including insurance companies, managed care companies and certain governmental payors such as Medicare. Our third-party payor customers represented approximately 30% and 17% of our net revenue for the nine months ended September 25, 2004 and September 27, 2003, respectively, and 43% and 44% of our net accounts receivable at September 25, 2004 and December 31, 2003, respectively.  We estimate bad debt expense to be approximately 4% to 11% of gross revenues from these third-party reimbursement customers in 2004, based on our historical collections experience.  If the financial condition of our customers were to deteriorate resulting in an impairment of their ability to make payments or if third-party payors were to deny claims for late filings, incomplete information or other reasons, additional provisions may be required.

 

Historically, we have relied heavily on independent third-party billing service providers to provide information about the accounts receivable of our third-party payor customers, including the data utilized to determine reserves for contractual allowances and doubtful accounts. We also continue to enhance our ability to analyze historical information, resolve issues related to our accounts receivable, and reduce our aging.  Based on information currently available to us, we believe we have provided adequate reserves for our third-party payor accounts receivable. If claims are denied, or amounts are otherwise not paid in excess of our estimates, the recoverability of our net accounts receivable could be reduced by a material amount. In addition, if our independent third-party insurance billing service provider is not successful in collecting amounts greater than or equal to our estimates, we may be required to increase our reserve estimates by a material amount.

 

Reserve for Excess and Obsolete Inventories.  We provide reserves for estimated excess or obsolete inventories equal to the amounts by which the cost of inventories on hand plus future purchase commitments exceed estimated market values based upon assumptions about future demand.  If future demand is less favorable than currently projected by management, additional inventory write-downs may be required.  In addition, reserves for inventories on hand in our OfficeCare locations are provided based on recent historical shrinkage rates of approximately 14%.  If actual shrinkage rates differ from our estimated shrinkage rates, revisions to the reserves may be required.  We also provide reserves for newer product inventories, as appropriate, based on any minimum purchase commitments and the current status of any FDA approval process, if required, and our level of sales of the new products.

 

Rebates.  We record estimated reductions to revenues for customer rebate programs and national account administration fees based upon historical experience and estimated revenue levels.  We offer certain of our distributors rebates based on sales volume, sales growth and to reimburse the distributor for certain discounts.

 

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Returns and Warranties.  We provide reserves for the estimated cost of returns and product warranties at the time revenue is recognized based on historical trends.  While we engage in extensive product quality programs and processes, including actively monitoring and evaluating the quality of our suppliers, our actual returns and warranty costs could differ from our estimates.  If actual product returns, failure rates, material usage or service costs differ from our estimates, revisions to estimated returns and/or warranty liabilities may be required.

 

Valuation Allowance for Deferred Tax Asset. As of September 25, 2004, we have approximately $53.9 million of net deferred tax assets on our balance sheet related primarily to tax deductible goodwill arising in connection with the Regentek acquisition and in connection with our reorganization in 2001 and not amortized for book purposes. Realization of our deferred tax assets is dependent on our ability to generate approximately $154.0 million of future taxable income over the next 15 years.  Our management believes that it is more likely than not that the deferred tax assets will be realized based on forecasted future taxable income.  However, there can be no assurance that we will meet our expectations of future taxable income.  Management will evaluate the realizability of the deferred tax assets on a quarterly basis to assess any need for valuation allowances.

 

Goodwill and Other Intangibles. In 2002, Statement of Financial Accounting Standards No. 142, or SFAS No. 142, Goodwill and Other Intangible Assets became effective and as a result, we ceased amortization of goodwill.  In lieu of amortization, we are required to perform an annual review for impairment.  Goodwill is considered to be impaired if we determine that the carrying value of the segment or reporting unit exceeds its fair value.   At October 1, 2003, our goodwill was evaluated for impairment and we determined that no impairment existed at that date and subsequent to that date, management has not become aware of any indicators of impairment.

