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Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-K

 

 

 

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

For the fiscal year ended December 31, 2014

or

 

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

For the transition period from                      to                     .

Commission file number 333-142188

 

 

DJO Finance LLC

(Exact name of Registrant as specified in its charter)

 

 

 

Delaware   20-5653965

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

 

1430 Decision Street

Vista, California

  92081
(Address of principal executive offices)   (Zip Code)

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

Securities registered pursuant to Section 12(b) of the Act:

 

Title of each class

 

Name of each exchange on which registered

None   None

Securities registered pursuant to Section 12(g) of the Act: None

 

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes  ¨    No  x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes  x    No  ¨

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  ¨    No  x (Note: As of January 1, 2014, the registrant was no longer subject to the filing requirements of Section 13 or 15(d) of the Exchange Act; however, the registrant filed all reports required to be filed during the period it was subject to Section 13 or 15(d) of the Exchange Act.)

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  x    No  ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  x

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

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

As of February 20, 2015, 100% of the issuer’s membership interests were owned by DJO Holdings LLC.

 

 

 


Table of Contents

DJO FINANCE LLC

FORM  10-K

TABLE OF CONTENTS

 

         Page
No.
 
  PART I   

Item 1.

  Business      3   

Item 1A.

  Risk Factors      18   

Item 2.

  Properties      31   

Item 3.

  Legal Proceedings      31   

Item 4.

  Mine Safety Disclosures      32   
  PART II   

Item 5.

  Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities      33   

Item 6.

  Selected Financial Data      34   

Item 7.

  Management’s Discussion and Analysis of Financial Condition and Results of Operations      35   

Item 7A.

  Quantitative and Qualitative Disclosures About Market Risk      50   

Item 8.

  Financial Statements and Supplementary Data      51   

Item 9.

  Changes in and Disagreements With Accountants on Accounting and Financial Disclosure      97   

Item 9A.

  Controls and Procedures      97   

Item 9B.

  Other Information      97   
  PART III   

Item 10.

  Directors, Executive Officers and Corporate Governance      98   

Item 11.

  Executive Compensation      103   

Item 12.

  Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters      117   

Item 13.

  Certain Relationships and Related Transactions, and Director Independence      119   

Item 14.

  Principal Accounting Fees and Services      120   
  PART IV   

Item 15.

  Exhibits, Financial Statement Schedules      121   

SIGNATURES

     128   

 

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FORWARD-LOOKING STATEMENTS

This Annual Report on Form 10-K (Annual Report) of DJO Finance LLC (DJOFL, or the Company) for the year ended December 31, 2014 contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended (the Securities Act) and Section 21E of the Securities Exchange Act of 1934, as amended (the Exchange Act), which are intended to be covered by the safe harbors created thereby. To the extent that any statements are not recitations of historical fact, such statements constitute forward-looking statements that, by definition, involve risks and uncertainties. Specifically, the sections entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Business” may contain forward-looking statements. These statements can be identified because they use words like “anticipates,” “believes,” “estimates,” “expects,” “forecasts,” “future,” “intends,” “plans,” and similar terms. These statements reflect only our current expectations. Forward-looking statements include statements concerning our plans, objectives, goals, strategies, future events, capital expenditures, future results, our competitive strengths, our business strategy, the trends in our industry and the benefits of our acquisitions.

Although we do not make forward-looking statements unless we believe we have a reasonable basis for doing so, we cannot guarantee their accuracy, and actual results may differ materially from those we anticipated due to a number of uncertainties, many of which are unforeseen, including, among others, the risks we face as described elsewhere in this filing. You should not place undue reliance on these forward-looking statements, which apply only as of the date of this Annual Report. In any forward-looking statement where we express an expectation or belief as to future results or events, such expectation or belief is expressed in good faith and is believed to have a reasonable basis, but there can be no assurance that any future results or events expressed by the statement of expectation or belief will be achieved or accomplished.

We believe it is important to communicate our expectations to holders of our notes. There may be events in the future, however, that we are unable to predict accurately or over which we have no control. The risk factors listed in Item 1A below, as well as any cautionary language in this Annual Report, provide examples of risks, uncertainties and events that may cause our actual results to differ materially from the expectations we describe in our forward-looking statements.

PART I.

 

ITEM 1. BUSINESS

Overview

We are a global developer, manufacturer and distributor of high-quality medical devices that provide solutions for musculoskeletal health, vascular health and pain management. Our products address the continuum of patient care from injury prevention to rehabilitation after surgery, injury or from degenerative disease, enabling people to regain or maintain their natural motion.

DJO Finance LLC (DJOFL) is a wholly owned indirect subsidiary of DJO Global, Inc (DJO). DJOFL is a Delaware limited liability company organized in 2006. Substantially all business activities of DJO are conducted by DJOFL and its wholly owned subsidiaries.

Except as otherwise indicated, references to “us”, “we”, “our”, or “the Company” in this Annual Report refers to DJOFL and its consolidated subsidiaries. Each one of the following trademarks, trade names or service marks, which is used in this Annual Report, is either (i) our registered trademark, (ii) a trademark for which we have a pending application, or (iii) a trademark or service mark for which we claim common law rights: Cefar®, Empi®, Exos™, Bell-Horn®, Compex®, Aircast®, DonJoy®, OfficeCare®, ProCare®, MotionCare™, SpinaLogic®, Dr. Comfort™, CMF™, OL1000™, and OL1000 SC™. All other trademarks, trade names or service marks of any other company appearing in this Annual Report belong to their respective owners.

Operating Segments and Products

We currently develop, manufacture and distribute our products through the following four operating segments; Bracing and Vascular; Recovery Sciences; Surgical Implant and International.

Our products are used by orthopedic specialists, spine surgeons, primary care physicians, pain management specialists, physical therapists, podiatrists, chiropractors, athletic trainers and other healthcare professionals to treat patients with musculoskeletal conditions resulting from degenerative diseases, deformities, traumatic events and sports related injuries. In addition, many of our non-surgical medical devices and related accessories are used by athletes and patients for injury prevention and at-home physical therapy treatment. Our product lines include rigid and soft orthopedic bracing, hot and cold therapy, bone growth stimulators, vascular

 

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therapy systems and compression garments, therapeutic shoes and inserts, electrical stimulators used for pain management and physical therapy products. Our surgical implant business offers a comprehensive suite of reconstructive joint products for the hip, knee and shoulder.

Our products are marketed under a portfolio of brands including Aircast®, DonJoy®, ProCare®, CMF™, Empi®, MotionCare™, Chattanooga, DJO Surgical, Dr. Comfort™, Compex®, Bell-Horn™ and ExosTM.

Our four operating segments enable us to reach a diverse customer base through multiple distribution channels and give us the opportunity to provide a wide range of medical devices and related products to orthopedic specialists and other healthcare professionals operating in a variety of patient treatment settings and to the retail consumer. These four segments constitute our reportable segments. See Note 18 of the Notes to Consolidated Financial Statements included in Part II, Item 8, herein for financial and other additional information regarding our segments.

Bracing and Vascular Segment

Our Bracing and Vascular segment, which generates its revenues in the United States, offers our rigid knee bracing products, orthopedic soft goods, cold therapy products, vascular systems, therapeutic footwear for the diabetes care market and compression therapy products, primarily under the DonJoy, ProCare, Aircast, Dr. Comfort, Bell-Horn and Exos brands. This segment also includes our OfficeCare channel, through which we maintain an inventory of soft goods and other products at healthcare facilities, primarily orthopedic practices, for immediate distribution to patients. The Bracing and Vascular segment primarily sells its products to orthopedic and sports medicine professionals, hospitals, podiatry practices, orthotic and prosthetic centers, home medical equipment providers and independent pharmacies. In 2014 we expanded our consumer channel to focus on marketing, selling and distributing our products, including bracing and vascular products, to professional and consumer retail customers and on-line. The bracing and vascular products sold through this channel will principally be sold under the DonJoy Performance, Bell-Horn and Doctor Comfort brands.

The following table summarizes our Bracing and Vascular segment product categories:

 

Product Category

  

Description

Rigid bracing and soft goods   

Soft goods

Lower extremity fracture boots

Ligament braces

Post-operative braces

Osteoarthritis braces

Ankle bracing

Shoulder, elbow and wrist braces

Back braces

Neck braces

ExosTM thermoformable braces

Cold and compression therapy    Cold and compression therapy products
Vascular therapy   

Vascular system pumps

Compression hosiery

Therapeutic shoes and inserts    Therapeutic footwear and related medical and comfort products

Recovery Sciences Segment

Our Recovery Sciences segment, which generates its revenues in the United States, consists of three key brands: Empi, CMF and Chattanooga. These products are sold to medical clinics, independent distributors or patient direct for consumer home use. For products sold directly to patients, we arrange billing to the patients and their third party payors, if applicable. Empi products are non-invasive, non-addictive and non-narcotic solutions for pain management and strength recovery. The CMF brand of bone growth stimulation products provides medical professionals with an effective tool for healing problem fractures and spinal fusion procedures. Chattanooga rehabilitation equipment is used for treating musculoskeletal, neurological and soft tissue disorders. These products include 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 This segment also provides professional and consumer retail customers our Compex electrostimulation device, which is used in training programs to aid muscle development and to accelerate muscle recovery after training sessions.

 

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The following table summarizes our Recovery Sciences segment product categories:

 

Product Category

  

Description

Home electrotherapy devices   

Transcutaneous electrical nerve stimulation (TENS)

Neuromuscular electrical stimulation (NMES)

Interferential electrical nerve stimulation

Electrodes

Iontophoresis    Needle-free transdermal drug delivery
Bone growth stimulation   

Non-union fracture bone growth stimulation devices

Adjunct to spinal fusion bone growth stimulation devices

Clinical electrotherapy   

TENS

NMES

Ultrasound / Acoustic wave therapy

Laser / Light therapy

Shortwave Diathermy

Electrodes

Patient care   

Patient safety devices

Continuous passive motion devices

Dynamic splinting

Back braces

Compounded pain relief cream

Physical therapy tables and traction products   

Treatment tables

Traction tables

Cervical traction for home use

Lumbar traction for home use

Hot, cold and compression therapy   

Dry heat therapy

Hot/cold therapy

Paraffin wax therapy

Moist heat therapy

Cold therapy

Compression therapy

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.

The following table summarizes our Surgical Implant segment product categories:

 

Product Category

  

Description

Knee implants   

Primary total joint replacement

Revision total joint replacement

Unicondylar joint replacement

Hip implants   

Primary replacement stems

Acetabular cup system

Revision joint replacement

Shoulder implants   

Primary total joint replacement

Fracture repair system

Revision total joint replacement (including reverse shoulder)

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. The product categories for our International segment are similar to the product categories for our domestic segments except certain products are tailored to international market requirements and preferences. In addition, our International segment sells a number of products, none of which is individually significant, that we do not sell domestically.

 

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On January 23, 2014, we acquired all of the outstanding shares of capital stock of Speetec Implantate GmbH (“Speetec”). Speetec is a distributor and manufacturer of knee, hip and shoulder arthroplasty products in Germany.

Research and Development

Our research and development programs focus on the development of new products, as well as the enhancement of existing products with the latest technology and updated designs. We seek to develop new technologies to improve durability, performance and usability of existing products, and to develop our manufacturing process to improve product performance and reduce manufacturing costs. In addition to our own research and development, we receive new product and invention ideas from orthopedic surgeons and other healthcare professionals. We also seek to obtain rights to ideas we consider promising from a clinical and commercial perspective through entering into either assignment or licensing agreements.

We conduct research and development programs at our facilities in Vista, California; Austin, Texas; and Ecublens, Switzerland. We spent $37.7 million, $33.2 million, and $27.9 million in 2014, 2013 and 2012, respectively, for research and development activities.

Marketing and Sales

Our products reach our customers, including hospitals and other healthcare facilities, physicians and other healthcare providers and end user patients and consumers, through several sales and distribution channels.

No particular customer or distributor accounted for 10% or more of product sales in any of our segments for the year ended December 31, 2014. Medicare and Medicaid together accounted for approximately 4.8% of our consolidated 2014 net sales.

Bracing and Vascular Segment

We market and sell our Bracing and Vascular segment products in several different ways. The DonJoy brand is primarily dedicated to the sale of our bracing and supports products to orthopedic surgeons, podiatrists, orthotic and prosthetic centers, hospitals, surgery centers, physical therapists, athletic trainers and other healthcare professionals. The DonJoy brand is mostly sold through independent commissioned sales representatives who are employed by independent sales agents. Because the DonJoy products generally require customer education in the application and use, DonJoy sales representatives are technical specialists who receive extensive training, and use their expertise to help fit the patient with the product and assist the orthopedic professional in choosing the appropriate product to meet the patient’s needs. After a sales representative receives a product order, we generally ship and bill the product directly to the orthopedic professional, and pay a sales commission to the agent. For certain custom rigid braces and other products, we sell directly to the patient and bill a third party payor, if applicable, on behalf of the patient. We enjoy long-standing relationships with most of our agents and sales representatives. Under the arrangements with the agents, each agent is granted an exclusive geographic territory for sales of our products and is not permitted to market products, or represent competitors who sell or distribute products, that compete with our existing products. The agents receive a commission, which varies based on the type of product being sold. If an agent fails to achieve specified sales quotas, we have the right to terminate our relationship with the agent. Certain DonJoy sales representatives also sell our Recovery Sciences and Vascular products.

The ProCare/Aircast brand is sold by direct and independent sales representatives that manage a network of distributors focused on selling our bracing and supports products to primary and acute care facilities. Vascular systems are also included in this brand. These products are generally sold in non-exclusive territories to third party distributors as well as through our direct sales force. Our distributors include large, national third party distributors such as Owens & Minor Inc., McKesson/HBOC, Allegiance Healthcare and PSS World Medical, regional medical and surgical distributors, outpatient surgery centers and medical products buying groups that consist of a number of healthcare providers who make purchases through the buying group. These distributors and our direct sales force generally sell our products to large hospital chains, primary care networks and orthopedic physicians for use by the patients. In addition, we sell our products through group purchasing organizations (GPOs) that are a preferred purchasing source for members of a buying group. These products generally do not require significant customer education for their use. Our vascular pumps are provided to primary and acute care facilities, supplemented by vascular system specialists. Our vascular systems pumps and related equipment are typically consigned to hospitals, and the hospitals then purchase the cuffs that are applied to each patient. We have recently introduced vascular pumps for home use.

Under the Dr. Comfort brand, we market and distribute our therapeutic footwear and related medical and comfort products primarily through the podiatry, home medical equipment (HME), pharmacy, and orthotic and prosthetic (O&P) channels through our sales force of direct and independent sales representatives. Compression hosiery is private labeled and sold to customers who resell the products.

 

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OfficeCare provides stock and bill arrangements for physician practices. Through OfficeCare, we maintain an inventory of bracing and supports products at approximately 2,000 orthopedic practices and other healthcare facilities for immediate distribution to patients. We then bill the patient or, if applicable, a third party payor.

Our Consumer channel, which we expanded in 2014, sells or plans to sell certain of our bracing products, primarily orthopedic soft goods, and footwear based on our therapeutic footwear in the professional retail and consumer retail markets. The Consumer channel is also developing products designed for consumers in the athletic and sports retail market. A wide variety of our bracing and vascular products are offered by the Consumer channel through an on-line web site.

In a marketing program conducted under the framework of Motion is Medicine™ and coordinated by the Bracing and Vascular and Recovery Cciences segments, we are offering to physicians and clinics a protocol of products that address the full spectrum of requirements to treat common indications, such as osteoarthritis of the knee or anterior cruciate ligament (ACL) injuries. Under this program, called MotionCare™, the physician has readily available for prescription our preventative products, pain management products and rehabilitative products to provide a conservative care regimen to patients. We plan to expand this MotionCare approach to other indications where a range of conservative care products would be beneficial to patients in treating chronic conditions or injuries and in preparing for and recovering from surgery.

Recovery Sciences Segment

We market and sell our Recovery Sciences segment products in several different ways, including the MotionCare program described above under the Bracing and Vascular segment. Our Empi brand includes prescription-based home therapy products primarily marketed to physicians and physical therapy clinics, which include hospital physical therapy departments, sports medicine clinics and pain management centers, through our sales force of direct and independent sales representatives. A physician such as an orthopedic surgeon generally prescribes our electrotherapy and orthotics products to patients. The physician will typically direct the patient to a physical therapy clinic to meet with a trained physical therapist who provides the patient with the prescribed product from our consigned inventory at the clinic. This sales process is facilitated by our extensive relationships with third party payors, such as managed care organizations, who ultimately pay us for the products prescribed to patients. For these reasons, we view physical therapists, physicians and third party payors as key decision makers in product selection and patient referral. Our home therapy products generally are eligible for third party reimbursement by government payors, such as Medicare and Medicaid, and private payors.

CMF non-union fracture bone growth stimulator devices (OL1000) and spine bone growth stimulator device (SpinaLogic) are sold by our direct and independent sales representatives specially trained to sell the product. Most of our bone growth stimulator products are sold directly to the patient and a third party payor is billed, if applicable, on behalf of the patient. A number of the direct and independent sales representatives in the Recovery Sciences segment sell both Empi and CMF products.

We sell our Chattanooga rehabilitation product lines to physical therapy clinics, primarily through a national network of independent distributors, which are managed by our employed sales managers. These distributors sell our clinical rehabilitation products to a variety of healthcare professionals, including physical therapists, athletic trainers, chiropractors, and sports medicine physicians. Except for distributors outside of the United States, we do not maintain formal distribution contracts for our clinical rehabilitation products. These distributors purchase products from us at discounts off our published list price. We maintain an internal marketing and sales support program to support our distributor network. This program comprises a group of individuals who provide distributor and end-user training, develop promotional materials, and attend trade shows each year.

Our Consumer Compex electrostimulation device is marketed and sold to fitness enthusiasts and competitive athletes in a direct-to-consumer model and through our on-line web site. We are planning to market and sell this device, as well as other Recovery Sciences products appropriate for sale directly to the end user, in the professional and consumer retail markets.

Surgical Implant Segment

We market and sell our Surgical Implant products to hospitals and orthopedic surgeons through a network of independent commissioned sales representatives who are employed by independent sales agents. Generally, our independent sales representatives sell a range of reconstructive joint products, including our products. We usually enter into agreements with sales agents for a term of one to five years. Agents are typically paid a sales commission and are eligible for bonuses if sales exceed certain preset objectives. Our independent sales representatives work for these agents. We assign each of our sales agents to an exclusive sales territory and require them to meet specific periodic sales targets. Substantially all of our sales agents agree not to sell competitive products. We provide our sales agents with product inventories, on consignment, for their use in marketing and filling customer orders.

        To a significant extent, sales of our surgical implant products depend on the preference of orthopedic surgeons. We maintain contractual relationships with orthopedic surgeons who assist us in developing our products and provide consulting services in connection with our products. In addition to providing design input into our new products, some of these orthopedic surgeons may give demonstrations using our products, speak about our products at medical seminars, train other orthopedic surgeons in the use of our products, and provide us with feedback on the acceptance of our products. We have also established relationships with surgeons who conduct clinical studies on various products, establish protocols for use of the products and participate at various symposia.

 

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International Segment

We sell our products internationally through a network of wholly owned subsidiaries and independent distributors. In Europe, we use sales forces of direct and independent salespersons and a network of independent distributors who call on healthcare professionals, as well as consumer retail stores, such as sporting equipment providers and pharmacies, to sell our products. We intend to continue to expand our direct and indirect distribution capabilities in attractive foreign markets.

Manufacturing

We use both in-house manufacturing capabilities and relationships with third party vendors to supply our products. Generally, we use third party vendors only when they have special manufacturing capabilities or when we believe it is appropriate based on certain factors, including our in-house capacity, lead-time control and cost. Although we have certain sole source supply agreements, we believe alternate vendors are available, and we believe that adequate capacity exists at our current vendors to meet our anticipated needs.

Our manufacturing facilities are generally certified by the International Organization for Standardization (ISO) and generally comply with the U.S. Food and Drug Administration (FDA) current Good Manufacturing Practice and Quality System Regulations (QSRs) requirements, which provide standards for safe and consistent manufacturing of medical devices and appropriate documentation of the manufacturing and distribution process. Many of our products carry the European Community Medical Device Directive (CE) certification mark.

Our manufacturing facility in Tijuana, Mexico is our largest manufacturing facility. Our Mexico facility has achieved ISO 13485 certification. This certification reflects internationally recognized quality standards for manufacturing and assists us in marketing our products. Our Vista, California facility has achieved certification to ISO 13485, the Canadian Medical Device Regulation and the European Medical Device Directive. Products manufactured at the Vista, California facility include our custom rigid knee bracing products, the pump portion of our vascular systems products, and our CMF products. Products manufactured at our Tijuana, Mexico facility include most of our bracing and supports product lines, and our Chattanooga products including electrotherapy devices, patient care products and CPM devices. Within both our Vista and Tijuana facilities, we operate vertically integrated manufacturing and packaging operations and many subassemblies and components are produced in-house. These include metal stamped parts, injection molded components and fabric-strapping materials. We also have extensive in-house tool and die fabrication capabilities, which typically provide savings in the development of tools and molds as well as flexibility to respond to and capitalize on market opportunities as they are identified.

In our Bracing and Vascular segment, the ETI factory in Asheboro, North Carolina, manufactures a full range of compression products, such as anti-embolism stockings; men’s and women’s daily wear and sports compression socks; sheer and surgical weight below knee, thigh length, and pantyhose compression stockings; braces and lymphoedema arm sleeves. The products are sold to worldwide OEM customers as well as to our internal distribution network. The factory specializes in circular knitting and is FDA and ISO 9001:2008 certified and sells under the CE mark in Europe. The primary raw materials used for the compression hosiery are yarn (spandex, nylon, and polyester), dyes, and woven elastics.

Also in our Bracing and Vascular segment, the Dr. Comfort manufacturing facility in Mequon, Wisconsin, manufactures therapeutic footwear and related medical and comfort products. These products are the custom insoles provided primarily as additional product with our Diabetic footwear collections as well as shoe modifications. The primary raw material is a foam ethylene vinyl acetate (EVA) copolymer that is machined to closely match the plantar surface of our customer. The facility is a registered manufacturer with the FDA.

Our home electrotherapy devices sold in the United States and certain components and related accessories are manufactured at our Clear Lake, South Dakota facility. Manufacturing activities at the Clear Lake facility include electronic and mechanical assembly, electrode fabrication and assembly and fabric sewing processes. Our electrotherapy products comprise a variety of components, including die cast metal parts, injection molded plastic parts, printed circuit boards, electronic components, lead wires, electrodes and other components. Parts for these components are purchased from outside suppliers or, in certain instances, manufactured on a custom basis. Our Clear Lake facility has achieved the ISO 13485:2003 certification. Our home electrotherapy devices sold outside the United States are primarily manufactured by third party vendors.

Many of the component parts and raw materials we use in our manufacturing and assembly operations are available from more than one supplier and are generally available on the open market. We source some of our finished products from manufacturers in

 

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China as well as other third party manufacturers. We also currently purchase certain CPM devices from a single supply source, Medireha, which is 50% owned by us. Our distribution agreement with Medireha grants us exclusive rights to the distribution of products that Medireha manufactures. The distribution agreement also requires that we purchase a certain amount of product annually and that we seek Medireha’s approval if we choose to manufacture or distribute products that are identical or similar, or otherwise compete with the products that are the subject of the distribution agreement.

In our Surgical Implant segment, we manufacture our products in our Austin, Texas facility. This manufacturing facility includes computer controlled machine tools, belting, polishing, cleaning, packaging and quality control. Our Austin facility has achieved the ISO 13485:2003 certification. The primary raw materials used in the manufacture of our surgical implant products are cobalt chromium alloy, stainless steel alloys, titanium alloy and ultra high molecular weight polyethylene. All products in our Surgical Implant segment go through in-house quality control, cleaning and packaging operations.

Many of the products for our International segment are manufactured in the same facilities as our domestic segments. We operate a manufacturing facility in Tunisia that provides Bracing and Vascular and Recovery Sciences products for the European markets. In addition, our German and French channels source certain of the products they sell from third party suppliers. Our French channel currently utilizes a single vendor for many of its home electrotherapy devices.

Intellectual Property

We own or have licensing rights to U.S. and foreign patents covering a wide range of our products and have filed applications for additional patents. We have numerous trademarks registered in the United States, a number of which are also registered in countries around the world. We also assert ownership of numerous unregistered trademarks, some of which have been submitted for registration in the United States and foreign countries. In the future, we will continue to apply for such additional patents and trademarks as we deem appropriate. Additionally, we seek to protect our non-patented know-how, trade secrets, processes and other proprietary confidential information, through a variety of methods; including having our vendors, employees and consultants sign invention assignment agreements, proprietary information agreements and confidentiality agreements and having our independent sales agents and distributors sign confidentiality agreements. Because many of our products are regulated, proprietary information created during our development of a new or improved product may have to be disclosed to the FDA or another U.S. or foreign regulatory agency in order for us to have the lawful right to market such product. We have distribution rights for certain products that are manufactured by others and hold both exclusive and nonexclusive licenses under third party patents and trade secrets that cover some of our existing products and products under development.

The validity of any of the patents or other intellectual property owned by or licensed to us may not be upheld if challenged by others in litigation. Due to these and other risks described in this Annual Report, we do not rely solely on our patents and other intellectual property to maintain our competitive position. We believe that the development and marketing of new products and improvement of existing ones is, and will continue to be, more important to our competitive position than relying solely on existing products and intellectual property.

Competition

The markets we compete in are highly competitive and fragmented. Some of our competitors, either alone or in conjunction with their respective corporate parent groups, have greater research and development, sales and marketing, and manufacturing capabilities than we do, and thus may have a competitive advantage over us. Although we believe that the design and quality of our products compare favorably with those of our competitors, if we are unable to offer products with the latest technological advances at competitive prices, our ability to compete successfully could be materially adversely affected.

Given our sales history, our history of product development and the experience of our management team, we believe we are capable of effectively competing in our markets in the future. Further, we believe the comprehensive range of products we offer enables us to reach a diverse customer base and to use multiple distribution channels in an attempt to increase our growth across our markets. In addition, we believe the various company and product line acquisitions we have made in recent years continue to improve the name recognition of our company and our products. Our ability to compete is affected by, among other things, our ability to:

 

    develop new products and innovative technologies,

 

    obtain regulatory clearance and compliance for our products,

 

    manufacture and sell our products cost-effectively,

 

    meet all relevant quality standards for our products and their markets,

 

    respond to competitive pressures specific to each of our geographic markets, including our ability to enforce non-compete agreements,

 

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    protect the proprietary technology of our products and manufacturing processes,

 

    market our products,

 

    attract and retain skilled employees and sales representatives, and

 

    establish and maintain distribution relationships.

All of our segments compete with large, diversified corporations and companies that are part of corporate groups that have significantly greater financial, marketing and other resources than we do, as well as numerous smaller niche companies.

Bracing and Vascular Segment

Our primary competitors in the rigid knee bracing market include companies such as Össur hf., the recent combination by merger of Breg, Inc. (Breg) and Bledsoe Brace Systems (Bledsoe), and Townsend Design. Competition in the rigid knee brace market is primarily based on product technology, quality and reputation, relationships with customers, service and price.

In the soft goods products market, our competitors include Biomet Inc. (Biomet), DeRoyal Industries, Össur hf. and Zimmer Holdings, Inc. (Zimmer). In the cold therapy products market, our competitors include Breg and Bledsoe and Stryker Corporation (Stryker). Competition in the soft goods and pain management markets is less dependent on innovation and technology and is primarily based on product range, quality, service and price.

The therapeutic footwear and related medical and comfort products market is highly fragmented with multiple channels, servicing customers as diverse as podiatrists, home medical equipment users, orthotists, retail pharmacy and numerous other service categories. Our competitors include several multi-product companies and numerous smaller niche competitors. Competition in the therapeutic footwear market tends to be based on product technology, quality and reputation, relationships with customers, service and price.

Several competitors have initiated stock and bill programs similar to our OfficeCare program, and there are numerous regional stock and bill competitors.

