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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 October 2, 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)

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.

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 November 4, 2010, 100% of the issuer’s membership interests were owned by DJO Holdings, LLC.

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DJO Finance LLC

INDEX

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DJO Finance LLC

Unaudited Condensed Consolidated Balance Sheets

(in thousands)

See accompanying notes to unaudited condensed consolidated financial statements.

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DJO Finance LLC

Unaudited Condensed Consolidated Statements of Operations

(in thousands)

See accompanying notes to unaudited condensed consolidated financial statements.

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DJO Finance LLC

Unaudited Condensed Consolidated Statements of Cash Flows

(in thousands)

See accompanying notes to unaudited condensed consolidated financial statements.

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DJO Finance LLC

Notes to Unaudited Condensed Consolidated Financial Statements

1.  BASIS OF PRESENTATION

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 and continues to be owned primarily by affiliates of Blackstone. As a result of the DJO Merger, DJO Opco (which on December 31, 2009, was merged into DJO, LLC) 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. Except as otherwise indicated, references to “us”, “we”, “our”, or “our Company”, refers to DJOFL and its consolidated subsidiaries.

On June 12, 2009, we sold our Empi Therapy Solutions (ETS) catalog business, formerly known as Rehab Medical Equipment, or RME, to Patterson Medical Supply, Inc. for approximately $21.8 million. As such, results of the ETS business for the three and nine month periods ended September 26, 2009 have been presented as discontinued operations in our unaudited condensed consolidated financial statements.

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.

The preparation of financial statements in conformity with accounting principles generally accepted in the United States (GAAP) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Estimates and assumptions are used in accounting for, among other things, contractual allowances, rebates, product returns, warranty obligations, allowances for doubtful accounts, valuation of inventories, self-insurance reserves, income taxes, loss contingencies, fair values of derivative instruments, fair values of long-lived assets and any related impairments, capitalization of costs associated with internally developed software, and stock-based compensation. Actual results could differ from those estimates.

The accompanying unaudited condensed consolidated financial statements include our accounts and all voting interest entities where we exercise a controlling financial interest through the ownership of a direct or indirect majority voting interest. All significant intercompany accounts and transactions have been eliminated in consolidation.

Our unaudited condensed consolidated financial statements have been prepared in accordance with GAAP and with the instructions to Form 10-Q and Article 10 of Regulation S-X for interim financial information. Accordingly, these financial statements do not include all of the information required by GAAP or Securities and Exchange Commission rules and regulations for complete financial statements. In the opinion of management, these financial statements reflect all adjustments (consisting of normal recurring adjustments) necessary for a fair presentation of the results of operations for the interim periods presented. The results of operations for any interim period are not necessarily indicative of results for the full year. 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.

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

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 fewer shipping days from year to year based on the days of the week on which holidays and December 31 fall. The three months ended October 2, 2010 and September 26, 2009 each included 63 shipping days. The nine months ended October 2, 2010 and September 26, 2009 included 192 and 188 shipping days, respectively.

2.  RECENT ACCOUNTING PRONOUNCEMENTS

In January 2010, we adopted the provisions of the Improvement to Financial Reporting by Enterprises Involved with Variable Interest Entities Topic of the Financial Accounting Standards Board (FASB) Codification. This Topic requires a qualitative approach to identifying a controlling interest financial interest in a variable interest entity (VIE), and requires ongoing assessment of whether an entity is a VIE, and whether an interest in a VIE makes the holder the primary beneficiary of the VIE. The adoption of this Topic had no impact on our consolidated financial statements.

In January 2010, we adopted the provisions of the FASB Codification which, among other matters, removes the concept of a qualifying special-purpose entity; creates more stringent conditions for reporting a transfer of a portion of a financial asset as a sale; establishes conditions for reporting a transfer of a portion of a financial asset as a sale; and changes the initial measurement of a transferor’s interest in transferred financial assets. The adoption of this Topic had no impact on our consolidated financial statements.