 

At December 31, 2003, our other intangible assets were evaluated for impairment as required by SFAS No. 144, Accounting for Impairment or Disposal of Long-Lived Assets. The determination of the fair value of certain acquired assets and liabilities is subjective in nature and often involves the use of significant estimates and assumptions.  Determining the fair values and useful lives of intangible assets requires the exercise of judgment.  Upon initially recording certain of our other intangible assets, including the intangible assets that were acquired in connection with the Regentek acquisition, we used independent valuation firms to assist us in determining the appropriate values for these assets.  Subsequently, we have used the same methodology and updated our assumptions.  While there are a number of different generally accepted valuation methods to estimate the value of intangible assets acquired, we primarily used the undiscounted cash flows expected to result from the use of the assets.  This method requires significant management judgment to forecast the future operating results used in the analysis.  In addition, other significant estimates are required such as residual growth rates and discount factors.  The estimates we have used are consistent with the plans and estimates that we use to manage our business and are based on available historical information and industry averages.

 

The value of our goodwill and other intangible assets could be exposed to impairments if we experience declines in operating results, if additional negative industry or economic trends occur, or if our future performance is below our projections or estimates.

 

Results of Operations

 

We operate our business on a manufacturing calendar, with our fiscal year always ending on December 31.  Each quarter is 13 weeks, consisting of one five-week and two four-week periods.  Our first and fourth quarters may have more or less operating days from year to year based on the days of the week on which holidays and December 31 fall.

 

In November 2003, we acquired the operations of Regentek.  The results of Regentek’s operations are included in the consolidated results of operations for the entire three and nine months ended September 25, 2004; however, for comparative purposes we have included pro forma financial information for the three and nine months ended September 27, 2003 as if Regentek was acquired as of January 1, 2003. Management uses the pro forma information presented to evaluate and manage operations.  We are providing this information to allow for additional financial analysis of our results of operations.

 

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Three Months Ended September 25, 2004 Compared To Three Months Ended September 27, 2003

 

Net Revenues. Set forth below are net revenues, in total and on a per day basis, for our reporting segments (in thousands):

 

Net revenues:

 

		Three months ended															Pro Forma Three months ended
		September 25, 2004			% of Net Revenues		September 27, 2003			% of Net Revenues		Increase			% Increase		September 27, 2003			% of Net Revenues
DonJoy		$	24,407		39.1		$	24,240		49.6		$	167		0.7		$	24,240		39.5
ProCare		12,939			20.7		12,382			25.4		557			4.5		12,382			20.2
Regentek		11,547			18.5		—			—		11,547			N/A		12,453			20.3
OfficeCare		6,942			11.1		6,637			13.6		305			4.6		6,637			10.8
International		6,636			10.6		5,591			11.4		1,045			18.7		5,591			9.2
Consolidated net revenues		$	62,471		100.0		$	48,850		100.0		$	13,621		27.9		$	61,303		100.0

 

Average revenues per day:

 

		Three months ended											Pro Forma Three months ended
		September 25, 2004			September 27, 2003			Increase			% Increase		September 27, 2003
DonJoy		$	387.4		$	384.8		$	2.6		0.7		$	384.8
ProCare		205.4			196.6			8.8			4.5		196.6
Regentek		183.3			—			183.3			N/A		197.7
OfficeCare		110.2			105.3			4.9			4.7		105.3
International		105.3			88.7			16.6			18.7		88.7
Consolidated average net revenues per day		$	991.6		$	775.4		$	216.2		27.9		$	973.1
Number of operating days		63			63

 

Net revenues in our DonJoy segment increased in the third quarter primarily due to increased sales of rigid knee braces into school athletic programs and sales of new products. These increases were partially offset by a negative impact from recent changes in the California workers compensation system and reduced sales of certain of our pain management products.  Net revenues in our ProCare segment increased due to growth in sales related to national contracts.  On a pro forma basis, net revenue in our Regentek segment decreased partly as a result of a negative impact caused by disruption from the integration of our Regentek sales organization into our DonJoy sales organization.  Revenues in our Regentek segment were also impacted by a decline in sales of our SpinaLogic product, which we believe was due to slow market conditions during the quarter and partly to underperformance in certain territories.  Net revenues in our OfficeCare segment increased due to the addition of 17 net new OfficeCare locations and a reduction in certain contra-revenue contractual allowances, offset by price reductions in our fracture boot products due to a change in the Medicare reimbursement code and lower patient volumes.  International revenues increased primarily due to increased sales of rigid knee braces and a $0.3 million benefit from favorable changes in exchange rates compared to the rates in effect in the third quarter of 2003.