Recovery Sciences Segment

The primary competitors of our Empi and Chattanooga products are Dynatronics Corporation, Mettler Electronics Corporation, Rich-Mar, Patterson Medical, Enraf-Nonius, Gymna-Uniphy, Acorn Engineering, International Rehabilitation Sciences, Inc. (d/b/a RS Medical), Zynex and EMSI. The physical therapy products market is highly competitive and fragmented. Our competitors in the CPM devices market include several multi-product companies with significant market share and numerous smaller niche competitors. Competition in these markets is based primarily on the quality and technical features of products, product pricing and contractual arrangements with third party payors and national accounts.

Our competitors for CMF products are large, diversified orthopedic companies. In the non-union bone growth stimulation market, our competitors include Orthofix International, N.V. (Orthofix), Biomet and Bioventus LLC, formerly known as Smith & Nephew plc, and in the spinal fusion market, we compete with Biomet and Orthofix. Competition in bone growth stimulation devices is limited as higher regulatory thresholds provide a barrier to market entry.

Our primary competitor in the dynamic splinting market is Dynasplint Systems, Inc.

Surgical Implant Segment

The market for orthopedic products similar to those produced by our surgical implant business is dominated by a number of large companies, including Biomet, DePuy, Inc. (a Johnson & Johnson company), Smith & Nephew plc, Stryker, and Zimmer, which are much larger and have significantly greater financial resources than we do. Our Surgical Implant segment also faces competition from U.S.-based companies similar in size to ours, such as Wright Medical Group, Inc. and Exactech, Inc. Competition in the market in which our Surgical Implant segment participates is based primarily on innovative design and technical capability, scale of field sales and service organization, breadth of product line, quality and price.

International Segment

Competition for the products in our International segment arises from many of the companies and types of companies that compete with our domestic segments and from foreign manufacturers whose costs may be lower due to their ability to manufacture products within their respective countries. Competition is based primarily on quality, innovative design and technical capability, breadth of product line, availability of and qualification for reimbursement, and price.

 

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Government Regulation

FDA and Similar Foreign Government Regulations

Our products are subject to rigorous government agency regulation in the United States and in other countries. In the United States, the FDA regulates the development, testing, labeling, manufacturing, storage, recordkeeping, pre-market clearance or approval, promotion, distribution and marketing of medical devices to ensure that medical products distributed in the United States are safe and effective for their intended uses. The FDA also regulates the export of medical devices manufactured in the United States to international markets. Our medical devices are subject to such FDA regulation.

Under the Food, Drug and Cosmetic Act, as amended, medical devices are generally classified into one of three classes depending on the degree of risk to patients using the device. Class I is the lowest risk classification and most Class I devices are exempt from pre-market submission requirements. Some Class I devices and most Class II devices require a pre-market notification to and clearance from FDA as set forth under § 510(k) of the Food, Drug and Cosmetic Act, as amended, also known as a “510(k)” submission. The 510(k) process is one in which the FDA seeks to determine if a device is “substantially equivalent” to a legally marketed device. Class III devices are the highest risk devices, and a Pre-Market Approval (PMA) application must be submitted to and approved by the FDA before the manufacturer of a Class III product can proceed in marketing the product.

We sell products in all three of the FDA classifications. All our currently marketed devices are either exempt from the FDA clearance and approval process (based on our interpretation of those regulations) or we have obtained the requisite clearances or approvals, as appropriate, required under federal medical device law. The FDA may disagree with our conclusion that clearances or approvals were not required for specific products and may require clearances or approval for such products. In these circumstances, we may be required to cease distribution of the product, the devices may be subject to seizure by the FDA or to a voluntary or mandatory recall, and we could be subject to significant fines and penalties.

Our manufacturing processes are also required to comply with the FDA’s current Good Manufacturing Practice requirements for medical devices, which are specified in FDA QSRs. The QSRs cover the methods and documentation of the design, testing, production processes, control, quality assurance, labeling, packaging and shipping of our products. Furthermore, our facilities, records and manufacturing processes are subject to periodic unscheduled inspections by the FDA and other agencies. We are also required to report to the FDA if our products cause or contribute to death or serious injury or malfunction in a way that would likely cause or contribute to death or serious injury were the malfunction to recur, and the FDA or other agencies may require the recall of products in the event of material defects or deficiencies in design or manufacturing. The FDA can also withdraw or limit our product approvals or clearances in the event of serious unanticipated health or safety concerns.

Even if regulatory approval or clearance of a medical device is granted, the FDA may impose limitations or restrictions on the use and indications for which the device may be labeled or promoted. Medical devices may be marketed only for the uses and indications for which they are cleared or approved. FDA regulations prohibit a manufacturer from promotion for an unapproved or off-label use.

The FDA has broad regulatory and enforcement powers. If the FDA determines we have failed to comply with applicable regulatory requirements, it can impose a variety of enforcement actions, from warning letters, fines, injunctions, consent decrees, and civil penalties, to suspension or delayed issuance of applications, seizure or recall of our products, total or partial shutdowns, withdrawals of approvals or clearances already granted, and criminal prosecution. The FDA can also require us to repair, replace, or refund the costs of devices we manufactured or distributed.

We must obtain export certificates from the FDA before we can export certain of our products. We are also subject to extensive regulations that are similar to those of the FDA in many of the foreign countries in which we sell our products, including those in Europe, our largest foreign market. These include product standards, packaging requirements, labeling requirements, import restrictions, tariff regulations, duties and tax requirements. In addition, the national health or social security organizations of certain countries, including certain countries outside Europe, require our products to be qualified before they can be marketed in those countries.

 

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Third Party Reimbursement

Our home therapy products, rigid knee braces, CMF products, and certain of our soft goods are generally prescribed by physicians and are eligible for third party reimbursement by government payors, such as Medicare and Medicaid, and private payors. Customer selection of our products depends, in part, on coverage of our products and whether third party payment amounts will be adequate. We believe that Medicare and other third party payors will continue to focus on measures to contain or reduce their costs through managed care and other methods. Medicare policies are important to our business not only because we must continue to meet the criteria for a qualified Medicare supplier, but also because private payors often model their policies after the Medicare program’s coverage and reimbursement policies.

In recent years, Congress has enacted a number of laws that affect Medicare reimbursement for and coverage of durable medical equipment (DME) and durable medical equipment, prosthetics, orthotics and supplies (DMEPOS), including many of our products. These laws have included temporary freezes or reductions in Medicare fee schedule updates. For instance, in March 2010, President Obama signed into law the Patient Protection and Affordable Care Act, which was amended by a second bill signed into law on March 30, 2010, known as the Health Care and Education Reconciliation Act (collectively referred to as the Affordable Care Act or ACA). Several provisions of the ACA specifically impact the medical equipment industry. Among other things, the ACA eliminated the full inflation update to the DMEPOS fee schedule for the years 2011 through 2014. Instead, beginning in 2011, the ACA reduces the inflation update for DMEPOS by a “productivity adjustment” factor intended to reflect productivity gains in delivering health care services. For 2015 the update factor is 1.5% (reflecting a 2.1% inflation update that is partially offset by 0.6% “productivity adjustment”).

Medicare payment for DMEPOS also can be impacted by the DMEPOS competitive bidding program, under which Medicare rates are based on bid amounts for certain products in designated geographic areas, rather than the Medicare fee schedule amount. Only those suppliers selected through the competitive bidding process within each designated competitive bidding area (CBA) are eligible to have their products reimbursed by Medicare. Our products were first included in competitive bidding in 2012 when Centers for Medicare & Medicaid Services (CMS) included TENS units in a recompetition of a prior round of competitive bidding in nine CBAs as part of a new “General Home Equipment and Related Supplies and Accessories” product category. Although we submitted bids to supply products in this category and were selected as a successful bidder in two CBAs, we did not enter into a contract to be a supplier in those two regions. The reimbursement rate in those two regions was established at a 46% reduction to the Medicare fee schedule rate, which is generally consistent with the results of competitive bidding for other items of DME. CMS has also announced that competitive bidding for TENS as a standalone product will be conducted in 2015 in 117 CBAs, with the reimbursement rates resulting from that bidding to be announced in the winter of 2016. We plan to participate in that round of competitive bidding. In conformance with statutory requirements, CMS will begin applying pricing data from competitive bidding outside of CBAs beginning in 2016. Specifically, the reimbursement rate outside of CBAs for TENS and certain other items subject to limited competitive bidding will be 110% of the average of the rates established in the nine CBAs through competitive bidding, with 50% of this reduction in the reimbursement rate implemented on January 1, 2016 and the full reduction implemented on July 1, 2016.

In addition, in 2013 CMS released a listing of codes that it considers to be off-the-shelf (OTS) orthotics and subject to competitive bidding in the future. When our orthotic products are subject to competitive bidding, if we are not a contract supplier (or subcontractor) in a particular region or if contract prices are significantly below Medicare fee schedule reimbursement levels, it could have a material adverse impact on our sales and profitability. CMS has not yet announced the schedule for competitive bidding for off-the-shelf orthotics. The Affordable Care Act (ACA) also authorizes the Secretary to use competitive bidding payment information to adjust OTS orthotics payments in areas outside of CBAs beginning in 2016.

The ACA established new disclosure requirements (sometimes referred to as the Physician Payment Sunshine Act) regarding financial arrangements between medical device and supplies manufacturers and physicians, including physicians who serve as consultants. The recordkeeping requirements became effective August 1, 2013. The first reports for data from August 2013 through December of 2013 were submitted in the spring of 2014 and made publicly available on September 30, 2014. The regulations require us to report annually to CMS all payments and other transfers of value to physicians and teaching hospitals for products payable under federal health care programs, as well as ownership or investments held by physicians or their family members. Failure to fully and accurately disclose transfers of value to physicians could subject us to civil monetary penalties. Several states also have enacted specific marketing and payment disclosure requirements and other states may do so in the future.

In response to pressure from certain groups (primarily orthotists), the United States Congress and state legislatures have periodically considered proposals that limit the types of individuals who can fit our orthotic device products or who can seek reimbursement for them. Several states have adopted legislation which imposes certification or licensing requirements on the measuring, fitting and adjusting of certain orthotic devices. Although some of these state laws exempt manufacturers’ representatives, other states’ laws subject the activities of such representatives to certification or licensing requirements. The state of Texas has adopted such a licensure law which the state regulatory board has interpreted as not including an exemption for manufacturer’s sales representatives acting under the supervision of a physician and has issued a cease and desist letter directed to the fitting activities of our sales representatives in that state. We have requested clarification of such letter. Additional states may be considering similar

 

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legislation. If these laws are enforced without an exemption for manufacturer’s sales representatives or without our sales representatives qualifying as certified or licensed persons, our ability to fit and bill these products will be adversely impacted. In addition, in July 2013 we were served with a subpoena under HIPAA (as defined and further described below) seeking documents relating to the fitting of custom-fabricated or custom-fitted orthoses in the States of New Jersey, Washington and Texas. The subpoena was issued by the United States Attorney’s Office for the District of New Jersey in connection with an investigation of compliance with professional licensing statutes in those states relating to the practice of orthotics. We have of supplied the documents requested under the subpoena.

Efforts have also been made to establish similar certification requirements at the federal level for the Medicare program. For example, in 2000, Congress passed the Medicare, Medicaid and SCHIP Benefits Improvement and Protection Act of 2000 (BIPA). BIPA contained a provision requiring, as a condition for payment by the Medicare program, that certain certification or licensing requirements be met for individuals and suppliers furnishing certain, but not all, custom-fabricated orthotic devices. CMS has not implemented this requirement to date. In July 2014, CMS promulgated regulations to define the “specialized training” that is needed to provide custom fitting of orthotics under the Medicare program if the fitter is not a certified orthotist. Under the proposed definition, CMS would consider only the following four categories of individuals to have such specialized training: a physician, a treating practitioner, an occupational therapist, or a physical therapist. Under this proposal, trained manufacturers’ representatives, certified athletic trainers, certified orthotic fitters, and other categories of individuals would not have been considered qualified to provide custom-fitting of orthotics. However, in the final rule published on November 6, 2014, CMS specified that it was not finalizing changes to this standard at this time.

Our international sales also depend in part upon the eligibility of our products for reimbursement through third party payors, the amount of reimbursement, and the allocation of payments between the patient and third party payors. Reimbursement practices vary significantly by country, with certain countries requiring products to undergo a lengthy regulatory review in order to be eligible for third party reimbursement. In addition, healthcare cost containment efforts similar to those we face in the United States are prevalent in many of the foreign countries in which our products are sold, and these efforts are expected to continue in the future, possibly resulting in the adoption of more stringent reimbursement standards. For example, in Germany, our largest foreign market, new regulations generally require adult patients to pay a portion of the cost of each medical technical device prescribed. This may adversely affect our sales and profitability by making it more difficult for patients in Germany to pay for our products. Any developments in our foreign markets that eliminate, reduce or materially modify coverage of, and reimbursement rates for, our products could have an adverse impact on our ability to sell our products.

Fraud and Abuse

We are subject to various and frequently changing federal and state laws and regulations pertaining to healthcare fraud and abuse. Many of these laws and regulations are vague or indefinite and may be interpreted or applied by a prosecutorial, regulatory, or judicial authority in a manner that could require us to make changes to our operations. Violations of these laws are punishable by criminal, civil and administrative sanctions, including, in some instances, loss of licenses and exclusion from participation in federal and state healthcare programs, including Medicare, Medicaid, Veterans Administration health programs and TRICARE (the health care program for active duty military, retirees and their families managed by the Department of Defense).

Anti-Kickback and Other Fraud Laws

Our operations are subject to federal and state anti-kickback laws. Certain provisions of the Social Security Act, commonly referred to as the Anti-Kickback Statute, prohibit persons from knowingly and willfully soliciting, receiving, offering or providing remuneration directly or indirectly to induce either the referral of an individual, or the furnishing, recommending, or arranging for a good or service, for which payment may be made under a federal healthcare program such as Medicare and Medicaid. The definition of remuneration has been broadly interpreted to include anything of value, including such items as gifts, discounts, waivers of payment, and providing anything at less than its fair market value. The U.S. Department of Health and Human Services (HHS) has issued regulations, commonly known as safe harbors, which set forth certain conditions, which if fully met, will assure healthcare providers and other parties that they will not be prosecuted under the Anti-Kickback Statute for their involvement in certain types of arrangements or activities. The penalties for violating the Anti-Kickback Statute include imprisonment for up to five years, fines of up to $25,000 per violation and possible exclusion from federal healthcare programs such as Medicare and Medicaid. Many states have adopted prohibitions similar to the Anti-Kickback Statute, some of which apply to the referral of patients for healthcare services reimbursed by any source, not only by the Medicare and Medicaid programs.

 

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HIPAA

The Health Insurance Portability and Accountability Act of 1996 (HIPAA) created two new federal crimes effective as of August 21, 1996, relating to healthcare fraud and false statements regarding healthcare matters. The healthcare fraud statute prohibits knowingly and willfully executing or attempting to execute a scheme or artifice to defraud any healthcare benefit program, including private payors. The false statements statute prohibits knowingly and willfully falsifying, concealing or covering up a material fact or making any materially false, fictitious or fraudulent statement or representation in connection with the delivery of or payment for healthcare benefits, items or services. HIPAA applies to any healthcare benefit plan, not just Medicare and Medicaid. Additionally, HIPAA granted expanded enforcement authority to HHS and the DOJ and provided enhanced resources to support the activities and responsibilities of the HHS, OIG and DOJ by authorizing large increases in funding for investigating fraud and abuse violations relating to healthcare delivery and payment. In addition, HIPAA mandates the adoption of standards for the electronic exchange of health information, as described below in greater detail under “Federal Privacy and Transaction Law and Regulations.”

Physician Self-Referral Laws

We may also be subject to federal and state physician self-referral laws. Federal physician self-referral legislation, commonly known as the Stark Law, prohibits, subject to certain exceptions, physician referrals of Medicare and Medicaid patients to an entity providing certain “designated health services” if the physician or an immediate family member of the physician or a physician organization in which the physician participates has any financial relationship with the entity. DME and orthotics are included as designated health services. The Stark Law also prohibits the entity receiving the referral from billing any good or service furnished pursuant to an unlawful referral, and any person collecting any amounts in connection with an unlawful referral is obligated to refund such amounts. A person who engages in a scheme to circumvent the Stark Law’s referral prohibition may be fined up to $100,000 for each such arrangement or scheme. The penalties for violating the Stark Law also include civil monetary penalties of up to $15,000 per referral and possible exclusion from federal healthcare programs such as Medicare and Medicaid. Various states have corollary laws to the Stark Law, including laws that require physicians to disclose any financial interest they may have with a healthcare provider to their patients when referring patients to that provider. Both the scope and exceptions for such laws vary from state to state.

False Claims Laws

Under multiple state and federal statutes, submissions of claims for payment that are “not provided as claimed” may lead to civil money penalties, criminal fines and imprisonment and/or exclusion from participation in Medicare, Medicaid and other federally funded state health programs. These false claims statutes include the federal False Claims Act, which prohibits the knowing filing of a false claim or the knowing use of false statements to obtain payment from the federal government. When an entity is determined to have violated the False Claims Act, it must pay three times the actual damages sustained by the government, plus mandatory civil penalties of between $5,500 and $11,000 for each separate false claim. Suits filed under the False Claims Act, known as “qui tam” actions, can be brought by any individual on behalf of the government, and such individuals, commonly known as whistleblowers, may share in any amounts paid by the entity to the government in fines or settlement. In addition, certain states have enacted laws modeled after the federal False Claims Act. Qui tam actions have increased significantly in recent years, causing greater numbers of healthcare companies to have to defend a false claim action, which may be costly and protracted, pay fines or be excluded from Medicare, Medicaid or other federal or state healthcare programs as a result of an investigation arising out of such action. A number of states have enacted false claims acts that are similar to the federal False Claims Act.

The federal government has used the federal False Claims Act to prosecute a wide variety of alleged false claims and fraud allegedly perpetrated against Medicare and state healthcare programs. Under the ACA, claims for items and services resulting from a violation of the federal Anti-Kickback Statute constitutes a false claim. The government and a number of courts also have taken the position that claims presented in violation of certain other statutes, including the Stark Law, can be considered a violation of the federal False Claims Act, based on the theory that a provider impliedly certifies compliance with all applicable laws, regulations and other rules when submitting claims for reimbursement.

On May 20, 2009, President Obama signed into law the Fraud Enforcement and Recovery Act of 2009 (FERA). Among other things, FERA modifies the federal False Claims Act by expanding liability to contractors and subcontractors who do not directly present claims to the federal government. FERA also expands False Claims Act liability for what is referred to as a “reverse false claim” by explicitly making it unlawful to knowingly conceal or knowingly and improperly avoid or decrease an obligation owed to the federal government. FERA also seeks to clarify that liability exists for attempts to avoid repayment of overpayments, including improper retention of federal funds. FERA is likely to increase both the volume and liability exposure of False Claims Act cases brought against healthcare entities. Additional fraud and abuse measures were adopted as part of the ACA, as noted above.

Just prior to the acquisition in 2011 of Dr. Comfort by DJO, Dr. Comfort entered into a settlement agreement with the U.S. Attorney’s Office for the Eastern District of Wisconsin and the Office of the Inspector General of HHS (OIG) resolving allegations by two whistleblowers that Dr. Comfort made false claims relating to products that allegedly did not meet Medicare standards, and that settlement agreement required Dr. Comfort to, among other things, enter into a five-year Corporate Integrity Agreement (CIA) covering its compliance program. Failure of Dr. Comfort to comply with certain obligations set forth in the CIA may result in the imposition of monetary (stipulated) penalties and/or Dr. Comfort’s exclusion from participation in the Federal health care programs.

 

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Customs and Import/Export Laws and Regulations

Our business is conducted world-wide, with raw material and finished goods imported from and exported to a substantial number of countries. In particular, a significant portion of our products are manufactured in our plant in Tijuana, Mexico and imported to the United States before shipment to domestic customers or export to other countries. We are subject to customs and import/export rules in the U.S. and other countries and to requirements for payment of appropriate duties and other taxes as goods move between countries. Customs authorities monitor our shipments and payments of duties, fees and other taxes and can perform audits to confirm compliance with applicable laws and regulations.

Foreign Corrupt Practices Act

We are also subject to the U.S. Foreign Corrupt Practices Act (the FCPA) , antitrust and anti-competition laws, and similar laws in foreign countries, any violation of which could create a substantial liability for us and also cause a loss of reputation in the market. The FCPA prohibits U.S. companies and their representatives officers, directors, employees, shareholders acting on their behalf and agents from corruptly offering, promising, authorizing or making payments, or giving anything of value, directly or indirectly, to foreign officials for the purpose of obtaining or retaining business abroad or otherwise obtaining favorable treatment. Companies must also maintain records that fairly and accurately reflect transactions and maintain an adequate system of internal accounting controls. In many countries, hospitals and clinics are government-owned and healthcare professionals employed by such hospitals and clinics, with whom we regularly interact, may be considered as meeting the definition of foreign officials for purposes of the FCPA. If we are found to have violated the FCPA or similar law, we may face sanctions including fines, criminal penalties, disgorgement of profits and suspension or debarment of our ability to contract with government agencies or receive export licenses.

Governmental Audits

Because we participate in governmental programs as a supplier of medical devices, our operations are subject to periodic surveys and audits by governmental entities or contractors to assure compliance with Medicare and Medicaid standards and requirements. To maintain our billing privileges, we are required to comply with certain supplier standards, including licensure and documentation requirements for our claims submissions. From time to time in the ordinary course of business, we, like other healthcare companies, are audited by, or receive claims documentation requests from, governmental entities, which may identify certain deficiencies based on our alleged failure to comply with applicable supplier standards or other requirements. Medicare contractors and Medicaid agencies periodically conduct pre-payment and post-payment reviews and other audits of claims and are under increasing pressure to more closely scrutinize healthcare claims and supporting documentation. Among other things, the ACA expanded the Recovery Audit Contractors (RAC) program, an audit tool that utilizes private companies operating on a contingent fee basis to identify and recoup Medicare overpayments. The Medicare and Medicaid programs also have broad authority to impose payment suspensions when they believe credible allegations of fraud exist. We have historically been subject to pre and post-payment reviews as well as audits of claims and may experience such reviews and audits of claims in the future. We review and assess such audits or reports and attempt to take appropriate corrective action. We are also subject to surveys of our facilities for compliance with the supplier standards. Noncompliance can result in, among other things, a revocation of Medicare billing privileges or termination from the Medicare program.

Federal Privacy and Transaction Law and Regulations

The Health Insurance Portability and Accountability Act of 1996, and its implementing regulations, as amended by the regulations promulgated pursuant to Health Information Technology for Economic and Clinical Health Act (HITECH Act), which we collectively refer to as HIPAA, contain substantial restrictions and requirements with respect to the use and disclosure of certain individually identifiable health information (referred to as protected health information, or PHI). These restrictions and requirements are set forth in the HIPAA Privacy, Security and Breach Notification Rules.

In many of our operations, we are a “covered entity” under HIPAA and therefore required to comply with the Privacy, Security and Breach Notification Rules, and are subject to significant civil and criminal penalties for failure to do so.We also provide services to customers that are covered entities themselves, and we are required to provide satisfactory written assurances to these customers through our written agreements that we will provide our services in accordance with HIPAA. Failure to comply with these contractual agreements could lead to loss of customers, contractual liability to our customers, and direct action by the federal government, including penalties.

On January 25, 2013, the Office for Civil Rights (OCR) of the Department of Health and Human Services published its final rule to modify the HIPAA Privacy, Security, Breach Notification and Enforcement Rules, including most revisions/additions made by the HITECH Act. The rule expanded the privacy and security requirements for business associates that create, receive, maintain or transmit protected health information for or on behalf of covered entities, increased penalties for noncompliance, and strengthened requirements for reporting of breaches of unsecured protected health information, among other changes. The rule also made business

 

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associates and their subcontractors directly liable for civil monetary penalties for impermissible uses and disclosures of protected health information. The rule became effective on March 23, 2013, and, with limited exception, entities and business associates covered by the rule were required to comply with most of the applicable requirements by September 23, 2013.

In addition to HIPAA, we must adhere to state patient confidentiality laws that are not preempted by HIPAA, including those that are more stringent than HIPAA requirements.

In November 2014, the Company experienced the loss of certain electronic protected health information following the theft of a laptop computer from the car of an IT consultant who was working for our Empi business in Shoreview, MN. The laptop belonged to the Company and contained reports which included patient data for approximately 160,000 patients. The data saved on the laptop computer was not encrypted. The Company has taken actions to notify all of the affected individuals and the media in most states as required by HIPAA. The Company has also provided the required notice to the Office of Civil Rights. As a result of this breach, the Company has undertaken additional remedial actions to strengthen its privacy and information security policies and infrastructure. We are unable to predict at this time whether or to what extent federal or state agencies will impose any civil monetary penalties or take other action as a result of this breach.

There are costs and administrative burdens associated with ongoing compliance with HIPAA and similar state law requirements. Any failure or perceived failure to comply carries with it the risk of significant penalties and sanctions. We cannot predict at this time the costs associated with ongoing compliance, or the ultimate impact of such laws and regulations on our results of operations, cash flows or financial condition.

Iran Sanctions Related Disclosure

Under the Iran Threat Reduction and Syrian Human Rights Act of 2012 (“ITRSHRA”), which added Section 13(r) of the Exchange Act, we are required to include certain disclosures in our periodic reports if we or any of our “affiliates” knowingly engaged in certain specified activities, transactions or dealings related to Iran or certain designated parties during the period covered by the report. An issuer must also concurrently file a separate notice with the SEC that such activities have been disclosed. We are not presently aware that we or our consolidated subsidiaries have knowingly engaged in any transaction or dealing reportable under Section 13(r) of the Exchange Act during the year ended December 31, 2014.

Because the SEC defines the term “affiliate” broadly, it includes any entity controlled by us as well as any person or entity that controls us or is under common control with us (“control” is also construed broadly by the SEC). As a result, The Blackstone Group L.P. (“Blackstone”), an affiliate of our major shareholder, and certain of the companies in which Blackstone’s affiliated funds are invested (“portfolio companies”), may be deemed to be our affiliates. During 2014, Blackstone included information in its periodic reports filed with the SEC regarding activities of its portfolio companies that require disclosure under the ITRSHR. These disclosures are reproduced in Exhibit 99.1 of this report and are incorporated by reference herein. We have no involvement in or control over such activities and we have not independently verified or participated in the preparation of the disclosures described in the filing.

Employees

As of December 31, 2014, we had approximately 4,940 employees. Of these, approximately 3,510 were engaged in production and production support, approximately 90 in research and development, approximately 980 in sales and support, and approximately 360 in various administrative capacities including third party billing. Of these employees, approximately 2,130 were located in the United States, approximately 1,960 were located in Mexico and approximately 850 were located in various other countries, primarily in Europe. We have not experienced any strikes or work stoppages, and our management considers our relationship with our employees to be good.

Segment and Geographic Information

Information about our segments and geographic areas can be found in Note 18 of the Notes to Consolidated Financial Statements included in Part II, Item 8, herein.

Available Information

We have made available free of charge through our website, www.DJOglobal.com, our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, other Exchange Act reports and all amendments to those reports as soon as reasonably practicable after such material is electronically filed with the Securities and Exchange Commission (SEC). This information can be found under the “Corporate Information—Investors-SEC reports” page of our website. DJO uses its website as a channel of distribution of material Company information. Financial and other material information regarding the Company is routinely

 

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posted and accessible on our website. Our SEC reports are also available free of charge on the SEC website at, www.sec.gov. Such reports can also be inspected and copied at the Public Reference Room of the SEC located at 100 F Street, N.E., Washington, D.C. 20549. Copies of such material can be obtained from the Public Reference Room of the SEC at prescribed rates. You may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. Our Code of Business Conduct and Ethics is available free of charge under the “Corporate Information—Investors-Corporate Governance” page of our website.

 

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ITEM 1A. RISK FACTORS

Our ability to achieve our operating and financial goals is subject to a number of risks, including risks relating to our business operations, our debt level and government regulations. If any of the following risks actually occur, our business, operating results, prospects or financial condition could be materially and adversely affected. The risks described below are not the only ones that we face. Additional risks not presently known to us or that we currently deem immaterial may also affect our business operations.