In September 2009, the FASB issued guidance concerning the determination of whether an arrangement involving multiple deliverables contains more than one unit of accounting and the manner in which consideration should be measured and allocated to the separate units of accounting in the multiple-element arrangement. This guidance 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 have a material effect on our financial position, results of operations, or cash flows.

3.  ACCOUNTS RECEIVABLE RESERVES

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

4.  INVENTORIES

Inventories consist of the following (in thousands):

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

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

5.  LONG-LIVED ASSETS

Goodwill

Changes in the carrying amount of our goodwill for the nine months ended October 2, 2010 are set forth below (in thousands):

(1)          On September 20, 2010 we acquired certain assets and contractual rights from our South African distributor for total consideration of $1.9 million, which included (i) a cash payment of $1.2 million on the closing date, (ii) forgiveness of $0.4 million of accounts receivable from the distributor and (iii) holdbacks of $0.3 million related primarily to potential indemnification claims, which will be paid in September 2011 if there are no such claims. Our primary reason for this acquisition was to improve the profitability of our sales in South Africa and expand the range of our products sold in this market, which will be aided by participating directly in the market, instead of through an independent distributor. The purchase price was allocated to the acquired tangible and identifiable intangible assets consisting of $0.4 million of inventory, $0.3 million of fixed assets and $1.1 million of finite-lived intangible assets. The $0.1 million excess of the purchase price over the fair value of these identifiable assets was recorded as goodwill.

Intangible assets, net

Identifiable intangible assets consisted of the following as of October 2, 2010 (in thousands):

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

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 balance as of October 2, 2010, we estimate that amortization expense will be as follows for the next five years and thereafter (in thousands):

6.  OTHER CURRENT LIABILITIES

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

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7.  DERIVATIVE INSTRUMENTS

We use derivative financial instruments to manage interest rate risk related to our variable rate credit facilities and risk related to foreign currency exchange rates. Our objective is to reduce the risk to earnings and cash flows associated with changes in interest rates and changes in foreign currency exchange rates. Before acquiring a derivative instrument to hedge a specific risk, we evaluate potential natural hedges. 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. We do not use derivative instruments for speculative or trading purposes.

All derivatives, whether designated as hedging relationships or not, are recorded on the balance sheet at fair value. The fair value of our derivatives is determined through the use of models that consider various assumptions, including time value, yield curves and other relevant economic measures which are inputs that are classified as Level 2 in the valuation hierarchy. 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. Our interest rate swap agreements are designated as cash flow hedges, and accordingly, effective portions of changes in the fair value of the derivatives are recorded in accumulated other comprehensive income (loss) and subsequently reclassified into our consolidated statement of operations when the hedged forecasted transaction affects income (loss). Ineffective portions of changes in the fair value of cash flow hedges are recognized in income (loss). Our foreign exchange contracts have not been designated as hedges, and accordingly, changes in the fair value of the derivatives are recorded in income (loss).

Interest Rate Swap Agreements.  Our senior secured 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. We have five interest rate swap agreements which we have designated as cash flow hedges for accounting purposes, and the hedges are considered effective. As such, the effective portion of the gain or loss on the derivative instrument is reported as a component of accumulated other comprehensive income (loss) and is reclassified into interest expense in our unaudited condensed consolidated statement of operations in the period in which it affects income (loss).

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Information regarding our interest rate swap agreements as of October 2, 2010 is presented below (in thousands):

(1)          For derivative instruments that were in effect as of October 2, 2010, we present a single date that represents the applicable final maturity date. For derivative instruments that become effective subsequent to October 2, 2010, we present a range of dates that represent the period covered by the applicable derivative instrument.

Foreign Exchange Rate Contracts.  We utilize Mexican Peso (MXP) foreign exchange forward contracts to hedge a portion of our exposure to fluctuations in foreign exchange rates, as our Mexico-based manufacturing operations incur costs that are largely denominated in MXP. These foreign exchange forward contracts expire weekly throughout fiscal year 2010.While our foreign exchange forward contracts act as economic hedges, we have not designated such instruments as hedges for accounting purposes. Therefore, gains and losses resulting from changes in the fair values of these derivative instruments are recorded in other income, net, in our unaudited condensed consolidated statements of operations.

