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Table of Contents

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

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

 

For the quarterly period ended September 26, 2009

 

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 333-142188

 

DJO Finance LLC

(Exact name of Registrant as specified in its charter)

 

Delaware

 

20-5653965

(State or other jurisdiction of
incorporation or organization)

 

(I.R.S. Employer
Identification Number)

 

 

 

1430 Decision Street
Vista, California

 

92081

(Address of principal executive offices)

 

(Zip Code)

 

Registrant’s telephone number, including area code: (800) 336-5690

 

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

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes o  No o

 

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer”, “accelerated filer”, and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer o

 

Accelerated filer o

 

 

 

Non-accelerated filer x
(Do not check if a smaller reporting company)

 

Smaller reporting company o

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o  No x

 

As of October 29, 2009, 100% of the issuer’s membership interests were owned by DJO Holdings LLC.

 

 

 



Table of Contents

 

DJO FINANCE LLC

FORM 10-Q

TABLE OF CONTENTS

 

 

 

 

 

Page
No.

 

 

PART I—Financial Information

 

 

Item 1.

 

Unaudited Condensed Consolidated Balance Sheets as of September 26, 2009 and December 31, 2008

 

3

 

 

Unaudited Condensed Consolidated Statements of Operations for the three and nine months ended September 26, 2009 and September 27, 2008

 

4

 

 

Unaudited Condensed Consolidated Statements of Cash Flows for the nine months ended September 26, 2009 and September 27, 2008

 

5

 

 

Notes to Unaudited Condensed Consolidated Financial Statements

 

6

Item 2.

 

Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

31

Item 3.

 

Quantitative and Qualitative Disclosures About Market Risk

 

45

Item 4.

 

Controls and Procedures

 

46

 

 

PART II—Other Information

 

 

Item 1.

 

Legal Proceedings

 

46

Item 1A.

 

Risk Factors

 

47

Item 6.

 

Exhibits

 

48

SIGNATURES

 

49

 

2



Table of Contents

 

PART I. FINANCIAL INFORMATION

 

ITEM 1. FINANCIAL STATEMENTS

 

DJO Finance LLC

 

Unaudited Condensed Consolidated Balance Sheets

 

(in thousands)

 

 

 

September 26,
2009

 

December 31,
2008

 

Assets

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

51,279

 

$

30,483

 

Accounts receivable, net

 

160,442

 

164,618

 

Inventories, net

 

97,112

 

103,166

 

Deferred tax assets, net

 

37,561

 

34,039

 

Prepaid expenses and other current assets

 

18,120

 

16,923

 

Total current assets

 

364,514

 

349,229

 

Property and equipment, net

 

84,721

 

86,262

 

Goodwill

 

1,193,044

 

1,191,566

 

Intangible assets, net

 

1,214,554

 

1,260,472

 

Other non-current assets

 

45,250

 

52,601

 

Total assets

 

$

2,902,083

 

$

2,940,130

 

 

 

 

 

 

 

Liabilities and Membership Equity

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Accounts payable

 

$

40,789

 

$

42,752

 

Accrued interest

 

42,175

 

10,966

 

Long-term debt and capital leases, current portion

 

11,294

 

11,549

 

Other current liabilities

 

102,907

 

104,401

 

Total current liabilities

 

197,165

 

169,668

 

Long-term debt and capital leases, net of current portion

 

1,803,889

 

1,832,044

 

Deferred tax liabilities, net

 

319,845

 

329,503

 

Other non-current liabilities

 

14,331

 

8,806

 

Total liabilities

 

2,335,230

 

2,340,021

 

 

 

 

 

 

 

Commitments and contingencies

 

 

 

 

 

 

 

 

 

 

 

Membership equity:

 

 

 

 

 

Additional paid-in capital

 

826,570

 

824,235

 

Accumulated deficit

 

(260,609

)

(221,842

)

Accumulated other comprehensive loss

 

(1,323

)

(4,027

)

DJO Finance LLC membership equity

 

564,638

 

598,366

 

Noncontrolling interests

 

2,215

 

1,743

 

Total membership equity

 

566,853

 

600,109

 

Total liabilities and membership equity

 

$

2,902,083

 

$

2,940,130

 

 

See accompanying notes to unaudited condensed consolidated financial statements.

 

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Table of Contents

 

DJO Finance LLC

 

Unaudited Condensed Consolidated Statements of Operations

 

(in thousands)

 

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 26,
2009

 

September 27,
2008

 

September 26,
2009

 

September 27,
2008

 

Net sales

 

$

236,186

 

$

235,515

 

$

688,951

 

$

708,902

 

Cost of sales

 

86,039

 

86,946

 

247,195

 

262,246

 

Gross profit

 

150,147

 

148,569

 

441,756

 

446,656

 

Operating expenses:

 

 

 

 

 

 

 

 

 

Selling, general and administrative

 

101,413

 

103,778

 

310,618

 

327,722

 

Research and development

 

5,616

 

6,773

 

17,581

 

20,679

 

Amortization of acquired intangibles

 

19,560

 

19,159

 

57,862

 

57,415

 

Operating income

 

23,558

 

18,859

 

55,695

 

40,840

 

Other income (expense):

 

 

 

 

 

 

 

 

 

Interest income

 

211

 

336

 

749

 

1,186

 

Interest expense

 

(39,173

)

(42,073

)

(117,319

)

(129,755

)

Other income (loss), net

 

1,422

 

(2,597

)

3,009

 

(966

)

Loss from continuing operations before income taxes

 

(13,982

)

(25,475

)

(57,866

)

(88,695

)

Benefit for income taxes

 

(2,969

)

(11,030

)

(19,901

)

(28,966

)

Loss from continuing operations

 

(11,013

)

(14,445

)

(37,965

)

(59,729

)

Income (loss) from discontinued operations, net of tax

 

(267

)

314

 

(434

)

1,133

 

Net loss

 

(11,280

)

(14,131

)

(38,399

)

(58,596

)

Less: Net income attributable to noncontrolling interests

 

94

 

298

 

368

 

793

 

Net loss attributable to DJO Finance LLC

 

$

(11,374

)

$

(14,429

)

$

(38,767

)

$

(59,389

)

 

See accompanying notes to unaudited condensed consolidated financial statements.

 

4



Table of Contents

 

DJO Finance LLC

 

Unaudited Condensed Consolidated Statements of Cash Flows

 

(in thousands)

 

 

 

Nine Months Ended

 

 

 

September 26,
2009

 

September 27,
2008

 

OPERATING ACTIVITIES:

 

 

 

 

 

Net loss

 

$

(38,399

)

$

(58,596

)

Adjustments to reconcile net loss to net cash provided by (used in) operating activities:

 

 

 

 

 

Depreciation

 

20,572

 

17,432

 

Amortization of intangibles

 

57,862

 

57,415

 

Amortization of debt issuance costs

 

9,597

 

9,857

 

Stock-based compensation

 

2,335

 

1,204

 

Asset impairments and loss on disposal of assets

 

465

 

1,361

 

Deferred income taxes

 

(22,574

)

(18,767

)

Provision for doubtful accounts and sales returns

 

25,433

 

15,411

 

Inventory reserves

 

6,296

 

4,540

 

Gain on disposal of discontinued operations

 

(393

)

 

Changes in operating assets and liabilities, net of acquired assets and liabilities:

 

 

 

 

 

Accounts receivable

 

(19,423

)

(33,919

)

Inventories

 

(1,164

)

4,360

 

Prepaid expenses, other assets and liabilities

 

(36

)

(4,904

)

Accrued interest

 

(31,209

)

33,701

 

Accounts payable and other current liabilities

 

53,205

 

(13,427

)

Net cash provided by operating activities

 

62,567

 

15,668

 

INVESTING ACTIVITIES:

 

 

 

 

 

Acquisition of businesses, net of cash acquired

 

(12,846

)

(3,879

)

Acquisition of intangible assets

 

(154

)

(1,216

)

Purchases of property and equipment

 

(19,133

)

(19,099

)

Proceeds from sale of discontinued operations

 

21,846

 

 

Other, net

 

78

 

1,214

 

Net cash used in investing activities

 

(10,209

)

(22,980

)

FINANCING ACTIVITIES:

 

 

 

 

 

Proceeds from debt and revolving line of credit

 

65,173

 

12,000

 

Payments of revolving line of credit

 

(94,834

)

(21,551

)

Net cash used in financing activities

 

(29,661

)

(9,551

)

Effect of exchange rate changes on cash and cash equivalents

 

(1,901

)

(236

)

Net increase (decrease) in cash and cash equivalents

 

20,796

 

(17,099

)

Cash and cash equivalents at beginning of period

 

30,483

 

63,471

 

Cash and cash equivalents at end of period

 

$

51,279

 

$

46,372

 

Supplemental disclosures of cash flow information:

 

 

 

 

 

Cash paid for interest

 

$

76,366

 

$

86,135

 

Cash paid for income taxes

 

$

1,859

 

$

1,603

 

Non-cash investing and financing activities:

 

 

 

 

 

Increases in property and equipment and in other liabilities in connection with capitalized software costs

 

$

3,568

 

$

 

 

See accompanying notes to unaudited condensed consolidated financial statements.

 

5



Table of Contents

 

DJO Finance LLC

 

Notes to Unaudited Condensed Consolidated Financial Statements

 

1. SUMMARY OF SIGNIFICANT ACCOUNTING PRINCIPLES

 

Basis of Presentation and Principles of Consolidation.  We are a global provider of high-quality, orthopedic devices, with a broad range of products used for rehabilitation, pain management and physical therapy. We also develop, manufacture and distribute a broad range of surgical reconstructive implant products. We offer healthcare professionals and patients a diverse range of orthopedic rehabilitation products addressing the complete spectrum of preventative, pre-operative, post-operative, clinical and home rehabilitation care. Our products are used by orthopedic specialists, spine surgeons, primary care physicians, pain management specialists, physical therapists, podiatrists, chiropractors, athletic trainers and other healthcare professionals to treat patients with musculoskeletal conditions resulting from degenerative diseases, deformities, traumatic events and sports-related injuries. In addition, many of our non-surgical medical devices and related accessories are used by athletes and patients for injury prevention and at-home physical therapy treatment.

 

In the first quarter of 2009, we changed how we report our segmented financial information in accordance with the Financial Accounting Standards Board’s (“FASB”) Accounting Standards Codification (“ASC”) 280-10-50 (formerly Financial Accounting Standards Statement (“SFAS”) No.131, “Disclosures about Segments of an Enterprise and Related Information”).  Prior to 2009, we included the international components of the Surgical, Chattanooga, and Empi businesses in either the Surgical or Domestic Rehabilitation segments, as their operations were managed domestically.  During the fourth quarter of 2008, we effected an operational reorganization which resulted in the non-U.S. components of all of our businesses being managed abroad.  Our restated segment information now reflects the international components of all of our businesses within our International segment.