Risks Related To Our Indebtedness

Our substantial leverage could adversely affect our ability to raise additional capital to fund our operations, limit our ability to react to changes in the economy or our industry, expose us to interest rate risk to the extent of our variable rate debt and prevent us from meeting our obligations under our indebtedness.

We are highly leveraged. As of December 31, 2014, our total indebtedness was $2,271.6 million, exclusive of net unamortized original issue discount of $0.7 million. We also had an additional $82.5 million available for borrowing under our revolving credit facility. Our high degree of leverage could have important consequences, including:

 

    making it difficult for us to make payments on our 8.75% second priority senior secured notes, our 9.875% senior unsecured notes, our 7.75% senior unsecured notes and our 9.75% senior subordinated notes (collectively, the Notes) and other debt,

 

    increasing our vulnerability to general economic and industry conditions,

 

    requiring a substantial portion of cash flow from operations to be dedicated to the payment of principal and interest on our indebtedness, therefore reducing our ability to use our cash flow to fund our operations, capital expenditures and future business opportunities,

 

    exposing us to the risk of increased interest rates as certain of our borrowings, including certain borrowings under our senior secured credit facilities, will be subject to variable rates of interest,

 

    limiting our ability to make strategic acquisitions or causing us to make non-strategic divestitures,

 

    limiting our ability to obtain additional financing for working capital, capital expenditures, product development, debt service requirements, acquisitions and general corporate or other purposes, and

 

    limiting our ability to adjust to changing market conditions and placing us at a competitive disadvantage compared to our competitors who are less highly leveraged.

Our debt agreements contain restrictions that limit our flexibility in operating our business.

Our senior secured credit facilities and the Indentures contain various covenants that limit our ability to engage in specified types of transactions. These covenants limit our and our restricted subsidiaries’ ability to, among other things:

 

    incur additional indebtedness or issue certain preferred shares,

 

    pay dividends on, repurchase or make distributions in respect of our capital stock or make other restricted payments,

 

    make certain investments,

 

    sell certain assets,

 

    create liens,

 

    consolidate, merge, sell or otherwise dispose of all or substantially all of our assets, and

 

    enter into certain transactions with our affiliates.

In addition, we are required to satisfy and maintain a specified senior secured leverage ratio. This covenant could materially adversely affect our ability to finance our future operations or capital needs. Furthermore, it may restrict our ability to conduct and expand our business and pursue our business strategies. Our ability to meet this senior secured leverage ratio can be affected by events beyond our control, including changes in general economic and business conditions, and we cannot assure you that we will meet the senior secured leverage ratio in the future or at all.

A breach of any of these covenants could result in a default under one or more of these agreements, including as a result of cross default provisions. Upon the occurrence of an event of default under our senior secured credit facilities, the lenders could elect to declare all amounts outstanding under our senior secured credit facilities to be immediately due and payable and terminate all

 

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commitments to extend further credit. Such actions by those lenders could cause cross defaults under our other indebtedness. If we were unable to repay those amounts, the lenders under our senior secured credit facilities could proceed against the collateral granted to them to secure that indebtedness. We have pledged substantially all of our assets as collateral under our senior secured credit facilities. If the lenders under our senior secured credit facilities accelerate the repayment of borrowings, we cannot assure you that we will have sufficient assets to repay the amounts borrowed under our senior secured credit facilities, as well as our unsecured indebtedness.

We may not be able to generate sufficient cash to service all of our indebtedness and may be forced to take other actions to satisfy our obligations under our indebtedness, which may not be successful.

Our ability to make scheduled payments on or to refinance our debt obligations depends on our financial condition and operating performance, which is subject to prevailing economic and competitive conditions and to certain financial, business and other factors beyond our control. We cannot assure you that we will maintain a level of cash flows from operating activities sufficient to permit us to pay the principal, premium, if any, and interest on our indebtedness.

If our cash flows and capital resources are insufficient to fund our debt service obligations, we may be forced to reduce or delay investments and capital expenditures, or to sell assets, seek additional capital or restructure or refinance our indebtedness. These alternative measures could affect the operation and growth of our business and may not be successful and may not permit us to meet our scheduled debt service obligations. If our operating results and available cash are insufficient to meet our debt service obligations, we could face substantial liquidity problems and might be required to dispose of material assets or operations to meet our debt service and other obligations. In that case, we may not be able to consummate those dispositions or to obtain the proceeds that we could realize from them, and the proceeds from those dispositions may not be adequate to meet any debt service obligations then due. Additionally, our senior secured credit facilities and the Indentures limit the use of the proceeds from dispositions of assets; as a result, we may not be permitted to use the proceeds from such dispositions to satisfy all current debt service obligations.

Substaintially all of our indebtedness matures in 2017 and 2018 and changes in the debt financing markets could negatively impact our ability to obtain attractive financing or re-financing for repayment of such indebtedness which would lead to increased financing costs and reduce our income.

Approximately $884.6 million principal amount of term loan borrowings under our senior secured credit facilities mature in September 2017 and approximately $1,370.0 million aggregate principal amount of our notes mature between October 2017 and April 2018. Any recurrence of the significant contraction in the market for debt financing that occurred in 2008 and 2009 or other adverse change relating to the terms of such debt financing with, for example, higher rates and/or more restrictive covenants, would have a material adverse impact on our business. To the extent that the credit markets and/or regulatory changes render such financing difficult to obtain or more expensive, this may negatively impact our operating performance. In addition, to the extent that the markets and/or regulatory changes make it difficult or impossible to refinance debt that is maturing in the near term, we may be unable to repay such debt at maturity and may be forced to sell assets, undergo a recapitalization or seek bankruptcy protection.

Risks Related To Our Business

If adequate levels of reimbursement and coverage from third party payors for our products are not obtained, healthcare providers and patients may be reluctant to use our products; and our revenue and profits may decline.

Our sales depend largely on whether there is adequate reimbursement and coverage by government healthcare programs, such as Medicare and Medicaid, and by private payors. We believe that surgeons, hospitals, physical therapists and other healthcare providers may not use, purchase or prescribe our products and patients may not purchase our products if these third party payors do not provide satisfactory coverage of and reimbursement for the costs of our products or the procedures involving the use of our products.

Third party payors continue to review their coverage policies carefully and can, without notice, reduce or eliminate reimbursement for our products or treatments that use our products. For instance, they may attempt to control costs by (i) authorizing fewer elective surgical procedures, including joint reconstructive surgeries, (ii) requiring the use of the least expensive product available, (iii) reducing the reimbursement for or limiting the number of authorized visits for rehabilitation procedures or (iv) otherwise restricting coverage or reimbursement of our products or procedures using our products.

Medicare payment for durable medical equipment, prosthetics, orthotics and supplies (DMEPOS) also can be impacted by the DMEPOS competitive bidding program, under which Medicare rates are based on bid amounts for certain products in designated geographic areas, rather than the Medicare fee schedule amount. Only those suppliers selected through the competitive bidding

 

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process within each designated competitive bidding area (CBA) are eligible to have their products reimbursed by Medicare. CMS also has adopted regulations to begin adjusting national DMEPOS fee schedules to take into account competitive bidding pricing. See “Government Regulations—Third Party Reimbursement” in the “Business” section above. If we are not selected as a contract supplier (or subcontractor) in a particular region under competitive bidding, or if contract or fee schedule prices are significantly below current Medicare fee schedule reimbursement levels, it could have an adverse impact on our sales and profitability.

Because many private payors model their coverage and reimbursement policies on Medicare, other third party payors’ coverage of, and reimbursement for, our products also could be negatively impacted by legislative, regulatory or other measures that restrict Medicare coverage or reduce Medicare reimbursement.

Our international sales also depend in part upon the coverage and eligibility for reimbursement of our products through government-sponsored healthcare payment systems and third party payors, the amount of reimbursement, and the cost allocation of payments between the patient and government-sponsored healthcare payment systems and third party payors. Coverage and reimbursement practices vary significantly by country, with certain countries requiring products to undergo a lengthy regulatory review in order to be eligible for third party coverage and reimbursement. In addition, healthcare cost containment efforts similar to those we face in the United States are prevalent in many of the foreign countries in which our products are sold, and these efforts are expected to continue in the future, possibly resulting in the adoption of more stringent reimbursement standards relating to our international operations.

Federal and state health reform and cost control efforts include provisions that could adversely impact our business and results of operations.

ACA is a sweeping measure designed to expand access to affordable health insurance, control health care spending, and improve health care quality. Several provisions of the ACA specifically affect the medical equipment industry. In addition to changes in Medicare DMEPOS reimbursement and an expansion of the DMEPOS competitive bidding program, the ACA provides that for sales on or after January 1, 2013, manufacturers, producers, and importers of specified taxable medical devices must pay an annual excise tax of 2.3% of a deemed price for these products. A limited number of our products are subject to the new tax. ACA also establishes enhanced Medicare and Medicaid program integrity provisions, including expanded documentation requirements for Medicare DMEPOS orders, more stringent procedures for screening Medicare and Medicaid DMEPOS suppliers, and new disclosure requirements regarding manufacturer payments to physicians and teaching hospitals, along with broader expansion of federal fraud and abuse authorities. Although the eventual impact of the ACA is still uncertain, it is possible that the legislation will have a material adverse impact on our business. Likewise, most states have adopted or are considering policies to reduce Medicaid spending as a result of state budgetary shortfalls, which in some cases include reduced reimbursement for DMEPOS items and/or other Medicaid coverage restrictions. As states continue to face significant financial pressures, it is possible that state health policy changes will adversely affect our profitability.

If we fail to meet Medicare accreditation and surety bond requirements or DMEPOS supplier standards, it could negatively affect our business operations.

Medicare DMEPOS suppliers (other than certain exempted professionals) must be accredited by an approved accreditation organization as meeting DMEPOS quality standards adopted by CMS including specific requirements for suppliers of custom-fabricated and custom-fitted orthoses and certain prosthetics. Medicare suppliers also are required to meet surety bond requirements. In addition, Medicare DMEPOS suppliers must comply with Medicare supplier standards in order to obtain and retain billing privileges, including meeting all applicable federal and state licensure and regulatory requirements. CMS periodically expands or otherwise clarifies the Medicare DMEPOS supplier standards and states periodically change licensure requirements, including licensure rules imposing more stringent requirements on out-of-state DMEPOS suppliers. We believe we currently are in compliance with these requirements. If we fail to maintain our Medicare accreditation status and/or do not comply with Medicare surety bond or supplier standard requirements or state licensure requirements in the future, or if these requirements are changed or expanded, it could adversely affect our profits and results of operations.

If we, our contract manufacturers, or our component suppliers fail to comply with the Food and Drug Administration’s (the FDA) Quality System Regulation, our manufacturing could be delayed, and our product sales and profitability could suffer.

Our manufacturing processes, and the manufacturing processes of our contract manufacturers and component suppliers are required to comply with the FDA’s Quality System Regulation, which covers current Good Manufacturing Practice requirements including procedures concerning (and documentation of) the design, testing, production processes, controls, quality assurance, labeling, packaging, storage and shipping of our devices. We also are subject to state requirements and licenses applicable to manufacturers of medical devices. In addition, we must engage in extensive recordkeeping and reporting and must make available our manufacturing facilities and records for periodic unscheduled inspections by governmental agencies, including the FDA, state

 

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authorities and comparable agencies in other countries. Moreover, if we fail to pass a Quality System Regulation inspection or to comply with these and other applicable regulatory requirements, we may receive a notice of a violation in the form of inspectional observations on Form FDA-483 or a warning letter, or we could otherwise be required to take corrective action and, in severe cases, we could suffer a disruption of our operations and manufacturing delays. If we fail to take adequate corrective actions, we could be subject to certain enforcement actions, including, among other things, significant fines, suspension of approvals, seizures or recalls of products, operating restrictions and criminal prosecutions. We cannot assure you that the FDA or other governmental authorities would agree with our interpretation of applicable regulatory requirements or that we have in all instances fully complied with all applicable requirements. Any notice or communication from the FDA regarding a failure to comply with applicable requirements could adversely affect our product sales and profitability. We have received FDA warnings letters in the past and we cannot assure you that the FDA will not take further action in the future.

Our contract manufacturers and our component suppliers are also required to comply with the FDA’s Quality System Regulations. We cannot assure anyone that our contract manufacturers’ or component suppliers’ facilities would pass any future quality system inspection. If our or any of our contract manufacturers’ or component suppliers’ facilities fail a quality system inspection, our product sales and profitability could be adversely affected.

The loss of the services of our key management and personnel could adversely affect our ability to operate our business.

Our executive officers have substantial experience and expertise in our industry. Our future success depends, to a significant extent, on the abilities and efforts of our executive officers and other members of our management team. We compete for such personnel with other companies, academic institutions, government entities and other organizations, and our failure to hire and retain qualified individuals for senior executive positions could have a material adverse impact on our business.

We may experience substantial fluctuations in our quarterly operating results and you should not rely on them as an indication of our future results.

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

 

    demand for many of our products, which historically has been higher in the fourth quarter when scholastic sports and ski injuries are more frequent,

 

    our ability to meet the demand for our products,

 

    the direct distribution of our products in foreign countries that have seasonal variations,

 

    the number, timing and significance of new products and product introductions and enhancements by us and our competitors, including delays in obtaining government review and clearance of medical devices,

 

    our ability to develop, introduce and market new and enhanced versions of our products on a timely basis,

 

    the impact of any acquisitions that occur in a quarter,

 

    the impact of any changes in generally accepted accounting principles,

 

    changes in pricing policies by us and our competitors and reimbursement rates by third party payors, including government healthcare agencies and private insurers,

 

    the loss of any of our significant distributors,

 

    changes in the treatment practices of orthopedic and spine surgeons, primary care physicians, and pain-management specialists, and their allied healthcare professionals, and

 

    the timing of significant orders and shipments.

Accordingly, our quarterly sales and operating results may vary significantly in the future and period-to-period comparisons of our results of operations may not be meaningful and should not be relied upon as indications of future performance. We cannot assure you that our sales will increase or be sustained in future periods or that we will be profitable in any future period.

Our reported results may be adversely affected by increases in reserves for contractual allowances, rebates, product returns, rental credits, uncollectible accounts receivable and inventory.

We have established reserves to account for contractual allowances, rebates, product returns and reserves for rental credits. Significant management judgment must be used and estimates must be made in connection with establishing the reserves for contractual allowances, rebates, product returns, rental credits, uncollectible accounts receivable and inventory and other allowances in any accounting period. If such judgments and estimates are inaccurate, our reserves for such items may have to be increased which could adversely affect our reported financial results by reducing our net revenues and/or profitability for the reporting period.

 

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We operate in a highly competitive business environment, and our inability to compete effectively could adversely affect our business prospects and results of operations.

We operate in highly competitive and fragmented markets. Our Bracing and Vascular, Recovery Sciences and International segments compete with both large and small companies, including several large, diversified companies with significant market share and numerous smaller niche companies, particularly in the physical therapy products market. Our Surgical Implant segment competes with a small number of very large companies that dominate the market, as well as other companies similar to our size. We may not be able to offer products similar to, or more desirable than, those of our competitors or at a price comparable to that of our competitors. Compared to us, many of our competitors have

 

    greater financial, marketing and other resources,

 

    more widely accepted products,

 

    a larger number of endorsements from healthcare professionals,

 

    a larger product portfolio,

 

    superior ability to maintain new product flow,

 

    greater research and development and technical capabilities,

 

    patent portfolios that may present an obstacle to the conduct of our business,

 

    stronger name recognition,

 

    larger sales and distribution networks, and/or

 

    international manufacturing facilities that enable them to avoid the transportation costs and foreign import duties associated with shipping our products manufactured in the United States to international customers.

Accordingly, we may be at a disadvantage with respect to our competitors. These factors may materially impair our ability to develop and sell our products.

The success of all of our products depends heavily on acceptance by healthcare professionals who prescribe and recommend our products, and our failure to maintain a high level of confidence by key healthcare professionals in our products could adversely affect our business.

We have maintained customer relationships with numerous orthopedic surgeons, primary care physicians, other specialist physicians, physical therapists, athletic trainers, chiropractors and other healthcare professionals. We believe that sales of our products depend significantly on their confidence in, and recommendations of, our products. Acceptance of our products depends on educating the healthcare community as to the distinctive characteristics, perceived benefits, clinical efficacy and cost-effectiveness of our products compared to the products offered by our competitors and on training healthcare professionals in the proper use and application of our products. Failure to maintain these customer relationships and develop similar relationships with other leading healthcare professionals could result in fewer recommendations of our products, which may adversely affect our sales and profitability.

The success of our surgical implant products depends on our relationships with leading surgeons who assist with the development and testing of our products, and our ability to comply with enhanced disclosure requirements regarding payments to physicians.

A key aspect of the development and sale of our surgical implant products is the use of designing and consulting arrangements with orthopedic surgeons who are well recognized in the healthcare community. These surgeons assist in the development and clinical testing of new surgical implant products. They also participate in symposia and seminars introducing new surgical implant products and assist in the training of healthcare professionals in using our new products. We may not be successful in maintaining or renewing our current designing and consulting arrangements with these surgeons or in developing similar arrangements with new surgeons. In that event, our ability to develop, test and market new surgical implant products could be adversely affected.

In addition, the Physician Payment Sunshine Act and related state marketing and payment disclosure requirements and industry guidelines could have an adverse impact on our relationships with surgeons, and there can be no assurances that such requirements and guidelines would not impose additional costs on us and/or adversely impact our consulting and other arrangements with surgeons.

 

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Proposed laws that would limit the types of orthopedic professionals who can fit, sell or seek reimbursement for our products could, if adopted, adversely affect our business.

Federal and state legislatures and regulators have periodically considered proposals to limit the types of orthopedic professionals who can fit or sell our orthotic products or who can seek reimbursement for them. Several states have adopted legislation imposing certification or licensing requirements on the measuring, fitting and adjusting of certain orthotic devices, and additional states may do so in the future. Although some of these state laws exempt manufacturers’ representatives, others do not. Such laws could reduce the number of potential customers by restricting our sales representatives’ activities in those jurisdictions and/or reduce demand for our products by reducing the number of professionals who fit and sell them. The adoption of such policies could have a material adverse impact on our business.

In addition, legislation has been adopted, but not implemented to date, requiring that certain certification or licensing requirements be met for individuals and suppliers furnishing certain custom-fabricated orthotic devices as a condition of Medicare payment. Medicare currently follows state policies in those states that require the use of an orthotist or prosthetist for furnishing of orthotics or prosthetics. In 2014 CMS proposed, but ultimately did not adopt, a regulatory change that would have narrowly defined the “specialized training” that is needed to provide custom fitting of orthotics under the Medicare program if the fitter is not a certified orthotists. We cannot predict whether additional restrictions will be implemented at the state or federal level or the impact of such policies on our business.

We rely on our own direct sales force for certain of our products, which may result in higher fixed costs than our competitors and may slow our ability to reduce costs in the face of a sudden decline in demand for our products.

We rely on our own direct sales force of representatives in the United States and in Europe to market and sell certain of the orthopedic rehabilitation products which are intended for use in the home and in rehabilitation clinics. Some of our competitors rely predominantly on independent sales agents and third party distributors. A direct sales force may subject us to higher fixed costs than those of companies that market competing products through independent third parties, due to the costs that we will bear associated with employee benefits, training, and managing sales personnel. As a result, we could be at a competitive disadvantage. Additionally, these fixed costs may slow our ability to reduce costs in the face of a sudden decline in demand for our products, which could have a material adverse impact on our results of operations.

If we fail to establish new sales and distribution relationships or maintain our existing relationships, or if our third party distributors and independent sales representatives fail to commit sufficient time and effort or are otherwise ineffective in selling our products, our results of operations and future growth could be adversely impacted.

The sale and distribution of certain of our orthopedic products, CMF products and our surgical implant products depend, in part, on our relationships with a network of third party distributors and independent commissioned sales representatives. These third party distributors and independent sales representatives maintain the customer relationships with the hospitals, orthopedic surgeons, physical therapists and other healthcare professionals that purchase, use and recommend the use of our products. Although our internal sales staff trains and manages these third party distributors and independent sales representatives, we do not directly monitor the efforts that they make to sell our products. In addition, some of the independent sales representatives that we use to sell our surgical implant products also sell products that directly compete with our core product offerings. These sales representatives may not dedicate the necessary effort to market and sell our products. If we fail to attract and maintain relationships with third party distributors and skilled independent sales representatives or fail to adequately train and monitor the efforts of the third party distributors and sales representatives that market and sell our products, or if our existing third party distributors and independent sales representatives choose not to carry our products, our results of operations and future growth could be adversely affected.

Our international operations expose us to risks related to conducting business in multiple jurisdictions outside the United States.

The international scope of our operations exposes us to economic, regulatory and other risks in the countries in which we operate. We generated 26.5% of our net revenues from customers outside the United States for the year ended December 31, 2014. Doing business in foreign countries exposes us to a number of risks, including the following:

 

    fluctuations in currency exchange rates,

 

    imposition of investment, currency repatriation and other restrictions by foreign governments,

 

    potential adverse tax consequences, including the imposition or increase of withholding and other taxes on remittances and other payments by foreign subsidiaries, which, among other things, may preclude payments or dividends from foreign subsidiaries from being used for our debt service, and exposure to adverse tax regimes,

 

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    difficulty in collecting accounts receivable and longer collection periods,

 

    the imposition of additional foreign governmental controls or regulations on the sale of our products,

 

    intellectual property protection difficulties,

 

    changes in political and economic conditions, including the recent political changes in Tunisia in which we maintain a small manufacturing facility and security issues in Mexico in which we maintain a significant manufacturing facility,

 

    difficulties in attracting high-quality management, sales and marketing personnel to staff our foreign operations,

 

    labor disputes,

 

    import and export restrictions and controls, tariffs and other trade barriers,

 

    increased costs of transportation or shipping,

 

    exposure to different approaches to treating injuries,

 

    exposure to different legal, regulatory and political standards, and

 

    difficulties of local governments in responding to severe weather emergencies, natural disasters or other such similar events.

In addition, as we grow our operations internationally, we will become increasingly dependent on foreign distributors and sales agents for our compliance and adherence to foreign laws and regulations that we may not be familiar with, and we cannot assure you that these distributors and sales agents will adhere to such laws and regulations or adhere to our own business practices and policies. Any violation of laws and regulations by foreign distributors or sales agents or a failure of foreign distributors or sales agents to comply with our business practices and policies could result in legal or regulatory sanctions against us or potentially damage our reputation in that respective international market. If we fail to manage these risks effectively, we may not be able to grow our international operations, and our business and results of operations may be materially adversely affected.

We may fail to comply with customs and import/export laws and regulations

Our business is conducted world-wide, with raw material and finished goods imported from and exported to a substantial number of countries. In particular, a significant portion of our products are manufactured in our plant in Tijuana, Mexico and imported to the United States before shipment to domestic customers or export to other countries. We are subject to customs and import/export rules in the U.S., including FDA regulatory requirements applicable to medical devices, detailed below, and in other countries, and to requirements for payment of appropriate duties and other taxes as goods move between countries. Customs authorities monitor our shipments and payments of duties, fees and other taxes and can perform audits to confirm compliance with applicable laws and regulations. Our failure to comply with import/export rules and restrictions or to properly classify our products under tariff regulations and pay the appropriate duty could expose us to fines and penalties and adversely affect our financial condition and business operations.

Fluctuations in foreign exchange rates may adversely affect our financial condition and results of operations and may affect the comparability of our results between financial periods.

Our foreign operations expose us to currency fluctuations and exchange rate risks. We are exposed to the risk of currency fluctuations between the U.S. Dollar and the Euro, Pound Sterling, Canadian Dollar, Mexican Peso, Swiss Franc, Australian Dollar, Japanese Yen, Norwegian Krone, Danish Krone, Swedish Krona, South African Rand, Tunisian Dinar and Indian Rupee. Sales denominated in foreign currencies accounted for 24.0% of our consolidated net sales for the year ended December 31, 2014, of which 17.1% were denominated in the Euro. Our exposure to fluctuations in foreign currencies arises because certain of our subsidiaries’ results are recorded in these currencies and then translated into U.S. Dollars for inclusion in our consolidated financial statements, and certain of our subsidiaries enter into purchase or sale transactions using a currency other than our functional currency. We utilize Mexican Peso (MXN) 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 MXN. As of December 31, 2014, we had outstanding MXN forward contracts to purchase an aggregate U.S. dollar equivalent of $0.5 million. As we continue to distribute and manufacture our products in selected foreign countries, we expect that future sales and costs associated with our activities in these markets will continue to be denominated in the applicable foreign currencies, which could cause currency fluctuations to materially impact our operating results. Changes in currency exchange rates may adversely affect our financial condition and results of operations and may affect the comparability of our results between reporting periods.

We may not be able to effectively manage our currency translation risks, and volatility in currency exchange rates may adversely affect our financial condition and results of operations.

 

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Our success depends on receiving regulatory approval for our products, and failure to do so could adversely affect our growth and operating results.

Our products are subject to extensive regulation in the United States by the FDA and by similar governmental authorities in the foreign countries where we do business. The FDA regulates virtually all aspects of a medical device’s development, testing, manufacturing, labeling, promotion, distribution and marketing, as well as modifications to existing products and the marketing of existing products for new indications. In general, unless an exemption applies, a medical device and modifications to the device or its indications must receive either pre-market approval or pre-market clearance from the FDA before it can be marketed in the United States. While in the past we have received such approvals and clearances, we may not be successful in the future in receiving such approvals and clearances in a timely manner or at all. See “Government Regulations—FDA and Similar Foreign Government Regulations” in the “Business” section above. If we begin to have significant difficulty obtaining such FDA approvals or clearances in a timely manner or at all, it could have a material adverse impact on our revenues and growth.

We may fail to receive positive clinical results for our products in development that require clinical trials, and even if we receive positive clinical results, we may still fail to receive the necessary clearance or approvals to market our products.

In the development of new products or new indications for, or modifications to, existing products, we may conduct or sponsor clinical trials. Clinical trials are expensive and require significant investment of time and resources and may not generate the data we need to support a submission to the FDA. Clinical trials are subject to regulation by the FDA and, if federal funds are involved or if an investigator or site has signed a federal assurance, are subject to further regulation by the Office for Human Research Protections and the National Institutes of Health. Failure to comply with such regulation, including, but not limited to, failure to obtain adequate consent of subjects, failure to adequately disclose financial conflicts or failure to report data or adverse events accurately, could result in fines, penalties, suspension of trials, and the inability to use the data to support an FDA submission.

If we fail to comply with the various regulatory regimes for the foreign markets in which we operate, our operational results could be adversely affected.

In many of the foreign countries in which we market our products, we are subject to extensive regulations, including those in Europe. The regulation of our products in the European Economic Area (which consists of the twenty-seven member states of the European Union, as well as Iceland, Liechtenstein and Norway) is governed by various directives and regulations promulgated by the European Commission and national governments. Only medical devices that comply with certain conformity requirements are allowed to be marketed within the European Economic Area. In addition, the national health or social security organizations of certain foreign countries, including certain countries outside Europe, require our products to be qualified before they can be marketed in those countries. Failure to receive or delays in the receipt of, relevant foreign qualifications in the European Economic Area or other foreign countries could have a material adverse impact on our business.

The FDA regulates the export of medical devices from the United States to foreign countries and certain foreign countries may require FDA certification that our products are in compliance with U.S. law. If we fail to obtain or maintain export certificates required for the export of our products, we could suffer a material adverse impact on our revenues and growth.

We are subject to laws concerning our marketing activities in foreign countries where we conduct business. For example, within the EU, the control of unlawful marketing activities is a matter of national law in each of the member states of the EU. The member states of the EU closely monitor perceived unlawful marketing activity by companies. We could face civil, criminal and administrative sanctions if any member state determines that we have breached our obligations under its national laws. In particular, as a result of conducting business in the U.K. through our subsidiary in that country, we are, in certain circumstances, subject to the anti-corruption provisions of the U.K. Bribery Act in our activities conducted in any country in the world. Industry associations also closely monitor the activities of member companies. If these organizations or authorities name us as having breached our obligations under their regulations, rules or standards, our reputation would suffer and our business and financial condition could be adversely affected. We are also subject to the U.S. Foreign Corrupt Practices Act (the FCPA), antitrust and anti-competition laws, and similar laws in foreign countries, any violation of which could create a substantial liability for us and also cause a loss of reputation in the market. From time to time, we may face audits or investigations by one or more domestic or foreign government agencies, compliance with which could be costly and time-consuming, and could divert our management and key personnel from our business operations. An adverse outcome under any such investigation or audit could subject us to fines or other penalties, which could adversely affect our business and financial results.

