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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 July 3, 2010

 

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)

 

State of 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

 

Smaller reporting company o

(Do not check if a smaller reporting company)

 

 

 

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 August 6, 2010, 100% of the issuer’s membership interests were owned by DJO Holdings, LLC. 

 

 

 



Table of Contents

 

DJO Finance LLC

INDEX

 

 

 

Page
Number

 

PART I—FINANCIAL INFORMATION

 

 

 

 

Item 1.

Financial Statements

 

 

Unaudited Condensed Consolidated Balance Sheets as of July 3, 2010 and December 31, 2009

1

 

Unaudited Condensed Consolidated Statements of Operations for the three and six months ended July 3, 2010 and June 27, 2009

2

 

Unaudited Condensed Consolidated Statements of Cash Flows for the six months ended July 3, 2010 and June 27, 2009

3

 

Notes to Unaudited Condensed Consolidated Financial Statements

4

Item 2.

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

27

Item 3.

Quantitative and Qualitative Disclosures About Market Risk

43

Item 4.

Controls and Procedures

44

 

PART II—OTHER INFORMATION

 

 

 

 

Item 1.

Legal Proceedings

45

Item 1A.

Risk Factors

46

Item 6.

Exhibits

47

 



Table of Contents

 

DJO Finance LLC

Unaudited Condensed Consolidated Balance Sheets

(in thousands)

 

 

 

July 3,
2010

 

December 31,
2009

 

Assets

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

34,084

 

$

44,611

 

Accounts receivable, net

 

146,852

 

146,212

 

Inventories, net

 

100,478

 

95,880

 

Deferred tax assets, net

 

39,742

 

40,448

 

Prepaid expenses and other current assets

 

24,912

 

14,725

 

Total current assets

 

346,068

 

341,876

 

Property and equipment, net

 

83,069

 

86,714

 

Goodwill

 

1,183,253

 

1,191,497

 

Intangible assets, net

 

1,145,853

 

1,187,677

 

Other assets

 

38,668

 

42,415

 

Total assets

 

$

2,796,911

 

$

2,850,179

 

 

 

 

 

 

 

Liabilities and Equity

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Accounts payable

 

$

50,678

 

$

42,144

 

Accrued interest

 

12,760

 

10,968

 

Current portion of debt and capital lease obligations

 

12,470

 

15,926

 

Other current liabilities

 

92,474

 

90,608

 

Total current liabilities

 

168,382

 

159,646

 

Long-term debt and capital lease obligations

 

1,797,959

 

1,796,944

 

Deferred tax liabilities, net

 

296,852

 

321,131

 

Other long-term liabilities

 

16,655

 

14,089

 

Total liabilities

 

2,279,848

 

2,291,810

 

 

 

 

 

 

 

Commitments and contingencies

 

 

 

 

 

Equity:

 

 

 

 

 

DJO Finance LLC membership equity:

 

 

 

 

 

Member capital

 

829,470

 

827,617

 

Accumulated deficit

 

(305,690

)

(272,275

)

Accumulated other comprehensive income (loss)

 

(9,049

)

518

 

Total membership equity

 

514,731

 

555,860

 

Noncontrolling interests

 

2,332

 

2,509

 

Total equity

 

517,063

 

558,369

 

Total liabilities and equity

 

$

2,796,911

 

$

2,850,179

 

 

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

 

Six Months Ended

 

 

 

July 3,
2010

 

June 27,
2009

 

July 3,
2010

 

June 27,
2009

 

 

 

 

 

 

 

 

 

 

 

Net sales

 

$

242,527

 

$

235,112

 

$

482,603

 

$

452,765

 

Cost of sales (exclusive of amortization of intangible assets of $9,062 and $17,981 for the three and six months ended July 3, 2010 and $9,506 and $19,004 for the three and six months ended June 27, 2009, respectively)

 

84,565

 

82,156

 

171,919

 

161,156

 

Gross profit

 

157,962

 

152,956

 

310,684

 

291,609

 

Operating expenses:

 

 

 

 

 

 

 

 

 

Selling, general and administrative

 

115,715

 

108,605

 

226,241

 

209,205

 

Research and development

 

5,460

 

6,162

 

11,031

 

11,965

 

Impairment of assets held for sale

 

1,147

 

 

1,147

 

 

Amortization of intangible assets

 

19,671

 

19,171

 

38,725

 

38,302

 

 

 

141,993

 

133,938

 

277,144

 

259,472

 

Operating income

 

15,969

 

19,018

 

33,540

 

32,137

 

Other income (expense):

 

 

 

 

 

 

 

 

 

Interest expense

 

(37,450

)

(39,555

)

(78,162

)

(78,146

)

Interest income

 

322

 

202

 

675

 

538

 

Other income (expense), net

 

(2,837

)

2,967

 

(3,617

)

1,587

 

 

 

(39,965

)

(36,386

)

(81,104

)

(76,021

)

Loss from continuing operations before income taxes

 

(23,996

)

(17,368

)

(47,564

)

(43,884

)

Income tax benefit

 

24,560

 

4,995

 

14,792

 

16,932

 

Income (loss) from continuing operations

 

564

 

(12,373

)

(32,772

)

(26,952

)

Loss from discontinued operations, net of tax

 

 

(577

)

 

(167

)

Net income (loss)

 

564

 

(12,950

)

(32,772

)

(27,119

)

Net income attributable to noncontrolling interests

 

321

 

135

 

643

 

274

 

Net income (loss) attributable to DJO Finance LLC

 

$

243

 

$

(13,085

)

$

(33,415

)

$

(27,393

)

 

See accompanying notes to unaudited condensed consolidated financial statements.

 

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Table of Contents

 

DJO Finance LLC

Unaudited Condensed Consolidated Statements of Cash Flows

(in thousands)

 

 

 

Six Months Ended

 

 

 

July 3,
2010

 

June 27,
2009

 

OPERATING ACTIVITIES:

 

 

 

 

 

Net loss

 

$

(32,772

)

$

(27,119

)

Adjustments to reconcile net loss to net cash provided by operating activities:

 

 

 

 

 

Depreciation

 

13,105

 

12,969

 

Amortization of intangible assets

 

38,725

 

38,302

 

Amortization of debt issuance costs and non-cash interest expense

 

7,193

 

6,457

 

Stock-based compensation expense

 

865

 

1,426

 

Loss on disposal of assets, net

 

660

 

253

 

Deferred income tax benefit

 

(17,547

)

(18,109

)

Provision for doubtful accounts and sales returns

 

17,388

 

17,375

 

Inventory reserves

 

2,840

 

2,157

 

Impairment of assets held for sale

 

1,147

 

 

Gain on disposal of discontinued operations

 

 

(458

)

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

 

 

 

 

 

Accounts receivable

 

(19,341

)

(15,061

)

Inventories

 

(8,619

)

(206

)

Prepaid expenses and other assets

 

(11,941

)

(2,952

)

Accrued interest

 

1,792

 

9,922

 

Accounts payable and other current liabilities

 

16,658

 

(299

)

Net cash provided by operating activities

 

10,153

 

24,657

 

INVESTING ACTIVITIES:

 

 

 

 

 

Purchases of property and equipment

 