 

We market and distribute our products through three operating segments, Domestic Rehabilitation, International, and Domestic Surgical Implant. Our Domestic Rehabilitation Segment offers to customers in the United States, non-invasive medical products that are used before and after surgery to assist in the repair and rehabilitation of soft tissue and bone, and to protect against further injury; electrotherapy devices and accessories used to treat pain and restore muscle function; iontophoretic devices and accessories used to deliver medication; clinical therapy tables, traction equipment and other clinical therapy equipment; orthotic devices used to treat joint and spine conditions; orthopedic soft goods; rigid knee braces; and vascular systems which include products intended to prevent deep vein thrombosis following surgery. Our Domestic Surgical Implant Segment offers a comprehensive suite of reconstructive joint products to customers in the United States.  Our International segment offers all of our products to customers outside the United States.

 

Except as otherwise indicated, references to “us”, “we”, “our”, “DJO”, or “our Company”, refers to DJO Finance LLC and its consolidated subsidiaries.

 

Noncontrolling interests reflect the 50% separate ownership of Medireha GmbH (“Medireha”) not owned by us, which we have consolidated due to our controlling interest. Our controlling interest consists of our 50% ownership and our control of one of the two director seats, our rights to prohibit certain business activities that are not consistent with our plans for the business and our exclusive distribution rights for products manufactured by Medireha. All significant intercompany balances and transactions have been eliminated in consolidation.

 

The accompanying unaudited condensed consolidated financial statements as of September 26, 2009 and for the three and nine months ended September 26, 2009 and September 27, 2008 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 the Company and the notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2008. The accompanying unaudited condensed consolidated financial statements as of September 26, 2009 and for the three and nine months ended September 26, 2009 and September 27, 2008 have been prepared on the same basis as the audited consolidated financial statements and include all adjustments consisting of normal recurring accruals 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 periods are not necessarily indicative of the results to be achieved for the entire year or future periods.  At October 29, 2009, there are no material subsequent events requiring additional disclosure in, or amendment to, our financial statements.

 

Use of Estimates.  The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make certain estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of

 

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Table of Contents

 

revenues and expenses during the reporting period. On an ongoing basis, management evaluates its estimates, including those related to contractual allowances, doubtful accounts, inventories, rebates, product returns, warranty obligations, self insurance, income taxes, goodwill and intangible assets and stock-based compensation. We base our estimates on historical experience and on various other assumptions that we believe are 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 could differ from those estimates.

 

Cash and Cash Equivalents.  Cash consists of deposits with financial institutions. We consider all short-term, highly liquid investments and investments in money market funds and commercial paper with original maturities of less than three months at the time of purchase to be cash equivalents. While our cash and cash equivalents are on deposit with high-quality institutions, such deposits exceed Federal Deposit Insurance Corporation insured limits.

 

Computer Software Costs.  Software is stated at cost less accumulated amortization and is amortized using the straight-line method over its estimated useful life ranging from three to seven years.  In accordance with ASC 350-40-25 (formerly American Institute of Certified Public Accountants Statement of Position (“SOP”) 98-1, “Accounting for  the Costs of Computer software Developed or Obtained for Internal Use”), we capitalize costs of internally developed software during the development stage.  Additionally, we capitalize related costs including external consulting costs, cost of software licenses, and internal payroll and payroll-related costs for employees who are directly associated with a software project.  Software assets are reviewed for impairment when events or circumstances indicate that the carrying value may not be recoverable over the remaining lives of the assets. Upgrades and enhancements are capitalized if they result in added functionality.  Recently we began implementing a new ERP system resulting in approximately $7.8 million of capitalized software costs as of September 26, 2009.

 

Derivative Financial Instruments.  We account for derivatives pursuant to ASC 815-20 (formerly SFAS No. 133, “Accounting for Derivative Instruments and Hedging”), which requires that all derivative instruments be recognized in the financial statements and measured at fair value regardless of the purpose or intent for holding them.

 

Foreign Exchange Forward Contracts

 

We use foreign exchange forward contracts to hedge expense commitments that are denominated in currencies other than the U.S. dollar. The purpose of our foreign currency hedging activities is to fix the dollar value of specific commitments and payments to foreign vendors. Before acquiring a derivative instrument to hedge a specific risk, potential natural hedges are evaluated.  While our foreign exchange contracts act as economic hedges, we have not designated such instruments as hedges under ASC 815-30 (formerly SFAS No. 133, “Accounting for Derivative Instruments and Hedging”).  We account for our foreign forward contracts in accordance with ASC 815-20-25 (formerly SFAS No. 157, “Fair Value Measurement”).  The classification of gains and losses resulting from changes in the fair values of derivatives is dependent on the intended use of the derivative and its resulting designation. The change in fair value of the ineffective portion of a hedge, and changes in the fair values of the derivative are recorded in other comprehensive income and are subsequently recognized in earnings when the hedged item affects earnings.   At September 26, 2009, the fair value of our foreign exchange forward contracts was a gain of $11.4 million and was determined through the use of models that consider various assumptions, including time value, yield curves, as well as other relevant economic measures, which are inputs that are classified as Level 2 in the valuation hierarchy.

 

Interest Rate Swap Agreements

 

We make use of debt financing as a source of funds and are therefore exposed to interest rate fluctuations in the normal course of business. Our credit facilities are subject to floating interest rates. We manage the risk of unfavorable movements in interest rates by hedging a portion of the outstanding loan balance, thereby locking in a fixed rate on a portion of the principal, reducing the effect of possible rising interest rates and making interest expense more predictable.  We have designated these interest rate swap agreements as cash flow hedges and account for our interest rate swap agreements in accordance with ASC 815-20.  At September 26, 2009, the fair value of our interest rate swap agreements was a loss of $18.6 million and was determined through the use of models that consider various assumptions, including time value, yield curves, as well as other relevant economic measures, which are inputs that are classified as Level 2 in the valuation hierarchy.

 

Foreign Currency Translation.  The financial statements of our international subsidiaries, where the local currency is the functional currency, are translated into U.S. dollars using period-end exchange rates for assets and liabilities and average exchange rates during the period for revenues and expenses. Cumulative translation gains and losses are excluded from results of operations and recorded as a separate component of consolidated membership 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 condensed consolidated statements of operations.

 

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Comprehensive loss consists of the following for the three and nine months ended September 26, 2009 (in thousands):

 

 

 

Three Months

 

Nine Months

 

 

 

DJO
Finance
LLC

 

Non-
controlling
Interests

 

Total

 

DJO
Finance
LLC

 

Non-
controlling
Interests

 

Total

 

Net income (loss), as reported

 

$

(11,374

)

$

94

 

$

(11,280

)

$

(38,767

)

$

368

 

$

(38,399

)

Foreign currency translation adjustments

 

4,499

 

 

4,499

 

6,152

 

 

6,152

 

Change in fair value of interest rate swap agreements, net of tax

 

454

 

 

454

 

(3,448

)

 

(3,448

)

Comprehensive income (loss)

 

$

(6,421

)

$

94

 

$

(6,327

)

$

(36,063

)

$

368

 

$

(35,695

)

 

Comprehensive loss consists of the following for the three and nine months ended September 27, 2008 (in thousands):

 

 

 

Three Months

 

Nine Months

 

 

 

DJO
Finance
LLC

 

Non-
controlling
Interests

 

Total

 

DJO
Finance
LLC

 

Non-
controlling
Interests

 

Total

 

Net income (loss), as reported

 

$

(14,429

)

$

298

 

$

(14,131

)

$

(59,389

)

$

793

 

$

(58,596

)

Foreign currency translation adjustments

 

(5,476

)

 

(5,476

)

(1,424

)

 

(1,424

)

Change in fair value of interest rate swap agreements, net of tax

 

804

 

 

804

 

(1,904

)

 

(1,904

)

Comprehensive income (loss)

 

$

(19,101

)

$

298

 

$

(18,803

)

$

(62,717

)

$

793

 

$

(61,924

)

 

Reclassifications.  The condensed consolidated financial statements and accompanying footnotes reflect certain reclassifications to prior year consolidated financial statements to conform to the current year presentation.

 

Discontinued Operations.  In determining whether a group of assets disposed of (or to be disposed of) should be presented as a discontinued operation, we make a determination of whether the group of assets being disposed of comprises a component of the entity; that is, whether it has historic operations and cash flows that can be clearly distinguished (both operationally and for financial reporting purposes). We also determine whether the cash flows associated with the group of assets have been significantly (or will be significantly) eliminated from our ongoing operations as a result of the disposal transaction and whether we have no significant continuing involvement in the operations of the group of assets after the disposal transaction. If these determinations can be made affirmatively, the results of operations of the group of assets being disposed of (as well as any gain or loss on the disposal transaction) are aggregated for separate presentation apart from our continuing operating results in our condensed consolidated financial statements. See Note 3 for a summary of discontinued operations.

 

Recent Accounting Pronouncements.  As of September 2009, we have adopted ASC 105-10 (formerly SFAS No. 168, “The FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles”), which makes the Codification the source of authoritative US Generally Accepted Accounting Principles recognized by the FASB and applied to non-governmental entities. ASC 105-10 does not change previously issued Accounting Standards, but reorganizes the Accounting Standards into Topics. In circumstances where previous Accounting Standards require a revision, FASB will issue an Accounting Standards Update (“ASU”) on the Topic.

 

In September 2009, the FASB issued ASU 2009-13, which amends ASC 605-25 (formerly EITF Issue No. 08-1, “Revenue Arrangements with Multiple Deliverables.”). ASU 2009-13 provides guidance concerning (1) the determination of whether an arrangement involving multiple deliverables contains more than one unit of accounting, and (2) the manner in which consideration should be measured and allocated to the separate units of accounting in the multiple-element arrangement and is effective for fiscal years beginning on or after June 15, 2010. We are currently evaluating the impact, if any, this issue will have on its consolidated financial statements. However, we do not expect that this issue will result in a change in current practice.

 

In June 2009, the FASB issued SFAS No. 167, “Amendments to FASB Interpretation No. 46 (R)” (“SFAS 167”) which amends certain requirements of FASB Interpretation No. 46, “Consolidation of Variable Interest entities” (“FIN 46”), including the addition of entities previously considered qualifying special-purpose entities.  As of September 26, 2009, this statement has not been transitioned into the ASC Codification, but is effective for fiscal years beginning after November 15, 2009.  We will adopt this statement as of the beginning of 2010 and are currently assessing the potential impact of adoption.