If the Department of Health and Human Services (HHS), the Office of Inspector General (OIG), the FDA or another regulatory agency determines that we have promoted off-label use of our products, we may be subject to various penalties, including civil or criminal penalties, and the off-label use of our products may result in injuries that lead to product liability suits, which could be costly to our business.

The OIG, the FDA and other regulatory agencies actively enforce regulations prohibiting the promotion of a medical device for a use that has not been cleared or approved by the FDA. Use of a device outside its cleared or approved indications is known as “off-label” use. Physicians may prescribe our products for off-label uses, as the FDA does not restrict or regulate a physician’s choice of

 

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treatment within the practice of medicine. However, if the OIG or the FDA, or another regulatory agency determines that our promotional materials, training, or activities constitute improper promotion of an off-label use, the regulatory agency could request that we modify our promotional materials, training, or activities, or subject us to regulatory enforcement actions, including the issuance of a warning letter, injunction, seizure, civil fine and criminal penalties. Although our policy is to refrain from statements and activities that could be considered off-label promotion of our products, the FDA, another regulatory agency, or the U.S. Department of Justice could disagree and conclude that we have engaged in off-label promotion and, potentially, caused the submission of false claims. In addition, the off-label use of our products may increase the risk of injury to patients, and, in turn, the risk of product liability claims. Product liability claims are expensive to defend and could divert our management’s attention and result in substantial damage awards against us.

Our compensation, marketing and sales practices may contain certain risks with respect to the manner in which these practices were historically conducted that could have a material adverse impact on us.

Although we believe our agreements and arrangements with healthcare providers are in compliance with applicable laws, under applicable federal and state healthcare fraud and abuse, anti-kickback, false claims and self-referral laws, it could be determined that our designing and consulting arrangements with surgeons, our marketing and sales practices, and our OfficeCare program fall outside permitted arrangements, thereby subjecting us to possible civil and/or criminal sanctions (including exclusion from the Medicare and Medicaid programs), which could have a material adverse impact on our business. These arrangements will be subject to increased visibility once the provisions of the Physician Payments Sunshine Act are fully implemented. Although we believe we maintain a satisfactory compliance program, it may not be adequate in the detection or prevention of violations. The form and effectiveness of our compliance program may be taken into account by the government in assessing sanctions, if any, should it be determined that violations of laws have occurred.

Audits or denials of our claims by government agencies could reduce our revenues or profits.

As part of our business operations, we submit claims on behalf of patients directly to, and receive payments directly from, the Medicare and Medicaid programs and private payors. Therefore, we are subject to extensive government regulation, including detailed requirements for submitting reimbursement claims under appropriate codes and maintaining certain documentation to support our claims. Medicare contractors and Medicaid agencies periodically conduct pre- and post-payment reviews and other audits of claims and are under increasing pressure to more closely scrutinize healthcare claims and supporting documentation. We have historically been subject to pre-payment and post-payment reviews as well as audits of claims and may experience such reviews and audits of claims in the future. Such reviews and/or similar audits of our claims including by Recovery Audit Contractors (private companies operating on a contingent fee basis to identify and recoup Medicare overpayments) could result in material delays in payment, as well as material recoupment or denials, which would reduce our net sales and profitability, or in exclusion from participation in the Medicare or Medicaid programs. Private payors may from time to time conduct similar reviews and audits.

Additionally, we participate in the government’s Federal Supply Schedule program for medical equipment, whereby we contract with the government to supply certain of our products. Participation in this program requires us to follow certain pricing practices and other contract requirements. Failure to comply with such pricing practices and/or other contract requirements could result in delays in payment or fines or penalties, which could reduce our revenues or profits.

Federal and state agencies have become increasingly vigilant in recent years in their investigation of various business practices under various healthcare “fraud and abuse” laws with respect to our business arrangements with prescribing physicians and other healthcare professionals, as well as our filing of DMEPOS claims for reimbursement.

We are, directly or indirectly through our customers, subject to various federal and state laws pertaining to healthcare fraud and abuse, including the Federal Anti-Kickback Statute, several federal False Claims statutes, HIPAA’s healthcare fraud statute and false statements statute, federal physician self-referral prohibition (Stark Law) and state equivalents to these statutes.

The federal government has significantly increased investigations of and enforcement activity involving medical device manufacturers with regard to alleged kickbacks and other forms of remuneration to physicians who use and prescribe their products. Such investigations often arise based on allegations of violations of the federal Anti-Kickback Statute and sometimes allege violations of the civil False Claims Act, in connection with off-label marketing of products to physicians and others. In addition, significant state and federal investigative and enforcement activity addresses alleged improprieties in the filings of claims for payment or reimbursement by Medicare, Medicaid, and other payors.

The fraud and abuse laws and regulations are complex, and even minor, inadvertent irregularities in submissions can potentially give rise to investigations and claims that the law has been violated. Any violations of these laws or regulations could result in a material adverse impact on our business, financial condition and results of operations. If there is a change in law, regulation or administrative or judicial interpretations, we may have to change one or more of our business practices to be in compliance with these laws. Required changes could be costly and time consuming. Any failure to make required changes could result in our losing business or our existing business practices being challenged as unlawful.

 

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Our activities are subject to Federal Privacy and Transaction Law and Regulations, which could have an impact on our operations.

HIPAA and the HIPAA Rules impact the transmission, maintenance, use and disclosure of PHI. As such, HIPAA and the HIPAA Rules apply to certain aspects of our business. To the extent applicable to our operations, we believe we are currently in compliance with HIPAA and the applicable HIPAA Rules. There are costs and administrative burdens associated with ongoing compliance with the HIPAA Rules and similar state law requirements. Any failure to comply with current and applicable future requirements could adversely affect our profitability.

Managed care and buying groups have put downward pressure on the prices of our products.

The growth of managed care and the advent of buying groups in the United States have caused a shift toward coverage and payments based on more cost-effective treatment alternatives. Buying groups enter into preferred supplier arrangements with one or more manufacturers of medical products in return for price discounts to members of these buying groups. Our failure to obtain new preferred supplier commitments from major group purchasing organizations or our failure to retain our existing preferred supplier commitments could adversely affect our sales and profitability. In international markets where we sell our products, we have historically experienced downward pressure on product pricing and other effects of healthcare cost control efforts that are similar to that which we have experienced in the United States. We expect a continued emphasis on healthcare cost controls and managed care in the United States and in these international markets, which could put further downward pressure on product pricing, which, in turn may adversely affect our sales and profitability.

Our marketed, approved, or cleared products are subject to the recall authority of U.S. and foreign regulatory bodies. Product recalls could harm our reputation and business.

We are subject to ongoing medical device reporting regulations that require us to report to the FDA and similar governmental authorities in other countries if we receive a report or otherwise learn that any of our products may have caused, or contributed to death or serious injury, or that any of our products has malfunctioned in a way that would be likely to cause, or contribute to, death or serious injury if the malfunction were to recur. The FDA and similar governmental authorities in other countries have the authority to require us to recall our products in the event of actual or potential material deficiencies or defects in design manufacturing, or labeling, and we have been subject to product recalls in the past. In addition, in light of an actual or potential material deficiency or defect in design, manufacturing, or labeling, we may voluntarily elect to recall our products. A government mandated recall or a voluntary recall initiated by us could occur as a result of actual or potential component failures, manufacturing errors, or design defects, including defects in labeling. Any recall would divert managerial and financial resources and could harm our reputation with our customers and with the healthcare professionals that use, prescribe and recommend our products. We could have product recalls that result in significant costs to us in the future, and such recalls could have a material adverse impact on our business.

Product liability claims may harm our business, particularly if the number of claims increases significantly or our product liability insurance proves inadequate.

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. Further, a significant increase in claims or adverse outcomes could prove our product liability insurance inadequate.

Our concentration of manufacturing operations in Mexico increases our business and competitive risks.

Our most significant manufacturing facility is our facility in Tijuana, Mexico, and we also have a relatively small manufacturing operation in Tunisia. Our current and future foreign operations are subject to risks of political and economic instability inherent in activities conducted in foreign countries. Because there are no readily accessible alternatives to these facilities, any event that disrupts manufacturing at or distribution or transportation from these facilities would materially adversely affect our operations. In addition, as a result of this concentration of manufacturing activities, our sales in foreign markets may be at a competitive disadvantage to products manufactured locally due to freight costs, custom and import duties and favorable tax rates for local businesses.

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

We rely on a limited number of foreign and domestic suppliers for the raw materials and components used in our products. One or more of our suppliers may decide to cease supplying us with raw materials and components for reasons beyond our control. FDA

 

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regulations may require additional testing of any raw materials or components from new suppliers prior to our use of those materials or components. In addition, in the case of a device which is the subject of a pre-market approval, we may be required to obtain prior FDA permission (which may or may not be given), which could delay or prevent our access or use of such raw materials or components. If we are unable to obtain materials we need from our suppliers or our agreements with our suppliers are terminated, and we cannot obtain these materials from other sources, we may be unable to manufacture our products to meet customer orders in a timely manner or within our manufacturing budget. In that event, our business and results of operations could be adversely affected.

In addition, we rely on third parties to manufacture some of our products. For example, we use a single source for many of the home electrotherapy devices our French channel distributes. If our agreements with these manufacturing companies were terminated, we may not be able to find suitable replacements within a reasonable amount of time or at all. Any such cessation, interruption or delay may impair our ability to meet scheduled deliveries of our products to our customers and may cause our customers to cancel orders. In that event, our reputation and results of operations may be adversely affected.

Some of our important suppliers are in China and other parts of Asia and provide predominately finished soft goods products. In the year ended December 31, 2014, we obtained 31.1% of our total purchased materials from suppliers in China and other parts of Asia. Political and economic instability and changes in government regulations in these areas could affect our ability to continue to receive materials from suppliers there. The loss of suppliers in China and other parts of Asia, any other interruption or delay in the supply of required materials or our inability to obtain these materials at acceptable prices and within a reasonable amount of time could impair our ability to meet scheduled product deliveries to our customers and could hurt our reputation and cause customers to cancel orders.

In addition, we purchase the microprocessor used in the OL1000 and SpinaLogic devices from a single manufacturer. Although there are feasible alternate microprocessors that might be used immediately, all are produced by a single supplier. In addition, there are single suppliers for other components used in the OL1000 and SpinaLogic devices and only two suppliers for the magnetic field sensor employed in them. Establishment of additional or replacement suppliers for these components cannot be accomplished quickly.

If our patents and other intellectual property rights do not adequately protect our products, we may lose market share to our competitors and may not be able to operate our business profitably. We may also become involved in litigation regarding our patents and other intellectual property rights which can have a material adverse effect on our operating results and financial condition.

We rely on a combination of patents, trade secrets, copyrights, trademarks, license agreements and contractual provisions to establish and protect our intellectual property rights in our products and the processes for the development, manufacture and marketing of our products.

We use non-patented, proprietary know-how, trade secrets, processes and other proprietary information and currently employ various methods to protect this proprietary information, including confidentiality agreements, invention assignment agreements and proprietary information agreements with vendors, employees, independent sales agents, distributors, consultants, and others. However, these agreements may be breached. The FDA or another governmental agency may require the disclosure of such information in order for us to have the right to market a product. The FDA may also disclose such information on its own initiative if it should decide that such information is not confidential business or trade secret information. Trade secrets, know-how and other unpatented proprietary technology may also otherwise become known to or independently developed by our competitors.

In addition, we also hold U.S. and foreign patents relating to a number of our components and products and have patent applications pending with respect to other components and products. We also apply for additional patents in the ordinary course of our business, as we deem appropriate. However, these precautions offer only limited protection, and our proprietary information may become known to, or be independently developed by, competitors, or our proprietary rights in intellectual property may be challenged, any of which could have a material adverse impact on our business, financial condition and results of operations. Additionally, we cannot assure you that our existing or future patents, if any, will afford us adequate protection or any competitive advantage, that any future patent applications will result in issued patents or that our patents will not be circumvented, invalidated or declared unenforceable.

We may become a party to lawsuits involving patents or other intellectual property. Such litigation is costly and time consuming. If we lose any of these proceedings, a court or a similar foreign governing body could invalidate or render unenforceable our owned or licensed patents or other intellectual property, require us to pay significant damages, seek licenses and/or pay ongoing royalties to third parties (which may not be available under terms acceptable to us, or at all), require us to redesign our products, or prevent us from manufacturing, using or selling our products, any of which would have an adverse impact on our results of operations and financial condition.

Any proceedings before the U.S. Patent and Trademark Office could result in adverse decisions as to the priority of our inventions and the narrowing or invalidation of claims in issued or pending patents. We could also incur substantial costs in any such proceedings. In addition, the laws of some of the countries in which our products are or may be sold may not protect our products and intellectual property to the same extent as U.S. laws, if at all. We may also be unable to protect our rights in trade secrets, trademarks and unpatented proprietary technology in these countries.

 

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

Our business strategy relies on certain assumptions concerning demographic and other trends that impact the market for our products. If these assumptions prove to be incorrect, demand for our products may be lower than we currently expect.

Our ability to achieve our business objectives is subject to a variety of factors, including the relative increase in the aging of the general population and an increase in participation in exercise and sports and more active lifestyles. In addition, our business strategy relies on an increasing awareness and clinical acceptance of non-invasive, non-systemic treatment and rehabilitation products, such as electrotherapy. We believe that these trends will increase the need for our orthopedic, physical therapy, regenerative and surgical implant products. The projected demand for our products could materially differ from actual demand if our assumptions regarding these trends and acceptance of our products by healthcare professionals and patients prove to be incorrect or do not materialize. If our assumptions regarding these factors prove to be incorrect, we may not be able to successfully implement our business strategy, which could adversely affect our results of operations. In addition, the perceived benefits of these trends may be offset by competitive or business factors, such as the introduction of new products by our competitors or the emergence of other countervailing trends.

We rely on information technology in our operations, and any material failure, inadequacy, interruption or security failure of that technology could harm our business, financial condition, results of operations and prospects.

We rely on information technology networks and systems, including the Internet, to process, transmit and store electronic information, and manage or support a variety of business processes, including medical records, financial transactions and records, personal identifying information, and payroll data. We rely on commercially available systems, software, tools and monitoring to provide security for processing, transmission and storage of confidential patient and other customer information, such as individually identifiable information, including information relating to health protected by HIPAA. Although we have taken steps to protect the security of our information systems and the data maintained in those systems, it is possible that our safety and security measures will not prevent the systems’ improper functioning or damage or the improper access or disclosure of personally identifiable information such as in the event of cyber-attacks. Security breaches, including physical or electronic break-ins, theft of mobile equipment, computer viruses, attacks by hackers and similar breaches can create system disruptions or shutdowns or the unauthorized disclosure of confidential information. If personal or otherwise protected information of our patients is improperly accessed, tampered with or distributed, we may incur significant costs to remediate possible injury to the affected patients and we may be subject to sanctions and civil or criminal penalties if we are found to be in violation of the privacy or security rules under HIPAA or other similar federal or state laws protecting confidential patient health information. Any failure to maintain proper functionality and security of our information systems could interrupt our operations, damage our reputation, subject us to liability claims or regulatory penalties and could have a material adverse effect on our business, financial condition, results of operations and prospects.

We could incur significant costs complying with environmental and health and safety requirements, or as a result of liability for contamination or other harm caused by hazardous materials that we use.

Our research and development and manufacturing processes involve the use of hazardous materials. We are subject to federal, state, local and foreign environmental requirements, including regulations governing the use, manufacture, handling, storage and disposal of hazardous materials, discharge to air and water, the cleanup of contamination and occupational health and safety matters. We cannot eliminate the risk of contamination or injury resulting from hazardous materials, and we may incur liability as a result of any contamination or injury. Under some environmental laws and regulations, we could also be held responsible for costs relating to any contamination at our past or present facilities and at third party waste disposal sites where we have sent wastes. These could include costs relating to contamination that did not result from any violation of law, and in some circumstances, contamination that we did not cause. We may incur significant expenses in the future relating to any failure to comply with environmental laws. Any such future expenses or liability could have a significant negative impact on our financial condition. The enactment of stricter laws or regulations, the stricter interpretation of existing laws and regulations or the requirement to undertake the investigation or remediation of currently unknown environmental contamination at our own or third party sites may require us to make additional expenditures, which could be material.

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

A significant portion of our rehabilitation products are manufactured in a facility in Tijuana, Mexico, with a number of products for the European market manufactured in a Tunisian facility. In Vista, California we manufacture our custom rigid bracing products,

 

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which remain in the United States to facilitate quick turnaround on custom orders, vascular products, and our CMF product line. Our clinical electrotherapy devices, patient care products, physical therapy and certain CPM devices are now manufactured in our facilities located in Tijuana, Mexico. Our home electrotherapy devices sold in the United States as well as some components and related accessories are manufactured at our facility in Clear Lake, South Dakota. In our Surgical Implant business, we manufacture our products in our manufacturing facility at Austin, Texas. These facilities and the manufacturing equipment we use to produce our products would be difficult to repair or replace. Our facilities may be affected by natural or man-made disasters. If one of our facilities were affected by a disaster, we would be forced to rely on third party manufacturers or shift production to another manufacturing facility. In such an event, we would face significant delays in manufacturing which would prevent us from being able to sell our products. In addition, our insurance may not be sufficient to cover all of the potential losses and may not continue to be available to us on acceptable terms, or at all.

Affiliates of Blackstone own substantially all of the equity interest in us and may have conflicts of interest with us or investors in the future.

As of February 20, 2015, affiliates of Blackstone collectively beneficially own 97.5% of DJO’s issued and outstanding capital stock and Blackstone designees hold a majority of the seats on DJO’s board of directors. As a result, affiliates of Blackstone have control over our decisions to enter into any corporate transaction and have the ability to prevent any transaction that requires the approval of security holders regardless of whether holders of the Notes believe that any such transactions are in their own best interests. For example, affiliates of Blackstone could collectively cause us to make acquisitions that increase the amount of indebtedness or to sell assets, or could cause us to issue additional capital stock or declare dividends. So long as affiliates of Blackstone continue to directly or indirectly own a significant amount of the outstanding shares of our common stock, they will continue to be able to strongly influence or effectively control our decisions. In addition, Blackstone has no obligation to provide us with any additional debt or equity financing.

Additionally, Blackstone and its affiliates are in the business of making investments in companies and may from time to time acquire and hold interests in businesses that compete directly or indirectly with us. Blackstone and its affiliates may also pursue acquisition opportunities that may be complementary to our business and, as a result, those acquisition opportunities may not be available to us.

If we do not achieve and maintain effective internal controls over financial reporting, we could fail to accurately report our financial results.

During the course of the preparation of our financial statements, we evaluate our internal controls to identify and correct deficiencies in our internal controls over financial reporting. In the event we are unable to identify and correct deficiencies in our internal controls in a timely manner, we may not record, process, summarize and report financial information accurately and within the time periods required for our financial reporting under the terms of the agreements governing our indebtedness.

It is possible that control deficiencies could be identified by our management or independent registered public accounting firm in the future or may occur without being identified. Such a failure could negatively impact the market price and liquidity of the Notes, cause holders of our Notes to lose confidence in our reported financial condition, lead to a default under our senior secured credit facilities and the Indentures and otherwise materially adversely affect our business and financial condition.

 

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ITEM 2. PROPERTIES

Information about our facilities is set forth in the following table:

 

Location

  

Use

  

Status

  

Lease

Termination Date

   Square Feet
(in thousands)

Vista, California

  

Corporate headquarters, operations, research and development

   Leased    August 2021    112

Tijuana, Mexico

  

Manufacturing and distribution facility

   Leased    September 2016    286

Asheboro, North Carolina

  

Manufacturing and distribution facility

   Owned    N/A    115

Indianapolis, Indiana

  

Distribution facility

   Leased    October 2016    110

Mequon, Wisconsin

  

Office, manufacturing and distribution facility

   Leased    June 2024    95

Shoreview, Minnesota

  

Office, operations, medical billing

   Leased    October 2018 (a)    94

Clear Lake, South Dakota

  

Manufacturing, distribution and refurbishment, and repair facility

   Owned    N/A    54

Sfax, Tunisia

  

Manufacturing facility

   Leased    Various    42

Austin, Texas

  

Operations and manufacturing facility, warehouse, research and development

   Leased    March 2019 (b)    53

Austin, Texas

  

Office and distribution facility

   Leased    February 2020    35

Vista, California

  

Manufacturing facility

   Leased    December 2018    53

Vista, California

  

Office and distribution facility

   Leased    February 2017    21

Arden Hills, Minnesota

  

Office and manufacturing facility

   Leased    September 2015    20

Freiburg, Germany

  

Research and development, distribution facility

   Leased    December 2016    20

Freiburg, Germany

  

Research and development, distribution facility

   Leased    June 2017    27

Mouguerre, France

  

Office and distribution facility

   Leased    December 2021    51

Sydney, Australia

  

Office and distribution facility

   Leased    April 2017    28

Mississauga, Canada

  

Office and distribution facility

   Leased    April 2020    30

Herentals, Belgium

  

Office and distribution facility

   Leased    March 2015    26

Freiburg, Germany

  

Office and distribution facility

   Leased    December 2020    23

Malmo, Sweden

  

Office and distribution facility

   Leased    March 2017    14

Guildford, United Kingdom

  

International headquarters, office, operations

   Leased    January 2025    12

Guildford, United Kingdom

  

Warehouse and distribution facility

   Leased    May 2016    12

Other various locations

  

Various

   Leased    Various    65

 

(a) Renewable, at our option, for one additional five-year term.
(b) Renewable, at our option, for two additional five-year terms.

 

ITEM 3. LEGAL PROCEEDINGS

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 impact on our financial position or results of operations.

Pain Pump Litigation

Over the past 7 years, we have been named in numerous product liability lawsuits involving our prior distribution of a disposable drug infusion pump product (pain pump) manufactured by two third-party manufacturers that was distributed through our Bracing and Vascular segment. We currently are a defendant in two U.S. cases and a lawsuit in Canada which has been granted class action status for a class of approximately 45 claimants. 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. All of these lawsuits allege that the use of these pumps with certain anesthetics for prolonged periods after certain shoulder surgeries or, less commonly, knee surgeries, has resulted in cartilage damage to the plaintiffs. In the past four years, we have entered into settlements with plaintiffs in approximately 140 pain pump lawsuits. Except for the payment by the Company of policy deductibles or self-insured retentions, our products liability carriers in three policy periods have paid the defense costs and settlements related to these claims, subject to reservation of rights to deny coverage for customary matters, including punitive damages and off-label promotion.

 

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Lawsuit by Insurance Carrier

In December 2013, one of our product liability insurance carriers, Ironshore Specialty Ins. Co. filed a complaint in the U.S. District Court for the Southern District of California, which seeks (a) either (i) rescission of an insurance policy (the “Policy”) purchased by the Company from the plaintiff and repayment by the Company of all amounts allegedly paid under the Policy, approximately $10 million, less premiums paid by the Company for the Policy, or, in the alternative, (ii) reformation of the Policy to exclude coverage for pain pump claims and repayment by the Company of all amounts allegedly paid under the Policy for such claims, in an unspecified amount; and/or (b) damages and other relief in an unspecified amount for alleged fraud and negligent misrepresentation based on an alleged failure by the Company and/or the involved Policy producers to disclose alleged material information while applying for the Policy. While we believe this case is without merit, we have brought third-party indemnification claims against our insurance broker and a wholesale broker who were involved in securing the Policy. The carrier under our directors and officers liability policy has agreed to reimburse defense costs incurred in this matter, subject to reservation of rights to deny coverage for customary matters. A tentative settlement has been reached in this case, which if completed will result in a dismissal of the lawsuit and complete resolution of this matter.

State Licensing Subpoenas

In July 2013 and October 2014, we were served with subpoenas under the Health Insurance Portability and Accountability Act (HIPAA) seeking documents relating to the fitting of custom-fabricated or custom-fitted orthoses in the States of New Jersey, Washington and Texas. The subpoenas were issued by the United States Attorney’s Office for the District of New Jersey in connection with an investigation of compliance with professional licensing statutes in those states relating to the practice of orthotics. We responded to the first subpoena, and are in the process of responding to the second subpoena.

BGS Qui Tam Action

We are a defendant in a qui tam action filed in Federal Court in Boston, Massachusetts, captioned United States, ex rel. Bierman v. Orthofix International, N.V. et al., in which the relator, or whistleblower, names us and each other company engaged in the external bone growth stimulator industry as defendants. The case was filed under seal in March 2005 and unsealed in March 2009, during which time the government investigated the claims made by relator and decided not to intervene in the case. The government continued its investigation of DJO for several years following the unsealing of the case but did not ultimately bring any criminal or civil charges against us relating to the investigation. The 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 bone growth stimulation devices by each defendant to the present by seeking reimbursement for such devices as purchased items rather than rental items. The relator also alleges that the defendants are engaged in other marketing practices constituting violations of the federal and various state false claim and anti-kickback statutes. Orthofix International, N.V. has settled with both the government and the relator, and the case continues against the remaining defendants, with the relator pressing for discovery after years of inactivity on the case. While we believe the case against us has no merit, we can make no assurances as to the resources that will be needed to respond to this matter or the final outcome of the case.

California Qui Tam Action

On October 11, 2013, we were served with a summons and complaint related to a qui tam action filed in U.S. District Court in Los Angeles, California in August 2012 and amended in December 2012 that names us as a defendant along with each of the other companies that manufactures and sells external bone growth stimulators for spinal applications. The case is captioned United States of America, et al.ex re. Doris Modglin and Russ Milko, v. DJO Global, Inc., DJO, LLC, DJO Finance LLC, Orthofix, Inc., Biomet, Inc., and EBI, LP., Case No. CV12-7152-MMM (JCGx) (C.D. Cal.). The plaintiffs, or relators, allege that the defendants have violated federal and state false claim acts by seeking reimbursement for bone growth stimulators for uses outside of the FDA approved indications for use for such products. The plaintiffs are seeking treble damages alleged to have been sustained by the U.S. and the states, penalties and attorney’s fees and costs. The federal government and all of the named states have declined to intervene in this case. We filed a motion to dismiss the second amended complaint, which motion was granted with leave to amend. Relators then filed a third amended complaint and we filed a motion to dismiss the third amended complaint and that motion is pending. We believe that this lawsuit is without merit and intend to vigorously defend this case.

 

ITEM 4. MINE SAFETY DISCLOSURES

None.

 

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PART II.

ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS, AND ISSUER PURCHASES OF EQUITY SECURITIES

As a result of the acquisition of DJO by Blackstone in November 2006, the common stock of DJO is privately held and there is no established trading market for DJO’s common stock.

During the year ended December 31, 2014, DJO issued 115,693 shares of its common stock upon the net exercise of vested stock options that had been granted to two former members of DJO’s Board of Directors in 2006 and to employees in 2007 in exchange for options that had previously been granted in the predecessor company to DJO (“Rollover Options”). Our stock incentive plan permits participants to exercise stock options using a net exercise method. In a net exercise, we withhold from the total number of shares that otherwise would be issued to a participant upon exercise of the stock option such number of shares having a fair market value at the time of exercise equal to the aggregate option exercise price and applicable income tax withholdings, and remit the remaining shares to the participant. The two former directors and employees exercised these Rollover Options for a total of 507,088 shares of DJO’s common stock, from which we withheld 391,395 shares to cover $6.5 million of aggregate option exercise price and income tax withholdings and issued the remaining 115,693 shares.

Additionally, during the year ended December 31, 2014, DJO issued 6,447 shares of its common stock upon the exercise of stock options. Net proceeds are included in Member capital in our Consolidated Balance Sheet as of December 31, 2014.