(14,495

)

(11,605

)

Cash paid in connection with acquisitions, net of cash acquired

 

(810

)

(4,046

)

Proceeds received upon disposition of discontinued operations, net

 

 

21,846

 

Other investing activities, net

 

(498

)

369

 

Net cash provided by (used in) investing activities

 

(15,803

)

6,564

 

FINANCING ACTIVITIES:

 

 

 

 

 

Proceeds from issuance of debt

 

118,130

 

55,072

 

Repayments of debt and capital lease obligations

 

(121,835

)

(73,996

)

Payment of debt issuance costs

 

(3,348

)

 

Investment by parent

 

988

 

 

Dividend by subsidiary to noncontrolling interests

 

(529

)

 

Net cash used in financing activities

 

(6,594

)

(18,924

)

Effect of exchange rate changes on cash and cash equivalents

 

1,717

 

(911

)

Net increase (decrease) in cash and cash equivalents

 

(10,527

)

11,386

 

Cash and cash equivalents at beginning of period

 

44,611

 

30,483

 

Cash and cash equivalents at end of period

 

$

34,084

 

$

41,869

 

Supplemental disclosures of cash flow information:

 

 

 

 

 

Cash paid for interest

 

$

71,041

 

$

61,653

 

Cash paid for taxes, net

 

$

2,659

 

$

15

 

Non-cash investing and financing activities:

 

 

 

 

 

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

 

$

500

 

$

1,889

 

 

See accompanying notes to unaudited condensed consolidated financial statements.

 

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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 believe that 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, 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.

 

Our current business activities are the result of a combination of ReAble Therapeutics, Inc. (“ReAble”), which was acquired by an affiliate of Blackstone Capital Partners V L.P. (“Blackstone”), and DJO Opco Holdings, Inc. (“DJO Opco”), formerly named DJO Incorporated.  On November 20, 2007, ReAble acquired DJO Opco through a merger transaction (the “DJO Merger”).  ReAble then changed its name to DJO Incorporated (“DJO”) and continues to be owned primarily by affiliates of Blackstone.  As a result of the DJO Merger, DJO Opco became a subsidiary of DJO Finance LLC (“DJOFL”), the entity filing this Quarterly Report on  Form 10-Q, which is itself a subsidiary of DJO Incorporated.

 

In the second quarter of 2010, we changed how we report our segment financial information to senior management.  Prior to the second quarter of 2010, our Bracing and Supports and Recovery Sciences businesses were reported together within the Domestic Rehabilitation Segment.  During the second quarter, as a result of our recent sales and marketing leadership reorganization, these businesses are now separately evaluated and managed.  Segment information for all periods presented has been restated to reflect this change.

 

We market and distribute our products through four operating segments, Bracing and Supports, Recovery Sciences, Surgical Implant, and International.  Our Bracing and Supports Segment offers to customers in the United States, orthopedic soft goods; rigid knee braces; cold therapy devices and vascular systems which include products intended to prevent deep vein thrombosis following surgery.  Our Recovery Sciences 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; and orthotic devices used to treat joint and spine conditions. Our 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”, “DJOFL”, “our”, “DJO”, or “our Company”, refers to DJO Finance LLC (DJOFL) 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.

 

Our unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”) for interim financial information. Accordingly, they do not include all of the information and disclosures required by GAAP for complete financial statements. These unaudited condensed consolidated financial statements should be read in conjunction with our consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2009. Our unaudited

 

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condensed consolidated financial statements have been prepared on the same basis as the audited consolidated financial statements and include all adjustments consisting of normal recurring adjustments which, in the opinion of management, are necessary for a fair presentation of the financial position, results of operations, and cash flows as of and 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.

 

We operate our business on a manufacturing calendar, with our fiscal year always ending on December 31. Each quarter is 13 weeks, consisting of two four-week periods and one five-week period. Our first and fourth quarters may have more or less operating days from year to year based on the days of the week on which holidays and December 31 fall. The three months ended July 3, 2010 and June 27, 2009 each included 64 days. The six months ended July 3, 2010 and June 27, 2009 included 129 and 125 days, respectively.

 

Use of Estimates.  The preparation of financial statements in conformity with GAAP 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 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.

 

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 Topic 350 (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, 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.  These assets are reviewed for impairment when events or circumstances indicate that the carrying value may not be recoverable over the remaining estimated useful lives of the assets. Upgrades and enhancements are capitalized if they result in added functionality.  In 2008, we began implementing a new ERP system, which has resulted in approximately $17.6 million of capitalized software costs as of July 3, 2010.

 

Derivative Financial Instruments.  We account for derivatives pursuant to ASC Topic 815 (formerly Financial Accounting Standards Board (“FASB”) Statements of Financial Accounting Standards (“SFAS”) No. 133, “Accounting for Derivative Instruments and Hedging”), and related amendments, which requires that all derivative instruments be recognized in the financial statements and measured at fair value regardless of their purpose or intent.

 

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 entering into 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 Topic 815. We determine the fair value of our foreign forward contracts in accordance with ASC Topic 820 (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 our derivatives is recorded in other income (expense), net, within the unaudited condensed consolidated statements of operations.  At July 3, 2010, the fair value of our foreign exchange forward contracts was an asset of $0.1 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

 

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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 over the term of the credit facilities. We have designated these interest rate swap agreements as cash flow hedges and account for our interest rate swap agreements in accordance with ASC Topic 815.  At July 3, 2010, the fair value of our interest rate swap agreements was a liability of $10.9 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 and Transactions.  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 accumulated other comprehensive income (loss) within 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 unaudited condensed consolidated statements of operations.

 

Comprehensive loss consists of the following for the three and six months ended July 3, 2010 (in thousands):

 

 

 

Three Months

 

Six Months

 

 

 

DJOFL

 

Non-
controlling
Interests

 

Total

 

DJOFL

 

Non-
controlling
Interests

 

Total

 

Net income (loss), as reported

 

$

243

 

$

321

 

$

564

 

$

(33,415

)

$

643

 

$

(32,772

)

Foreign currency translation adjustments, net of tax

 

(2,459

)

 

(2,459

)

(9,765

)

 

(9,765

)

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

 

580

 

 

580

 

198

 

 

198

 

Comprehensive loss

 

$

(1,636

)

$

321

 

$

(1,315

)

$

(42,982

)

$

643

 

$

(42,339

)

 

Comprehensive loss consists of the following for the three and six months ended June 27, 2009 (in thousands):

 

 

 

Three Months

 

Six Months

 

 

 

DJOFL

 

Non-
controlling
Interests

 

Total

 

DJOFL

 

Non-
controlling
Interests

 

Total

 

Net loss, as reported

 

$

(13,085

)

$

135

 

$

(12,950

)

$

(27,393

)

$

274

 

$

(27,119

)

Foreign currency translation adjustments, net of tax

 

4,747

 

 

4,747

 

1,653

 

 

1,653

 

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

 

(556

)

 

(556

)

(3,902

)

 

(3,902

)

Comprehensive loss

 

$

(8,894

)

$

135

 

$

(8,759

)

$

(29,642

)

$

274

 

$

(29,368

)

 

Reclassifications.  The financial statements and notes thereto reflect certain reclassifications to prior year amounts to conform to the current year presentation.