 

In June 2009, the FASB issued SFAS No. 166, “Accounting for the Transfers of Financial Assets as amendment of FASB Statement No. 140” (“SFAS 166”) which amends SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets” (“SFAS 140”).  SFAS 166 makes the following amendments to SFAS 140: 1) removes concept of qualifying special-purpose entities from SFAS 140; 2) modifies the financial components approach used and limits the circumstances in which a transferor has not transferred the original financial asset to an entity that is not consolidated with the transferor in the financial statements; 3) establishes conditions for reporting a transfer of a portion of a financial asset as a sale; 4) redefines a participating interest; 5) clarifies that an entity must consider all arrangements or agreements made contemporaneously with, or in contemplation of, a transfer, even if not entered into at the time of the transfer; 6) clarifies that the transferor must evaluate whether it, its consolidated affiliates included in the financial statements being presented, or its agency effectively control the transferred financial asset directly or indirectly; 7) requires that the transferor recognize and initially measure at fair value all assets obtained and liabilities incurred as a result of the a transfer of an entire asset or group of financial assets accounted for as a sale; 8) removes special provisions for guaranteed mortgage securitizations to require them to be treated that same as any other transfer of financial assets; 9) Removes fair value practicability

 

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exception from measuring the proceeds received by a transferor in a transfer that meet the conditions for sale accounting at fair value; and 10) requires enhanced disclosures.  As of September 26, 2009, this statement has not been transitioned into the ASC Codification, but is effective for fiscal years beginning after November 15, 2009.  We will adopt this statement as of the beginning of 2010 and are currently assessing the potential impact of adoption.

 

In May 2009, the FASB issued, and we adopted, ASC 855-10 (formerly SFAS No. 165, “Subsequent Events”), which requires entities to disclose certain events that occur after the balance sheet date but before the financial statements are issued.  In addition, ASC 855-10 requires entities to disclose the date through which the entity evaluated subsequent events and the basis for such date.

 

As of January 1, 2009, we adopted ASC 815-10-65 (formerly SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities”), which requires entities to disclose the fair values of derivative instruments and their gains and losses in a tabular format and to provide enhanced disclosures about (a) how and why they use derivative instruments, (b) how derivative instruments and related hedged items are accounted for under ASC 815-20 and its related interpretations, and (c) how derivative instruments and related hedged items affect their financial performance, and cash flows.  Except for adding the required disclosures (see Note 15) the adoption of ASC 815-10-65 had no impact on our consolidated financial statements.

 

We have adopted ASC 810-10 (formerly SFAS No. 160, “Non-controlling Interests in Consolidated Financial Statements-an amendment of ARB No. 51, Consolidated Financial Statements”) which amends Accounting Research Bulletin No. 51, “Consolidated Financial Statements”, to establish accounting and reporting standards for the noncontrolling interest in a subsidiary.  This standard defines a noncontrolling interest, previously called a minority interest, as the portion of equity in a subsidiary not attributable, directly or indirectly, to a parent.  ASC 810-10 requires, among other items, that a noncontrolling interest be included in the consolidated statement of financial position within equity separate from the parent’s equity; consolidated net income to be reported at amounts inclusive of both the parent’s and noncontrolling interest’s shares; and if a subsidiary is deconsolidated, any retained noncontrolling equity investment in the former subsidiary be measured at fair value and a gain or loss be recognized in net income based on such fair value.  We have applied the presentation and disclosure requirements of ASC 810-10 retrospectively.

 

We have adopted ASC 805-10 (formerly SFAS No. 141R, “Business Combinations”) as of January 1, 2009, which requires the acquiring entity in a business combination to recognize all the assets acquired and liabilities assumed in the transaction; establishes the acquisition-date fair value as the measurement objective for all assets acquired and liabilities assumed; and requires the acquirer to disclose to investors and other users all of the information they need to evaluate and understand the nature and financial effect of the business combination (see Note 2).

 

2. ACQUISITIONS

 

We account for acquisitions in accordance with ASC 805-10, with the results of operations attributable to each acquisition included in the condensed consolidated financial statements from the date of acquisition.

 

Acquisition of Chattanooga Group Inc.

 

On August 4, 2009 we acquired Chattanooga Group Inc., a Canadian distributor of certain of our products (“Chattanooga Canada”), for $7.2 million.  Our primary reason for the acquisition of Chattanooga Canada was to move from an indirect sales model (i.e., sales to distributors at a discount) to a direct sales model, resulting in increased gross profit and operating income.  Pursuant to the terms of the acquisition agreement and included within the purchase price, is a $1.4 million holdback and a $1.4 million promissory note.  The holdback provides security for potential indemnification claims and, if not used for such, indemnification claims will be paid to the sellers.  The holdback also provides for the accrual of interest at an annual rate of 2.5% for the first 18 months and a variable rate thereafter.  Fifty percent of the holdback with interest is due in January 2011 and the remainder of the balance with interest is due in three years, upon expiration of the tax statute of limitations period.  The note provides for the accrual of interest at an annual rate of 6% with the principal and interest due in August 2010.

 

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The fair values of the assets acquired and the liabilities assumed were estimated in accordance with ASC 805-10.  The purchase price was allocated as follows to the fair values of the net tangible and intangible asset acquired:

 

 

 

Chattanooga
Canada

 

Cash

 

$

59

 

Accounts receivable

 

423

 

Inventories

 

261

 

Liabilities assumed

 

(475

)

Intangible assets

 

5,311

 

Deferred tax liability

 

(1,779

)

Goodwill

 

3,369

 

Total purchase price

 

$

7,169

 

 

The purchase price allocation of the Chattanooga Canada acquisition included approximately $5.0 million assigned to intangible assets related to certain customer relationships existing on the acquisition date and $0.3 million assigned to intangible assets related to a 5-year noncompetition agreement with the seller. The value of the customer relationships was based upon an estimate of the future discounted cash flows that would be derived from sales to those customers.  The value of the noncompetition agreement was based on an estimate of the future discounted cash flows that compares scenarios with and without the noncompetition agreement in place.

 

Goodwill represents the excess of the purchase price over the fair value of tangible and identifiable intangible assets acquired and liabilities assumed. For the Chattanooga Canada acquisition, a value of approximately $3.4 million, representing the difference between the total purchase price and the aggregate fair value assigned to the net tangible assets acquired and the liabilities assumed and the identifiable intangible assets acquired, was assigned to goodwill. The remainder of the goodwill balance is related to estimated synergies in the purchase price. As a result of the acquisition, we anticipate cost savings driven by operating efficiencies.

 

Acquisition of Empi Canada Inc.

 

On August 4, 2009 we acquired Empi Canada Inc., a Canadian distributor of certain of our products (“Empi Canada”), for $7.4 million.  Our primary reason for the acquisition of Empi Canada was to move from an indirect sales model (i.e., sales to distributors at a discount) to a direct sales model, resulting in increased gross profit and operating income.  Pursuant to the terms of the acquisition agreement and included within the purchase price, is a $1.4 million holdback and a $1.4 million promissory note.  The holdback provides security for potential indemnification claims and, if not used for such, indemnification claims will be paid to the sellers.  The holdback also provides for the accrual of interest at an annual rate of 2.5% for the first 18 months and a variable rate thereafter.  Fifty percent of the holdback with interest is due in January 2011 and the remainder of the balance with interest is due in three years, upon expiration of the tax statute of limitations period.  The note provides for the accrual of interest at an annual rate of 6% with the principal and interest due in August 2010.

 

The fair values of the assets acquired and the liabilities assumed were estimated in accordance with ASC 805-10.  The purchase price was allocated as follows to the fair values of the net tangible and intangible asset acquired:

 

 

 

Empi Canada

 

Cash

 

$

29

 

Accounts receivable

 

300

 

Inventories

 

536

 

Other assets

 

19

 

Liabilities assumed

 

(133

)

Intangible assets

 

2,686

 

Deferred tax liability

 

(900

)

Goodwill

 

4,869

 

Total purchase price

 

$

7,406

 

 

The purchase price allocation of the Empi Canada acquisition included approximately $2.5 million assigned to intangible assets related to certain customer relationships existing on the acquisition date and $0.2 million assigned to intangible assets related to a 5-year noncompetition agreement with the seller.  This value of the customer relationships was based upon an estimate of the future discounted cash flows that would be derived from sales to those customers.  The value of the noncompetition agreement was based on an estimate of the future discounted cash flows that compares scenarios with and without the noncompetition agreement in place.

 

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Goodwill represents the excess of the purchase price over the fair value of tangible and identifiable intangible assets acquired and liabilities assumed. For the Empi Canada acquisition, a value of approximately $4.9 million, representing the difference between the total purchase price and the aggregate fair value assigned to the net tangible assets acquired and the liabilities assumed and the identifiable intangible assets acquired, was assigned to goodwill. The remainder of the goodwill balance is related to estimated synergies in the purchase price. As a result of the acquisition, we anticipate cost savings driven by operating efficiencies.

 

Acquisition of DonJoy Orthopaedics Pty., Ltd.

 

On February 3, 2009 we acquired DonJoy Orthopaedics Pty., Ltd. an Australian distributor of certain of our products (“DJO Australia”), for $3.7 million.  Our primary reason for the acquisition of DJO Australia was to move from an indirect sales model (i.e., sales to distributors at a discount) to a direct sales model, resulting in increased gross profit and operating income.  Pursuant to the terms of the acquisition agreement and included within the purchase price at fair value, is an additional amount of up to $0.5 million payable to the selling shareholder of DJO Australia if certain revenue targets are met by December 31, 2009.

 

The fair values of the assets acquired and the liabilities assumed were estimated in accordance with ASC 805-10.  The purchase price was allocated as follows to the fair values of the net tangible and intangible asset acquired:

 

 

 

DJO Australia

 

Cash

 

$

912

 

Accounts receivable

 

397

 

Inventories

 

725

 

Other assets

 

12

 

Liabilities assumed

 

(636

)

Intangible assets

 

1,614

 

Deferred tax liability

 

(484

)

Goodwill

 

899

 

Total purchase price

 

$

3,439

 

 

The purchase price allocation of the DJO Australia acquisition included approximately $1.6 million assigned to intangible assets related to certain customer relationships existing on the acquisition date. This value was based upon an estimate of the future discounted cash flows that would be derived from those customers.