During the year ended December 31, 2013, DJO issued 72,151 shares of common stock upon the net exercise of Rollover Options. During the year ended December 31, 2013, the net exercise method was employed by the participants to exercise Rollover Options to acquire 221,057 shares of our common stock; we withheld 148,906 of the shares subject to the Rollover Options to cover $2.5 million of aggregate option exercise price and income tax withholdings and issued the remaining 72,151 shares to the participants.

During the year ended December 31, 2012, DJO sold 121,506 shares of its common stock at $16.46 per share, consisting of 60,753 shares purchased by the new Chairman of its Board of Directors, and 60,753 shares purchased by another new member of the Board of Directors. Additionally, DJO issued 18,622 shares of its common stock upon the exercise of stock options. Net proceeds from these sales were $2.0 million.

The proceeds from these stock sales were contributed by DJO to us, and were used for working capital purposes. All such sales were subject to execution of a stockholder agreement including certain rights and restrictions (See Note 17 of the Notes to Consolidated Financial Statements).

As of February 20, 2015, there were 37 holders of DJO’s common stock.

As of February 20, 2015, 100% of DJOFL’s membership interests were owned by DJO Holdings LLC.

 

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ITEM 6. SELECTED FINANCIAL DATA

The following table presents data as of and for the periods indicated and has been derived from the audited historical consolidated financial statements. The data reported for all periods includes the results of operations attributable to businesses acquired from the date of acquisition. This selected financial data should be read in conjunction with the audited consolidated financial statements and related notes thereto, and Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in this Annual Report.

 

     Year Ended December 31,  

($ in thousands)

   2014     2013     2012     2011     2010  

Statement of Operations Data:

          

Net sales

   $ 1,229,166      $ 1,175,457      $ 1,129,420      $ 1,074,770      $ 965,973   

Loss from continuing operations (1)

     (89,562     (202,562     (118,368     (213,587     (51,675

Net loss attributable to DJOFL (1)

     (90,534     (203,452     (119,150     (214,469     (52,532

Depreciation and amortization

     128,810        128,666        127,459        121,151        103,519   

Balance Sheet Data (at period end):

          

Cash and cash equivalents

   $ 31,144      $ 43,578      $ 31,223      $ 38,169      $ 38,132   

Total assets

     2,598,493        2,694,779        2,862,416        2,894,860        2,779,790   

Long-term debt, net of current portion

    
2,261,941
  
   
2,251,167
  
    2,223,816        2,159,091        1,816,291   

DJOFL membership (deficit) equity

     (124,234     (21,926     182,092        295,813        504,139   

 

(1) Results for the years ended December 31, 2013, 2012, and 2011 include aggregate goodwill and intangible asset impairment charges of $106.6 million, $7.4 million, and $141.0 million, respectively.

 

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ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Forward Looking Statements

This report, and the following management’s discussion and analysis, contain “forward looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. To the extent that any statements are not recitations of historical fact, such statements constitute forward-looking statements that, by definition, involve risks and uncertainties. These statements can be identified because they use words like “anticipates”, “believes”, “estimates”, “expects”, “forecasts”, “future”, “intends”, “plans” and similar terms. Specifically, statements referencing, without limitation, growth in sales of our products, profit margins and the sufficiency of our cash flow for future liquidity and capital resource needs may be forward-looking statements. These forward-looking statements are further qualified by important factors that could cause actual results to differ materially from those in the forward-looking statements. These factors are described in Item 1A, Risk Factors, noted above. Results actually achieved may differ materially from expected results included in these statements as a result of these or other factors.

Introduction

This management’s discussion and analysis of financial condition and results of operations is intended to provide an understanding of our results of operations, financial condition and where appropriate, factors that may affect future performance. The following discussion should be read in conjunction with the audited consolidated financial statements and notes thereto as well as the other financial data included elsewhere in this Annual Report.

Overview of Business

We are a global developer, manufacturer and distributor of high-quality medical devices that provide solutions for musculoskeletal health, vascular health and pain management. Our products address the continuum of patient care from injury prevention to rehabilitation after surgery, injury or from degenerative disease, enabling people to regain or maintain their natural motion.

Our products are used by orthopedic specialists, spine surgeons, primary care physicians, pain management specialists, physical therapists, podiatrists, chiropractors, athletic trainers and other healthcare professionals. In addition, many of our medical devices and related accessories are used by athletes and patients for injury prevention and at-home physical therapy treatment. Our product lines include rigid and soft orthopedic bracing, hot and cold therapy, bone growth stimulators, vascular therapy systems and compression garments, therapeutic shoes and inserts, electrical stimulators used for pain management and physical therapy products. Our surgical implant business offers a comprehensive suite of reconstructive joint products for the hip, knee and shoulder.

Our products are marketed under a portfolio of brands including Aircast®, DonJoy®, ProCare®, CMF™, Empi®, Chattanooga, DJO Surgical, Dr. Comfort™, Compex®, Bell-Horn™ and Exos™.

Operating Segments

The company’s continuing operations fall into four operating segments; Bracing and Vascular; Recovery Sciences; Surgical Implant; and International. See Note 18 to our Consolidated Financial Statements for financial and other additional information regarding our segments.

Some of the tables below present financial information for our reportable segments for the periods presented. Segment results exclude the impact of amortization of intangible assets, certain general corporate expenses, and non-recurring and integration charges.

 

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Recent Acquisitions

On January 23, 2014, we acquired all of the outstanding shares of capital stock of Speetec Implantate GmbH (“Speetec”). Speetec is a distributor and manufacturer of knee, hip and shoulder arthroplasty products in Germany.

On July 1, 2013 we acquired certain assets of Blue Leaf Medical CC (“Blue Leaf”). The assets acquired relate to certain vascular product lines in South Africa, Namibia, Botswana, Mozambique and Zambia.

On March 7, 2013 we acquired certain assets of Vasyli Medical Asia/Pacific Pty Ltd. (“Vasyli”). The assets acquired relate to the distribution of certain vascular product lines in Australia and New Zealand.

On December 28, 2012, we acquired all of the outstanding shares of capital stock of Exos Corporation (Exos). Exos is a medical device company focused on thermoformable external musculoskeletal stabilization systems for the treatment of fractures and other injuries requiring stabilization.

Results of Operations

The following table sets forth our statements of operations as a percentage of net sales ($ in thousands):

 

     Year Ended December 31,  
     2014     2013     2012  

Net sales

   $ 1,229,166        100.0   $ 1,175,457        100.0   $ 1,129,420        100.0

Costs and operating expenses:

            

Cost of sales (exclusive of amortization of intangible assets (1))

     495,397        40.3        471,665        40.2        443,859        39.3   

Selling, general and administrative

     499,205        40.6        477,990        40.7        460,111        40.7   

Research and development

     37,742        3.1        33,221        2.8        27,892        2.5   

Amortization of intangible assets

     93,071        7.6        95,539        8.1        97,243        8.6   

Impairment of goodwill

     —          —          102,000        8.7        —          —     

Impairment of intangible assets

     —          —          4,600        0.3        7,397        0.7   
  

 

 

     

 

 

     

 

 

   
  1,125,415      91.6      1,185,015      100.8      1,036,502      91.8   
  

 

 

     

 

 

     

 

 

   

Operating income (loss)

  103,751      8.4      (9,558   (0.8   92,918      8.2   

Other (expense) income:

Interest expense, net

  (174,291   (14.2   (177,542   (15.1   (182,854   (16.1

Loss on modification and extinguishment of debt

  (938   (0.1   (1,059   (0.1   (36,889   (3.3

Other (expense) income, net

  (5,194   (0.4   (1,287   (0.1   3,553      0.3   
  

 

 

     

 

 

     

 

 

   
  (180,423   (14.7   (179,888   (15.3   (216,190   (19.1
  

 

 

     

 

 

     

 

 

   

Loss from continuing operations before income taxes

  (76,672   (6.3   (189,446   (16.1   (123,272   (10.9

Income tax (provision) benefit

  (12,890   (1.0   (13,116   (1.1   4,904      0.5   
  

 

 

     

 

 

     

 

 

   

Net loss

  (89,562   (7.3   (202,562   (17.2   (118,368   (10.4

Net income attributable to noncontrolling interests

  (972   (0.1   (890   (0.1   (782   (0.1
  

 

 

     

 

 

     

 

 

   

Net loss attributable to DJOFL

$ (90,534   (7.4 )%  $ (203,452   (17.3 )%  $ (119,150   (10.5 )% 
  

 

 

     

 

 

     

 

 

   

 

(1) Cost of sales is exclusive of amortization of intangible assets of $34,368, $35,125, and $38,355 for the years ended December 31, 2014, 2013 and 2012, respectively.

 

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Year Ended December 31, 2014 (2014) Compared to Year Ended December 31, 2013 (2013)

Net Sales. Our net sales for 2014 were $1,229.2 million, compared to net sales of $1,175.5 million for 2013, representing a 4.6% increase year over year. In constant currency, excluding an unfavorable impact of $3.0 million related to changes in foreign exchange rates in effect in 2014 compared to the rates in effect in 2013, net sales increased by $56.7 million, or 4.8%, to $1,232.2 million for 2014 from $1,175.5 million for 2013.

The following table sets forth the mix of our net sales by business segment ($ in thousands):

 

     2014      % of Net
Sales
    2013      % of Net
Sales
    Increase
(Decrease)
    % Increase
(Decrease)
 

Bracing and Vascular

   $ 504,590         41.1   $ 476,492         40.5   $ 28,098        5.9

Recovery Sciences

     299,122         24.3        312,783         26.6        (13,661     (4.4

Surgical Implant

     100,139         8.1        87,088         7.4        13,051        15.0   

International

     325,315         26.5        299,094         25.5        26,221        8.8   
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

   

Total net sales

   $ 1,229,166         100.0   $ 1,175,457         100.0   $ 53,709        4.6
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

   

 

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Net sales in our Bracing and Vascular segment were $504.6 million for 2014, increasing 5.9% from net sales of $476.5 million for 2013. Growth in net sales in this segment is being driven by sales of new bracing and compression system products, as well as new account acquisition in our OfficeCare channel.

Net sales in our Recovery Sciences segment were $299.1 million for 2014, decreasing 4.4% from net sales of $312.8 million for 2013. The decrease was primarily driven by changes in reimbursement for certain Empi products and slower than anticipated CMF product sales.

Net sales in our Surgical Implant segment were $100.1 million for 2014, increasing 15.0% from net sales of $87.1 million for 2013. The increase was driven by strong sales of our shoulder products as well as sales of new hip products and overall strong sales execution.

Net sales in our International segment were $325.3 million for 2014, increasing 8.8% from net sales of 299.1 million for 2013. In constant currency, excluding an unfavorable impact of $3.0 million related to changes in foreign exchange rates in effect in 2014 compared to the rates in effect in 2013, net sales for 2014 for the International segment increased 9.8% compared to net sales for 2013. Growth in net sales in this segment is being driven by sales from new products, improved sales execution, and increased sales penetration in certain geographies.

Cost of Sales. Costs of sales increased to $495.4 million for 2014, from $471.7 million for 2013. As a percentage of net sales, costs of sales remained fairly consistent at 40.3% for 2014, compared to 40.2% for 2013.

Selling, General and Administrative (SG&A). SG&A expenses increased to $499.2 million for 2014, from $478.0 million in 2013. As a percentage of net sales, SG&A expenses remained fairly consistent at 40.6% for 2014, compared to 40.7% for 2013. The increase was driven by higher variable selling costs due to a relative increase in sales for the Bracing and Vascular and Surgical Implant segments, an increase in accounts receivable allowance for doubtful accounts in our reimbursement channels due to a trend over the past three quarters in slower collections and uncertainty as to the continuation and duration of such trend, and an increase in reorganization and integration costs, offset by savings in wages and related costs of benefits.

Our SG&A expenses are impacted by significant non-recurring integration charges and other adjustments related to our ongoing restructuring activities and acquisitions. We incurred the following SG&A expenses in connection with such activities during the periods presented (in thousands):

 

     2014      2013  

Integration charges:

     

Global business unit reorganization and integration

   $ 7,304       $ 5,438   

Acquisition related expenses and integration

     325         1,152   

CFO transition

     227         1,673   

Litigation and regulatory costs and settlements, net

     5,730         3,563   

Automation projects

     5,867         5,550   

Other non-recurring items

     4,981         8,526   
  

 

 

    

 

 

 
$ 24,434    $ 25,902   
  

 

 

    

 

 

 

Research and Development (R&D). R&D expenses increased to $37.7 million for 2014, from $33.2 million in 2013. As a percentage of net sales, R&D expense increased to 3.1% in 2014 from 2.8% in 2013, reflecting an increase in our new product development activities primarily in our Bracing and Vascular segment.

Amortization of Intangible Assets. Amortization of intangible assets decreased to $93.1 million for 2014, from $95.6 million for 2013. The decrease is due to certain intangible assets reaching full amortization primarily in our patents and technology category, partially offset by an increase in intangible assets resulting from our acquisition of Speetec.

Interest Expense, net. Our interest expense, net decreased to $174.3 million for 2014, from $177.5 million for 2013. The decrease is due to lower weighted average interest rates on our senior secured credit facilities.

Loss on Modification and Extinguishment of Debt. Loss on modification and extinguishment of debt for 2014 consists of $0.3 million of arrangement and amendment fees and other fees and expenses incurred in connection with the amendment of our senior secured credit facilities and $0.6 million related to the non-cash write off of unamortized debt issuance costs and original issue discount associated with the portion of our original term loans which were extinguished. Loss on modification and extinguishment of debt for 2013 consists of $0.9 million in arrangement and amendment fees and other fees and expenses incurred in connection with the March 2013 amendment of our senior secured credit facilities and $0.2 million related to the non-cash write off of unamortized debt issuance costs and original issue discount associated with term loans which were extinguished.

 

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Other Expense, Net. Other expense, net increased to $5.2 million for 2014, from $1.3 million for 2013. Results for both periods presented primarily represent net realized and unrealized foreign currency translation gains and losses.

Income Tax Provision. We recorded income tax expense of $12.9 million on pre-tax losses of $76.7 million, resulting in a negative effective tax rate of 16.8% in 2014. For 2013, we recorded income tax expense of $13.1 million on pre-tax losses of $189.4 million, resulting in a negative effective tax rate of 6.9%. We are subject to federal and state income tax in the United States and in the various foreign countries where we do business. Our tax rates are negative because our U.S. federal tax losses, and certain state tax losses, are unavailable to offset income taxes arising in other states and in the foreign jurisdictions where we are subject to tax. In addition, we do not currently recognize a tax benefit for our US and state tax loss carryovers because we cannot conclude that it is more likely than not they will offset future taxable income.

We recorded income tax expense, although there were pretax losses, primarily because of the existence of a full deferred tax asset valuation allowance at the beginning of each period. This circumstance generally results in a zero net tax provision since the income tax expense or benefit that would otherwise be recognized is offset by the change to the valuation allowance. However, income tax expense recorded for the years ended December 31, 2014 and 2013 included the accrual of non-cash tax expense related to an additional valuation allowance in connection with the tax amortization of indefinite-lived intangible assets, that was not available to offset existing deferred tax assets.

Year Ended December 31, 2013 (2013) Compared to Year Ended December 31, 2012 (2012)

Net Sales. Our net sales for 2013 were $1,175.5 million, compared to net sales of $1,129.4 million for 2012, representing a 4.1% increase year over year. In constant currency, excluding a favorable impact of $3.2 million related to changes in foreign exchange rates in effect in 2013 compared to the rates in effect in 2012, net sales increased by $42.9 million, or 3.8%, to $1,172.3 million for 2013 from $1,129.4 million for 2012.

The following table sets forth the mix of our net sales by business segment ($ in thousands):

 

     2013      % of Net
Sales
    2012      % of Net
Sales
    Increase
(Decrease)
    % Increase
(Decrease)
 

Bracing and Vascular

   $ 476,492         40.5   $ 444,444         39.4   $ 32,048        7.2

Recovery Sciences

     312,783         26.6        331,461         29.3        (18,678     (5.6

Surgical Implant

     87,088         7.4        72,980         6.5        14,108        19.3   

International

     299,094         25.5        280,535         24.8        18,559        6.6   
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

   

Total net sales

   $ 1,175,457         100.0   $ 1,129,420         100.0   $ 46,037        4.1
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

   

Net sales in our Bracing and Vascular segment were $476.5 million for 2013, increasing 7.2% from net sales of $444.4 million for 2012. Growth in net sales in this segment is being driven by sales of new products as a result of our acquisition of Exos as well as increased sales of existing products.

Net sales in our Recovery Sciences segment were $312.8 million for 2013, decreasing 5.6% from net sales of $331.5 million for 2012. The decrease was primarily driven by changes in reimbursement for certain Empi products and by slow market conditions for Chattanooga capital equipment.

Net sales in our Surgical Implant segment were $87.1 million for 2013, increasing 19.3% from net sales of $73.0 million for 2012. The increase was driven by strong sales of our shoulder products as well as sales of new products and strong sales execution.

Net sales in our International segment were $299.1 million for 2013, increasing 6.6% from net sales of $280.5 million for 2012. In constant currency, excluding a favorable impact of $3.2 million related to changes in foreign exchange rates in effect in 2013 compared to the rates in effect in 2012, net sales for 2013 for the International segment increased 5.5% compared to net sales for 2012. Growth in net sales in this segment is being driven by sales from new products, improved sales execution and increased sales penetration in certain geographies.

Cost of Sales. Costs of sales increased to $471.7 million for 2013, from $443.9 million for 2012. As a percentage of net sales, costs of sales increased from 40.2% for 2013, compared to 39.3% for 2012.

 

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Selling, General and Administrative (SG&A). SG&A expenses increased to $478.0 million for 2013, from $460.1 million in 2012. As a percentage of net sales, SG&A expense remained consistent at 40.7% for 2013 and 2012.

Our SG&A expenses are impacted by significant non-recurring integration charges and other adjustments related to our ongoing restructuring activities and acquisitions. We incurred the following SG&A expenses in connection with such activities during the periods presented (in thousands):

 

     2013      2012  

Integration charges:

     

Global business unit reorganization and integration

   $ 5,438       $ 6,042   

Acquisition related expenses and integration

     1,152         2,277   

CEO transition

     —          183   

CFO transition

     1,673         —    

Litigation and regulatory costs and settlements, net

     3,563         11,247   

Other non-recurring items

     8,526         3,150   

Automation projects

     5,550         4,905   
  

 

 

    

 

 

 
   $ 25,902       $ 27,804   
  

 

 

    

 

 

 

Research and Development (R&D). R&D expenses increased to $33.2 million for 2013, from $27.9 million in 2012. As a percentage of net sales, R&D expense increased to 2.8% in 2013 from 2.5% in 2012, reflecting an increase in our new product development activities, including expenses incurred in 2013 by Exos, which we acquired in December 2012.

Amortization of Intangible Assets. Amortization of intangible assets was $95.5 million in 2013 and $97.2 million for 2012. The decrease is due to certain intangible assets reaching full amortization primarily in our patents and technology category, partially offset by an increase in our patents and technology intangible assets resulting from our 2012 acquisition of Exos.

Impairment of Goodwill and Intangible Assets. We determined that the carrying values of our Empi and Chattanooga reporting units were in excess of their estimated fair values. As a result, in the fourth quarter of 2013 we recorded goodwill impairment charges of $52.5 million for the Empi reporting unit and $49.5 million for the Chattanooga reporting unit. The goodwill impairment in our Empi reporting unit resulted primarily from reductions in our projected operating results and estimated future cash flows due to unfavorable decisions made by certain third party payors related to insurance pricing for certain products sold by the Empi reporting unit. The goodwill impairment in the Chattanooga reporting unit resulted primarily from reductions in our projected operating results and estimated future cash flows due to slow market conditions for capital equipment. In addition, during the year ended December 31, 2013 we recorded intangible asset impairment charges of $4.5 million related to our Empi trade name.

In 2012, we began the process of changing the trade name used for our German operations from Ormed to DJO to be consistent with our global strategy. In conjunction with this change, we revised our assumption as to the useful life of the Ormed trade name intangible asset, which resulted in changing the remaining estimated life of the asset from indefinite to three years. These changes triggered an impairment review of the intangible asset. Based on the application of a differential cash flow method, whereby an investor would be willing to pay a price equal to the present value of the incremental cash flows attributable to the economic benefit derived from defending the trade name in the market, we determined that the carrying amount of the asset was in excess of its estimated fair value. As a result, we recorded an impairment charge of $7.4 million.

Interest Expense, net. Our interest expense, net was $177.5 million for 2013 and $182.9 million for 2012. The decrease is due to lower weighted average interest rates on our senior secured credit facilities.

Loss on Modification and Extinguishment of Debt. Loss on modification and extinguishment of debt for 2013 consists of $0.9 million in arrangement and amendment fees and other fees and expenses incurred in connection with the amendment of our senior secured credit facilities and $0.2 million related to the non-cash write off of unamortized debt issuance costs and original issue discount associated with term loans which were extinguished. Loss on modification and extinguishment of debt for year ended December 31, 2012 consists of $17.3 million in premiums related to the repurchase or redemption of our 10.875% Senior unsecured notes and $12.7 million related to the non-cash write off of unamortized debt issuance costs related to the 10.875% Senior unsecured notes, net of $2.5 million related to the non-cash write off of unamortized original issue premium associated with the 10.875% Senior unsecured notes, $8.6 million of arrangement and amendment fees and other fees and expenses incurred in connection with the March 2012 amendment of our senior secured credit facilities and $0.8 million related to the non-cash write off of unamortized debt issuance costs and original issue discount associated with a portion of our original term loans which were extinguished.

 

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Other (Expense) Income, Net. Other (expense) income, net was $(1.3) million for 2013 and 3.6 million for 2012. Results for both periods presented primarily represent net realized and unrealized foreign currency translation gains and losses.

Income Tax (Provision) Benefit. We recorded an income tax expense of $13.1 million on pre-tax losses of $189.4 million, resulting in a negative effective tax rate of 6.9% in 2013. In 2012 we recorded an income tax benefit of $4.9 million on a pre-tax loss of $123.3 million, resulting in an effective tax rate of 4.0%. The change in our effective tax rates from 2012 to 2013 occurs primarily because we no longer recorded tax benefits relating to our tax loss carryforwards beginning 2013 as we could not conclude it was more likely than not they would offset future taxable income.

Recent Accounting Pronouncements

In July 2013, the Financial Accounting Standards Board (the “FASB”) issued an accounting standard update regarding the financial statement presentation of an unrecognized tax benefit when a net operating loss carryforward, a similar tax loss, or a tax credit carryforward exists. The guidance is effective prospectively for fiscal years, and interim periods within those years, beginning after December 15, 2013, with an option for early adoption. The adoption of this standard did not have an impact on the Company’s consolidated financial statements.

In April 2014, the FASB issued accounting standards update, which includes amendments that change the requirements for reporting discontinued operations and require additional disclosures about discontinued operations. Under the new guidance, only disposals representing a strategic shift in operations—that is, a major effect on the organization’s operations and financial results should be presented as discontinued operations. Examples include a disposal of a major geographic area, a major line of business, or a major equity method investment. Additionally, the update requires expanded disclosures about discontinued operations that will provide financial statement users with more information about the assets, liabilities, income, and expenses of discontinued operations. The guidance is effective prospectively for fiscal years beginning after December 15, 2014 and interim periods within annual periods beginning on or after December 15, 2015. The adoption of this standard has the potential to impact the Company’s accounting for and disclosure of any future discontinued operations.

In May 2014, the FASB issued an accounting standards update related to revenue from contracts with customers. The new standard provides a five-step approach to be applied to all contracts with customers. The accounting standards update also requires expanded disclosures about revenue recognition. The guidance is effective for fiscal years beginning after December 15, 2016 and interim periods within that reporting period. Early adoption is not permitted. The Company is currently evaluating the new guidance to determine the impact it may have to its consolidated financial statements.

In June 2014, the FASB issued an accounting standards update related accounting for share-based payments. The standard requires that a performance target that affects vesting and that could be achieved after the requisite service period be treated as a performance condition. The guidance is effective for annual periods and interim periods within those annual periods, beginning after December 15, 2015. Early application is permitted. Adoption of this new guidance is not expected to have a material effect on the Company’s financial statements.

In August 2014, the FASB issued an accounting standards update related to going concern disclosures. The standard requires an entity’s management to evaluate whether there are conditions or events that raise substantial doubt about the entity’s ability to continue as a going concern within one year after the date that the financial statements are issued. The guidance is effective for annual reporting periods ending after December 15, 2016, and interim periods thereafter. Early application is permitted. Adoption of this new guidance is not expected to have a material effect on the Company’s financial statements.

Liquidity and Capital Resources

As of December 31, 2014, our primary sources of liquidity consisted of cash and cash equivalents totaling $31.1 million and our $100.0 million revolving credit facility, of which $82.5 million was available. Our revolving credit balance was $17.0 million as of December 31, 2014 and we have provided a $0.5 million letter of credit related to collateral requirements under our product liability insurance policy. Working capital at December 31, 2014 was $235.6 million.

We believe that our existing cash, plus the amounts we expect to generate from operations and amounts available through our revolving credit facility, will be sufficient to meet our operating needs for the next twelve months, including working capital requirements, capital expenditures, and debt and interest repayment obligations. While we currently believe that we will be able to meet all of the financial covenants imposed by our senior secured credit facilities, there is no assurance that we will in fact be able to do so or that, if we do not, we will be able to obtain from our lenders waivers of default or amendments to the senior secured credit facilities. We and our subsidiaries, affiliates, or significant shareholders (including Blackstone and its affiliates) may from time to time, in our or their sole discretion, purchase, repay, redeem or retire any of our outstanding debt or equity securities (including any publicly issued debt securities), in privately negotiated or open market transactions, by tender offer or otherwise.

 

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Cash Flows

Operating activities provided $46.5 million, $29.8 million and $44.6 million of cash for 2014, 2013 and 2012, respectively. Cash provided by operating activities for all years presented primarily represented our net loss, adjusted for non-cash expenses and changes in working capital. In 2014, changes in working capital largely consisted of increases in inventories which used cash of $20.5 million compared to providing cash of $4.5 million in 2013 and using cash of $21.9 million in 2012. For 2014, 2013 and 2012, cash paid for interest was $165.5 million, $171.4 million and $162.6 million, respectively.

Investing activities used $58.4 million, $41.1 million and $64.0 million of cash for 2014, 2013 and 2012 respectively. Cash used in investing activities for 2014 primarily consisted of $52.8 million for purchases of property and equipment primarily for surgical instruments to support growth, IT automation technology, manufacturing equipment for new products and more efficient production, and $4.6 million related to the acquisition of Speetec. Cash used in investing activities for 2013 primarily consisted of purchases of property and equipment of $37.5 million primarily for surgical instruments and IT automation technology, and $2.0 million related to the acquisition of assets from our vascular distributors in Australia and South Africa. Cash used in investing activities for 2012 primarily consisted of purchases of property and equipment of $33.0 million and cash paid for the acquisition of Exos of $30.0 million, net of cash acquired.

Financing activities used cash of $23 thousand in 2014 and provided $23.3 million and $12.0 million of cash in 2013 and 2012, respectively. Cash used in financing activities in 2014 consisted of proceeds from the borrowings under our senior secured credit facilities, offset by payments of the senior secured credit facilities, payments related to the repurchase of Rollover Options from our former chief financial officer upon her departure, and payment of contingent consideration related to the acquisition of Exos. Cash provided in financing activities in 2013 consisted of proceeds from the borrowings under our senior secured credit facilities, offset by payments of the senior secured credit facilities. Cash provided by financing activities in 2012 consisted of proceeds from borrowings under our senior secured credit facilities and our new 8.75% Notes, offset by repayments of our original senior secured credit facilities and our 10.875% Notes and the payment of $55.9 million of debt issuance, modification and extinguishment costs. During 2012, we received an investment of $2.0 million from DJO, our indirect parent, related to proceeds from the sale of common stock.