 

Recent Accounting Pronouncements.  In January 2010, we adopted ASC Topic 810 (formerly SFAS No. 167, “Amendments to FASB Interpretation No. 46 (R)”).  ASC Topic 810 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. The adoption of ASC Topic 815 had no impact on our consolidated financial statements.

 

In January 2010, we adopted ASC Topic 860 (formerly 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

 

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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 the same as any other transfer of financial assets; 9) Removes fair value practicability exception from measuring the proceeds received by a transferor in a transfer that meets the conditions for sale accounting at fair value; and 10) requires enhanced disclosures. The adoption of ASC Topic 860 had no impact on our consolidated financial statements.

 

In September 2009, the FASB issued ASU 2009-13, which amends ASC Topic 605 (formerly Emerging Issues Task Force (“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 our consolidated financial statements. However, we do not expect that this issue will result in a change in current practice.

 

2.  ACCOUNTS RECEIVABLE RESERVES

 

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

 

 

 

Six Months Ended

 

 

 

July 3,
2010

 

June 27,
 2009

 

Balance, beginning of period

 

$

48,306

 

$

36,521

 

Provision for doubtful accounts and sales returns

 

17,388

 

17,375

 

Write-offs, net of recoveries

 

(17,468

)

(9,345

)

Balance, end of period

 

$

48,226

 

$

44,551

 

 

3.  INVENTORIES

 

Inventories consist of the following (in thousands):

 

 

 

July 3,
2010

 

December 31,
2009

 

Components and raw materials

 

$

27,097

 

$

29,967

 

Work in process

 

5,619

 

3,745

 

Finished goods

 

56,289

 

50,558

 

Inventory held on consignment

 

22,347

 

24,121

 

 

 

111,352

 

108,391

 

Less inventory reserves

 

(10,874

)

(12,511

)

 

 

$

100,478

 

$

95,880

 

 

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

 

 

 

Six Months Ended

 

 

 

July 3,
2010

 

June 27,
2009

 

Balance, beginning of period

 

$

12,511

 

$

17,798

 

Provision charged to cost of sales

 

2,840

 

2,157

 

Write-offs, net of recoveries

 

(4,477

)

(4,908

)

Balance, end of period

 

$

10,874

 

$

15,047

 

 

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

 

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4.  GOODWILL AND INTANGIBLE ASSETS

 

Changes in the carrying amount of goodwill for the six months ended July 3, 2010 are as follows (in thousands):

 

Balance, beginning of period

 

$

1,191,497

 

Foreign currency translation adjustments

 

(8,244

)

Balance, end of period

 

$

1,183,253

 

 

Identifiable intangible assets consisted of the following as of July 3, 2010 (in thousands):

 

 

 

Gross
Carrying
Amount

 

Accumulated
Amortization

 

Net
Carrying
Amount

 

Intangible assets subject to amortization, net:

 

 

 

 

 

 

 

Technology-based

 

$

458,150

 

$

(112,366

)

$

345,784

 

Customer-based

 

488,442

 

(117,087

)

371,355

 

 

 

$

946,592

 

$

(229,453

)

717,139

 

Indefinite-lived intangible assets:

 

 

 

 

 

 

 

Trademarks and trade names

 

 

 

 

 

428,269

 

Foreign currency translation adjustments

 

 

 

 

 

445

 

 

 

 

 

 

 

$

1,145,853

 

 

Identifiable intangible assets consisted of the following as of December 31, 2009 (in thousands):

 

 

 

Gross
Carrying
Amount

 

Accumulated
Amortization

 

Net
Carrying
Amount

 

Intangible assets subject to amortization, net:

 

 

 

 

 

 

 

Technology-based

 

$

458,726

 

$

(94,385

)

$

364,341

 

Customer-based

 

487,998

 

(96,906

)

391,092

 

 

 

$

946,724

 

$

(191,291

)

755,433

 

Indefinite-lived intangible assets:

 

 

 

 

 

 

 

Trademarks and trade names

 

 

 

 

 

428,269

 

Foreign currency translation adjustments

 

 

 

 

 

3,975

 

 

 

 

 

 

 

$

1,187,677

 

 

Our intangible assets with finite useful lives are being amortized using the straight-line method over their estimated useful lives ranging from one to 20 years. Based on our amortizable intangible asset balances as of July 3, 2010, we estimate that amortization expense will be as follows for the next five years and thereafter (in thousands):

 

Remaining 2010

 

$

38,491

 

2011

 

75,675

 

2012

 

74,441

 

2013

 

69,189

 

2014

 

67,368

 

Thereafter

 

391,975

 

 

 

$

717,139

 

 

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Table of Contents

 

5.  OTHER CURRENT LIABILITIES

 

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

 

 

 

July 3,
2010

 

December 31,
2009

 

Wages and related expenses

 

$

24,064

 

$

20,668

 

Other accrued liabilities

 

18,103

 

17,933

 

Commissions and royalties

 

12,063

 

12,953

 

Accrued product liability insurance premiums

 

8,737

 

 

Professional fees

 

6,076

 

5,529

 

Interest rate swap derivative

 

5,540

 

9,701

 

Rebates

 

5,477

 

4,482

 

Taxes payable

 

4,264

 

3,061

 

Accrued product liability claims

 

2,514

 

1,988

 

Warranties

 

2,219

 

1,714

 

Accrued ERP costs

 

1,852

 

5,800

 

Integration costs

 

1,565

 

6,779

 

 

 

$

92,474

 

$

90,608

 

 

6.  DEBT AND CAPITAL LEASE OBLIGATIONS

 

Debt and capital lease obligations consists of the following (in thousands):

 

 

 

July 3,
2010

 

December 31,
2009

 

Term loan under Senior Secured Credit Facility, net of unamortized original issue discount ($7.6 million and $9.3 million at July 3, 2010 and December 31, 2009, respectively)

 

$

927,828

 

$

1,034,427

 

10.875% Senior Notes, net of unamortized original issue premium ($4.7 million at July 3, 2010)

 

679,661

 

575,000

 

11.75% Senior Subordinated Notes

 

200,000

 

200,000

 

Notes payable for acquisitions

 

2,828

 

2,860

 

Capital lease obligations

 

112

 

228

 

Other

 

 

355

 

Total debt and capital lease obligations

 

1,810,429

 

1,812,870

 

Current maturities

 

(12,470

)

(15,926

)

Long-term debt and capital lease obligations

 

$

1,797,959

 

$

1,796,944

 

 

Senior Secured Credit Facility

 

On November 20, 2007, we entered into the Senior Secured Credit Facility which consisted 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 was being amortized as additional interest expense, using the effective interest method over the term of the term loan facility increasing the reported outstanding balance accordingly. In the first quarter of 2010, we made a voluntary prepayment of $101.5 million towards the aggregate principal amount of our term loan under the Senior Secured Credit Facility. In addition, based on annual excess cash flow, as defined, for the year ended December 31, 2009, we were required to make a prepayment of the term loan outstanding under our Senior Secured Credit Facility of approximately $2.0 million, which we paid in March 2010. As a result of our prepayments, we accelerated the amortization associated with our unamortized original issue discount by approximately $0.8 million, relating to the portion of the term loans that were repaid.