 

Goodwill represents the excess of the purchase price over the fair value of tangible and identifiable intangible assets acquired and liabilities assumed. For the DJO Australia acquisition, a value of approximately $0.9 million, representing the difference between the total purchase price and the aggregate fair value assigned to the net tangible assets acquired and the liabilities assumed and the identifiable intangible assets acquired, was assigned to goodwill.

 

3. DISCONTINUED OPERATIONS

 

On June 12, 2009 we sold our Empi Therapy Solutions (“ETS”) catalog business, formerly known as Rehab Medical Equipment, or RME, to Patterson Medical Supply, Inc. for approximately $21.0 million plus an additional payment related to the retention by DJO of certain outstanding liabilities.  Our ETS business, which was included within our Domestic Rehabilitation Segment, sold a wide range of proprietary and third party rehabilitation products to physical therapists and chiropractors through printed catalog and an on-line e-commerce site.  Financial data for the three and nine months ended September 26, 2009 and September 27, 2008 related to discontinued operations includes the following (in thousands):

 

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 26,
2009

 

September 27,
2008

 

September 26,
2009

 

September 27,
2008

 

Total revenues

 

$

 

$

8,122

 

$

13,450

 

$

24,264

 

 

 

 

 

 

 

 

 

 

 

Pre-tax income (loss)

 

$

(504

)

$

515

 

$

6,390

 

$

1,872

 

Income tax provision (benefit)

 

(237

)

201

 

6,824

 

739

 

Net income (loss)

 

$

(267

)

$

314

 

$

(434

)

$

1,133

 

 

Included within discontinued operations for the three and nine months ended September 26, 2009 is a pre-tax gain on disposal of discontinued operations of $6.5 million. The effective tax rate of the discontinued operations for the nine months ended September 26, 2009 is 107%, and differs from the amount which would have been recorded using the US statutory tax rate due primarily to a large difference in the book and tax basis of goodwill.

 

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4. ACCOUNTS RECEIVABLE RESERVES

 

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

 

 

 

Nine Months Ended

 

 

 

September 26,
2009

 

September 27,
 2008

 

Balance, beginning of period

 

$

36,521

 

$

32,417

 

Provision for doubtful accounts and sales returns

 

25,433

 

15,411

 

Write-offs, net of recoveries

 

(16,334

)

(19,124

)

Balance, end of period

 

$

45,620

 

$

28,704

 

 

5. INVENTORIES

 

Inventories consist of the following (in thousands):

 

 

 

September 26,
2009

 

December 31,
2008

 

Components and raw materials

 

$

28,349

 

$

34,015

 

 

 

 

 

 

 

Work in process

 

4,236

 

5,310

 

Finished goods

 

56,997

 

59,835

 

Inventory held on consignment

 

24,729

 

21,804

 

 

 

114,311

 

120,964

 

Less—inventory reserves

 

(17,199

)

(17,798

)

 

 

$

97,112

 

$

103,166

 

 

A summary of the activity in our reserves for estimated slow moving, excess, obsolete and otherwise impaired inventory is presented below (in thousands):

 

 

 

Nine Months Ended

 

 

 

September 26,
2009

 

September 27,
2008

 

Balance, beginning of period

 

$

17,798

 

$

18,996

 

Provision charged to cost of sales

 

6,296

 

4,540

 

Write-offs, net of recoveries

 

(6,895

)

(7,458

)

 

 

 

 

 

 

Balance, end of period

 

$

17,199

 

$

16,078

 

 

The write-offs to the reserve were principally related to the disposition of fully reserved inventory.

 

6. GOODWILL AND INTANGIBLE ASSETS

 

A summary of adjustments to our goodwill balance for the nine months ended September 26, 2009 is as follows (in thousands):

 

Balance, beginning of period

 

$

1,191,566

 

Sale of a business

 

(11,986

)

Foreign currency translation

 

4,327

 

Acquisitions (See Note 2)

 

9,137

 

Balance, end of period

 

$

1,193,044

 

 

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Identifiable intangible assets consisted of the following as of September 26, 2009 (in thousands):

 

 

 

Gross Carrying
Amount

 

Accumulated
Amortization

 

Intangible Assets,
Net

 

Amortizable intangible assets:

 

 

 

 

 

 

 

Technology-based

 

$

458,763

 

$

(85,000

)

$

373,763

 

Customer-based

 

487,998

 

(86,900

)

401,098

 

 

 

$

946,761

 

$

(171,900

)

774,861

 

Indefinite-lived intangible assets:

 

 

 

 

 

 

 

Trademarks

 

 

 

 

 

435,267

 

Accumulated foreign currency translation adjustments

 

 

 

 

 

4,426

 

Net identifiable intangible assets

 

 

 

 

 

$

1,214,554

 

 

Identifiable intangible assets consisted of the following as of December 31, 2008 (in thousands):

 

 

 

Gross Carrying
Amount

 

Accumulated
Amortization

 

Intangible Assets,
Net

 

Amortizable intangible assets:

 

 

 

 

 

 

 

Technology-based

 

$

458,612

 

$

(56,501

)

$

402,111

 

Customer-based

 

478,387

 

(57,537

)

420,850

 

 

 

$

936,999

 

$

(114,038

)

822,961

 

Indefinite-lived intangible assets:

 

 

 

 

 

 

 

Trademarks

 

 

 

 

 

435,267

 

Accumulated foreign currency translation adjustments

 

 

 

 

 

2,244

 

Net identifiable intangible assets

 

 

 

 

 

$

1,260,472

 

 

Our amortizable intangible assets are being amortized over the estimated useful lives of 10 and nine years on a weighted average basis for technology-based and customer-based intangible assets, respectively.

 

Estimated amortization expense related to identifiable intangible assets for the next five years and thereafter is as follows (in thousands):

 

Remaining 2009

 

$

19,588

 

2010

 

77,081

 

2011

 

75,674

 

2012

 

74,256

 

2013

 

69,399

 

Thereafter

 

458,863

 

 

 

$

774,861

 

 

7. OTHER CURRENT LIABILITIES

 

Other current liabilities consist of the following (in thousands):

 

 

 

September 26,
2009

 

December 31,
2008

 

Wages and related expenses

 

$

23,004

 

$

21,695

 

Commissions and royalties

 

12,206

 

13,799

 

Taxes

 

4,451

 

4,943

 

Professional fees

 

5,477

 

2,453

 

Rebates

 

3,791

 

4,812

 

Accrued ERP costs

 

6,309

 

6,763

 

Interest rate swap derivatives

 

16,029

 

13,272

 

Restructuring costs

 

5,156

 

2,505

 

Other accrued liabilities

 

26,484

 

34,159

 

 

 

$

102,907

 

$

104,401

 

 

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8. LONG-TERM DEBT AND CAPITAL LEASES

 

Long-term debt (including capital lease obligations) consists of the following (in thousands):

 

 

 

September 26,
2009

 

December 31,
2008

 

Term loan under Senior Secured Credit Facility, net of unamortized original issue discount ($9.7 million and $10.9 million at September 26, 2009 and December 31, 2008, respectively)

 

$

1,039,320

 

$

1,043,404

 

Revolving loans outstanding under Senior Secured Credit Facility

 

 

24,000

 

10.875% Senior notes

 

575,000

 

575,000

 

11.75% Senior subordinated notes

 

200,000

 

200,000

 

Loans and revolving credit facilities at various European banks

 

597

 

891

 

Capital lease obligations and other

 

266

 

298

 

 

 

1,815,183

 

1,843,593

 

Less current portion

 

(11,294

)

(11,549

)

Long-term debt and capital leases, net of current portion

 

$

1,803,889

 

$

1,832,044

 

 

Senior Secured Credit Facility

 

On November 20, 2007, we entered into the Senior Secured Credit Facility which consists of a $1,065.0 million term loan facility maturing May 2014 and a $100.0 million revolving credit facility maturing November 2013. We issued the term loan facility at a 1.2% discount, resulting in net proceeds of $1,052.4 million. The original $12.6 million discount is being amortized as additional interest expense over the term of the term loan facility and increases the reported outstanding balance accordingly. The market value of our term loan facility was approximately $1,001.8 million as of September 26, 2009 and was determined using trading prices for our term loan on or near that date. As of September 26, 2009, no amounts were drawn related to our revolving credit facility.

 

Interest Rate and Fees.  Borrowings under the Senior Secured Credit Facility bear interest at a rate equal to an applicable margin plus, at our option, either (a) a base rate determined by reference to the higher of (1) the prime rate of Credit Suisse and (2) the federal funds rate plus 0.50% or (b) the Eurodollar rate determined by reference to the costs of funds for deposits in U.S. dollars for the interest period relevant to each borrowing adjusted for required reserves. The initial applicable margin for borrowings under the term loan facility and the revolving credit facility is 2.00% with respect to base rate borrowings and 3.00% with respect to Eurodollar borrowings. The applicable margin for borrowings under the term loan facility and the revolving credit facility may be reduced subject to us attaining certain leverage ratios.

 

We use interest rate swap agreements in an effort to hedge our exposure to fluctuating interest rates related to a portion of our Senior Secured Credit Facility (See note 15).  On November 20, 2007, we entered into an interest rate swap agreement for a notional amount of $515.0 million at a fixed LIBOR rate of 4.205%. This swap agreement amortizes through December 2009. As of September 26, 2009, the remaining notional amount of the swap was $435.0 million. In February 2009, we entered into two additional non-amortizing interest rate swap agreements. The first is for a notional amount of $550.0 million at a fixed LIBOR rate of 1.04% beginning February 2009 through December 2009 (with a notional amount of $550.0 million as of September 26, 2009). The second is for a notional amount of $750.0 million at a fixed LIBOR rate of 1.88% beginning January 2010 through December 2010.  In August 2009, we entered into four new non-amortizing interest swap agreements with notional amounts aggregating $300.0 million.  Each of the four agreements has a term beginning January 2011 through December 2011. The four agreements are at a weighted average fixed LIBOR rate of 2.5825%.   As of September 26, 2009, our weighted average interest rate for all borrowings under the Senior Secured Credit Facility was 5.3%.

 

In addition to paying interest on outstanding principal under the Senior Secured Credit Facility, we are required to pay a commitment fee to the lenders under the revolving credit facility with respect to the unutilized commitments thereunder. The current commitment fee rate is 0.50% per annum. The commitment fee rate may be reduced subject to us attaining certain leverage ratios. We must also pay customary letter of credit fees.

 

Principal Payments.  We are required to pay annual payments in equal quarterly installments on the loans under the term loan facility in an amount equal to 1.00% of the funded total principal amount through February 2014, with any remaining amount payable in May 2014. Principal amounts outstanding under the revolving credit facility are due and payable in full at maturity.