Information regarding the notional and fair value of our foreign exchange forward contracts as of October 2, 2010 and December 31, 2009 is presented in the table below (in thousands):

The following table summarizes the fair value of derivative instruments in our unaudited condensed consolidated balance sheets (in thousands):

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

(1)          Represents the loss on derivative instruments designated as cash flow hedges, which has been reclassified from accumulated other comprehensive income (loss) into interest expense during the periods presented.

The pre-tax loss on derivative instruments designated as cash flow hedges recognized in accumulated other comprehensive income (loss) is presented below (in thousands):

8.  FAIR VALUE MEASUREMENTS

Financial assets and liabilities are classified based on the lowest level of input that is significant to the fair value measurements. Our assessment of the significance of a particular input to the fair value measurements requires judgment, and may affect the valuation of the assets and liabilities being measured and their placement within the fair value hierarchy. The following tables present the balances of assets and liabilities measured at fair value on a recurring basis (in thousands):

(1)   Fair value measurements based on quoted prices in active markets for identical assets or liabilities.

(2)   Fair value measurements based on observable inputs other than quoted prices in active markets for identical assets and liabilities.

(3)   No observable valuation inputs in the market.

9.  DEBT AND CAPITAL LEASE OBLIGATIONS

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

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Senior Secured Credit Facility

On November 20, 2007, we entered into the Senior Secured Credit Facility consisting 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. We are amortizing the $12.6 million discount using the effective interest method, thereby increasing the reported outstanding balance through the maturity date of the term loan facility.

On January 14, 2010, we entered into Amendment No. 1 to the Senior Secured Credit Facility, which permitted us to issue up to an additional $150.0 million in aggregate principal amount of new 10.875% Notes on or prior to March 1, 2010, as long as the net cash proceeds were used to make a voluntary prepayment of the term loans. In connection with this amendment, we incurred $1.1 million of arrangement and lender consent fees, which we expensed during the first quarter of 2010. On January 20, 2010, we issued $100.0 million of new 10.875% Notes, as described below, and made a $101.5 million voluntary prepayment of the term loans in accordance with the terms of Amendment No. 1 to the Senior Secured Credit Facility. In addition, pursuant to the excess cash flow provisions of the Senior Secured Credit Facility, as described below, we also made a $2.0 million prepayment of the term loans during March 2010. In connection with these prepayments, we accelerated $0.8 million of amortization of the then remaining unamortized original issue discount during the first quarter of 2010. Additionally, we recognized a non-cash loss of $1.9 million attributable to the write off of the then remaining unamortized debt issuance costs related to the portion of the term loans that were repaid.

As of October 2, 2010, the market value of our term loan facility was $898.0 million. We determine market value using trading prices for our term loan on or near that date.

Interest Rates.  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, as defined 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. 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 7).

Fees.  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 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 full at maturity in May 2014.

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 issuance or incurrence of debt by DJOFL and its restricted subsidiaries, other than proceeds from debt permitted to be incurred under the Senior Secured Credit Facility and related amendments. Any mandatory prepayments are applied to the term loan facility in direct order of maturity. We reinvested the net proceeds from our 2009 asset sales 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.

Guarantee and Security.  All obligations under the Senior Secured Credit Facility are unconditionally guaranteed by DJO Holdings LLC (DJO 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 DJO Holdings, DJOFL and each Guarantor.