 

The market value of our term loan facility was approximately $893.3 million as of July 3, 2010 and was determined using trading prices for our term loan on or near that date. As of July 3, 2010, 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 our attaining certain leverage ratios.

 

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Table of Contents

 

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 14).  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% which expired at December 31, 2009. In February 2009, we entered into two non-amortizing interest rate swap agreements. One agreement was for a notional amount of $550.0 million at a fixed LIBOR rate of 1.04% beginning February 2009 and expired at December 31, 2009. The other agreement was 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 non-amortizing interest rate 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 July 3, 2010, our weighted average interest rate for all borrowings under the Senior Secured Credit Facility was 4.58%.

 

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 our 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.

 

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 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. Any mandatory prepayments are applied to the term loan facilities in direct order of maturity.  Based on excess cash flows, as defined, for the year ended December 31, 2009, we were required to make a prepayment of the term loan outstanding under our Senior Secured Credit Facility of approximately $2.0 million, which we paid in March 2010. We expect to reinvest the net proceeds from our 2009 asset sales during 2010 as permitted by our credit agreement and, as such, our calculation of 2009 excess cash flows excluded those net proceeds. 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.  In January 2010, we issued $100 million of new 10.875% Senior Notes and used the net proceeds, along with cash on hand, to make a voluntary prepayment of $101.5 million towards the aggregate principal amount of our term loan under the Senior Secured Credit Facility.

 

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.

 

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Table of Contents

 

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 4.00:1 for the trailing twelve months ended July 3, 2010, 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. As of July 3, 2010, our maximum senior secured leverage ratio was within the covenant level, and we were in compliance with all other applicable covenants.

 

10.875% Senior Notes

 

On November 20, 2007, DJOFL and DJO Finance Corporation (“Finco”) (collectively, the “Issuers”) issued $575.0 million aggregate principal amount of 10.875% Senior Notes (the “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.

 

On January 20, 2010, we issued $100.0 million aggregate principal amount of new 10.875% Senior Notes, pursuant to the 10.875% Indenture that also governs our existing 10.875% Notes due 2014. The net proceeds of the issuance (excluding approximately $2.0 million of interest accrued from November 15, 2009 to January 19, 2010, which was included in the interest payment we made to noteholders on May 15, 2010), along with cash on hand, were used to repay $101.5 million aggregate principal amount of existing term loans under the Senior Secured Credit Facility. In connection with the issuance of these notes, we received a premium of $5.0 million, which is being amortized over the term of the note, as a reduction to interest expense in our unaudited condensed consolidated statements of operations.  Collectively, the new 10.875% Senior Notes and the existing 10.875% Notes are referred to as the 10.875% Notes.

 

The 10.875% Notes require semi-annual interest payments of approximately $36.7 million each May 15 and November 15 and are due November 15, 2014. The market value of the 10.875% Notes was approximately $703.7 million as of July 3, 2010 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.

 

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.

 

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Table of Contents

 

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 July 3, 2010, we were in compliance with all applicable covenants.

 

11.75% Senior Subordinated Notes

 

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 $11.8 million each May 15 and November 15 and are due November 15, 2014.

 

The market value of the 11.75% Notes was approximately $205.0 million as of July 3, 2010 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 Issuance Costs

 

We incurred $30.7 million, $27.7 million (including $3.3 million incurred during the six months ended July 3, 2010 in connection with the sale of the new 10.875% Senior Notes), and $10.2 million of debt issuance 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 as of July 3, 2010 (unaudited) and December 31, 2009. Debt issuance costs are being amortized over the terms of the respective debt instruments through November 2014. As a result of the prepayment of $101.5 million of aggregate principal amount of existing term loans under the Senior Secured Credit Facility in the first quarter of 2010, we recognized a loss of approximately $1.9 million, due to the write off of unamortized debt issuance costs relating to the portion of the term loans that were repaid.

 

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Table of Contents

 

7.  STOCK OPTION PLANS AND STOCK-BASED COMPENSATION

 

2007 Stock Incentive Plan

 

We have one active equity compensation plan, the DJO Incorporated 2007 Incentive Stock Plan (the “2007 Plan”), under which we are authorized to grant options up to 7,500,000 shares of Common Stock of our indirect parent, DJO Incorporated, 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. 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”). As initially adopted, another one-third of stock options will vest over a specified performance period (typically 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. As amended in March 2009, the final one-third of stock options will vest based upon achieving a minimum internal rate of return (“IRR”) and a minimum return of money on invested capital (“MOIC”), as defined in the DJO Form Option Agreement; 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 (“Enhanced Market-Return Tranche”).

 

In March 2010, the Compensation Committee approved further modifications to the terms of the outstanding options and the DJO Form Option Agreement. The Time-Based Tranche and Enhanced Market-Return Tranche terms remain the same as discussed above. The financial performance targets for the future years of the Performance-Based Tranche were replaced by targets with different financial metrics. These new targets are similar to the Enhanced Market-Return Tranche as they require achievement of a minimum IRR and 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 (referred to herein as the “Market-Return Tranche”). As a result of this modification, the Market-Return 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 the Time-Based Tranche upon the occurrence of a change-in-control. Specifically, 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. This provision does not operate to vest the Market-Return or the Enhanced Market-Return Tranches which require the achievement of the IRR and MOIC targets by Blackstone on its equity investment in us.

 

Employee Stock Options

 

During the six months ended July 3, 2010 we granted 483,550 stock options under the 2007 Plan to senior management, and certain other employees.

 

We recorded non-cash compensation expense of approximately $0.4 million and $0.9 million for the three and six months ended July 3, 2010, respectively, associated with stock options issued under the 2007 Plan. We recorded non-cash compensation expense of approximately $0.8 million and $1.3 million for the three and six months ended June 27, 2009, respectively, associated with stock options issued under the 2007 Plan. We record compensation expense for awards with a service or market condition ratably over the service period. We record compensation expense for awards with a performance condition only to the extent deemed probable of achievement.  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. To date, no amount has been recorded for the Market Return or the Enhanced Market-Return Tranches, as achievement of the performance component is not deemed probable at this time.

 

The fair value of each option is estimated on the date of grant, using the Black-Scholes-Merton option pricing model for service 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 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. As a result of the 2009 and 2010 modifications, we will no longer use the original grant date fair value to measure compensation cost related to the Market-Return and Enhanced Market-Return tranches, and have re-assessed the assumptions used to determine the fair value of options at the date of modification and at subsequent grant dates.

 

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Table of Contents

 

The assumptions used to calculate the fair value of options granted are evaluated and revised, as necessary, to reflect market conditions and experience. The following table presents the assumptions we used in calculating the fair value of employee stock options for the six months ended July 3, 2010 and June 27, 2009:

 

 

 

Six Months Ended

 

 

 

July 3,
2010

 

June 27,
2009

 

Assumptions used to estimate fair value of awards granted:

 

 

 

 

 

Expected volatility

 

34.2 – 34.5

%

34.4

%

Risk—free interest rate

 

2.8 – 3.0

%

2.3

%

Expected term

 

6.4 – 7.0 years

 

6.3 years

 

Expected dividend yield

 

none

 

none

 

 

Non-Employee Stock Options

 

During the six months ended July 3, 2010 we granted 1,200 stock options under the 2007 Plan to non-employees, with an exercise price of $16.46 per share, which is equal to 100% of the estimated fair market value of the stock. Non-cash compensation expense was $0.1 million for each of the three and six month periods ended July 3, 2010 and June 27, 2009, respectively.