 

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Prepayments.  The Senior Secured Credit Facility requires us to prepay outstanding term loans, subject to certain exceptions, with (1) 50% (which percentage can be reduced to 25% or 0% upon our attaining certain leverage ratios) of our annual excess cash flow, as defined; (2) 100% of the net cash proceeds above an annual amount of $25.0 million from non-ordinary course asset sales (including insurance and condemnation proceeds) by DJO Finance LLC (“DJOFL”) and its restricted subsidiaries, subject to certain exceptions to be agreed upon, including a 100% reinvestment right if reinvested or committed to reinvest within 15 months of such sale or disposition so long as reinvestment is completed within 180 days thereafter; and (3) 100% of the net cash proceeds from issuances or incurrences of debt by DJOFL and its restricted subsidiaries, other than proceeds from debt permitted to be incurred under the Senior Secured Credit Agreement. The foregoing mandatory prepayments will be applied to the term loan facilities in direct order of maturity.  We have not been required to make any mandatory pre-payments through September 26, 2009.  We may voluntarily prepay outstanding loans under the Senior Secured Credit Facility at any time without premium or penalty, provided that voluntary prepayments of Eurodollar loans made on a date other than the last day of an interest period applicable thereto shall be subject to customary breakage costs.

 

Guarantee and Security.  All obligations under the Senior Secured Credit Facility are unconditionally guaranteed by DJO Holdings LLC (“Holdings”) and each existing and future direct and indirect wholly-owned domestic subsidiary of DJOFL other than immaterial subsidiaries, unrestricted subsidiaries and subsidiaries that are precluded by law or regulation from guaranteeing the obligations (collectively, the “Guarantors”).

 

All obligations under the Senior Secured Credit Facility, and the guarantees of those obligations, are secured by pledges of 100% of the capital stock of DJOFL, 100% of the capital stock of each wholly owned domestic subsidiary and 65% of the capital stock of each wholly owned foreign subsidiary that is, in each case, directly owned by DJOFL or one of the Guarantors; and a security interest in, and mortgages on, substantially all tangible and intangible assets of Holdings, DJOFL and each Guarantor.

 

Certain Covenants and Events of Default.  The Senior Secured Credit Facility contains a number of covenants that, among other things, restrict, subject to certain exceptions, our and our subsidiaries’ ability to:

 

·                  incur additional indebtedness;

·                  create liens on assets;

·                  change fiscal years;

·                  enter into sale and leaseback transactions;

·                  engage in mergers or consolidations;

·                  sell assets;

·                  pay dividends and other restricted payments;

·                  make investments, loans or advances;

·                  repay subordinated indebtedness;

·                  make certain acquisitions;

·                  engage in certain transactions with affiliates;

·                  restrict the ability of restricted subsidiaries that are not Guarantors to pay dividends or make distributions;

·                  amend material agreements governing our subordinated indebtedness; and

·                  change our lines of business.

 

In addition, the Senior Secured Credit Facility requires us to maintain a maximum senior secured leverage ratio of 4.50:1 as of the twelve months ended September 26, 2009, stepping down over time to 3.25:1 by the end of 2011. The Senior Secured Credit Facility also contains certain customary affirmative covenants and events of default. Our maximum senior secured leverage ratio was within the covenant level as of September 26, 2009.

 

10.875% Senior Notes Payable

 

On November 20, 2007, DJOFL and DJO Finance Corporation (“Finco”) (collectively, the “Issuers”) issued $575.0 million aggregate principal amount of 10.875% Notes under an agreement dated as of November 20, 2007 (the “10.875% Indenture”) among the Issuers, the guarantors party thereto and The Bank of New York Mellon (formerly known as The Bank of New York), as trustee.

 

The 10.875% Notes require semi-annual interest payments of approximately $31.3 million each May 15 and November 15 and are due November 15, 2014. The market value of the 10.875% Notes was approximately $582.2 million as of September 26, 2009 and was determined using trading prices for the 10.875% Notes on or near that date. We believe the trading prices reflect certain differences between prevailing market terms and conditions and the actual terms of our 10.875% Notes.

 

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Optional Redemption.  Under the 10.875% Indenture, prior to November 15, 2011, the Issuers have the option to redeem some or all of the 10.875% Notes for cash at a redemption price equal to 100% of the then outstanding principal balance plus an applicable make-whole premium plus accrued and unpaid interest. Beginning on November 15, 2011, the Issuers may redeem some or all of the 10.875% Notes at a redemption price of 105.438% of the then outstanding principal balance plus accrued and unpaid interest. The redemption price decreases to 102.719% and 100% of the then outstanding principal balance at November 2012 and November 2013, respectively. Additionally, from time to time, before November 15, 2010, the Issuers may redeem up to 35% of the 10.875% Notes at a redemption price equal to 110.875% of the principal amount then outstanding, in each case, with proceeds we raise, or a direct or indirect parent company raises, in certain offerings of equity of DJOFL or its direct or indirect parent companies, as long as at least 65% of the aggregate principal amount of the notes issued remains outstanding.

 

Change of Control.  Upon the occurrence of a change of control, unless DJOFL has previously sent or concurrently sends a notice exercising its optional redemption rights with respect to all of the then-outstanding 10.875% Notes, DJOFL will be required to make an offer to repurchase all of the then-outstanding 10.875% Notes at 101% of their principal amount, plus accrued and unpaid interest.

 

Covenants.  The 10.875% Indenture contains covenants limiting, among other things, our and our restricted subsidiaries’ ability to incur additional indebtedness or issue certain preferred and convertible shares, pay dividends on, redeem, repurchase or make distributions in respect of the capital stock of DJO or make other restricted payments, make certain investments, sell certain assets, create liens on certain assets to secure debt, consolidate, merge, sell or otherwise dispose of all or substantially all of our assets, enter into certain transactions with affiliates, and designate our subsidiaries as unrestricted subsidiaries. As of September 26, 2009, we were in compliance with all applicable covenants.

 

11.75% Senior Subordinated Notes Payable

 

The Issuers issued $200.0 million aggregate principal amount of 11.75% senior subordinated notes in November 2006 (the “11.75% Notes”). The 11.75% Notes require semi-annual interest payments of approximately $11.0 million each May 15 and November 15 and are due November 15, 2014.

 

The market value of the 11.75% Notes was approximately $185.0 million as of September 26, 2009 and was determined using trading prices for the 11.75% Notes on or near that date. We believe the trading prices reflect certain differences between prevailing market terms and conditions and the actual terms of our 11.75% Notes.

 

The 11.75% Notes contain similar provisions as the 10.875% Notes with respect to change of control and covenant requirements. Under the Indenture governing the 11.75% Notes (the “11.75% Indenture”), prior to November 15, 2010, the Issuers have the option to redeem some or all of the 11.75% Notes for cash at a redemption price equal to 100% of the then outstanding principal balance plus an applicable make-whole premium plus accrued and unpaid interest. Beginning on November 15, 2010, the Issuers may redeem some or all of the 11.75% Notes at a redemption price of 105.875% of the then outstanding principal balance plus accrued and unpaid interest on the 11.75% Notes. The redemption price decreases to 102.938% and 100% of the then outstanding principal balance at November 2011 and November 2012, respectively. Additionally, from time to time, before November 15, 2009, the Issuers may redeem up to 35% of the 11.75% Notes at a redemption price equal to 111.75% of the principal amount then outstanding, in each case, with proceeds we raise, or a direct or indirect parent company raises, in certain offerings of equity of DJOFL or its direct or indirect parent companies, as long as at least 65% of the aggregate principal amount of the notes issued remains outstanding.

 

Our ability to continue to meet the covenants related to our indebtedness specified above in future periods will depend, in part, on events beyond our control, and we may not continue to meet those ratios. A breach of any of these covenants in the future could result in a default under the Senior Secured Credit Facility, the 11.75% Indenture and the 10.875% Indenture (collectively, the “Indentures”), at which time the lenders could elect to declare all amounts outstanding under the Senior Secured Credit Facility to be immediately due and payable. Any such acceleration would also result in a default under the Indentures.

 

Debt Issue Costs

 

We incurred $30.7 million, $24.5 million, and $10.2 million of debt issue costs in connection with the Senior Secured Credit Facility, the 10.875% Notes, and the 11.75% Notes, respectively. These costs have been capitalized and are included in other non-current assets in the condensed consolidated balance sheets at September 26, 2009 and December 31, 2008. Debt issue costs are being amortized over the terms of the respective debt instruments through November 2014.

 

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9. STOCK OPTION PLANS AND STOCK-BASED COMPENSATION

 

2007 Stock Incentive Plan

 

We have one active equity plan, the DJO Incorporated 2007 Incentive Stock Plan (the “2007 Plan”), which is authorized to grant options up to 7,500,000 shares, subject to adjustment in certain events. Options issued under the 2007 Plan can be either incentive stock options or non-qualified stock options. The exercise price of stock options granted will not be less than 100% of the fair market value of the underlying shares on the date of grant, and will expire no more than ten years from the date of grant. In addition, we adopted a form of non-statutory stock option agreement (the “DJO Form Option Agreement”) for employee stock option awards under the 2007 Plan. Under the DJO Form Option Agreement, one-third of stock options will vest over a specified period of time (typically five years) contingent solely upon the awardees’ continued employment with us (“Time-Based Tranche”). Another one-third of stock options will vest over a specified performance period (typically four to five years) from the date of grant upon the achievement of certain pre-determined performance targets based on Adjusted EBITDA and free cash flow on an annual basis (“Performance-Based Tranche”), as defined in the DJO Form Option Agreement.  The final one-third of stock options was originally determined to vest based upon achieving enhanced pre-determined performance targets based on Adjusted EBITDA and free cash flow (“Enhanced Performance-Based Tranche”), but has been modified as described herein. The DJO Form Option Agreement includes certain forfeiture provisions upon an awardees’ separation from service with us.