Certain Covenants and Events of Default.  The Senior Secured Credit Facility contains 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,

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·                  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 3.75:1 for the trailing twelve months ended October 2, 2010, stepping down to 3.25:1 beginning with the trailing twelve months ended December 31, 2011. The Senior Secured Credit Facility also contains certain customary affirmative covenants and events of default. As of October 2, 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 (DJO Finco) (collectively, the Issuers) issued $575.0 million aggregate principal amount of 10.875% Senior Notes (the 10.875% Notes) due 2014, 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, the Issuers issued $100.0 million aggregate principal amount of new 10.875% Notes, pursuant to the 10.875% Indenture that governs our existing 10.875% Notes due 2014. We issued the new 10.875% Notes at a 5.0% premium, resulting in gross proceeds of $105.0 million. We are amortizing the premium over the term of the new 10.875% Notes using the effective interest method, thereby decreasing the reported outstanding balance through the maturity date. Net proceeds from 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 holders of the new 10.875% Notes on May 15, 2010), along with cash on hand, were used to repay $101.5 million of existing term loans under the Senior Secured Credit Facility. 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.

As of October 2, 2010, the market value of the 10.875% Notes was $730.7 million. We determine market value using trading prices for the 10.875% Notes on or near that date. We believe the trading prices as of October 2, 2010 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.

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 October 2, 2010, we were in compliance with all applicable covenants.

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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 required semi-annual interest payments of approximately $11.8 million each May 15 and November 15.

As of October 2, 2010, the market value of the 11.75% Notes was approximately $212.5 million. We determine market value using trading prices for the 11.75% Notes on or near that date.

The 11.75% Notes contained provisions similar to 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 had 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.

On October 18, 2010, we issued $300.0 million of new 9.75% Senior Subordinated Notes (9.75% Notes), and used a portion of the proceeds to repurchase $199.85 million aggregate principal amount of the 11.75% Notes for total consideration of $213.0 million plus $9.8 million of accrued interest through the settlement date. We intend to redeem the remaining $150,000 aggregate principal amount of the 11.75% Notes during November 2010 at a redemption price of 105.875% (see Note 18 for additional information).

Our ability to continue to meet the covenants related to our indebtedness specified above and in Note 18, 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 10.875% Indenture, and the Indenture which governs the 9.75% Notes issued on October 18, 2010 (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

As of October 2, 2010 and December 31, 2009, we had $34.8 million and $38.9 million, respectively, of unamortized debt issuance costs which were included in other non-current assets in our unaudited condensed consolidated balance sheets. We incurred $0.1 million, and $3.5 million of debt issuance costs which were capitalized, during the three and nine months ended October 2, 2010, respectively, in connection with the sale of the new 10.875% Notes and the registered exchange offer of the notes, which was completed in April 2010. For the three and nine months ended October 2, 2010, amortization of debt issuance costs was $1.7 million and $7.6 million, respectively. For the three and nine months ended September 26, 2009, amortization of debt issuance costs was $2.7 million and $8.4 million, respectively.

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.

For the three and nine months ended October 2, 2010, we recorded income tax benefits of approximately $3.2 million and $18.0 million, respectively, on pre-tax losses of approximately $10.7 million and $58.3 million, resulting in effective tax rates of 29.8% and 30.9%, respectively. For the three and nine months ended September 26, 2009, we recorded an income tax benefit of approximately $3.0 million and $19.9 million, respectively, on pre-tax losses of approximately $14.0 million and $57.9 million, respectively, resulting in effective tax rates of 20.8% and 34.3%, respectively.

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 2006. The Internal Revenue Service (IRS) completed its field examination of the 2005 and 2006 tax years during the first half of 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 nine months ended October 2, 2010, we increased our gross unrecognized tax benefits by $0.5 million. As of October 2, 2010, our total gross unrecognized tax benefits were $19.6 million, including a cumulative $2.1 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 of 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. All unrecognized tax benefits will impact our effective tax rate upon recognition. We believe that it is reasonably possible that an increase of $0.4 million in unrecognized tax benefits related to various immaterial state exposures may be necessary within the next twelve months.