 

8.  MEMBERSHIP EQUITY

 

In June 2010, DJO Incorporated, our indirect parent, sold 62,748 shares of its common stock, at $16.46 per share in an offering to certain accredited investors comprised of employees, directors and independent sales agents, subject to the execution of a stockholders agreement including certain rights and restrictions. The proceeds were contributed to us as an additional investment, and were included in member capital in our unaudited condensed consolidated balance sheet as of July 3, 2010. The investment of approximately $1.0 million (after deducting issuance costs) will be used for working capital purposes.  In addition, subsequent to July 3, 2010, 24,304 additional shares were issued pursuant to this offering.  The offering terminated as of July 31, 2010.

 

9. SEGMENT AND GEOGRAPHIC INFORMATION

 

We provide a broad array of orthopedic rehabilitation and regeneration products, as well as surgical implants to customers in the United States and abroad.  In the second quarter of 2010, we changed how we report our segment financial information to senior management. Prior to the second quarter of 2010, our Bracing and Supports and Recovery Sciences businesses were reported together within the Domestic Rehabilitation Segment.  During the second quarter, as a result of our recent sales and marketing leadership reorganization, these businesses are now separately evaluated and managed. Segment information for all periods presented has been restated to reflect this change.  We currently develop, manufacture and distribute our products through the following four operating segments:

 

Bracing and Supports Segment

 

Our Bracing and Supports Segment, which generates its revenues in the United States, offers our DonJoy, ProCare and Aircast products, including rigid knee bracing, orthopedic soft goods, cold therapy products, and vascular systems.  This segment 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.

 

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Table of Contents

 

Recovery Sciences Segment

 

Our Recovery Sciences Segment, which generates its revenues in the United States, is divided into four main businesses:

 

·                  Empi.  Our Empi business unit offers our home electrotherapy, iontophoresis, and home traction products. We primarily sell these products directly to patients or to physical therapy clinics. For products sold to patients, we arrange billing to the patients and their third party payors.

 

·                  Regeneration.  Our Regeneration business unit primarily sells our bone growth stimulation products. We sell these products either directly to patients or to independent distributors. For products sold to patients, we arrange billing to the patients and their third party payors.

 

·                  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, which range 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.

 

Surgical Implant Segment

 

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

 

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.

 

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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

 

Six Months Ended

 

 

 

July 3,
2010

 

June 27,
2009

 

July 3,
2010

 

June 27,
2009

 

Net sales:

 

 

 

 

 

 

 

 

 

Bracing and Supports

 

$

78,915

 

$

74,789

 

$

153,931

 

$

142,836

 

Recovery Sciences

 

87,273

 

84,816

 

171,477

 

163,973

 

Surgical Implant

 

15,214

 

16,378

 

32,176

 

31,681

 

International

 

61,125

 

59,129

 

125,019

 

114,275

 

 

 

$

242,527

 

$

235,112

 

$

482,603

 

$

452,765

 

 

 

 

 

 

 

 

 

 

 

Gross profit:

 

 

 

 

 

 

 

 

 

Bracing and Supports

 

$

43,983

 

$

41,728

 

$

85,344

 

$

78,602

 

Recovery Sciences

 

66,409

 

64,471

 

129,020

 

123,785

 

Surgical Implant

 

10,813

 

12,864

 

24,275

 

24,762

 

International

 

37,671

 

34,706

 

75,400

 

66,211

 

Expenses not allocated to segments and eliminations

 

(914

)

(813

)

(3,355

)

(1,751

)

 

 

$

157,962

 

$

152,956

 

$

310,684

 

$

291,609

 

 

 

 

 

 

 

 

 

 

 

Operating income:

 

 

 

 

 

 

 

 

 

Bracing and Supports

 

$

17,605

 

$

18,262

 

$

33,240

 

$

30,890

 

Recovery Sciences

 

29,466

 

27,133

 

54,479

 

48,247

 

Surgical Implant

 

1,396

 

3,717

 

4,144

 

6,177

 

International

 

15,717

 

12,868

 

31,035

 

22,931

 

Expenses not allocated to segments and eliminations

 

(48,215

)

(42,962

)

(89,358

)

(76,108

)

 

 

$

15,969

 

$

19,018

 

$

33,540

 

$

32,137

 

 

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.  We do not allocate assets to reportable segments because a significant portion of our assets are shared by segments.

 

Geographic Area

 

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

 

 

 

Three Months Ended

 

Six Months Ended

 

 

 

July 3,
2010

 

June 27,
2009

 

July 3,
2010

 

June 27,
2009

 

Net sales:

 

 

 

 

 

 

 

 

 

United States

 

$

175,240

 

$

170,725

 

$

347,744

 

$

332,743

 

Germany

 

18,249

 

17,953

 

39,321

 

34,700

 

Other Europe, Middle East, & Africa

 

25,796

 

32,779

 

51,602

 

61,393

 

Asia Pacific

 

6,914

 

3,798

 

13,147

 

6,848

 

Other

 

16,328

 

9,857

 

30,789

 

17,081

 

 

 

$

242,527

 

$

235,112

 

$

482,603

 

$

452,765

 

 

10.  INCOME TAXES

 

Income taxes for the interim periods presented have been included in our unaudited condensed consolidated financial statements on the basis of an estimated annual effective tax rate, adjusted for discrete items. The income 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 nondeductible expenses, foreign taxes, deferred taxes on the assumed repatriation of foreign earnings, and the existence of valuation allowances in foreign jurisdictions. Based on changes in our annual 2010 financial projection as of July 3, 2010, the income tax benefit recorded for the three months ended July 3, 2010 was $24.6 million on a pre-tax loss of $24.0 million, resulting in an effective tax rate of 102%. This tax benefit included the reversal of certain tax expense amounts recorded for the three months ended April 3, 2010, bringing our year-to-date tax benefit to $14.8 million, reflecting an effective tax rate of 31.1% of our year-to-date pretax loss. Given the relationship between fixed dollar tax items and pre-tax financial results, the projected annual effective tax rate can change materially based on small variations of income.

 

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For the three and six months ended June 27, 2009, we recorded income tax benefits of approximately $5.0 million and $16.9 million, respectively, on pre-tax losses of approximately $17.4 million and $43.9 million, resulting in effective tax rates of 28.7% and 38.5%, respectively. The difference in the tax benefit recorded during the three and six months ended July 3, 2010 and the three and six months ended June 27, 2009 is primarily due to differences in the projected annualized effective tax rates for each year as determined by the Company.  In addition, a beneficial impact of a tax law change was recorded during the first quarter of 2009 as a discrete item.