Indebtedness

As of December 31, 2014, we had $2,271.6 million in aggregate indebtedness outstanding, exclusive of a net unamortized original issue discount of $0.7 million. The principal amount and carrying value of our debt was as follows for December 31, 2014 and 2013 (in thousands):

 

     2014      2013  
     Principal
Amount
     Carrying
Value
     Principal
Amount
     Carrying
Value
 

Senior secured credit facilities:

           

Revolving credit facility

   $ 17,000       $ 17,000       $ 38,000       $ 38,000   

Term loans

     884,560         879,476         853,400         846,297   
  

 

 

    

 

 

    

 

 

    

 

 

 
     901,560         896,476         891,400         884,297   

Note financing:

           

8.75% second priority senior secured notes

     330,000         334,377         330,000         335,490   

9.875% senior unsecured notes

     440,000         440,000         440,000         440,000   

7.75% senior unsecured notes

     300,000         300,000         300,000         300,000   

9.75% senior subordinated notes

     300,000         300,000         300,000         300,000   
  

 

 

    

 

 

    

 

 

    

 

 

 
     1,370,000         1,374,377         1,370,000         1,375,490   
  

 

 

    

 

 

    

 

 

    

 

 

 

Other debt:

     63         63         —          —    
  

 

 

    

 

 

    

 

 

    

 

 

 

Total indebtedness

   $ 2,271,623       $ 2,270,916       $ 2,261,400       $ 2,259,787   
  

 

 

    

 

 

    

 

 

    

 

 

 

Senior Secured Credit Facilities. Our senior secured credit facilities at December 31, 2014 consist of $884.6 million of term loans which mature on September 15, 2017 and a $100.0 million revolving credit facility which matures on March 15, 2017. Our revolving credit balance was $17.0 million at December 31, 2014 and we have provided a $0.5 million letter of credit related to collateral requirements under our product liability insurance policy.

 

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The interest rate margins applicable to borrowings under the senior secured revolving credit facilities are, at our option, either (a) the Eurodollar rate, plus 325 basis points or (b) a base rate determined by reference to the highest of (1) the prime rate, (2) the federal funds rate, plus 0.50% and (3) the Eurodollar rate for a one-month interest period, plus, in each case, 325 basis points. The interest rate margins applicable to the term loans are, at our option, either (a) the Eurodollar rate plus 325 basis points or (b) a base rate plus 325 basis points. There is a minimum LIBOR rate applicable to the Eurodollar component of interest rates on term loan borrowings of 1.00%. The applicable margin for borrowings under the senior secured revolving credit facilities may be reduced, subject to our attaining certain leverage ratios. As of December 31, 2014, our weighted average interest rate for all borrowings under the senior secured credit facilities was 4.23%.

We are required to pay annual payments in equal quarterly installments on the term loans in an amount equal to 1.00% of the funded total principal amount through June 2017, with any remaining amount payable in full at maturity in September 2017.

Note Financing. Our outstanding notes mature at various dates in 2017 and 2018. Assuming we are in compliance with the terms of the indentures governing the notes, we are not required to repay principal related to any of the notes prior to the final maturity dates of the notes. We pay interest semi-annually on the notes.

See Note 12 to our Consolidated Financial Statements for additional information regarding our indebtedness.

Certain Covenants and Related Compliance. Pursuant to the terms of the senior secured credit facilities, we are required to maintain a maximum senior secured first lien leverage ratio of consolidated first lien net debt to Adjusted EBITDA of 4.75:1 for the trailing twelve months ended December 31, 2014. Adjusted EBITDA is defined as net income (loss) attributable to DJOFL, plus interest expense, net, income tax (provision) benefit and depreciation and amortization, further adjusted for certain non-cash items, non-recurring items and other adjustment items, as permitted in calculating covenant compliance under our senior secured credit facilities and the Indentures governing our 8.75% Notes, 9.875% Notes, 7.75% Notes and 9.75% Notes (collectively, the Notes). Adjusted EBITDA is a material component of these covenants. As of December 31, 2014, our actual senior secured first lien leverage ratio was within the required ratio at 3.08:1. Adjusted EBITDA should not be considered as an alternative to net income or other performance measures presented in accordance with GAAP, or as an alternative to cash flow from operations as a measure of our liquidity. Adjusted EBITDA does not represent net income (loss) or cash flow from operations as those terms are defined by GAAP and does not necessarily indicate whether cash flows will be sufficient to fund cash needs. In particular, the definition of Adjusted EBITDA in the Indentures and our senior secured credit facilities allows us to add back certain non-cash, extraordinary, unusual or non-recurring charges that are deducted in calculating net loss. However, these are expenses that may recur, vary greatly and are difficult to predict. While Adjusted EBITDA and similar measures are frequently used as measures of operations and the ability to meet debt service requirements, Adjusted EBITDA is not necessarily comparable to other similarly titled captions of other companies due to the potential inconsistencies in the method of calculation.

Under the Indentures governing the Notes, our ability to incur additional debt, subject to specified exceptions, is tied to either improving the ratio of our Adjusted EBITDA to fixed charges or having this ratio be at least 2.00:1 on a pro forma basis after giving effect to such incurrence. Additionally, our ability to make certain restricted payments is also tied to having an Adjusted EBITDA to fixed charges ratio of at least 2.00:1 on a pro forma basis, as defined, subject to specified exceptions. Our ratio of Adjusted EBITDA to fixed charges for the twelve months ended December 31, 2014, measured on that date, was 1.70:1. Notwithstanding these limitations, the aggregate amount of term loan increases and revolving commitment increases shall not exceed the greater of (i) $150.0 million and (ii) the additional aggregate amount of secured indebtedness which would be permitted to be incurred as of any date of determination (assuming for this purpose that the full amount of any revolving credit increase had been utilized as of such date) such that, after giving pro forma effect to such incurrence (and any other transactions consummated on such date), the senior secured leverage ratio for the immediately preceding test period would not be greater than 4.75:1. Fixed charges is defined in the Indentures as consolidated interest expense plus all cash dividends or other distributions paid on any series of preferred stock of any restricted subsidiary and all dividends or other distributions accrued on any series of disqualified stock.

As described above, our senior secured credit facilities and the Notes governed by the Indentures represent significant components of our capital structure. Under the senior secured credit facilities, we are required to maintain compliance with a specified senior secured first lien leverage ratio and which ratio is determined based on our Adjusted EBITDA. If we fail to comply with the senior secured first lien leverage ratio under our senior secured credit facilities, we would be in default. Upon the occurrence of an event of default under the senior secured credit facilities, the lenders could elect to declare all amounts outstanding under the senior secured credit facilities to be immediately due and payable and terminate all commitments to extend further credit. If we were unable to repay those amounts, the lenders under the senior secured credit facilities could proceed against the collateral granted to them to secure that indebtedness. We have pledged substantially all of our assets as collateral under the senior secured credit facilities. Any

 

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acceleration under the senior secured credit facilities would also result in a default under the Indentures governing the Notes, which could lead to the note holders electing to declare the principal, premium, if any, and interest on the then outstanding Notes immediately due and payable. In addition, under the Indentures governing the Notes, our and our subsidiaries’ ability to engage in activities such as incurring additional indebtedness, making investments, refinancing subordinated indebtedness, paying dividends and entering into certain merger transactions is governed, in part, by our ability to satisfy tests based on Adjusted EBITDA.

Our ability to meet the covenants specified above will depend on future events, some of which are beyond our control, and we cannot assure you that we will meet those covenants. A breach of any of these covenants in the future could result in a default under our senior secured credit facilities and the Indentures, at which time the lenders could elect to declare all amounts outstanding under our senior secured credit facilities to be immediately due and payable. Any such acceleration would also result in a default under the Indentures.

The following table provides a reconciliation from our net loss to Adjusted EBITDA for the years ended December 31, 2014, 2013 and 2012. The terms and related calculations are defined in the credit agreement relating to our senior secured credit facilities and the Indentures.

 

    Year Ended December 31,  

(in thousands)

  2014     2013     2012  

Net loss attributable to DJO Finance LLC

  $ (90,534   $ (203,452   $ (119,150

Interest expense, net

    174,291        177,542        182,854   

Income tax expense (benefit)

    12,890        13,116        (4,904

Depreciation and amortization

    128,810        128,666        127,459   

Non-cash charges (a)

    (142     107,723        10,769   

Non-recurring and integration charges (b)

    42,558        30,600        32,584   

Other adjustment items, before permitted pro forma adjustments (c)

    14,383        10,500        41,402   
 

 

 

   

 

 

   

 

 

 
  282,256      264,695      271,014   

Permitted pro forma adjustments (d)

Pre-acquisition Adjusted EBITDA

  —       —       1,590   

Future cost savings

  —       —       1,396   
 

 

 

   

 

 

   

 

 

 

Adjusted EBITDA

$ 282,256    $ 264,695    $ 274,000   
 

 

 

   

 

 

   

 

 

 

 

(a) Non-cash items are comprised of the following:

 

     Year Ended December 31,  

(in thousands)

   2014      2013      2012  

Stock compensation expense

   $ 1,869       $ 2,155       $ 2,339   

Impairment of goodwill and intangible assets

     —          106,600         7,397   

Impairment of fixed assets and assets held for sale

     —          —          975   

Purchase accounting adjustments (1)

     (1,250      (1,568      —    

(Gain) loss on disposal of assets, net

     (761      536         58   
  

 

 

    

 

 

    

 

 

 

Total non-cash items

$ (142 $ 107,723    $ 10,769   
  

 

 

    

 

 

    

 

 

 

 

(1) Purchase accounting adjustments for the twelve months ended December 31, 2014 consist of $0.2 million of amortization of fair market value inventory adjustments, net of $1.5 million in adjustments to the contingent consideration for Speetec. Purchase accounting adjustments for 2013 consist of $0.9 million of amortization of fair market value inventory adjustments, net of $2.5 million in adjustments to the contingent consideration for Exos.

 

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(b) Non-recurring and integration charges are comprised of the following:

 

     Year Ended December 31,  

(in thousands)

   2014      2013      2012  

Integration charges:

        

Global business unit reorganization and integration

   $ 10,030       $ 7,077       $ 7,025   

Acquisition related expenses and integration (1)

     331         1,863         3,020   

CEO transition

     —          —          183   

CFO transition

     227         1,673         —    

Litigation and regulatory costs and settlements, net (2) (3)(4)

     5,752         3,906         12,582   

Other non-recurring items (5) (6) (7)

     20,351         10,531         4,129   

ERP implementation and other automation projects

     5,867         5,550         5,645   
  

 

 

    

 

 

    

 

 

 

Total non-recurring and integration charges

   $ 42,558       $ 30,600       $ 32,584   
  

 

 

    

 

 

    

 

 

 

 

(1) Consists of direct acquisition costs and integration expenses related to acquired businesses and costs related to potential acquisitions.
(2) For the twelve months ended December 31, 2014, litigation and regulatory costs consisted of $0.9 million in litigation costs related to ongoing product liability issues related to our discontinued pain pump products and $4.9 million related to other litigation and regulatory costs and settlements.
(3) For the twelve months ended December 31, 2013, litigation and regulatory costs consisted of $3.1 million in litigation costs related to ongoing product liability issues related to our discontinued pain pump products, $3.7 million related to other litigation and regulatory costs and settlements, net of $2.0 million received related to an indemnity claim from a third party pain pump manufacturer and a settlement with its insurance carrier, and a $0.9 million favorable cost estimate adjustment for the post-market surveillance study required by the FDA related to our discontinued metal-on-metal hip implant products.
(4) For the twelve months ended December 31, 2012, litigation and regulatory costs consisted $4.7 million in litigation costs related to ongoing product liability issues related to our discontinued pain pump products, $3.8 million related to other litigation and regulatory costs and settlements, $2.8 million of estimated costs to complete a post-market surveillance study required by the FDA related to our discontinued metal-on-metal hip implant products and a $1.3 million judgment related to a French litigation matter we intend to appeal.
(5) For the twelve months ended December 31, 2014, other non-recurring items consist of $1.7 million in incremental Empi bad debt expense related to CMS’s decision to deny coverage for TENS for the treatment of chronic low back pain outside of clinical studies (the Medicare CLBP decision), $13.7 million in specifically identified non-recurring operational and regulatory projects, $2.2 million in expenses related to our Tunisia factory fire and $2.8 million in professional fees and other non-recurring charges.
(6) For the twelve months ended December 31, 2013, other non-recurring items consist of $5.8 million in incremental Empi bad debt expense related to the Medicare CLBP decision, $1.9 million in specifically identified non-recurring operational and regulatory projects, $0.9 million in expenses related to our Tunisia factory fire and $2.0 million in other non-recurring travel & professional fees.
(7) For the twelve months ended December 31, 2012, other non-recurring items consist of $2.6 million in non-recurring human resource talent initiatives, $0.8 million in specifically identified non-recurring operational and regulatory projects, $0.3 million related to the move of one of our factories and $0.4 million in other non-recurring professional fees.

 

(c) Other adjustment items before permitted pro forma adjustments are comprised of the following:

 

     For the Year Ended December 31,  

(in thousands)

   2014      2013      2012  

Blackstone monitoring fee

   $ 7,000       $ 7,000       $ 7,000   

Noncontrolling interests

     972         890         781   

Loss on modification and extinguishment of debt (1) (2)(3)

     938         1,059         36,889   

Other (4)

     5,473         1,551         (3,268
  

 

 

    

 

 

    

 

 

 

Total other adjustment items before permitted pro forma adjustments

   $ 14,383       $ 10,500       $ 41,402   
  

 

 

    

 

 

    

 

 

 

 

(1) Loss on modification and extinguishment of debt for the twelve months ending December 31, 2014 consists of $0.3 million of arrangement and amendment fees and other fees and expenses incurred in connection with the amendment of our senior secured credit facilities and $0.6 million related to the non-cash write off of unamortized debt issuance costs and original issue discount associated with the portion of our original term loans which were extinguished.
(2) Loss on modification and extinguishment of debt for the twelve months ending December 31, 2013 consists of $0.9 million in arrangement and amendment fees and other fees and expenses incurred in connection with the March 2013 amendment of our senior secured credit facilities and $0.2 million related to the non-cash write off of unamortized debt issuance costs and original issue discount associated with term loans which were extinguished.

 

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  (3) Loss on modification and extinguishment of debt for the twelve months ending December 31, 2012 consists of $17.2 million in premiums related to the fourth quarter 2012 repurchase or redemption of our 10.875% Senior Secured Notes (“10.875% Notes”), $12.7 million related to the non-cash write off of unamortized debt issuance costs related to the 10.875% Notes and $0.1 million in legal and other fees, net of $2.5 million related to the non-cash write off of unamortized original issue premium associated with the 10.875% Notes, $8.6 million of arrangement and amendment fees and other fees and expenses incurred in connection with the March 2012 amendment of our senior secured credit facilities and $0.8 million related to the non-cash write off of unamortized debt issuance costs and original issue discount associated with a portion of our term loans which were extinguished.
  (4) Other adjustments consist primarily of net realized and unrealized foreign currency transaction gains and losses.

 

(d) Permitted pro forma adjustments include:

 

    Pre-acquisition Adjusted EBITDA related to the acquisition acquired businesses.

 

    Future cost savings for the year ended December 31, 2012 included $0.6 million for Dr. Comfort, $0.3 million for Circle City, $0.2 million for Exos and $0.3 million for ETI.

 

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Contractual Commitments

As of December 31, 2014, our consolidated contractual commitments are as follows (in thousands):

 

     Payment due:  
     Total      2015      2016-2017      2018-2019      Thereafter  

Long-term debt obligations

   $ 2,271,623       $ 8,975       $ 1,192,648       $ 1,070,000       $ —     

Interest payments (1)

     495,742         162,793         307,479         25,470         —     

Operating lease obligations

     73,254         17,374         25,343         16,318         14,219   

Purchase obligations

     101,564         73,564         14,000         14,000         —     
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total contractual commitments

   $ 2,942,183       $ 262,706       $ 1,539,470       $ 1,125,788       $ 14,219   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

(1) $1,370.0 million principal amount of long-term debt is subject to fixed interest rates and $901.6 million of principal amount of long-term debt is subject to a floating interest rate. Interest payments for the floating rate debt were determined using an average assumed effective interest rate of 4.25%, which is equal to the average assumed effective interest rate for the term loans under the senior secured credit facilities over the remainder of their term.

As of December 31, 2014, we had entered into purchase commitments for inventory, capital expenditures and other services totaling $73.3 million in the ordinary course of business. In addition, under the amended transaction and monitoring fee agreement entered into in November 2007, the purchase obligations shown above include DJO’s obligation to pay a $7.0 million annual monitoring fee to Blackstone Management Partners V L.L.C. through 2019. See Item 13. “Certain Relationships and Related Transactions and Director Independence” for a more detailed description of the monitoring fee agreement.

The amounts presented in the table above may not necessarily reflect our actual future cash funding requirement because the actual timing of future payments made may vary from the stated contractual obligation.

Critical Accounting Policies and Estimates

Our management’s discussion and analysis of financial condition and results of operations is based upon our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to reserves for contractual allowances, doubtful accounts, rebates, product returns and rental credits, goodwill and intangible assets, deferred tax assets and liabilities and inventory. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. To the extent that actual events differ from our estimates and assumptions, there could be a material adverse effect on our consolidated financial statements.

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

Reserves for Contractual Allowances, Doubtful Accounts, Rebates, Product Returns and Rental Credits

We have established reserves to account for contractual allowances, doubtful accounts, rebates, product returns and rental credits. Significant management judgment must be used and estimates must be made in connection with establishing these reserves.

We maintain provisions for estimated contractual allowances for reimbursement amounts from our third party payor customers based on negotiated contracts and historical experience for non-contracted payors. We report these allowances as reductions to our gross revenue. We estimate the amount of the reduction based on historical experience and invoices generated in the period, and we consider the impact of new contract terms or modifications of existing arrangements with our customers. We have contracts with certain third party payors for our third party reimbursement billings, which call for specified reductions in reimbursement of billed amounts based upon contractual reimbursement rates. For the years ended December 31, 2014, 2013 and 2012, we reserved for and reduced gross revenues from third party payors by estimated contractual allowances of 35%, 40% and 35%, respectively.

 

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Our reserve for doubtful accounts is based upon estimated losses from customers who are billed directly and the portion of third party reimbursement billings that ultimately become the financial responsibility of the end user patients. Direct-billed customers represented approximately 66%, 73% and 72% of our net revenues for the year ended December 31, 2014, 2013 and 2012, respectively. Direct-billed customers represented approximately 67% and 71% of our net accounts receivable at December 31, 2014 and 2013, respectively. We experienced write-offs related to direct-billed customers of less than 1% of related net revenues in each of the years ended December 31, 2014, 2013 and 2012.

Our third party reimbursement customers including insurance companies, managed care companies and certain governmental payors, such as Medicare, include all of our OfficeCare customers, most of our Empi customers, and certain other customers of our Recovery Sciences and Bracing and Vascular segments. Our third party payor customers represented approximately 34%, 27% and 28% of our net revenues for the years ended December 31, 2014, 2013 and 2012, respectively. Third party payor customers represented approximately 33% and 30%, respectively, of our net accounts receivable at December 31, 2014 and 2013. For the years ended December 31, 2014, 2013 and 2012, we estimate bad debt expense to be approximately 6%, 6% and 4%, respectively, of gross revenues from these third party reimbursement customers. If the financial condition of our customers were to deteriorate resulting in an impairment of their ability to make payments or if third party payors were to deny claims for late filings, incomplete information or other reasons, additional provisions may be required. Additions to this reserve are reflected as Selling, general and administrative expense in our Consolidated Statements of Operations.

Our reserve for rebates accounts for incentives that we offer certain of our distributors. These rebates are substantially attributable to sales volume, sales growth or to reimburse the distributor for certain discounts. We record estimated reductions to revenue for customer rebate programs based upon historical experience and estimated revenue levels.

Our reserve for product returns accounts for estimated customer returns of our products after purchase. These returns are mainly attributable to a third party payor’s refusal to provide reimbursement for the product or the inability of the product to adequately address the patient’s condition. We provide for this reserve by reducing gross revenue based on our historical rate of returns.

Our reserve for rental credit recognizes a timing difference between billing for a sale and processing a rental credit associated with some of our rehabilitation devices. Many insurance providers require patients to rent our rehabilitation devices for a period of one to three months prior to purchase. If the patient has a long-term need for the device, these insurance companies may authorize purchase of the device after such time period. When the device is purchased, most providers require that rental payments previously made on the device be credited toward the purchase price. These credits are processed at the time the payment is received for the purchase of the device, which creates a time lag between billing for a sale and processing the rental credit. Our rental credit reserve estimates unprocessed rental credits based on the number of devices converted to purchase. The reserve is calculated by first assessing the number of our products being rented during the relevant period and our historical conversion rate of rentals to sales, and then reducing our revenue by the applicable amount. We provide for these reserves by reducing our gross revenue. The cost to refurbish rented products is expensed as incurred to Cost of sales in our Consolidated Statements of Operations.

Inventory Reserves

We provide reserves for estimated excess and obsolete inventories equal to the difference between the costs of inventories on hand and the costs of projected inventories required based upon assumptions about future demand. If future demand is less favorable than currently projected by management, additional inventory write-downs may be required. We also provide reserves for newer product inventories, as appropriate, based on any minimum purchase commitments and our level of sales of the new products.

We consign a portion of our inventory to allow our products to be immediately dispensed to patients. This requires inventory to be on hand for the products we sell through consignment arrangements. It also increases the sensitivity of these products to obsolescence reserve estimates. As this inventory is not in our possession, we maintain additional reserves for estimated shrinkage of these inventories based on the results of periodic inventory counts and historical trends.

Goodwill and Intangible Assets

We evaluate the carrying value of goodwill and indefinite life intangible assets annually on the first day of the fourth quarter or whenever events or circumstances indicate the carrying value may not be recoverable. We evaluate the carrying value of finite life intangible assets whenever events or circumstances indicate the carrying value may not be recoverable. Significant assumptions are required to estimate the fair value of goodwill and intangible assets, most notably estimated future cash flows generated by these assets. As such, these fair valuation measurements use significant unobservable inputs. Changes to these assumptions could require us to record impairment charges on these assets.

 

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In performing our 2014 goodwill impairment test, we estimated the fair values of our reporting units using the income approach which includes the discounted cash flow method and the market approach which includes the use of market multiples. These fair value measurements are categorized within Level 3 of the fair value hierarchy. The discounted cash flows for each reporting unit were based on discrete financial forecasts developed by management for planning purposes, and required significant judgment with respect to forecasted sales, gross margin, selling, general and administrative expenses, depreciation, income taxes, capital expenditures, working capital requirements and the selection and use of an appropriate discount rate. For purposes of calculating the discounted cash flows of our reporting units, we used estimated revenue growth rates averaging between 1% and 6% for the discrete forecast period. Cash flows beyond the discrete forecasts were estimated using a terminal value calculation, which incorporated historical and forecasted financial trends for each identified reporting unit and considered long-term earnings growth rates for publicly traded peer companies. Future cash flows were then discounted to present value at discount rates ranging from 9.6% to 11.3%, and terminal value growth rates ranging from 1.4% to 3.0%. Publicly available information regarding comparable market capitalization was also considered in assessing the reasonableness of the cumulative fair values of our reporting units estimated using the discounted cash flow methodology. We determined that the fair value of the six reporting units with goodwill assigned to them exceeds their carrying value and no reporting unit was at risk of failing the test. The percentage by which fair value of the six reporting units exceeded their carrying value ranged from 30.9% to 126.1%. As such, we determined that the goodwill of our reporting units was not impaired.

In the fourth quarter of 2014 we tested our indefinite lived trade name intangible assets for impairment. This test work compares the fair value of the asset with its carrying amount. To determine the fair value we applied the relief from royalty (RFR) method. Under the RFR method, the value of the trade name is determined by calculating the present value of the after-tax cost savings associated with owning the asset and therefore not being required to pay royalties for its use during the asset’s indefinite life. Significant judgments inherent in this analysis include the selection of appropriate discount rates, estimating future cash flows and the identification of appropriate terminal growth rate assumptions. Discount rate assumptions are based on an assessment of the risk inherent in the projected future cash generated by the respective intangible assets. Future cash flows were discounted to present value at discount rates ranging from 9.6% to 11.3%, and terminal value growth rates ranging from 1.4% to 3.0%. Also subject to judgment are assumptions about royalty rates, which are based on the estimated rates at which similar brands and trademarks are being licensed in the marketplace. We used market average royalty rates ranging from 0.5% to 5.0%. These fair value measurements are categorized within Level 3 of the fair value hierarchy. We determined that that the fair value of these trade names exceed their carrying value. The percentage by which the fair value of these trade names exceeded their carrying value ranged from 10.5% to 89.6%. As such, we determined that these indefinite lived intangible assets are not impaired.

The estimates we have used are consistent with the plans and estimates that we use to manage our business, however, it is possible that the plans may change and estimates used may prove to be inaccurate. If our actual results, or the plans and estimates used in future impairment analyses, are lower than the original estimates used to assess the recoverability of these assets, we could incur significant impairment charges.

See Note 7 of the Notes to Consolidated Financial Statements included in Part II, Item 8, herein for further discussion of goodwill and intangible assets.

Deferred Tax Asset Valuation Allowance

We recognize deferred tax assets and liabilities based on the differences between the financial statement carrying amount and the tax basis of assets, liabilities and net operating loss carryforwards. We establish valuation allowances when the recovery of a deferred tax asset is not likely based on historical income, projected future income, the expected timing of the reversals of temporary differences and the implementation of tax-planning strategies.

We generated additional deferred tax liabilities related to tax amortization of acquired indefinite lived intangible assets because these assets were not amortized for financial reporting purposes. The tax amortization in current and future years gives rise to a deferred tax liability which will only reverse at the time of ultimate sale or book impairment. Due to the uncertain timing of this reversal, the temporary differences associated with indefinite lived intangibles cannot be considered a source of future taxable income for purposes of determining a valuation allowance. As such, the deferred tax liability cannot be used to offset the deferred tax asset related to the net operating loss carry forward for tax purposes that is generated by the same amortization. This “naked credit” gives rise to the need for additional valuation allowance.

Our gross deferred tax asset balance was $280.3 million at December 31, 2014 and is primarily related to reserves for accounts receivable and inventory, accrued expenses, and net operating loss carryforwards (see Note 15 of the notes to Consolidated Financial Statements included in Part II, Item 8, herein). As of December 31, 2014, we maintained a valuation allowance of $137.5 million due to uncertainties related to our ability to realize certain deferred tax assets. The valuation allowance maintained is primarily related to net operating loss carryforwards and capital loss carryforwards not expected to be realized.

 

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ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We are exposed to certain market risks as part of our ongoing business operations, primarily risks from changing interest rates and foreign currency exchange rates that could impact our financial condition, results of operations, and cash flows.

Interest Rate Risk

Our primary exposure is to changing interest rates. We have historically managed our interest rate risk by including components of both fixed and variable debt in our capital structure. For our fixed rate debt, interest rate changes may affect the market value of the debt, but do not impact our earnings or cash flow. Conversely, for our variable rate debt, interest rate changes generally do not affect the fair market value of the debt, but do impact future earnings and cash flow, assuming other factors are constant. As of December 31, 2014, we have $1,370.0 million of aggregate fixed rate notes and $901.6 million of borrowings under the senior secured credit facilities which bear interest at floating rates based on the Eurodollar rate, as defined therein. A hypothetical 100 basis point increase in variable interest rates for the floating rate borrowings under our senior secured credit facilities would have impacted our earnings and cash flow for the year ended December 31, 2014 by $1.6 million. As of December 31, 2014, our term loans are subject to a 1.00% minimum LIBOR rate which is higher than the actual LIBOR rate of 0.16% as of December 31, 2014. Accordingly, a hypothetical 100 basis point increase in the LIBOR rate during the year ended December 31, 2014 would have increased the rate applicable to our variable debt by only 0.16%. We may use derivative financial instruments where appropriate to manage our interest rate risk. However, as a matter of policy, we do not enter into derivative or other financial investments for trading or speculative purposes.

Foreign Currency Risk

Due to the global reach of our business, we are exposed to market risk from changes in foreign currency exchange rates, particularly with respect to the U.S. dollar compared to the Euro and the Mexican Peso (MXN). Our wholly owned foreign subsidiaries are consolidated into our financial results and are subject to risks typical of an international business including, but not limited to, differing economic conditions, changes in political climate, differing tax structures, other regulations and restrictions and foreign exchange volatility. To date, we have not used international currency derivatives to hedge against our investment in our European subsidiaries or their operating results, which are converted into U.S. Dollars at period-end and average foreign exchange rates, respectively. However, as we continue to expand our business through acquisitions and organic growth, the sales of our products that are denominated in foreign currencies has increased, as well as the costs associated with our foreign subsidiaries which operate in currencies other than the U.S. dollar. Accordingly, our future results could be materially impacted by changes in these or other factors.