 

During March 2009, we made modifications to the terms of the outstanding options and the 2007 Plan. The Time-Based Tranche terms remain the same as discussed above. The performance conditions for the portion of the options within the Performance-Based Tranche that vest based on 2009 financial performance were modified to require achievement of the levels of Adjusted EBITDA and free cash flow that were established in connection with our 2009 budget process. As with the original terms of such options, the optionees may earn 80% or more of such portion of options upon achievement of at least a minimum threshold amount of the budgeted Adjusted EBITDA and of the free cash flow targets for 2009. The financial targets for the Performance-Based Tranches for the years 2010-2012 remain unchanged and we added financial targets for 2013-2015. The vesting provisions of the Performance-Based Tranche were modified to provide that upon achievement of the annual target for a given year, the annual portion of the tranche associated with all prior years will also vest to the extent not previously vested. The financial performance targets for the entire Enhanced Performance-Based Tranche were replaced by targets with different financial metrics. These new targets require achievement of a minimum internal rate of return (“IRR”) and multiple of invested capital (“MOIC”), each measured with respect to Blackstone’s aggregate investment in our capital stock, to be achieved by Blackstone following a liquidation of all or a portion of its investment in our capital stock. As a result of this modification, the Enhanced Performance-Based Tranche has both a performance component and a market condition component.

 

Options granted under the 2007 Plan contain change-in-control provisions that cause the vesting of a portion of the tranches upon the occurrence of a change-in-control, as follows: 1) the option shares in the Time-Based Tranche will become immediately exercisable upon the occurrence of a change-in-control if the optionee remains in continuous employment of the Company until the consummation of the change-in-control and 2) the option shares of the Performance-Based Tranche for the year in which such change-in-control is consummated and for any subsequent performance periods will become immediately exercisable if the optionee remains in continuous employment of the Company until the consummation of the change-in-control. This provision does not operate to vest the Enhanced Performance-Based Tranche which requires the achievement of the IRR and MOIC targets by Blackstone on its equity investment in us.

 

Employee Stock Options

 

During the nine months ended September 26, 2009 we granted 708,932 stock options under the 2007 Plan to our executive officers, senior management, and certain other employees.

 

For the three and nine months ended September 26, 2009, we recorded non-cash compensation expense of approximately $0.9 million and $2.2 million, respectively, associated with stock options issued under the 2007 Plan.  During the first half of 2008, the achievement of 2008 targets was deemed probable and we recorded non-cash compensation expense of approximately $0.4 million. At September 27, 2008, the Company reassessed the probability of achieving 2008 targets and determined that achievement of such targets was no longer probable.  As such, for the three months ended September 27, 2008, we recorded a net reversal of non-cash compensation expense of approximately $22,000.  For the nine months ended September 27, 2008, we recorded non-cash compensation expense of approximately $1.2 million associated with stock options under the 2007 Plan.

 

The fair value of each option award is estimated on the date of grant, or modification, using the Black-Scholes-Merton option pricing model for service and performance based awards, and a binomial model for market based awards. In estimating fair value for new options issued under the 2007 Plan, expected volatility was based completely on historical volatility of comparable publicly-traded companies. As our historical share option exercise experience does not provide a reasonable basis upon which to estimate the

 

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expected term, we used the simplified approach to calculate the expected term. Expected life is calculated in two tranches based on the employment level defined as executive or employee. The risk-free rate used in calculating fair value of service and performance-based stock options for periods within the expected term of the option is based on the U.S. Treasury yield bond curve in effect at the time of grant.

 

We record expense for awards with a performance condition only to the extent deemed probable of achievement, with the exception of market-based options previously modified during the first quarter of 2008 and reallocated to the Time-Based and Performance-Based Tranches.  The expense related to the previously modified options is recognized ratably over the expected term of the stock options using the original grant-date fair value regardless of the probability of achieving the performance conditions.  We are required to reassess at each reporting period whether the achievement of any performance condition is probable, at which time we would recognize the related compensation expense over the remaining performance or service period, if any. During 2008 we did not recognize compensation expense associated with our Performance-Based Tranche as the performance targets under the original grant were not achieved.  As a result of the modification of the 2009 targets and our actual results for the nine months ended September 26, 2009, we now believe that it is probable that we will achieve the 2009 performance targets.  As such, for the nine months ended September 26, 2009, we recognized compensation expense for the modified options and the annual portion of the tranche associated with the 2008 options that were not previously vested.  To date, no amount has been recorded for the Enhanced Performance-Based Tranche, as achievement of the performance component is not deemed probable at this time.

 

As a result of the 2009 modification, we will no longer use the original grant date fair value to measure compensation cost and have re-assessed the assumptions used to determine the fair value of options at the date of modification and at subsequent grant dates. The following table presents the assumptions we used in calculating the fair value of employee stock options for the nine months ended September 26, 2009 and September 27, 2008:

 

 

 

Nine Months Ended

 

 

 

September 26,
2009

 

September 27,
2008

 

Expected dividends

 

0.0%

 

0.0%

 

Expected volatility

 

34.4 – 34.7%

 

27.4% – 60.0%

 

Risk-free rate

 

2.30 – 2.79%

 

3.21% – 4.70%

 

Expected term (in years)

 

6.1 – 6.3 years

 

4.7 – 7.1 years

 

 

Non-Employee Stock Options

 

During the nine months ended September 26, 2009 we granted 24,800 stock options under the 2007 Plan to non-employees (“non-employee options”). The non-statutory stock option agreement for the non-employees states that the options have an exercise price of $16.46 per share, which was equal to 100% of the estimated fair market value of the stock and will become effective upon the defined effective date and expire ten years from that date. A number of shares equal to 25% of the options granted become vested and exercisable at the end of each of the first four years subsequent to the effective date, provided the optionee is still affiliated with and providing services to the Company. The non-employee option agreement does not include any performance requirements on the optionee’s part in order to vest in the options granted.  Non-employee options are accounted for in accordance with ASC 505-50 (formerly Emerging Issues Task Force Issue No. 96-18, “Accounting for Equity Instruments That are Issued to Other Than Employees for Acquiring, or in Counjunction with Selling Goods or Services”) which states that the fair value of each option will be re-measured at the end of each reporting period until vested, when the final fair value of the vesting of the option is determined.

 

10. SEGMENT AND GEOGRAPHIC INFORMATION

 

We provide a broad array of orthopedic rehabilitation and regeneration products, as well as implants to customers in the United States and abroad.  In the first quarter of 2009, we changed how we report financial information to the Chief Operating Decision Maker.  Prior to 2009, we included the international components of the Surgical, Chattanooga, and Empi businesses in either the Surgical or Domestic Rehabilitation segments, as their operations were managed domestically.  During the fourth quarter of 2008, we effected an operational reorganization which resulted in the non-U.S. components of all of our businesses being managed abroad.  As a result, the segment financial data for the three and nine months ended September 26, 2009 reflects this new segmentation and the data for the three and nine months ended September 27, 2008, as noted below, has been restated to reflect this change.  We currently develop, manufacture and distribute our products through the following three operating segments.

 

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Domestic Rehabilitation Segment

 

Our Domestic Rehabilitation Segment, which generates its revenues in the United States, is divided into five main businesses:

 

·                  Bracing and Supports.  Our Bracing and Supports business unit offers our DonJoy, ProCare and Aircast products, including rigid knee bracing, orthopedic soft goods, cold therapy products, and vascular systems.  This business unit also includes our OfficeCare business, through which we maintain an inventory of soft goods and other products at healthcare facilities, primarily orthopedic practices, for immediate distribution to patients.

 

·                  Empi.  Our Empi business unit offers products in the categories of home electrotherapy, iontophoresis, and home traction.

 

·                  Regeneration.  Our Regeneration business unit primarily sells our bone growth stimulation products.  These products are sold through a combination of certain DonJoy sales representatives and additional independent and employed sales representatives dedicated to selling these products either directly to patients or independent distributors.  We arrange billing to these third party payors or patients for products directly sold to the patients.

 

·                  Chattanooga.  Our Chattanooga business unit offers products in the clinical rehabilitation market in the categories of clinical electrotherapy devices, clinical traction devices, and other clinical products and supplies such as treatment tables, continuous passive motion (“CPM”) devices and dry heat therapy.

 

·                  Athlete Direct.  Our Athlete Direct business unit offers our Compex electrostimulation device to consumers, ranging from people interested in improving their fitness to competitive athletes, to assist in athletic training programs through muscle development and to accelerate muscle recovery after training sessions.

 

International Segment

 

Our International Segment, which generates most of its revenues in Europe, sells all of our products and certain third party products through a combination of direct sales representatives and independent distributors.

 

Domestic Surgical Implant Segment

 

Our Domestic Surgical Implant Segment develops, manufactures and markets a wide variety of knee, hip and shoulder implant products that serve the orthopedic reconstructive joint implant market in the United States.

 

Information regarding our reportable business segments is presented below (in thousands). This information excludes the impact of certain expenses not allocated to segments, primarily general corporate expenses and non-recurring charges related to our integration activities. All prior periods presented have been restated to reflect our current reportable segments.

 

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 26,
2009

 

September 27,
2008

 

September 26,
2009

 

September 27,
2008

 

Net sales:

 

 

 

 

 

 

 

 

 

Domestic Rehabilitation Segment

 

$

162,182

 

$

162,521

 

$

468,991

 

$

468,104

 

International Segment

 

58,588

 

58,485

 

172,863

 

194,794

 

Domestic Surgical Implant Segment

 

15,416

 

14,509

 

47,097

 

46,004

 

Consolidated net sales

 

$

236,186

 

$

235,515

 

$

688,951

 

$

708,902

 

 

 

 

 

 

 

 

 

 

 

Gross profit:

 

 

 

 

 

 

 

 

 

Domestic Rehabilitation Segment

 

$

108,523

 

$

101,127

 

$

310,910

 

$

296,606

 

International Segment

 

32,434

 

35,669

 

98,645

 

117,726

 

Domestic Surgical Implant Segment

 

11,779

 

11,888

 

36,541

 

37,864

 

Expenses not allocated to segments/Eliminations

 

(2,589

)

(115

)

(4,340

)

(5,540

)

Consolidated gross profit

 

$

150,147

 

$

148,569

 

$

441,756

 

$

446,656

 

 

 

 

 

 

 

 

 

 

 

Operating income:

 

 

 

 

 

 

 

 

 

Domestic Rehabilitation Segment

 

$

48,402

 

$

36,903

 

$

127,539

 

$

100,936

 

International Segment

 

10,625

 

12,239

 

33,556

 

43,803

 

Domestic Surgical Implant Segment

 

2,805

 

2,767

 

8,982

 

8,983

 

Expenses not allocated to segments/Eliminations

 

(38,274

)

(33,050

)

(114,382

)

(112,882

)

Consolidated operating income

 

$

23,558

 

$

18,859

 

$

55,695

 

$

40,840

 

 

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The accounting policies of the reportable segments are the same as the accounting policies of the Company. We allocate resources and evaluate the performance of segments based on net sales, gross profit, operating income and other non-GAAP measures as defined. Moreover, we do not allocate assets to reportable segments because a significant portion of assets are shared by the segments.