 

We and our subsidiaries file income tax returns in the U.S. federal jurisdiction and 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. The Internal Revenue Service (“IRS”) completed its field examination of the 2005 and 2006 tax years during the three months ended July 3, 2010.  The IRS has proposed material adjustments related to transaction cost, stock option, and bad debt deductions included in our 2006 tax return.  We intend to appeal each of the proposed adjustments vigorously through the IRS appeals process.  However, should the IRS’ proposed adjustments be upheld in appeals, a material reduction in our currently unreserved net operating losses could result.  At December 31, 2009, our gross unrecognized tax benefits were $19.1 million.  For the six months ended July 3, 2010, we increased our gross unrecognized tax benefits by $0.7 million. Our total gross unrecognized tax benefits were $19.8 million at July 3, 2010, including a cumulative $2.0 million related to interest and penalties.  There is a reasonable possibility that the closing of the IRS appeals process could result in a material reduction to our unrecognized tax benefits within the next twelve months.  Due to the fact that the appeals process has not been finalized, the amount of the unrecognized tax benefits that may be reduced cannot be reasonably estimated.  Due to our adoption of ASC Topic 805 (formerly SFAS No. 141R, “Business Combinations”) on January 1, 2009, all unrecognized tax benefits will impact our effective tax rate upon recognition. We believe that it is reasonably possible that an increase of $0.2 million in unrecognized tax benefits related to various immaterial state exposures may be necessary within the next twelve months.

 

11.  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 Chattanooga activities to our existing facilities occurred during the first half of 2010. A summary of the activity relating to the restructuring for the six months ended July 3, 2010 is as follows (in thousands):

 

 

 

Severance &
Employee
Retention

 

Other

 

Total

 

Balance at December 31, 2009

 

4,049

 

405

 

4,454

 

Expensed during period

 

1,111

 

123

 

1,234

 

Payments made during period

 

(4,317

)

(444

)

(4,761

)

Balance at July 3, 2010

 

$

843

 

$

84

 

$

927

 

 

Total severance and employee retention related expenses incurred to date as a result of the transition of our Chattanooga activities are $6.6 million, and are included within selling, general and administrative, and research and development expenses in our unaudited condensed consolidated statements of operations. We do not expect to incur additional material severance and employee retention expenses in conjunction with the Chattanooga integration.

 

As a result of our integration of the operations of our Chattanooga division, we exited the facilities in Hixson, and listed the buildings for sale during the six months ended July 3, 2010. Due to a decline in the fair market value of the buildings, we recorded an impairment charge of $1.1 million during the six months ended July 3, 2010, which has been reflected as impairment of assets held for sale in our unaudited condensed consolidated statements of operations. The fair market value of the buildings held for sale is approximately $2.8 million, and is included in other current assets in our unaudited condensed consolidated balance sheet at July 3, 2010.

 

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12.  COMMITMENTS AND CONTINGENCIES

 

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

 

The manufacture and sale of orthopedic devices and related products exposes us to a significant risk of product liability claims. From time to time, we have been, and we are currently, subject to a number of product liability claims alleging that the use of our products resulted in adverse effects. Even if we are successful in defending against any liability claims, such claims could nevertheless distract our management, result in substantial costs, harm our reputation, adversely affect the sales of all our products and otherwise harm our business. If there is a significant increase in the number of product liability claims, our business could be adversely affected.

 

We are currently named as one of several defendants in approximately 100 product liability cases, including a lawsuit in Canada seeking class action status, related to a disposable drug infusion pump product manufactured by two third party manufacturers that we distributed through our Bracing and Supports 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 carriers and to our products liability carriers. Although both manufacturers have rejected our tenders of indemnity, we are in discussions with both to reach a resolution of the indemnity issue. The products liability carriers for both manufacturers have accepted coverage for our defense of these claims.  The base policy for one of the manufacturers has been exhausted and the excess liability carriers for that manufacturer are not obligated to provide a defense until a $5 million self-insured retention has been paid and our underlying insurance has been exhausted.  Our products liability carrier has accepted coverage of these cases, subject to a reservation of the right to deny coverage for customary matters, including punitive damages and off-label promotion. The lawsuits allege damages ranging from unspecified amounts to claims between $1.0 million and $10.0 million. These cases are in varying stages from initial pleading and discovery to pre-trial preparation. We could be exposed to material liabilities if our insurance coverage is not available or inadequate and the resources of the two manufacturers, including their respective products liability insurance policies, are unavailable or insufficient to pay the defense costs and settlements or judgments in these cases.

 

On August 2, 2010, we were served with a subpoena under the Health Insurance Portability and Accountability Act (“HIPAA”) seeking numerous documents related to our activities involving the infusion pumps discussed above. The subpoena which was issued by the United States Attorney’s Office, Central District of California, refers to an official investigation of Federal health care offenses. We are reviewing the subpoena, but do not have any additional information regarding the focus of the investigation. We believe that our actions related to our prior distribution of these infusion pumps have been in compliance with applicable legal standards. We can make no assurance as to the resources that will be needed to respond to the subpoena or the final outcome of any investigation or further action.

 

We maintain product liability insurance that is subject to annual renewal. Our current policy covers claims reported between July 1, 2010 and June 30, 2011.  No carriers were prepared to cover claims for this reporting period arising out of the pain pump product described above and therefore our current policies exclude coverage for those products.  For the current policy year, we maintain coverage limits (together with excess policies) of up to $50 million, with self-insured retentions of $500,000 per claim for claims relating to the IceMan cold therapy unit, $500,000 per claim for claims relating to invasive products, $75,000 per claim for claims relating to non-invasive products other than the IceMan device, and an aggregate self-insured retention of $2.25 million.  We purchased supplemental extended reporting period (“SERP”) coverage for our $80 million limit product liability program that expired on June 30, 2010, and this supplemental coverage is limited to pain pump claims.  Except for the additional excess coverage mentioned below, this SERP coverage does not provide additional limits to the aggregate $80 million limit on the expiring program but does provide that the existing limits of the expiring program will remain available for claims reported for an extended period of time. Specifically, pain pump claims may be reported under the $10 million base policy for an indefinite period of time and for a period of five years under the excess layers. We also purchased additional coverage of $25 million excess of $80 million with a five year reporting period. Thus, the SERP coverage has a total limit of $105 million (less amounts paid for claims reported under the expiring program). This coverage is subject to a self-insured retention of $500,000 per claim for claims related to pain pumps, with an aggregate self-insured retention of $1.0 million for all products liability claims under either the expiring program or the SERP program. In addition, the layer of $25 million excess over $55 million has a separate self-insured retention of $50,000 per claim.  Our two products liability programs prior to the program that expired on June 30, 2010 cover claims reported between July 1, 2007 and February 15, 2008 and between February 15, 2008 and July 1, 2009, respectively.  The 2007-2008 policy provides for coverage (together with excess policies) of up to a limit of $20 million and the 2008-2009 policy provides for coverage (together with excess policies) of up to a limit of $25 million.  Certain of the pain pump cases described above were reported under and are covered by these two policies as well as the expiring program.