 

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Gross Profit. Set forth below is gross profit information for our reporting segments (in thousands):

 

		Three months ended															Pro Forma Three months ended
		September 25, 2004			% of Net Revenues		September 27, 2003			% of Net Revenues		Increase (Decrease)			% Increase (Decrease)		September 27, 2003			% of Net Revenues
DonJoy		$	14,410		59.0		$	13,864		57.2		$	546		3.9		$	13,864		57.2
ProCare		5,152			39.8		5,428			43.8		(276		)	(5.1	)	5,428			43.8
Regentek		10,076			87.3		—			—		10,076			N/A		10,375			83.3
OfficeCare		5,703			82.2		5,345			80.5		358			6.7		5,345			80.5
International		4,097			61.7		3,565			63.8		532			14.9		3,565			63.8
Consolidated Gross Profit		$	39,438		63.1		$	28,202		57.7		$	11,236		39.8		$	38,577		62.9

 

The increase in consolidated gross profit and gross profit margin is primarily related to ongoing manufacturing cost reduction initiatives, the favorable impact of higher gross margins associated with the products sold in our Regentek segment and a reduction in expenses associated with employee incentives. Gross profit for the third quarter increased over prior year in the DonJoy segment primarily due to a favorable product mix, including increased sales in our DonJoy insurance channel, which carry a higher gross margin than sales in our DonJoy direct channel.  ProCare gross profit in the third quarter decreased from the prior year due to increased sales through our national contracts, which carry lower gross margins.  On a pro forma basis and excluding the impact of one-time purchase accounting adjustments, the Regentek gross profit in the third quarter increased over prior year due to reduced costs of goods sold for these products and a higher mix of insurance sales, which have higher average selling prices and therefore generate higher gross margins as compared to wholesale sales. OfficeCare gross profit in the third quarter 2004 increased over the prior year period primarily due to certain price increases in this segment and a reduction in certain contractual allowances offset by price reductions due to a change in the Medicare reimbursement code for certain fracture boot products.  International gross profit in the third quarter decreased over the prior year period primarily due to changes in product mix offset by the favorable impact of changes in exchange rates.

 

Operating Expenses.  Set forth below is operating expense information (in thousands):

 

		Three months ended															Pro Forma Three months ended
		September 25, 2004			% of Net Revenues		September 27, 2003			% of Net Revenues		Increase			% Increase		September 27, 2003			% of Net Revenues
Sales and marketing		$	19,092		30.6		$	14,039		28.7		$	5,053		36.0		$	18,959		30.9
General and administrative		7,114			11.4		4,236			8.7		2,878			67.9		5,390			8.8
Research and development		1,307			2.1		1,139			2.3		168			14.7		1,412			2.3
Amortization of acquired intangibles		1,152			1.8		—			—		1,152			N/A		1,152			1.9
Restructuring costs		2,085			3.3		(497		)	(1.0	)	2,582			N/A		(497		)	(0.8	)
Consolidated operating expenses		$	30,750		49.2		$	18,917		38.7		$	11,833		62.6		$	26,416		43.1

 

Sales and Marketing Expenses.  The increase in sales and marketing expenses is primarily attributed to $5.1 million of expenses related to the Regentek segment.  In addition, selling and marketing expenses increased on both an actual and pro forma basis due to costs associated with increased commissions on increased sales, additional sales personnel, increased advertising and marketing programs and the impact of unfavorable foreign exchange rate changes.  These increases were offset by a reduction in expenses associated with employee incentives.  Our international segment also incurred expenses in the current quarter related to our new subsidiaries in France and Denmark, added in September 2003 and September 2004, respectively.

 

General and Administrative Expenses. The increase in general and administrative expenses is primarily attributed to $0.9 million of expenses related to the Regentek segment, increased professional fees related to compliance with section 404 of the Sarbanes-Oxley Act, and legal costs, including the settlement of a contract dispute, offset by a reduction in expenses associated with employee incentives.

 

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