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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 was completed during the first half of 2010. A summary of the activity relating to the restructuring for the nine months ended October 2, 2010 is as follows (in thousands):

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 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 facilities in Hixson, and listed the buildings for sale during the first half of 2010.  Based on the current estimated fair market value of the buildings, we recorded an impairment charge of $1.1 million during the first half of 2010, which has been reflected as impairment of assets held for sale in our unaudited condensed consolidated statement of operations. The fair market value of the buildings held for sale is estimated to be approximately $2.8 million, and is included in other current assets in our unaudited condensed consolidated balance sheet at October 2, 2010.

12.  STOCK OPTION PLANS AND STOCK-BASED COMPENSATION

We have one active equity compensation plan, the DJO Incorporated 2007 Incentive Stock Plan (the 2007 Stock Option Plan), under which we are authorized to grant awards of stock, options, and other stock-based awards for 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 Stock Option 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 Stock Option Plan. Under the DJO Form Option Agreement, one-third of stock options will vest over a specified period of time (typically five years) from the date of grant contingent solely upon the awardees’ continued employment with us (the Time-Based Tranche). As initially adopted, another one-third of stock options were to vest over a specified performance period (typically five years) from the date of grant upon the achievement of certain pre-determined annual performance targets based on Adjusted EBITDA and free cash flow, as defined (the Performance-Based Tranche). 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; each measured with respect to Blackstone’s aggregate investment in DJO Incorporated capital stock, to be achieved by Blackstone following a liquidation of all or a portion of its investment in DJO Incorporated capital stock (the 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 vesting terms of the Time-Based Tranche and Enhanced Market-Return Tranche remain the same as discussed above. As modified, the financial performance targets for future years of the Performance-Based Tranche were replaced by new IRR and MOIC targets, similar to the Enhanced Market-Return Tranche, each measured with respect to Blackstone’s aggregate investment in DJO Incorporated capital stock, to be achieved by Blackstone following a liquidation of all or a portion of its investment in DJO Incorporated capital stock (referred to hereafter 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.

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Options granted under the 2007 Stock Option Plan contain change-in-control provisions that would result in accelerated vesting of the Time-Based Tranche upon the occurrence of a change-in-control. Specifically, the Time-Based Tranche would 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. However, this change-in-control provision does not apply to the Market-Return or the Enhanced Market-Return Tranches.

During the three months ended October 2, 2010 we granted 107,500 stock options, including 5,000 to non-employee distributors, with a weighted average grant date fair value of $6.46 per share for the Time-Based Tranche, and an exercise price of $16.46 per share. We granted 138,150 stock options, including 24,000 to non-employee distributors, with a weighted average grant date fair value of $6.40 per share for the Time-Based Tranche, and an exercise price of $16.46 per share during the three months ended September 26, 2009.

During the nine months ended October 2, 2010 we granted 592,250 stock options, including 6,200 to non-employee distributors, with a weighted average grant date fair value of $6.66 per share for the Time-Based Tranche, and an exercise price of $16.46 per share. We granted 733,732 stock options, including 24,800 to non-employee distributors, with a weighted average grant date fair value of $6.31 per share for the Time-Based Tranche, and an exercise price of $16.46 per share during the nine months ended September 26, 2009.

The following table summarizes certain assumptions we used to estimate the fair value of the Time-Based Tranche of stock options granted during the periods presented:

We recorded non-cash stock-based compensation expense of $0.4 million and $1.3 million for the three and nine months ended October 2, 2010, respectively. We recorded non-cash compensation expense of $0.9 million and $2.3 million for the three and nine months ended September 26, 2009, respectively. For the each of the three and nine months periods ended October 2, 2010 and September 26, 2009, we only recognized non-cash compensation expense for options in the Time-Based Tranche, as the performance and market components of the Market-Return and Enhanced Market-Return Tranches are not deemed probable at this time.

13.  EQUITY

During the three and nine months ended October 2, 2010, DJO Incorporated sold 24,304 and 87,052 shares of its Common Stock, respectively, 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. Net proceeds from this offering during the three and nine months ended October 2, 2010 were approximately $0.4 million and $1.4 million, respectively. These proceeds were contributed by DJO Incorporated to us and have been included in member capital in our unaudited condensed consolidated balance sheet as of October 2, 2010. The proceeds will be used for working capital purposes.