 

If a products 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 products liability claim could also result in our having to recall some of our products, which could result in significant costs to us. Our condensed consolidated balance sheets as of July 3, 2010 (unaudited) and December 31, 2009, include accrued liabilities of approximately $2.5 million and $2.0 million, respectively, for expenses related to products liability claims for products other than our pain pump products.  The amounts

 

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accrued are based upon previous claims 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. In addition, our unaudited condensed consolidated balance sheet as of July 3, 2010 includes accrued liabilities of $8.7 million for the SERP for product claims related to our discontinued pain pump products.

 

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 a defendant 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. This case is captioned United States ex rel. Beirman v. Orthofix International, N.V., et al., Civil Action No. 05-10557 (D. Mass.). 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 anti-kickback statutes. On December 4, 2009, we filed a motion to dismiss the relator’s complaint.  The relator filed a second amended complaint in May 2010 that, among other things, dropped The Blackstone Group as a defendant.  We plan to file another motion to dismiss directed at the second amended complaint. 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 HIPAA seeking numerous documents relating to the marketing and sale by us of bone growth stimulators. On September 21, 2009, we were served with a second HIPAA subpoena related to this DOJ investigation seeking additional documents relating to the marketing and sale by us of bone growth stimulators. We believe that these subpoenas are 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. We believe that our marketing practices in the bone growth stimulation business are in compliance with applicable legal standards and we intend to defend this case and investigation vigorously. We can make no assurance as to the resources that will be needed to respond to these matters or the final outcome of such action.

 

13.  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. 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. 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. For each of the three and six month periods presented, we recognized $1.75 million and $3.5 million, respectively, related to the monitoring fee, which is recorded as a component of selling, general and administrative expense in our unaudited condensed consolidated statements of operations.

 

14.  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 (“MXP”) due to our Mexico-based manufacturing operations that incur costs that are largely denominated in MXP. As part of our risk management strategy, we use derivative instruments to hedge portions of our exposure. While our foreign exchange forward contracts act as economic hedges, we have not designated such instruments as hedges under ASC Topic 815.  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 July 3, 2010, we had foreign exchange forward

 

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contracts, with a notional amount of MXP 228.0 million, or approximately $17.1 million. These foreign exchange forward contracts expire weekly throughout the fiscal year 2010.

 

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 over the term of the credit facilities. 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% which expired on December 31, 2009.  In February 2009, we entered into two non-amortizing interest rate swap agreements.  One agreement was for a notional amount of $550.0 million at a fixed LIBOR rate of 1.04% beginning in February 2009 which expired on December 31, 2009.  The other agreement was 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 non-amortizing interest rate 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 Topic 815.

 

In accordance with ASC Topic 820, 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 July 3, 2010, 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 the fair value of our derivative instruments as of July 3, 2010 (unaudited) and December 31, 2009 (in thousands):

 

 

 

July 3,
2010

 

December 31,
2009

 

Current derivative assets:

 

 

 

 

 

Foreign exchange forward contracts

 

$

113

 

$

89

 

 

 

 

 

 

 

Derivative liabilities:

 

 

 

 

 

Current portion of interest rate swaps

 

$

5,540

 

$

9,701

 

Long-term portion of interest rate swaps

 

5,380

 

1,543

 

 

 

$

10,920

 

$

11,244

 

 

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

 

 

 

 

 

Three Months Ended

 

Six Months Ended

 

 

 

Location of gain (loss)

 

July 3,
2010

 

June 27,
2009

 

July 3,
2010

 

June 27,
2009

 

Foreign exchange forward contracts

 

Other income (expense), net

 

$

113

 

$

(366

)

$

1,241

 

$

(3,372

)

Interest rate swaps

 

Interest expense

 

(2,998

)

(4,251

)

(6,193

)

(7,628

)

 

 

 

 

$

(2,885

)

$

(4,617

)

$

(4,952

)

$

(11,000

)

 

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15.  SUPPLEMENTAL GUARANTOR CONDENSED CONSOLIDATING FINANCIAL STATEMENTS

 

DJOFL and its direct wholly-owned subsidiary, Finco, issued the 10.875% Notes with aggregate principal amounts of $575.0 million and $100.0 million on November 20, 2007 and January 20, 2010, respectively. 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 July 3, 2010 and December 31, 2009 and for the three and six months ended July 3, 2010 and June 27, 2009, respectively.

 

DJO Finance LLC

Unaudited Condensed Consolidating Balance Sheets

As of July 3, 2010

(in thousands)

 

 

 

DJOFL

 

Guarantors

 

Non —
Guarantors

 

Eliminations

 

Consolidated

 

Assets

 

 

 

 

 

 

 

 

 

 

 

Current assets:

 

 

 

 

 

 

 

 

 

 

 

Cash and cash equivalents

 

$

3,972

 

$

13,069

 

$

17,043

 

$

 

$

34,084

 

Accounts receivable, net

 

 

114,716

 

32,136

 

 

146,852

 

Inventories, net

 

 

84,095

 

24,765

 

(8,382

)

100,478

 

Deferred tax assets, net

 

 

36,025

 

3,863

 

(146

)

39,742

 

Prepaid expenses and other current assets

 

73

 

21,517

 

3,322

 

 

24,912

 

Total current assets

 

4,045

 

269,422

 

81,129

 

(8,528

)

346,068

 

Property and equipment, net

 

 

74,319

 

12,990

 

(4,240

)

83,069

 

Goodwill

 

 

1,108,702

 

102,468

 

(27,917

)

1,183,253

 

Intangible assets, net

 

 

1,111,154

 

34,699

 

 

1,145,853

 

Investment in subsidiaries

 

1,297,702

 

1,659,562

 

32,124

 

(2,989,388

)

 

Intercompany receivables

 

1,007,613

 

 

 

(1,007,613

)

 

Other non-current assets

 

36,460

 

754

 

1,424

 

30

 

38,668

 

Total assets

 

$

2,345,820

 

$

4,223,913

 

$

264,834

 

$

(4,037,656

)

$

2,796,911

 

 

 

 

 

 

 

 

 

 

 

 

 

Liabilities and Equity

 

 

 

 

 

 

 

 

 

 

 

Current liabilities:

 

 

 

 

 

 

 

 

 

 

 

Accounts payable

 

$

 

$

43,901

 

$

6,777

 

$

 

$

50,678

 

Current portion of debt and capital lease obligations

 

9,594

 

50

 

2,826

 

 

12,470

 

Other current liabilities

 

23,599

 

61,829

 

19,806

 

 

105,234

 

Total current liabilities

 

33,193

 

105,780

 

29,409

 

 

168,382

 

Long-term debt and capital lease obligations

 

1,797,896

 

63

 

 

 

1,797,959

 

Deferred tax liabilities, net

 

 

283,333

 

13,519

 

 

296,852

 

Intercompany payables, net

 

 

913,179

 

94,434

 

(1,007,613

)

 

Other long-term liabilities

 

 

15,183

 

1,472

 

 

16,655

 

Total liabilities

 

1,831,089

 

1,317,538

 

138,834

 

(1,007,613

)

2,279,848

 

Noncontrolling interests

 

 

 

2,332

 

 

2,332

 

Total membership equity

 

514,731

 

2,906,375

 

123,668

 

(3,030,043

)

514,731

 

Total liabilities and equity

 

$

2,345,820

 

$

4,223,913

 

$

264,834

 

$

(4,037,656

)