For the year ended December 31, 2014, sales denominated in foreign currencies accounted for 24.0% of our consolidated net sales, of which 17.1% were denominated in the Euro. In addition, our exposure to fluctuations in foreign currencies arises because certain of our subsidiaries enter into purchase or sale transactions using a currency other than its functional currency. Accordingly, our future results could be materially impacted by changes in foreign exchange rates or other factors. Occasionally, we seek to reduce the potential impact of currency fluctuations on our business through hedging transactions. During the year ended December 31, 2014, we utilized MXN 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 MXN (see Note 10 of the notes to the audited consolidated financial statements included in Part II, Item 8, herein). As of December 31, 2014, these foreign exchange forward contracts are short term contracts expiring in January 2015.

 

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ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

DJO Finance LLC

Annual Report on Form 10-K

For the year ended December 31, 2014

INDEX TO AUDITED CONSOLIDATED FINANCIAL STATEMENTS

 

     Page No.

Consolidated Financial Statements:

  

Report of Independent Registered Public Accounting Firm

   52

Consolidated Balance Sheets at December 31, 2014 and 2013

   53

Consolidated Statements of Operations for the Years Ended December 31, 2014, 2013 and 2012

   54

Consolidated Statements of Comprehensive Loss for the Years Ended December 31, 2014, 2013 and 2012

   55

Consolidated Statements of (Deficit) Equity for the Years Ended December 31, 2014, 2013 and 2012

   56

Consolidated Statements of Cash Flows for the Years Ended December 31, 2014, 2013 and 2012

   57

Notes to Consolidated Financial Statements

   58

 

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors of DJO Finance LLC

We have audited the accompanying consolidated balance sheets of DJO Finance LLC as of December 31, 2014 and 2013, and the related consolidated statements of operations, comprehensive loss, (deficit) equity and cash flows for each of the three years in the period ended December 31, 2014. Our audits also included the financial statement schedule listed in the Index at Item 15(a). These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were not engaged to perform an audit of the Company’s internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of DJO Finance LLC at December 31, 2014 and 2013 and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2014, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.

 

/s/ ERNST & YOUNG LLP

San Diego, California

February 20, 2015

 

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DJO Finance LLC

Consolidated Balance Sheets

(in thousands)

 

     December 31,  
     2014     2013  
Assets     

Current assets:

    

Cash and cash equivalents

   $ 31,144      $ 43,578   

Accounts receivable, net

     188,060        185,088   

Inventories, net

     175,340        154,983   

Deferred tax assets, net

     24,598        27,527   

Prepaid expenses and other current assets

     17,172        27,951   
  

 

 

   

 

 

 

Total current assets

  436,314      439,127   

Property and equipment, net

  120,107      107,829   

Goodwill

  1,141,188      1,149,331   

Intangible assets, net

  868,031      958,993   

Other assets

  32,853      39,499   
  

 

 

   

 

 

 

Total assets

$ 2,598,493    $ 2,694,779   
  

 

 

   

 

 

 
Liabilities and Deficit

Current liabilities:

Accounts payable

$ 62,960    $ 56,374   

Accrued interest

  29,600      29,682   

Current portion of debt obligations

  8,975      8,620   

Other current liabilities

  99,145      109,472   
  

 

 

   

 

 

 

Total current liabilities

  200,680      204,148   

Long-term debt obligations

  2,261,941      2,251,167   

Deferred tax liabilities, net

  243,123      242,028   

Other long-term liabilities

  14,365      16,718   
  

 

 

   

 

 

 

Total liabilities

$ 2,720,109    $ 2,714,061   
  

 

 

   

 

 

 

Commitments and contingencies

Deficit:

DJO Finance LLC membership deficit:

Member capital

  839,781      838,769   

Accumulated deficit

  (952,412   (861,878

Accumulated other comprehensive (loss) income

  (11,603   1,183   
  

 

 

   

 

 

 

Total membership deficit

  (124,234   (21,926

Noncontrolling interests

  2,618      2,644   
  

 

 

   

 

 

 

Total deficit

  (121,616   (19,282
  

 

 

   

 

 

 

Total liabilities and deficit

$ 2,598,493    $ 2,694,779   
  

 

 

   

 

 

 

See accompanying Notes to Consolidated Financial Statements.

 

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DJO Finance LLC

Consolidated Statements of Operations

(in thousands)

 

     Year ended December 31,  
     2014     2013     2012  

Net sales

   $ 1,229,166      $ 1,175,457      $ 1,129,420   

Costs and operating expenses:

      

Cost of sales (exclusive of amortization of intangible assets of $34,368, $35,125, and $38,355 for the year ended December 31, 2014, 2013 and 2012, respectively)

     495,397        471,665        443,859   

Selling, general and administrative

     499,205        477,990        460,111   

Research and development

     37,742        33,221        27,892   

Amortization of intangible assets

     93,071        95,539        97,243   

Impairment of goodwill

     —         102,000        —      

Impairment of intangible assets

     —         4,600        7,397   
  

 

 

   

 

 

   

 

 

 
  1,125,415      1,185,015      1,036,502   
  

 

 

   

 

 

   

 

 

 

Operating income (loss)

  103,751      (9,558   92,918   

Other (expense) income:

Interest expense, net

  (174,291   (177,542   (182,854

Loss on modification and extinguishment of debt

  (938   (1,059   (36,889

Other (expense) income, net

  (5,194   (1,287   3,553   
  

 

 

   

 

 

   

 

 

 
  (180,423   (179,888   (216,190
  

 

 

   

 

 

   

 

 

 

Loss before income taxes

  (76,672   (189,446   (123,272

Income tax (provision) benefit

  (12,890   (13,116   4,904   
  

 

 

   

 

 

   

 

 

 

Net loss

  (89,562   (202,562   (118,368

Net income attributable to noncontrolling interests

  (972   (890   (782
  

 

 

   

 

 

   

 

 

 

Net loss attributable to DJO Finance LLC

$ (90,534 $ (203,452 $ (119,150
  

 

 

   

 

 

   

 

 

 

See accompanying Notes to Consolidated Financial Statements.

 

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DJO Finance LLC

Consolidated Statements of Comprehensive Loss

(in thousands)

 

     Year Ended December 31,  
     2014     2013     2012  

Net loss

   $ (89,562   $ (202,562   $ (118,368

Other comprehensive (loss) income, net of taxes:

      

Foreign currency translation adjustments, net of tax benefit (provision) of $3,871, $(1,212), and $(1,386) for the year ended December 31, 2014, 2013, and 2012, respectively

     (13,167     19        1,108   
  

 

 

   

 

 

   

 

 

 

Other comprehensive (loss) income

  (13,167   19      1,108   
  

 

 

   

 

 

   

 

 

 

Comprehensive loss

  (102,729   (202,543   (117,260

Comprehensive income attributable to non-controlling interests

  (591   (1,010   (824
  

 

 

   

 

 

   

 

 

 

Comprehensive loss attributable to DJO Finance LLC

$ (103,320 $ (203,553 $ (118,084
  

 

 

   

 

 

   

 

 

 

See accompanying Notes to Consolidated Financial Statements.

 

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DJO Finance LLC

Consolidated Statements of (Deficit) Equity

(in thousands)

 

     DJO Finance LLC     Non-controlling
interests
    Total
(deficit)
equity
 
   Member
capital
    Accumulated
Deficit
    Accumulated
other
comprehensive
income (loss)
    Total
membership
(deficit)
equity
     

Balance at December 31, 2011

   $ 834,871      $ (539,276   $ 218      $ 295,813      $ 2,143      $ 297,956   

Net (loss) income

     —           (119,150     —           (119,150     782        (118,368

Other comprehensive income, net of taxes

     —           —           1,066        1,066        42        1,108   

Investment by parent

     2,000        —           —           2,000        —           2,000   

Stock-based compensation

     2,339        —           —           2,339        —           2,339   

Exercise of stock options

     24        —           —           24        —           24   

Dividend paid by subsidiary to owners of non-controlling interests

     —           —           —           —           (649     (649
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance at December 31, 2012

  839,234      (658,426   1,284      182,092      2,318      184,410   

Net (loss) income

  —         (203,452   —         (203,452   890      (202,562

Other comprehensive (loss) income, net of taxes

  —         —         (101   (101   120      19   

Stock-based compensation

  2,155      —         —         2,155      —         2,155   

Cancellation of vested options

  (2,001   —         —         (2,001   —         (2,001

Exercise of stock options

  (619   —         —         (619   —         (619

Dividend paid by subsidiary to owners of non-controlling interests

  —         —         —         —         (684   (684
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance at December 31, 2013

  838,769      (861,878 $ 1,183    $ (21,926 $ 2,644    $ (19,282

Net (loss) income

  —         (90,534   —         (90,534 )   972      (89,562

Other comprehensive loss, net of taxes

  —         —         (12,786   (12,786   (381   (13,167

Stock-based compensation

  1,869      —         —         1,869      —         1,869   

Exercise of stock options

  (857   —         —         (857   —         (857

Dividend paid by subsidiary to owners of non-controlling interests

  —         —         —         —         (617   (617
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance at December 31, 2014

$ 839,781    $ (952,412 $ (11,603 $ (124,234 $ 2,618    $ (121,616
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

See accompanying Notes to Consolidated Financial Statements.

 

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DJO Finance LLC

Consolidated Statements of Cash Flows

(in thousands)

 

     Year Ended December 31,  
     2014     2013     2012  

Cash Flows From Operating Activities:

      

Net loss

   $ (89,562   $ (202,562   $ (118,368

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

      

Depreciation

     35,739        33,127        30,216   

Amortization of intangible assets

     93,071        95,539        97,243   

Amortization of debt issuance costs and non-cash interest expense

     8,692        8,012        9,732   

Stock-based compensation expense

     1,869        2,155        2,339   

Impairment of goodwill

     —           102,000        —      

Impairment of intangible assets

     —           4,600        7,397   

(Gain) loss on disposal of assets, net

     (843     1,108        1,686   

Deferred income tax provision (benefit)

     6,358        4,738        (11,581

Loss on modification and extinguishment of debt

     938        1,059        36,889   

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

      

Accounts receivable

     (7,271     (17,865     (7,264

Inventories

     (20,531     4,473        (21,937

Prepaid expenses and other assets

     11,064        (8,755     1,313   

Accrued interest

     (81     (1,969     10,723   

Accounts payable and other current liabilities

     7,044        4,120        6,231   
  

 

 

   

 

 

   

 

 

 

Net cash provided by operating activities

  46,487      29,780      44,619   
  

 

 

   

 

 

   

 

 

 

Cash Flows From Investing Activities:

Purchases of property and equipment

  (52,793   (37,484   (32,950

Cash paid in connection with acquisitions, net of cash acquired

  (4,587   (1,953   (29,909

Other investing activities, net

  (1,038   (1,626   (1,106
  

 

 

   

 

 

   

 

 

 

Net cash used in investing activities

  (58,418   (41,063   (63,965
  

 

 

   

 

 

   

 

 

 

Cash Flows From Financing Activities:

Proceeds from issuance of debt

  1,000,294      549,417      1,342,450   

Repayments of debt obligations

  (990,219   (523,037   (1,276,045

Payment of debt issuance, modification and extinguishment costs

  (1,812   (2,387   (55,827

Payment of contingent consideration

  (5,690   —         —      

Investment by parent

  —         —         2,000   

Cash paid in connection with the cancellation of vested options

  (2,001   —         —      

Dividend paid by subsidiary to owners of noncontrolling interests

  (617   (684   (649

Exercise of stock options

  22      —         24   
  

 

 

   

 

 

   

 

 

 

Net cash (used in) provided by financing activities

  (23   23,309      11,953   
  

 

 

   

 

 

   

 

 

 

Effect of exchange rate changes on cash and cash equivalents

  (480   329      447   
  

 

 

   

 

 

   

 

 

 

Net (decrease) increase in cash and cash equivalents

  (12,434   12,355      (6,946

Cash and cash equivalents, beginning of year

  43,578      31,223      38,169   
  

 

 

   

 

 

   

 

 

 

Cash and cash equivalents, end of year

$ 31,144    $ 43,578    $ 31,223   
  

 

 

   

 

 

   

 

 

 

Supplemental disclosures of cash flow information:

Cash paid for interest

$ 165,469    $ 171,361    $ 162,579   

Cash paid for taxes, net

$ 7,442    $ 7,834    $ 4,704   

See accompanying Notes to Consolidated Financial Statements.

 

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Notes to Consolidated Financial Statements

1. ORGANIZATION AND BASIS OF PRESENTATION

Organization and Business

We are a global developer, manufacturer and distributor of medical devices that provide solutions for musculoskeletal health, vascular health and pain management. Our products address the continuum of patient care from injury prevention to rehabilitation after surgery, injury or from degenerative disease, enabling people to regain or maintain their natural motion. Our products are used by orthopedic specialists, spine surgeons, primary care physicians, pain management specialists, physical therapists, podiatrists, chiropractors, athletic trainers and other healthcare professionals. Our product lines include rigid and soft orthopedic bracing, hot and cold therapy, bone growth stimulators, vascular therapy systems and compression garments, therapeutic shoes and inserts, electrical stimulators used for pain management and physical therapy products. Our surgical implant business offers a comprehensive suite of reconstructive joint products for the hip, knee and shoulder.

DJO Finance LLC (DJOFL) is a wholly owned indirect subsidiary of DJO Global, Inc. (DJO). Substantially all business activities of DJO are conducted by DJOFL and its wholly owned subsidiaries. Except as otherwise indicated, references to “us,” “we,” “DJOFL,” “our,” or “the Company,” refers to DJOFL and its consolidated subsidiaries.

Infrequent Events

In September 2013, a fire occurred at our factory in Tunisia. As a result of the fire, certain inventory and fixed assets were destroyed and the leased facility became inoperable. Estimated losses of $5.0 million related to destroyed inventory and fixed assets, excess expenses incurred and building reconstruction costs were recorded for the year ended December 31, 2013. Additionally, we recorded $1.3 million in revenue from business interruption insurance proceeds for the year ended December 31, 2013. Final claims were settled against the policies in September 2014. As a result, estimated losses were adjusted to $3.3 million, and additional $2.3 million in revenue from business interruption insurance proceeds was recorded for the year ended December 31, 2014. The activity in the corresponding insurance receivable was follows (in thousands):

 

     Year Ended  
     December 31, 2014  

Balance, beginning of period

   $ 6,261   

Change in estimated losses

     (1,617

Business interruption

     2,274   

Claim payments

     (6,918
  

 

 

 

Balance, end of period

   $ —     
  

 

 

 

Segment Reporting

We market and distribute our products through four operating segments, Bracing and Vascular, Recovery Sciences, Surgical Implant, and International. Our Bracing and Vascular, Recovery Sciences, and Surgical Implant segments generate their revenues within the United States. Our Bracing and Vascular segment offers rigid knee braces, orthopedic soft goods, cold therapy products, vascular systems, compression therapy products and therapeutic footwear for the diabetes care market. Our Recovery Sciences segment offers home electrotherapy, iontophoresis, home traction products, bone growth stimulation products and clinical physical therapy equipment. Our Surgical Implant segment offers a comprehensive suite of reconstructive joint products for the knee, hip and shoulder. Our International segment offers all of our products to customers outside the United States. See Note 18 for additional information about our reportable segments.

Use of Estimates

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.

 

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Basis of Presentation

We consolidate the results of operations of our 50% owned subsidiary, Medireha GmbH (Medireha), and reflect the 50% share of results not owned by us as noncontrolling interests in our Consolidated Statements of Operations. We maintain control of Medireha through certain rights that enable us to prohibit certain business activities that are not consistent with our plans for the business and provide us with exclusive distribution rights for products manufactured by Medireha.

2. SIGNIFICANT ACCOUNTING POLICIES

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 remaining maturities of less than three months at the time of purchase to be cash equivalents. While our cash and cash equivalents are on deposit with high-quality institutions, such deposits exceed Federal Deposit Insurance Corporation insured limits.

Allowance for Doubtful Accounts. We make estimates of the collectibility of accounts receivable. Management analyzes accounts receivable historical collection rates and bad debts write-offs, customer concentrations, customer credit-worthiness and current economic trends when evaluating the adequacy of the allowance for doubtful accounts.

Sales Returns and Allowances. We make estimates of the amount of sales returns and allowances that will eventually be incurred. Management analyzes sales programs that are in effect, contractual arrangements, market acceptance and historical trends when evaluating the adequacy of sales returns and allowance accounts. We estimate contractual discounts and allowances for reimbursement amounts from our third party payor customers based on negotiated contracts and historical experience.

Inventories. We state our inventories at the lower of cost or market. We use standard cost methodology to determine cost basis for our inventories. This methodology approximates actual cost on a first-in, first-out basis. We establish reserves for slow moving and excess inventory, product obsolescence, shrinkage and other valuation impairments based on future demand and historical experience.

Property and Equipment. Property and equipment are stated at cost less accumulated depreciation and amortization. Depreciation is calculated using the straight-line method over the estimated useful lives of the assets that range from three to 25 years. Leasehold improvements and equipment under capital leases are amortized on a straight-line basis over the shorter of the lease term or estimated useful life of the asset. We capitalize surgical implant instruments that we provide to surgeons, free of charge, for use while implanting our products and the related depreciation expense is recorded as a component of Selling, general and administrative expense. We also capitalize electrotherapy devices that we rent to patients and record the related depreciation expense in cost of sales.

Software Developed For Internal Use. Software is stated at cost less accumulated amortization and is amortized on a straight-line basis over estimated useful lives ranging from three to ten years. 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. Software assets are reviewed for impairment when events or circumstances indicate that the carrying value may not be recoverable. Upgrades and enhancements are capitalized if they result in added functionality. Amortization expense related to internally developed software was $2.0 million, $1.9 million and $1.9 million for the years ended December 31, 2014, 2013 and 2012, respectively.

As of December 31, 2014 and 2013, we had $8.5 million and $10.5 million respectively, of unamortized internally developed software costs included within property and equipment in our Consolidated Balance Sheets.

Intangible Assets. Our primary intangible assets are goodwill, customer relationships, patents and technology and trademarks and trade names. Goodwill represents the excess purchase price over the fair value of the identifiable net assets acquired in business combinations. Goodwill and intangible assets with indefinite useful lives are not amortized, but instead are tested for impairment at least annually. Intangible assets with definite lives are amortized over their respective estimated useful lives and reviewed for impairment when circumstances warrant.

We evaluate the carrying value of goodwill and indefinite life intangible assets annually on the first day of the fourth quarter or whenever events or circumstances indicate the carrying value may not be recoverable. We evaluate the carrying value of finite life intangible assets whenever events or circumstances indicate the carrying value may not be recoverable. Significant assumptions are required to estimate the fair value of goodwill and intangible assets, most notably estimated future cash flows generated by these assets. As such, these fair valuation measurements use significant unobservable inputs, which are inputs that are classified as Level 3 in the fair value hierarchy. Changes to these assumptions could require us to record impairment charges on these assets.

Warranty Costs. We provide expressed warranties on certain products for periods typically ranging from one to three years. We estimate our warranty obligations at the time of sale based upon historical experience and known product issues, if any.

 

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A summary of the activity in our warranty reserves is as follows (in thousands):

 

     Year Ended December 31,  
     2014     2013     2012  

Balance, beginning of year

   $ 1,847      $ 1,488      $ 1,756   

Amount charged to expense for estimated warranty costs

     1,788        1,138        338   

Deductions for actual costs incurred

     (1,693     (779     (606
  

 

 

   

 

 

   

 

 

 

Balance, end of year

   $ 1,942      $ 1,847      $ 1,488   
  

 

 

   

 

 

   

 

 

 

Self Insurance. We are partially self-insured for certain employee health benefits and product liability claims. Accruals for losses are provided based upon claims experience and actuarial assumptions, including provisions for incurred but not reported losses.

Revenue Recognition. We recognize revenue when all four of the following criteria are met: (i) persuasive evidence that an arrangement exists; (ii) shipment of goods and passage of title occurs; (iii) the selling price is fixed or determinable; and (iv) collectibility is reasonably assured.

We sell our products through a variety of distribution channels. We generally recognize revenue when we ship our products to our customers. We include amounts billed to customers for freight in revenue. We recognize revenue, both rental and purchase, for products sold directly to patients or their third party insurance payors, when our product has been dispensed or shipped to the patient and the patient’s insurance has been verified.

We record revenues from sales or our surgical implant products when the products are used in a surgical procedure (implanted in a patient).

We reduce revenue by estimates of potential future product returns and other allowances. Revenues are also reduced by rebates related to sales transacted through distribution agreements that provide the distributors with a right to return inventory or take certain pricing adjustments based on sales mix or volume. Provisions for product returns and other allowances are recorded as a reduction to revenue in the period sales are recognized.

Advertising Costs. We expense advertising costs as they are incurred. For the years ended December 31, 2014, 2013 and 2012, advertising costs were $4.7 million, $6.4 million and $6.5 million, respectively. In 2013 we revised our definition of advertising costs to exclude certain other marketing and promotion costs. The amounts for the year ended December 31, 2012 have been revised to conform to the current definition.

Shipping and Handling Expenses. Shipping and handling expenses are included within cost of sales in our Consolidated Statements of Operations.

Stock Based Compensation. We maintain a stock option plan under which stock options of our indirect parent, DJO, have been granted to both employees and non-employees. All share based payments to employees are recognized in the financial statements based on their grant date fair values and our estimates of forfeitures. We amortize stock-based compensation for service-based awards granted on a straight-line basis over the requisite service (vesting) period for the entire award. Other awards vest upon the achievement of certain pre-determined performance targets, and compensation expense is recognized to the extent the achievement of the performance targets is deemed probable.

 

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Income Taxes. Income taxes are accounted for under the asset and liability method, whereby deferred tax assets and liabilities are recognized and measured using enacted tax rates in effect for each taxing jurisdiction in which we operate for the year in which those temporary differences are expected to be recognized. Net deferred tax assets are then reduced by a valuation allowance if we believe it more-likely-than-not such net deferred tax assets will not be realized.

Foreign Currency Translation and Transactions. The reporting currency of DJOFL is the U.S. Dollar. Assets and liabilities of foreign subsidiaries (including intercompany balances for which settlement is not anticipated in the foreseeable future) are translated at the spot rate in effect at the applicable reporting date, and our Consolidated Statement of Operations is translated at the average exchange rates in effect during the applicable period. The resulting unrealized cumulative translation adjustment, net of applicable income taxes, is recorded as a component of other comprehensive income (loss) in our Consolidated Statement of Comprehensive Loss. Cash flows from our operations in foreign countries are translated at the average rate for the applicable period. The effect of exchange rates on cash balances held in foreign currencies are separately reported in our Consolidated Statements of Cash Flows.

Transactions denominated in currencies other than our or our subsidiaries’ functional currencies are recorded based on exchange rates at the time such transactions arise. Changes in exchange rates with respect to amounts recorded in our Consolidated Balance Sheets related to such transactions result in transaction gains and losses that are reflected in our Consolidated Statements of Operations as either unrealized (based on the applicable period end translation) or realized (upon settlement of the transactions). For the years ended December 31, 2014, 2013 and 2012, foreign transaction (losses) gains were $(5.3) million, $(1.5) million and $3.6 million, respectively.

Derivative Financial Instruments. All derivative instruments are recognized in the financial statements and measured at fair value regardless of the purpose or intent for holding them.

We use foreign exchange forward contracts to hedge expense commitments that are denominated in currencies other than the U.S. dollar. The purpose of our foreign currency hedging activities is to fix the dollar value of specific commitments and payments to foreign vendors. Before acquiring a derivative instrument to hedge a specific risk, potential natural hedges are evaluated. While our foreign exchange contracts act as economic hedges, we have not designated such instruments as hedges for accounting purposes. Therefore, gains and losses resulting from changes in the fair values of these derivative instruments are recorded in other income (expense), net, in our Consolidated Statements of Operations.

The fair value of our derivative instruments has been determined through the use of models that consider various assumptions, including time value and other relevant economic measures, which are inputs that are classified as Level 2 in the fair value hierarchy (see Notes 10 and 11).

Comprehensive Income (Loss). Comprehensive income (loss) includes net income (loss) as per our Consolidated Statement of Operations and other comprehensive income (loss). Other comprehensive income (loss), which is comprised of unrealized gains and losses on foreign currency translation adjustments, net of tax, is included in our Consolidated Statement of Comprehensive Loss.

Concentration of Credit Risk. We sell the majority of our products in the United States to orthopedic professionals, hospitals, distributors, specialty dealers, insurance companies, managed care companies and certain governmental payors such as Medicare. International sales comprised 26.5%, 25.5% and 24.8% of our net sales for the years ended December 31, 2014, 2013 and 2012, respectively. International sales are generated from a diverse group of customers through our wholly owned subsidiaries and certain independent distributors. Credit is extended based on an evaluation of the customer’s financial condition and generally collateral is not required. We provide a reserve for estimated bad debts. Management reviews and revises its estimates for credit losses from time to time and such credit losses have generally been within management’s estimates. In each of the years ended December 31, 2014, 2013 and 2012, we had no individual customer or distributor that accounted for 10% or more of our total annual net sales.

Fair Value of Financial Instruments. The carrying amounts of our short-term financial instruments, including cash and cash equivalents, accounts receivable and accounts payable, approximate fair values due to their short-term nature. See Note 12 for information concerning the fair value of our variable and fixed rate debt.

Recent Accounting Standards. In July 2013, the Financial Accounting Standards Board (the “FASB”) issued an accounting standard update regarding the financial statement presentation of an unrecognized tax benefit when a net operating loss carryforward, a similar tax loss, or a tax credit carryforward exists. The guidance is effective prospectively for fiscal years, and interim periods within those years, beginning after December 15, 2013, with an option for early adoption. The adoption of this standard did not have an impact on the Company’s consolidated financial statements.

In April 2014, the FASB issued accounting standards update, which includes amendments that change the requirements for reporting discontinued operations and require additional disclosures about discontinued operations. Under the new guidance, only disposals representing a strategic shift in operations—that is, a major effect on the organization’s operations and financial results

 

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should be presented as discontinued operations. Examples include a disposal of a major geographic area, a major line of business, or a major equity method investment. Additionally, the update requires expanded disclosures about discontinued operations that will provide financial statement users with more information about the assets, liabilities, income, and expenses of discontinued operations. The guidance is effective prospectively for fiscal years beginning after December 15, 2014 and interim periods within annual periods beginning on or after December 15, 2015. The adoption of this standard has the potential to impact the Company’s accounting for and disclosure of any future discontinued operations.

In May 2014, the FASB issued an accounting standards update related to revenue from contracts with customers. The new standard provides a five-step approach to be applied to all contracts with customers. The accounting standards update also requires expanded disclosures about revenue recognition. The guidance is effective for fiscal years beginning after December 15, 2016 and interim periods within that reporting period. Early adoption is not permitted. The Company is currently evaluating the new guidance to determine the impact it may have to its consolidated financial statements.

In June 2014, the FASB issued an accounting standards update related accounting for share-based payments. The standard requires that a performance target that affects vesting and that could be achieved after the requisite service period be treated as a performance condition. The guidance is effective for annual periods and interim periods within those annual periods, beginning after December 15, 2015. Early application is permitted. Adoption of this new guidance is not expected to have a material effect on the Company’s financial statements.

In August 2014, the FASB issued an accounting standards update related to going concern disclosures. The standard requires an entity’s management to evaluate whether there are conditions or events that raise substantial doubt about the entity’s ability to continue as a going concern within one year after the date that the financial statements are issued. The guidance is effective for annual reporting periods ending after December 15, 2016, and interim periods thereafter. Early application is permitted. Adoption of this new guidance is not expected to have a material effect on the Company’s financial statements.