 

Geographic Area

 

Following are our net sales by geographic area, based on location of customer (in thousands):

 

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 26,
2009

 

September 27,
2008

 

September 26,
2009

 

September 27,
2008

 

Net sales:

 

 

 

 

 

 

 

 

 

United States

 

$

177,598

 

$

177,030

 

$

516,088

 

$

514,108

 

Germany

 

18,612

 

6,692

 

53,312

 

47,912

 

Other Europe, Middle East, & Africa

 

25,528

 

40,586

 

81,174

 

114,271

 

Asia Pacific

 

3,429

 

3,678

 

10,277

 

10,196

 

Other

 

11,019

 

7,529

 

28,100

 

22,415

 

 

 

$

236,186

 

$

235,515

 

$

688,951

 

$

708,902

 

 

11. INCOME TAXES

 

Income taxes for the interim periods presented have been included in the accompanying unaudited condensed consolidated financial statements on the basis of an estimated annual effective tax rate, adjusted for discrete items. The tax benefit for these periods differed from the amount which would have been recorded using the U.S. statutory tax rate due primarily to the impact of foreign taxes, including favorable adjustments related to prior year foreign taxes, unfavorable adjustments related to deferred foreign exchange gains, deferred taxes on the assumed repatriation of foreign earnings and the favorable impact of new California legislation discussed below.

 

For the three and nine months ended September 26, 2009, we recorded an income tax benefit of approximately $3.0 million and $19.9 million, respectively, on pre-tax losses of approximately $13.9 million and $57.8 million, respectively.  For the three and nine months ended September 27, 2008, we recorded an income tax benefit of approximately $11.0 million and $29.0 million, respectively, on pre-tax losses of approximately $25.5 million and $88.7 million, respectively.

 

During the first quarter of 2009, the state of California enacted legislation which will allow corporate taxpayers to elect to use a single sales factor apportionment formula to apportion business income to California for tax years beginning on or after January 1, 2011. We anticipate making this election in fiscal year 2011 and thereafter. In the first quarter of 2009, we recorded a tax benefit of $3.8 million related to the enactment of this legislation which represents a reduction in our net deferred tax liabilities due to a lower effective state tax rate.

 

We and our subsidiaries file income tax returns in the U.S. federal jurisdiction, various states and foreign jurisdictions. With few exceptions, we are no longer subject to U.S. federal, state and local, or non-U.S. income tax examinations by tax authorities for years before 2005. At December 31, 2008, our gross unrecognized tax benefits were $15.4 million.  For the three and nine months ended September 26, 2009, we increased our gross unrecognized tax benefits by $0.4 million and $0.7 million, respectively, due to additions and settlements of unrecognized tax benefits related to tax positions of prior years.  For the three and nine months ended September 26, 2009, we recognized an additional $0.1 million and $0.4 million, respectively, in interest and penalties.  Our total gross unrecognized tax benefits were $16.1 million at September 26, 2009, including $1.6 million related to interest and penalties.  We do not anticipate a decrease in any gross uncertain tax positions within the next twelve months.  Due to the adoption of ASC 805-740 (formerly SFAS No. 141R, “Business Combinations”) on  January 1, 2009, all of our unrecognized tax benefits will impact our effective tax rate upon recognition. We believe that it is reasonably possible that an increase of $0.4 million in unrecognized tax benefits related to various immaterial state exposures may be necessary within the next twelve months.

 

12. RESTRUCTURING AND RELATED CHARGES

 

In June 2009, we announced our plans to close our Chattanooga manufacturing and distribution facility, located in Hixson, Tennessee, and to integrate the operations of the Chattanooga site into our other existing sites. The transition of our Chattanooga activities is expected to take approximately nine to 12 months to complete. As a result of this transition, we expect to incur approximately $6.0 million to $8.0 million of cash expenses, mainly related to one-time termination benefits and employee retention.

 

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A summary of the activity relating to the restructuring for the period from June 1, 2009 through September 26, 2009 is as follows (in thousands):

 

 

 

Severance &
Employee
Retention

 

Other

 

Total

 

Balance, beginning of period

 

$

 

$

 

$

 

Expensed during period

 

985

 

 

985

 

Payments made during period

 

(25

)

 

(25

)

Balance at June 27, 2009

 

960

 

 

960

 

Expensed during period

 

2,171

 

305

 

2,476

 

Payments made during period

 

(391

)

(31

)

(422

)

Balance at September 26, 2009

 

$

2,740

 

$

274

 

$

3,014

 

 

Expenses incurred related to the transition of our Chattanooga activities are recorded within selling, general and administrative expense on our statement of operations.

 

13. COMMITMENTS AND CONTINGENCIES

 

The manufacture and sale of orthopedic devices and related products exposes us to significant risks of product liability claims, lawsuits and product recalls. From time to time, we have been, and we are currently, the subject of a number of product liability claims and lawsuits relating to our products. We are currently defendants in approximately 80 product liability cases related to a disposable drug infusion pump product manufactured by two third party manufacturers that we distributed through our Bracing and Supports business unit of our Domestic Rehabilitation segment. We discontinued our sale of these products in the second quarter of 2009. These cases have been brought against the manufacturers and certain distributors of these pumps, and in some cases, the manufacturers of the anesthetics used in these pumps. All of these lawsuits allege that the use of these pumps with certain anesthetics in certain shoulder surgeries over prolonged periods have resulted in cartilage damage to the plaintiffs. We have sought indemnity and tendered the defense of these cases to the two manufacturers who supplied these pumps to us, to their products liability carrier and to our product liability carrier. The product liability carrier for both of the two manufacturers has accepted coverage for our defense of these claims; however, both manufacturers have rejected our tenders of indemnity.  Our product liability carrier has also accepted coverage of these cases, subject to customary reservations, and was providing us with the defense until the carrier for the manufacturers began providing a defense. The lawsuits allege damages ranging from unspecified amounts to claims between $1.0 million and $10.0 million. These cases are in varying stages of discovery.

 

We maintain product liability insurance which is subject to annual renewal and our recently renewed policy (together with excess policies) provides for coverage of up to a limit of $25.0 million, subject to a self-insured retention of $50,000 on non-invasive products (other than our IceMan cold therapy product), a self-insured retention of $250,000 on invasive products (other than our pain pump products) and a self-insured retention of $500,000 for pain pumps and the IceMan cold therapy product, with an aggregate self-insured retention of $1.0 million for all product liability claims. We believe our current product liability insurance coverage is adequate. However, 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. In addition, in certain instances, a product liability claim could also result in our having to recall some of our products, which could result in significant costs to us. As of September 26, 2009 and December 31, 2008, we have accrued approximately $2.0 million and $1.8 million, respectively, for product liability claims expenses based upon previous claim experience in part due to the fact that in 2003 we exceeded the coverage limits in effect at that time for certain historical product liability claims involving one of our discontinued surgical implant products and such products are excluded from coverage under our current policies.

 

Due to the nature of our business, we are subject to a variety of audits by government agencies and other private interests.  In the first quarter of 2008, we received a U.S. Food and Drug Administration (“FDA”) Form 483 “Inspectional Observations” in connection with an FDA audit of the Chattanooga business unit of our Domestic Rehabilitation Segment, stating that we failed to report certain customer complaints claiming that our muscle stimulator devices malfunctioned, and that we did not adequately implement corrective and preventive action to prevent recurrence of potential product failures relating to our muscle stimulator devices. The FDA auditor also recommended that we recall a series of ultrasound devices that had experienced operating issues in 2005, and we are implementing such a recall. We received a warning letter from the FDA in June 2008 relating to reporting issues on the muscle stimulator device complaints and requesting software verification and validation plans and reports regarding the correction of problems associated with the ultrasound product. We believe that we have addressed these areas of concern adequately. In a recent FDA audit of our Chattanooga facility, as a follow-up to the warning letter we received in June 2008, the FDA issued no Form 483 “Inspectional Observations.”  However, we cannot assure you that the FDA will not take further action along these lines in the future.

 

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In the third quarter of 2009, we received an FDA Form 483 “Inspectional Observations” in connection with an FDA audit of our Domestic Surgical Implant Segment, stating that we failed to follow our standard operating procedures to ensure that the designs of certain products were correctly transferred into production; we failed to adequately analyze certain quality data to identify existing and potential causes of nonconforming product and quality problems, resulting in disposal or reworking of certain nonconforming parts in the later stages of our production processes; our complaint handling procedures were not well defined to ensure that all complaints are processed in a uniform and timely manner; and we failed to follow our standard operating procedures related to procurement to minimize receipt of nonconforming materials from suppliers. We are reviewing these inspectional observations to determine the appropriate remedial action. We cannot assure you that the FDA will not take further action in the future, including issuing a warning letter related to these observations.

 

On April 15, 2009, we became aware of a Qui Tam action filed in Federal Court in Boston, Massachusetts in March 2005 and amended in December 2007 that names us as defendants along with each of the other companies that manufactures and sells external bone growth stimulators, as well as our principal stockholder, The Blackstone Group, and the principal stockholder of one of the other companies in the bone growth stimulation business.  The case was sealed when originally filed and unsealed in March 2009.  The plaintiff, or relator, alleges that the defendants have engaged in Medicare fraud and violated Federal and state false claims acts from the time of the original introduction of the devices by each defendant to the present by seeking reimbursement for bone growth stimulators as a purchased item rather than a rental item.  The relator also alleges that the defendants are engaged in other marketing practices constituting violations of the Federal and various state antikickback statutes.  Shortly before becoming aware of the Qui Tam action, we were advised that our bone growth stimulator business was the subject of an investigation by the Department of Justice (“DOJ”), and on April 10, 2009, we were served with a subpoena under the Health Insurance Portability and Accountability Act seeking numerous documents relating to the marketing and sale by us of bone growth stimulators.  We believe that this subpoena is related to the DOJ’s investigation of the allegations in the Qui Tam action, although the DOJ has decided not to intervene in the Qui Tam action at this time.  The Company believes that its marketing practices in the bone growth stimulation business are in compliance with applicable legal standards and intends to defend this case vigorously.