$

2,796,911

 

 

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DJO Finance LLC

Unaudited Condensed Consolidating Statements of Operations

For the Three Months Ended July 3, 2010

(in thousands)

 

 

 

DJOFL

 

Guarantors

 

Non-
Guarantors

 

Eliminations

 

Consolidated

 

Net sales

 

$

 

$

205,053

 

$

32,765

 

$

4,709

 

$

242,527

 

Cost of sales (exclusive of amortization of intangible assets of $9,062 included below)

 

 

74,732

 

7,280

 

2,553

 

84,565

 

Gross profit

 

 

130,321

 

25,485

 

2,156

 

157,962

 

Operating expenses:

 

 

 

 

 

 

 

 

 

 

 

Selling, general and administrative

 

 

96,052

 

19,663

 

 

115,715

 

Research and development

 

 

4,542

 

918

 

 

5,460

 

Impairment of assets held for sale

 

 

1,147

 

 

 

1,147

 

Amortization of intangible assets

 

 

18,716

 

955

 

 

19,671

 

 

 

 

120,457

 

21,536

 

 

141,993

 

Operating income

 

 

9,864

 

3,949

 

2,156

 

15,969

 

Other income (expense):

 

 

 

 

 

 

 

 

 

 

 

Interest expense

 

(37,124

)

(10,464

)

(863

)

11,001

 

(37,450

)

Interest income

 

9,205

 

1,970

 

148

 

(11,001

)

322

 

Other income (expense), net

 

28,162

 

4,683

 

(2,211

)

(33,471

)

(2,837

)

 

 

243

 

(3,811

)

(2,926

)

(33,471

)

(39,965

)

Income (loss) before income taxes

 

243

 

6,053

 

1,023

 

(31,315

)

(23,996

)

Income tax provision (benefit)

 

 

(25,863

)

1,303

 

 

(24,560

)

Net income (loss)

 

243

 

31,916

 

(280

)

(31,315

)

564

 

Net income attributable to noncontrolling interests

 

 

 

321

 

 

321

 

Net income (loss) attributable to DJO Finance LLC

 

$

243

 

$

31,916

 

$

(601

)

$

(31,315

)

$

243

 

 

DJO Finance LLC

Unaudited Condensed Consolidating Statements of Operations

For the Six Months Ended July 3, 2010

(in thousands)

 

 

 

DJOFL

 

Guarantors

 

Non-
Guarantors

 

Eliminations

 

Consolidated

 

Net sales

 

$

 

$

415,864

 

$

103,114

 

$

(36,375

)

$

482,603

 

Cost of sales (exclusive of amortization of intangible assets of $17,981 included below)

 

 

158,296

 

50,968

 

(37,345

)

171,919

 

Gross profit

 

 

257,568

 

52,146

 

970

 

310,684

 

Operating expenses:

 

 

 

 

 

 

 

 

 

 

 

Selling, general and administrative

 

 

186,147

 

40,094

 

 

226,241

 

Research and development

 

 

9,274

 

1,757

 

 

11,031

 

Impairment of assets held for sale

 

 

1,147

 

 

 

1,147

 

Amortization of intangible assets

 

 

36,793

 

1,932

 

 

38,725

 

 

 

 

 

233,361

 

43,783

 

 

277,144

 

Operating income

 

 

24,207

 

8,363

 

970

 

33,540

 

Other income (expense):

 

 

 

 

 

 

 

 

 

 

 

Interest expense

 

(77,466

)

(21,251

)

(1,796

)

22,351

 

(78,162

)

Interest income

 

19,955

 

2,773

 

298

 

(22,351

)

675

 

Other income (expense), net

 

24,096

 

(20,825

)

(2,942

)

(3,946

)

(3,617

)

 

 

(33,415

)

(39,303

)

(4,440

)

(3,946

)

(81,104

)

Income (loss) before income taxes

 

(33,415

)

(15,096

)

3,923

 

(2,976

)

(47,564

)

Income tax provision (benefit)

 

 

(17,079

)

2,287

 

 

(14,792

)

Net income (loss)

 

(33,415

)

1,983

 

1,636

 

(2,976

)

(32,772

)

Net income attributable to noncontrolling interests

 

 

 

643

 

 

643

 

Net income (loss) attributable to DJO Finance LLC

 

$

(33,415

)

$

1,983

 

$

993

 

$

(2,976

)

$

(33,415

)

 

22



Table of Contents

 

DJO Finance LLC

Unaudited Condensed Consolidating Statements of Cash Flows

For the Six Months Ended July 3, 2010

(in thousands)

 

 

 

DJOFL

 

Guarantors

 

Non-
Guarantors

 

Eliminations

 

Consolidated

 

OPERATING ACTIVITIES:

 

 

 

 

 

 

 

 

 

 

 

Net income (loss)

 

$

(33,415

)

$

1,983

 

$

1,636

 

$

(2,976

)

$

(32,772

)

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

 

 

 

 

 

 

 

 

 

 

 

Depreciation

 

 

10,811

 

2,358

 

(64

)

13,105

 

Amortization of intangible assets

 

 

36,793

 

1,932

 

 

38,725

 

Amortization of debt issuance costs and non-cash interest expense

 

7,193

 

 

 

 

7,193

 

Stock-based compensation expense

 

 

865

 

 

 

865

 

Loss on disposal of assets, net

 

 

709

 

129

 

(178

)

660

 

Deferred income tax benefit

 

 

(17,409

)

(138

)

 

(17,547

)

Non-cash income from subsidiaries

 

(21,332

)

513,115

 

20,877

 

(512,660

)

 

Provision for doubtful accounts and sales returns

 

 

17,054

 

334

 

 

17,388

 

Inventory reserves

 

 

2,472

 

368

 

 

2,840

 

Impairment of assets held for sale

 

 

1,147

 

 

 

1,147

 

Changes in operating assets and liabilities:

 

 

 

 

 

 

 

 

 

 

 

Accounts receivable

 

 

(18,733

)

(608

)

 

(19,341

)

Inventories

 

 

(3,993

)

(2,392

)

(2,234

)

(8,619

)

Prepaid expenses and other assets

 

92

 

11,954

 

(23,987

)

 

(11,941

)

Accounts payable and other current liabilities

 

1,632

 

18,345

 

(1,527

)

 

18,450

 

Net cash provided by (used in) operating activities

 

(45,830

)

575,113

 

(1,018

)

(518,112

)

10,153

 

INVESTING ACTIVITIES:

 

 

 

 

 

 

 

 

 

 

 

Cash paid in connection with acquisitions, net of cash acquired

 

 

(810

)

 

 

(810

)

Purchases of property and equipment

 

 

(12,904

)

(3,096

)

1,505

 

(14,495

)

Other investing activities, net

 

 

69

 

(567

)

 

(498

)

Net cash used in investing activities

 

 

(13,645

)

(3,663

)

1,505

 

(15,803

)

FINANCING ACTIVITIES:

 

 

 

 

 

 

 

 

 

 

 

Intercompany

 

49,449

 

(566,251

)

195

 

516,607

 

 

Proceeds from issuance of debt

 

118,000

 

 

130

 

 

118,130

 

Repayments of debt and capital lease obligations