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Comprehensive loss consists of the following for the periods presented (in thousands):

14.  RELATED PARTY TRANSACTIONS

Blackstone Management Partners V L.L.C. (BMP), an affiliate of our major shareholder, provides certain monitoring, advisory and consulting services to us for an annual monitoring fee equal to the greater of $7.0 million or 2% of consolidated EBITDA as defined in the Transaction and Monitoring Fee Agreement, payable in the first quarter of each year. The monitoring fee agreement will continue until the earlier of November 2019, or such date as DJOFL and BMP may mutually determine. DJOFL has agreed 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 November 2019. For each of the three and nine month periods presented, we recognized $1.75 million and $5.25 million, respectively, related to the annual monitoring fee, which is recorded as a component of SG&A expense in our unaudited condensed consolidated statements of operations.

15.  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 (pain 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. These lawsuits are about equally divided between the two manufacturers. Both manufacturers have rejected our tenders of indemnity. Until early 2010, the base policy for one of the manufacturers was paying for our defense, but that policy has been exhausted by defense costs of the Company and the manufacturer and by settlements, and a second policy has been significantly eroded by defense costs of the Company and the manufacturer and is expected to be exhausted by

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settlements in the near future. This manufacturer has ceased operations, has little assets and no additional insurance coverage. The Company has asserted indemnification rights against the successor to this manufacturer and intends to pursue its claims appropriately. The base policy for the other manufacturer has been exhausted and the excess liability carriers for that manufacturer have not accepted coverage for the Company, and are not expected to provide for its defense. The Company and this manufacturer have been cooperating in jointly negotiating settlements of those lawsuits in which both parties are named. Our products liability carriers have 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. In August 2010, one of our excess carriers for the period ending July 1, 2010 and for the supplemental extended reporting period (SERP) discussed below, which is insuring $10 million in excess of $25 million, informed us that it has reserved its right to rescind the policy based on an alleged failure by us and our insurance broker to disclose material information. We disagree with this allegation and are seeking to resolve the issue with this carrier. The lawsuits allege damages ranging from unspecified amounts to claims between $1.0 million and $10.0 million. 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.

In mid-2010, we were named in three multi-plaintiff lawsuits alleging that the plaintiffs had been injured following use of certain cold therapy products manufactured by the Company. These lawsuits are in their early stages and were brought by 16, 11 and 19 plaintiffs, respectively. The complaints are not specific as to the nature of the injuries, but allege various product liability theories, including inadequate warnings regarding the risks associated with the use of cold therapy and failure to incorporate certain safety features into the design. No specific dollar amounts of damages are alleged. We could be exposed to material liabilities if our insurance coverage is not available or inadequate 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 pain pumps discussed above. The subpoena which was issued by the United States Attorney’s Office, Central District of California, refers to an official investigation by the U.S. Department of Justice (DOJ) and the U.S. Food and Drug Administration (FDA) of Federal healthcare offenses. We are producing documents that are responsive to the subpoena. We believe that our actions related to our prior distribution of these pain 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 related to the pain pump products 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 our cold therapy units, $500,000 per claim for claims relating to invasive products, $75,000 per claim for claims relating to non-invasive products other than our cold therapy products, and an aggregate self-insured retention of $2.25 million. We purchased 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 product 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 product 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 October 2, 2010 (unaudited) and December 31, 2009, include accrued liabilities of approximately $1.7 million and $2.0 million, respectively, for expenses related to products liability claims for products other than our pain pump products. The amounts 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.

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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 have filed 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 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.

16. 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.

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 consumers ranging from fitness enthusiasts to competitive athletes our Compex electrostimulation device, which is used in athletic training programs to aid muscle development and to accelerate muscle recovery after training sessions.

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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.

Information regarding our reportable business segments is presented below (in thousands). Segment results exclude the impact of certain general corporate expenses and charges related to various integration activities, as defined. All prior periods presented have been restated to reflect our current reportable segments.