 

14. RELATED PARTY TRANSACTIONS

 

Blackstone Management Partners V L.L.C. (“BMP”), an affiliate of our major shareholder, provides certain monitoring, advisory and consulting services to us for an annual monitoring fee equal to the greater of $7.0 million or 2% of consolidated EBITDA as defined in the Transaction and Monitoring Fee Agreement, payable in the first quarter of each year. At any time in connection with or in anticipation of a change of control of DJOFL, a sale of all or substantially all of DJOFL’s assets or an initial public offering of common stock of DJOFL, BMP may elect to receive, in lieu of remaining annual monitoring fee payments, a single lump sum cash payment equal to the then-present value of all then-current and future annual monitoring fees payable under the transaction and monitoring fee agreement, assuming a hypothetical termination date of the agreement to be the twelfth anniversary of such election. The monitoring fee agreement will continue until the earlier of the twelfth anniversary of the date of the agreement or such date as DJOFL and BMP may mutually determine. DJOFL will agree to indemnify BMP and its affiliates, directors, officers, employees, agents and representatives from and against all liabilities relating to the services contemplated by the transaction and monitoring fee agreement and the engagement of BMP pursuant to, and the performance of BMP and its affiliates of the services contemplated by, the transaction and monitoring fee agreement. For each of the three and nine month periods ended September 26, 2009 and September 27, 2008, we recognized $1.75 million and $5.25 million, respectively, related to the monitoring fee, which is recorded as a component of selling, general and administrative expense in the unaudited condensed consolidated statements of operations.

 

15. DERIVATIVE INSTRUMENTS

 

We operate internationally and are therefore exposed to foreign currency exchange rate fluctuations in the normal course of our business, in particular to changes in the Mexican Peso due to our Mexico-based manufacturing operations that incur costs that are largely denominated in Mexican Pesos. As part of our risk management strategy, we use derivative instruments to hedge portions of our exposure. While our foreign exchange contracts act as economic hedges, we have not designated such instruments as hedges under ASC 815-20.  Before acquiring a derivative instrument to hedge a specific risk, potential natural hedges are evaluated. Derivative instruments are only utilized to manage underlying exposures that arise from our business operations. Factors considered in the decision to hedge an underlying market exposure include the materiality of the risk, the volatility of the market, the duration of the hedge, and the availability, effectiveness and cost of derivative instruments.  At September 26, 2009, we had 53 foreign exchange forward contracts, with a notional amount of $10.9 million and an aggregate fair market value of approximately $11.4 million. These foreign exchange forward contracts expire weekly throughout the fiscal year 2009.

 

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Additionally, we make use of debt financing as a source of funds and are therefore exposed to interest rate fluctuations in the normal course of business. Our credit facilities are subject to floating interest rates. We manage the risk of unfavorable movements in interest rates by hedging a portion of the outstanding loan balance, thereby locking in a fixed rate on a portion of the principal, reducing the effect of possible rising interest rates and making interest expense more predictable.  On November 20, 2007, we entered into an interest rate swap agreement related to the Senior Secured Credit Facility for a notional amount of $515.0 million at a fixed LIBOR rate of 4.205% amortizing through an expiration date in December 2009 (the notional amount was $435.0 million as of September 26, 2009).  In February 2009, we entered into two new non-amortizing interest rate swap agreements.  The first agreement is for a notional amount of $550.0 million at a fixed LIBOR rate of 1.04% beginning February 2009 amortizing through December 2009 (the notional amount was $550.0 million as of September 26, 2009).  The second agreement is for a notional amount of $750.0 million at a fixed LIBOR rate of 1.88% with a term beginning January 2010 through December 2010.  In August 2009, we entered into four new non-amortizing interest swap agreements with notional amounts aggregating $300.0 million.  Each of the four agreements has a term beginning January 2011 through December 2011. The four agreements are at a weighted average fixed LIBOR rate of 2.5825%.  We have designated these interest rate swap agreements as cash flow hedges under ASC 815-20.

 

In accordance with ASC 820-10-35 (formerly SFAS No. 157, “Fair Value Measurements”), we follow the three levels of the fair value hierarchy for disclosure of the inputs to valuation. This hierarchy prioritizes the inputs into three broad levels as follows. Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities. Level 2 inputs are quoted prices for similar assets and liabilities in active markets or inputs that are observable for the asset or liability, either directly or indirectly through market corroboration, for substantially the full term of the financial instrument. Level 3 inputs are unobservable inputs based on our own assumptions used to measure assets and liabilities at fair value. A financial asset or liability’s classification within the hierarchy is determined based on the lowest level input that is significant to the fair value measurement. At September 26, 2009, the fair value of our interest rate swap agreements and our foreign currency exchange forward contracts were determined through the use of models that consider various assumptions, including time value, yield curves, as well as other relevant economic measures, which are inputs that are classified as Level 2 in the valuation hierarchy.

 

The following table summarizes our derivative instruments, which, since the fair values reflect gains and losses are, included within our assets and other current and non-current liabilities, respectively, in our condensed consolidated balance sheets (in thousands):

 

 

 

September 26,
2009

 

December 31,
2008

 

Assets:

 

 

 

 

 

Foreign exchange contracts

 

$

427

 

$

 

Total derivative assets

 

$

427

 

$

 

 

 

 

 

 

 

Liabilities:

 

 

 

 

 

Foreign exchange contracts

 

$

 

$

4,162

 

Interest rate swaps

 

18,599

 

13,272

 

Total derivative liabilities

 

$

18,599

 

$

17,434

 

 

The following table summarizes the effect our derivative instruments have on our condensed consolidated statements of operations (in thousands):

 

 

 

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

Location of Gain or
(Loss)

 

September 26,
2009

 

September 27,
2008

 

September 26,
2009

 

September 27,
2008

 

 

 

 

 

 

 

 

 

 

 

 

 

Foreign exchange contracts

 

Other income (expense), net

 

$

427

 

$

163

 

$

(2,945

)

$

914

 

Interest rate swaps

 

Interest expense

 

(5,001

)

(1,741

)

(12,629

)

(2,823

)

Total net loss

 

 

 

$

(4,574

)

$

(1,578

)

$

(15,574

)

$

(1,909

)

 

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16. SUPPLEMENTAL GUARANTOR CONDENSED CONSOLIDATING FINANCIAL STATEMENTS

 

On November 20, 2007, DJOFL and its direct wholly-owned subsidiary, Finco, issued the 10.875% Notes with an aggregate principal amount of $575.0 million. On November 3, 2006, DJOFL and Finco issued the 11.75% Notes with an aggregate principal amount of $200.0 million. Finco was formed solely to act as a co-issuer of the notes, has only nominal assets and does not conduct any operations. The Indentures generally prohibit Finco from holding any assets, becoming liable for any obligations, or engaging in any business activity. The 10.875% Notes are jointly and severally, fully and unconditionally guaranteed, on an unsecured senior basis by all of the DJOFL’s domestic subsidiaries (other than the co-issuer) that are 100% owned, directly or indirectly, by DJOFL (the “Guarantors”). The 11.75% Notes are jointly and severally, fully and unconditionally guaranteed, on an unsecured senior subordinated basis by the Guarantors. Our foreign subsidiaries (the “Non-Guarantors”) do not guarantee the notes. The Guarantors also unconditionally guarantee the Senior Secured Credit Facility.

 

The following tables present the financial position, results of operations and cash flows of DJOFL, the Guarantors, the Non-Guarantors and certain eliminations as of September 26, 2009 and December 31, 2008 and for the three and nine months ended September 26, 2009 and September 27, 2008, respectively.

 

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DJO Finance LLC

 

Unaudited Condensed Consolidating Balance Sheets

As of September 26, 2009

(in thousands)

 

 

 

DJOFL

 

Guarantors

 

Non-
Guarantors

 

Eliminations

 

Consolidated

 

Assets

 

 

 

 

 

 

 

 

 

 

 

Current assets:

 

 

 

 

 

 

 

 

 

 

 

Cash and cash equivalents

 

$

3,532

 

$

28,322

 

$

19,425

 

$

 

$

51,279

 

Accounts receivable, net

 

 

122,899

 

37,543

 

 

160,442

 

Inventories, net

 

 

81,587

 

24,806

 

(9,281

)

97,112

 

Deferred tax assets, net

 

 

37,759

 

1,022

 

(1,220

)

37,561

 

Prepaid expenses and other current assets

 

29

 

15,892

 

2,199

 

 

18,120

 

Total current assets

 

3,561

 

286,459

 

84,995

 

(10,501

)

364,514

 

Property and equipment, net

 

 

73,913

 

12,825

 

(2,017

)

84,721

 

Goodwill

 

 

1,108,703

 

84,341

 

 

1,193,044

 

Intangible assets, net

 

 

1,173,055

 

41,499

 

 

1,214,554

 

Investment in subsidiaries

 

1,242,942

 

2,262,373

 

70,344

 

(3,575,659

)

 

Intercompany receivable

 

1,151,653

 

 

 

(1,151,653

)

 

Other non-current assets

 

41,597

 

887

 

2,766

 

 

45,250

 

Total assets

 

$

2,439,753

 

$

4,905,390

 

$

296,770

 

$

(4,739,830

)

$

2,902,083

 

Liabilities and Membership Equity

 

 

 

 

 

 

 

 

 

 

 

Current liabilities:

 

 

 

 

 

 

 

 

 

 

 

Accounts payable

 

$

 

$

34,782

 

$

6,008

 

$

(1

)

$

40,789

 

Long-term debt and capital leases, current portion

 

10,650

 

175

 

469

 

 

11,294

 

Other current liabilities

 

60,795

 

57,280

 

27,007

 

 

145,082

 

Total current liabilities

 

71,445

 

92,237

 

33,484

 

(1

)

197,165

 

Long-term debt and capital leases, net of current portion

 

1,803,670

 

82

 

137

 

 

1,803,889

 

Deferred tax liabilities, net

 

 

305,761

 

15,158

 

(1,074

)

319,845

 

Intercompany payable, net

 

 

1,019,878

 

131,775

 

(1,151,653

)

 

Other non-current liabilities

 

 

11,458

 

2,873

 

 

14,331

 

Total liabilities

 

1,875,115

 

1,429,416

 

183,427

 

(1,152,728

)

2,335,230

 

Total membership equity

 

564,638

 

3,475,974

 

113,343

 

(3,587,102

)

566,853

 

Total liabilities and membership equity

 

$

2,439,753

 

$

4,905,390

 

$

296,770

 

$

(4,739,830

)

$

2,902,083

 

 

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Table of Contents

 

DJO Finance LLC

 

Unaudited Condensed Consolidating Balance Sheets

As of December 31, 2008

(in thousands)

 

 

 

DJOFL

 

Guarantors

 

Non-
Guarantors

 

Eliminations

 

Consolidated

 

Assets

 

 

 

 

 

 

 

 

 

 

 

Current assets:

 

 

 

 

 

 

 

 

 

 

 

Cash and cash equivalents

 

$

 

$

14,373

 

$

16,110

 

$

 

$

30,483

 

Accounts receivable, net