3. ACQUISITIONS

On January 23, 2014, we acquired all of the outstanding shares of capital stock of Speetec Implantate GmbH (“Speetec”). Speetec is a distributor and manufacturer of knee, hip and shoulder arthroplasty products in Germany. The purchase price consisted of a cash payment at closing of $5.0 million, a holdback of $1.3 million for potential indemnity claims and $1.6 million for the fair value of contingent consideration. The fair value of contingent consideration equals approximately 25% of the total potential contingent consideration of $7.3 million. The valuation was based on the probability weighted average estimate of achievement of revenue targets for 2014 and 2015.

The indemnity holdback accrues interest at the Euribor rate plus 100 basis points and is 50% payable in March 2015 and March 2016, respectively, if not used for indemnification claims. The contingent consideration is 50% payable in March 2015 and March 2016, respectively, if earned.

On July 1, 2013 we acquired certain assets of Blue Leaf Medical CC, (“Blue Leaf”) for a total purchase price of $0.6 million. The assets acquired relate to certain vascular product lines in South Africa, Namibia, Botswana, Mozambique and Zambia. The purchase price consisted of a cash payment at closing of $0.4 million, $0.1 million for the purchase of inventory on hand at closing and $0.1 million which was held back to provide security for potential indemnification claims. The hold back payment was paid to the sellers in September 2014.

On March 7, 2013 we acquired certain assets of Vasyli Medical Asia/Pacific Pty Ltd, (“Vasyli”) for a total purchase price of $2.2 million. The assets acquired relate to the distribution of certain vascular product lines in Australia and New Zealand. The purchase price consisted of a cash payment at closing of $1.3 million, $0.5 million for the purchase of inventory on hand at closing and $0.4 million which was held back to provide security for potential indemnification claims. The hold back payment was paid to the sellers in March 2014. Additionally, there was $0.3 million of contingent consideration payable one year from the acquisition date if certain revenue targets were met by December 31, 2013; however, these targets were not achieved and therefore no payment was made.

Our primary reason for the acquisitions was to move from an indirect sales model (i.e., sales to distributors at a discount) to a direct sales model, resulting in increased gross profit and operating income. All goodwill associated with these acquisitions is allocated to our International reporting segment.

 

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On December 28, 2012, we acquired all of the outstanding shares of capital stock of Exos Corporation (Exos) for a total purchase price of $40.6 million. The purchase price consisted of a cash payment of $31.2 million, settlement of the existing distributor agreement with Exos at a fair value of $1.2 million and $8.2 million for the fair value of contingent consideration. Of the initial cash payment, $3.0 million was withheld from the closing date payment and was paid to a third party escrow agent to secure the indemnity obligations of the seller. The $10.0 million contingent consideration was initially measured at a fair value of $8.2 million based on the probability weighted estimate of approximately 95% for the achievement of certain specified milestones and the budgeted 2013 Exos product line revenues.

Exos is a medical device company focused on thermoformable external musculoskeletal stabilization systems for the treatment of fractures and other injuries requiring stabilization. All goodwill arising from the Exos acquisition was allocated to our Bracing and Vascular reporting segment. In connection with the acquisition of Exos, we incurred $1.3 million of direct acquisition costs comprised of $0.5 million of legal and other professional fees and $0.8 million of transaction and advisory fees to Blackstone Advisory Partners L.P., and Blackstone Management Partners LLC, affiliates of our major shareholder (see Note 17). These costs are included in Selling, general and administrative expense in our Consolidated Statement of Operations. The acquisition was partially funded using proceeds from $25.0 million of new term loans issued on December 28, 2012 (see Note 12).

The purchase price for each of these acquisitions was allocated to the fair values of the net tangible and intangible assets acquired as follows (in thousands):

 

(in thousands):

   Speetec      Blue Leaf      Vasyli      Exos  

Cash

   $ 489      $ —        $ —        $ 1,282   

Accounts receivable

     608        —          —          1,138   

Inventory

     2,766         59         542         1,754   

Other current assets

     154        —          31         105   

Property and equipment

     379        —          12         584   

Other non-current assets

     —          —          —          12   

Liabilities assumed

     (1,642 )      —          —          (474

Deferred tax liabilities

     (1,003 )      —          —          (9,137

Identifiable intangible assets (1):

           

Customer relationships

     2,861         90         308         —    

Technology

     —          —          —          24,200   

Non-compete

     569         111         930         1,900   

Trademarks and trade names

     320        —          —          1,000   

Goodwill (2)

     2,383         322         363         18,211   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total purchase price

$ 7,884    $ 582    $ 2,186    $ 40,575   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

(1) The fair value of customer relationships was assigned to relationships with major customers existing on the acquisition date based upon an estimate of the future discounted cash flows that would be derived from those customers, after deducting contributory asset charges.

The fair value of technology was determined primarily by estimating the present value of future royalty costs that will be avoided due to our ownership of the patents and technology acquired.

The fair value of non-compete agreements relate to non-compete agreements entered into with certain members of senior management. The values were determined by estimating the present value of the cash flows associated with having these agreements in place, less the present value of the cash flows assuming the non-compete agreements were not in place.

The fair value of trademarks and trade names was determined primarily by estimating the present value of future royalty costs that will be avoided due to our ownership of the trade names and trademarks acquired.

The useful lives of the intangible assets acquired were estimated based on the underlying agreements and/or the future economic benefit expected to be received from the assets.

 

(2) Goodwill represents the excess purchase price over the fair value of the identifiable net assets acquired. Among the factors which resulted in the recognition of goodwill for the Speetec acquisition was the opportunity to expand our direct presences in the German market with our surgical products. Among the factors which resulted in the recognition of goodwill for the Blue Leaf and Vasyli assets was the opportunity to expand our direct presence in the local markets with our vascular products. Among the factors which resulted in the recognition of goodwill for Exos was improved our margins on the sale of Exos products and being able to control the rights to future products developed by Exos.

 

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4. ACCOUNTS RECEIVABLE RESERVES

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

 

     Year Ended December 31,  
     2014     2013     2012  

Balance, beginning of year

   $ 32,957      $ 25,211      $ 35,649   

Provision for doubtful accounts

     40,164        33,129        19,586   

Write-offs, net of recoveries

     (31,719     (25,383     (30,024
  

 

 

   

 

 

   

 

 

 

Balance, end of year

   $ 41,402      $ 32,957      $ 25,211   
  

 

 

   

 

 

   

 

 

 

Our allowance for sales returns balance was $3.6 million $3.9 million, and $4.0 million as of December 31, 2014, 2013 and 2012, respectively.

5. INVENTORIES

Inventories consist of the following (in thousands):

 

     December 31,2014     December 31,2013  

Components and raw materials

   $ 59,578      $ 59,825   

Work in process

     5,718        7,373   

Finished goods

     103,042        83,502   

Inventory held on consignment

     30,978        27,969   
  

 

 

   

 

 

 
     199,316        178,669   

Inventory reserves

     (23,976     (23,686
  

 

 

   

 

 

 
   $ 175,340      $ 154,983   
  

 

 

   

 

 

 

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

 

     Year Ended December 31,  
     2014     2013     2012  

Balance, beginning of year

   $ 23,686      $ 17,313      $ 14,146   

Provision charged to costs of sales

     8,924        10,121        6,350   

Write-offs, net of recoveries

     (8,634     (3,748     (3,183
  

 

 

   

 

 

   

 

 

 

Balance, end of year

   $ 23,976      $ 23,686      $ 17,313   
  

 

 

   

 

 

   

 

 

 

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

 

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6. PROPERTY AND EQUIPMENT, NET

Property and equipment consists of the following (in thousands):

 

     December 31,
2014
    December 31,
2013
    Depreciable lives
(years)

Land

   $ 266      $ 266      Indefinite

Buildings and improvements

     28,967        27,229      3 to 25

Equipment

     137,468        132,688      2 to 7

Software

     38,627        33,817      3 to 10

Furniture and fixtures

     12,618        12,223      3 to 8

Surgical implant instrumentation

     78,275        55,841      5

Construction in progress

     12,027        7,919      N/A
  

 

 

   

 

 

   
     308,248        269,983     

Accumulated depreciation and amortization

     (188,141     (162,154  
  

 

 

   

 

 

   

Property and equipment, net

   $ 120,107      $ 107,829     
  

 

 

   

 

 

   

Depreciation and amortization expense relating to property and equipment was $35.7 million, $33.1 million and $30.2 million for the years ended December 31, 2014, 2013 and 2012, respectively.

7. LONG-LIVED ASSETS

Goodwill

Changes in the carrying amount of goodwill for the year ended December 31, 2014 are presented in the table below (in thousands):

 

     Bracing &
Vascular
     Recovery
Sciences
    Surgical
Implant
    International     Total  

Balance, beginning of period

           

Goodwill

   $ 483,258       $ 495,999      $ 47,406      $ 348,774      $ 1,375,437   

Accumulated impairment losses

     —           (178,700     (47,406     —          (226,106
  

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 
     483,258         317,299        —          348,774        1,149,331   

Acquisitions (see Note 3)

     —           —          —          2,383        2,383   

Foreign currency translation

     —           —          —          (10,526     (10,526

Balance, end of period

           

Goodwill

     483,258         495,999        47,406        340,631        1,367,294   

Accumulated impairment losses

     —           (178,700     (47,406     —          (226,106
  

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 
   $ 483,258       $ 317,299      $ —        $ 340,631      $ 1,141,188   
  

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

In performing our 2014 goodwill impairment test, we estimated the fair values of our reporting units using the income approach which includes the discounted cash flow method and the market approach which includes the use of market multiples. These fair value measurements are categorized within Level 3 of the fair value hierarchy. The discounted cash flows for each reporting unit were based on discrete financial forecasts developed by management for planning purposes, and required significant judgment with respect to forecasted sales, gross margin, selling, general and administrative expenses, depreciation, income taxes, capital expenditures, working capital requirements and the selection and use of an appropriate discount rate. For purposes of calculating the discounted cash flows of our reporting units, we used estimated revenue growth rates averaging between 1% and 6% for the discrete forecast period. Cash flows beyond the discrete forecasts were estimated using a terminal value calculation, which incorporated historical and forecasted financial trends for each identified reporting unit and considered long-term earnings growth rates for publicly traded peer companies. Future cash flows were then discounted to present value at discount rates ranging from 9.6% to 11.3%, and terminal value growth rates ranging from 1.4% to 3.0%. Publicly available information regarding comparable market capitalization was also considered in assessing the reasonableness of the cumulative fair values of our reporting units estimated using the discounted cash flow methodology. We determined that the fair value of the six reporting units with goodwill assigned to them exceeds their carrying value and no reporting unit was at risk of failing the test. The percentage by which the fair value of the six reporting units exceeded their carrying value ranged from 30.9% to 126.1%. As such, we determined that the goodwill of our reporting units was not impaired.

 

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In the fourth quarter of 2013, we determined that the carrying values of our Empi and Chattanooga reporting units were in excess of their estimated fair values. As a result, we recorded goodwill impairment charges for the Empi and Chattanooga reporting units of $52.5 million and $49.5 million, respectively. The impairment charges were included in Impairment of goodwill and intangible assets in our Consolidated Statement of Operations. The goodwill impairment in our Empi reporting unit resulted primarily from reductions in our projected operating results due to unfavorable decisions made by certain third party payors related to insurance pricing for certain products sold by the Empi reporting unit. The goodwill impairment in the Chattanooga reporting unit resulted primarily from reductions in our projected operating results and estimated future cash flows due to slow market conditions for capital equipment.

Intangible Assets

Identifiable intangible assets consisted of the following (in thousands):

 

December 31, 2014

   Gross Carrying
Amount
     Accumulated
Amortization
    Intangible
Assets, Net
 

Definite-lived intangible assets:

       

Customer relationships

   $ 569,360       $ (341,353   $ 228,007   

Patents and technology

     486,466         (264,132     222,334   

Trademarks and trade names

     25,970         (9,902     16,068   

Distributor contracts and relationships

     4,771         (3,401     1,370   

Non-compete agreements

     6,824         (4,723     2,101   
  

 

 

    

 

 

   

 

 

 
   $ 1,093,391       $ (623,511     469,880   
  

 

 

    

 

 

   

Indefinite-lived intangible assets:

       

Trademarks and trade names

          398,151   
       

 

 

 

Net identifiable intangible assets

        $ 868,031   
       

 

 

 

 

December 31, 2013

   Gross Carrying
Amount
     Accumulated
Amortization
    Intangible
Assets, Net
 

Definite-lived intangible assets:

       

Customer relationships

   $ 570,070       $ (290,359   $ 279,711   

Patents and technology

     486,246         (230,111     256,135   

Trademarks and trade names

     25,820         (7,102     18,718   

Distributor contracts and relationships

     5,054         (3,183     1,871   

Non-compete agreements

     6,423         (3,149     3,274   
  

 

 

    

 

 

   

 

 

 
   $ 1,093,613       $ (533,904     559,709   
  

 

 

    

 

 

   

Indefinite-lived intangible assets:

       

Trademarks and trade names

          399,284   
       

 

 

 

Net identifiable intangible assets

        $ 958,993   
       

 

 

 

In the fourth quarter of 2014 we tested our indefinite lived trade name intangible assets for impairment. This test work compares the fair value of the asset with its carrying amount. To determine the fair value we applied the relief from royalty (RFR) method. Under the RFR method, the value of the trade name is determined by calculating the present value of the after-tax cost savings associated with owning the asset and therefore not being required to pay royalties for its use during the asset’s indefinite life. Significant judgments inherent in this analysis include the selection of appropriate discount rates, estimating future cash flows and the identification of appropriate terminal growth rate assumptions. Discount rate assumptions are based on an assessment of the risk inherent in the projected future cash generated by the respective intangible assets. Future cash flows were discounted to present value at discount rates ranging from 9.6% to 11.3%, and terminal value growth rates ranging from 1.4% to 3.0%. Also subject to judgment are assumptions about royalty rates, which are based on the estimated rates at which similar brands and trademarks are being licensed in the marketplace. We used market average royalty rates ranging from 0.5% to 5.0%. These fair value measurements are categorized within Level 3 of the fair value hierarchy. We determined that that the fair value of these trade names exceed their carrying value. The percentage by which the fair value of these trade names exceeded their carrying value ranged from 10.5% to 89.6%. As such, we determined that these indefinite lived intangible assets are not impaired. This fair value measurement is categorized within Level 3 of the fair value hierarchy.

 

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In the fourth quarter of 2013 we determined that the carrying value of our Empi trade name was in excess of its estimated fair value, and recorded an impairment charge of $4.5 million. The impairment charge was included in Impairment of goodwill and intangible assets line item in the Consolidated Statement of Operations.

Our definite lived intangible assets are being amortized using the straight line method over their remaining weighted average useful lives of 5.1 years for customer relationships, 8.3 years for patents and technology, 2.7 years for distributor contracts and relationships, 6.2 years for trademarks and trade names, and 2.2 years for non-compete agreements. Based on our amortizable intangible asset balance as of December 31, 2014, we estimate that amortization expense will be as follows for the next five years and thereafter (in thousands):

 

2015

$ 88,405   

2016

  83,874   

2017

  72,712   

2018

  62,552   

2019

  51,742   

Thereafter

  110,595   
  

 

 

 
$ 469,880   
  

 

 

 

Our goodwill and intangible assets by segment are as follows (in thousands):

 

December 31, 2014

   Goodwill      Intangible
Assets, Net
 

Bracing and Vascular

   $ 483,258       $ 487,122   

Recovery Sciences

     317,299         218,260   

International

     340,631         150,128   

Surgical Implant

     —           12,521   
  

 

 

    

 

 

 
$ 1,141,188    $ 868,031   
  

 

 

    

 

 

 

 

December 31, 2013

   Goodwill      Intangible
Assets, Net
 

Bracing and Vascular

   $ 483,258       $ 527,806   

Recovery Sciences

     317,299         250,725   

International

     348,774         165,569   

Surgical Implant

     —          14,893   
  

 

 

    

 

 

 
$ 1,149,331    $ 958,993   
  

 

 

    

 

 

 

 

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8. OTHER CURRENT LIABILITIES

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

 

     December 31,
2014
     December 31,
2013
 

Accrued wages and related expenses

   $ 32,220       $ 33,128   

Accrued commissions

     16,611         16,489   

Accrued rebates

     12,981         10,731   

Accrued other taxes

     4,987         4,734   

Accrued professional expenses

     2,682         3,372   

Income taxes payable

     2,477         2,877   

Deferred tax liability

     343         445   

Other accrued liabilities

     26,844         37,696   
  

 

 

    

 

 

 
$ 99,145    $ 109,472   
  

 

 

    

 

 

 

9. EMPLOYEE BENEFIT PLANS

We have multiple qualified defined contribution plans, which allow for voluntary pre-tax contributions by employees. We pay all general and administrative expenses of the plans and make matching and may make certain discretionary contributions to the plans. Based on 100% of the first 1% and 50% of the next 5% of compensation deferred by employees (subject to IRS limits and non-discrimination testing), we made matching contributions of $4.1 million, $4.2 million and $4.0 million, to the plans for the years ended December 31, 2014, 2013 and 2012, respectively. The plans provide for discretionary contributions by us, as approved by the Board of Directors. There have been no such discretionary contributions through December 31, 2014. In addition, we made contributions to our international pension plans of $1.7 million, $1.1 million and $1.3 million for the years ended December 31, 2014, 2013 and 2012, respectively.

10. DERIVATIVE INSTRUMENTS

From time to time, 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 fair value 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 foreign exchange contracts have not been designated as hedges, and accordingly, changes in the fair value of the derivatives are recorded in income (loss).

Foreign Exchange Rate Contracts. We utilize Mexican Peso (MXN) 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 MXN. Foreign exchange forward contracts held as of December 31, 2014 are short term contracts expiring in January 2015. 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 (expense), net, in our accompanying Consolidated Statements of Operations.

Information regarding the notional amounts of our foreign exchange forward contracts is presented in the table below (in thousands):

 

     Notional Amount (MXN)      Notional Amount (USD)  
     December 31,
2014
     December 31,
2013
     December 31,
2014
     December 31,
2013
 

Foreign exchange contracts not designated as hedges

     7,682         302,730       $ 526       $ 22,959   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

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The following table summarizes the fair value of derivative instruments in our Consolidated Balance Sheets (in thousands):

 

    

Balance Sheet Location

   December 31,
2014
     December 31,
2013
 

Derivative Liabilities:

        

Foreign exchange forward contracts not designated as hedges

   Other current liabilities    $ 4       $ 44   
     

 

 

    

 

 

 

The following table summarizes the effect our derivative instruments have on our Consolidated Statements of Operations (in thousands):

 

          Year Ended December 31,  
    

Location of gain (loss)

   2014      2013      2012  

Foreign exchange forward contracts not designated as hedges

   Other income (expense), net    $ 40         (821      1,322   
     

 

 

    

 

 

    

 

 

 
$ 40    $ (821 $ 1,322   
     

 

 

    

 

 

    

 

 

 

11. 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.

During the year ended December 31, 2014, we remeasured the fair value of contingent consideration related to our January 2014 acquisition of Speetec. We initially valued the contingent consideration at $1.6 million which equaled approximately 25% of the total potential contingent consideration of $7.3 million. The valuation was based on the probability weighted average estimate of achievement of revenue targets for 2014 and 2015. The fair value of the expected payment was then calculated using a 9.9% discount rate as the contingent consideration is 50% payable in March 2015 and March 2016, respectively, if earned. Our remeasurement of the fair value based on the probability of achieving the Speetec revenue targets and the discounted present value of the current estimate of the future contingent payments reduced the net fair value of the contingent consideration to zero. This fair value measurement is categorized within Level 3 of the fair value hierarchy.

During the year ended December 31, 2013, we remeasured the fair value of the contingent consideration related to our December 2012 acquisition of Exos Corporation. We initially valued the contingent consideration at $8.2 million based on the probability weighted estimate of approximately 95% for the achievement of certain specified milestones and the budgeted 2013 Exos product line revenues. Our remeasurement of the fair value based on the probability of achieving the budgeted Exos revenue and certain specified milestones and the discounted present value of the current estimate of the future contingent payment resulted in a reduction of $2.5 million to the net fair value of the contingent consideration. This fair value measurement is categorized within Level 3 of the fair value hierarchy. The $5.7 million of contingent consideration was paid to Exos Corporation in April 2014.

The following tables present the balances of financial assets and liabilities measured at fair value on a recurring basis (in thousands):

 

As of December 31, 2014

   Quoted Prices
in Active
Markets for
Identical Assets
(Level 1)
     Significant
Other
Observable

Inputs
(Level 2)
     Significant
Unobservable
Inputs
(Level 3)
     Recorded
Balance
 

Liabilities:

           

Foreign exchange forward contracts not designated as hedges

   $ —         $ 4       $ —        $ 4   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

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As of December 31, 2013

   Quoted Prices
in Active
Markets for
Identical Assets
(Level 1)
     Significant
Other
Observable
Inputs
(Level 2)
     Significant
Unobservable
Inputs
(Level 3)
     Recorded
Balance
 

Liabilities:

           

Foreign exchange forward contracts not designated as hedges

   $ —        $ 44       $ —        $ 44   
  

 

 

    

 

 

    

 

 

    

 

 

 

Contingent consideration

   $ —        $ —        $ 5,690       $ 5,690   
  

 

 

    

 

 

    

 

 

    

 

 

 

The table below presents reconciliation of all financial assets and liabilities measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the year ended December 31, 2014 (in thousands):

 

     Year Ended  
     December 31, 2014  

Balance, beginning of period

   $ 5,690   

Acquisitions

     1,627   

Payment of contingent consideration

     (5,690

Adjustment of contingent consideration included in SG&A

     (1,482

Foreign currency translation

     (145
  

 

 

 

Balance, end of period

   $ —     
  

 

 

 

 

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12. DEBT

Debt obligations consist of the following (in thousands):

 

     December 31,
2014
    December 31,
2013
 

Senior secured credit facilities:

    

Revolving credit facility

   $ 17,000      $ 38,000   

Term Loan:

    

$884.6 million New Tranche B term loans, net of unamortized original issuance discount of $5.1 million as of December 31, 2014

     879,476        —     

$853.4 million Tranche B term loans, net of unamortized original issuance discount of $7.1 million as of December 31, 2013

     —          846,297   

8.75% Second priority senior secured notes, including unamortized original issue premium of $4.4 million and $5.5 million as of December 31, 2014 and December 31, 2013, respectively

     334,377        335,490   

9.875% Senior unsecured notes

     440,000        440,000   

7.75% Senior unsecured notes

     300,000        300,000   

9.75% Senior subordinated notes

     300,000        300,000   

Other

     63        —     
  

 

 

   

 

 

 

Total debt

     2,270,916        2,259,787   

Current maturities

     (8,975     (8,620
  

 

 

   

 

 

 

Long-term debt

   $ 2,261,941      $ 2,251,167   
  

 

 

   

 

 

 

Senior Secured Credit Facilities

Our senior secured credit facilities consist of term loans and a $100.0 million revolving credit facility, originally entered into on November 20, 2007 and subsequently amended and restated on March 20, 2012.

On March 21, 2013, we entered into an amendment to the senior secured credit facilities which, among other things, (1) provided for the issuance of $421.4 million of additional term loans issued at par, the proceeds of which were used to prepay existing term loans; (2) extended the maturity of the term loans issued under the original senior secured credit facilities to September 15, 2017 (“extended term loans”); (3) combined the additional term loans and the extended term loans into one new tranche (“tranche B term loans”); (4) reduced the interest rate margin applicable to all borrowings under the senior secured credit facilities; and (5) set the senior secured first lien leverage ratio covenant at a level of 4.25x for the duration of the agreement.

On April 8, 2014, we entered into an amendment (the “Amendment”) to the senior secured credit facilities that, among other things, (1) provided for the issuance of $851.2 million of refinancing term loans (the “Refinancing Term Loans”) at par, the proceeds of which were used to prepay existing tranche B term loans; (2) provided for the issuance of $40.0 million of incremental term loans (the “Incremental Term Loans”) at par, the proceeds of which were used, among other things, to prepay the loans then-outstanding under the revolving credit facility and fees and expenses associated with the Amendment; (3) combined the Refinancing Term Loans and the Incremental Term Loans into one new tranche ( the “New Tranche B Term Loans”); (4) reduced the interest rate margin applicable to all borrowings (including the revolving borrowing) under the senior secured credit facilities; and (5) set the senior secured first lien leverage ratio covenant at a level of 4.75x for the duration of the agreement. The remaining unamortized original issue discounts from the previous term loan issuances are being amortized over the term of the New Tranche B Term Loans using the effective interest method.

As of December 31, 2014, the market values of our New Tranche B Term Loans and drawings under our revolving credit facility were $862.4 million and $15.6 million, respectively. We determine market value using trading prices for the senior secured credit facilities on or near that date. This fair value measurement is categorized within Level 2 of the fair value hierarchy.

Interest Rates. Effective April 8, 2014, the interest rate margins applicable to borrowings under the senior secured revolving credit facilities are, at our option, either (a) the Eurodollar rate, plus 325 basis points or (b) a base rate determined by reference to the

 

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highest of (1) the prime rate, (2) the federal funds rate, plus 0.50% and (3) the Eurodollar rate for a one-month interest period, plus in each case 325 basis points. The interest rate margins applicable to the New Tranche B Term Loans are, at our option, either (a) the Eurodollar rate plus 325 basis points or (b) a base rate plus 325 basis points. There is a minimum LIBOR rate applicable to the Eurodollar component of interest rates on New Tranche B Term Loans of 1.00%. The applicable margin for borrowings under the senior secured revolving credit facilities may be reduced, subject to our attaining certain leverage ratios. As of December 31, 2014, our weighted average interest rate for all borrowings under the senior secured credit facilities was 4.23%.

Fees. In addition to paying interest on outstanding principal under the senior secured credit facilities, we are required to pay a commitment fee to the lenders under the senior secured revolving credit facilities with respect to the unutilized commitments thereunder. The current commitment fee rate is 0.50% per annum, subject to step-downs based upon the achievement of 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 New Tranche B Term Loans in an amount equal to 1.00% of the funded total principal amount through June 2017, with any remaining amount payable in full at maturity in September 2017.

Prepayments. The senior secured credit facilities require 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 in the credit agreement relating to the senior secured credit facilities (such agreement, the “Credit Agreement”); (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 us and our restricted subsidiaries, subject to certain exceptions, including a 100% reinvestment right if reinvested or committed to be reinvested within 15 months of such asset sale or disposition so long as such reinvestment is completed within 180 days thereafter; and (3) 100% of the net cash proceeds from the issuance or incurrence of debt by us and our restricted subsidiaries, other than proceeds from debt permitted to be incurred under the senior secured credit facilities and related amendments. Any mandatory prepayments are applied to the term loan facility in direct order of maturity. We were not required to make any such prepayments in the year ended December 31, 2014.

Subject to certain exceptions, voluntary prepayments of the New Tranche B Term Loans within one year of the effective date of the Amendment are subject to a 1.0% “soft call” premium, while other voluntary prepayments of outstanding loans under the senior secured credit facilities may be made 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 facilities are unconditionally guaranteed by DJO Holdings LLC (“DJO Holdings”) and each of our existing and future direct and indirect wholly-owned domestic subsidiaries 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 facilities, and the guarantees of those obligations, are secured by pledges of 100% of our capital stock, 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 us 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 facilities contain 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;

 

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    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 facilities require us to maintain a maximum senior secured first lien leverage ratio of consolidated senior secured first lien debt to Adjusted EBITDA (as defined in the Credit Agreement) of 4.75:1 for the trailing twelve months ended December 31, 2014. The senior secured credit facilities also contain certain customary affirmative covenants and events of default. As of December 31, 2014, our actual senior secured first lien net leverage ratio was 3.08:1, and we were in compliance with all other applicable covenants.

8.75% Second Priority Senior Secured Notes

On March 20, 2012 and October 1, 2012, we issued $330.0 million aggregate principal amount of 8.75% second priority senior secured notes (8.75% Notes) maturing on March 15, 2018. The 8.75% Notes are guaranteed jointly and severally and on a senior secured basis by each of DJOFL’s existing and future direct and indirect wholly-owned domestic subsidiaries that guarantee any of DJOFL’s indebtedness, or any indebtedness of DJOFL’s domestic subsidiaries, or is an obligor under the senior secured credit facilities.

Pursuant to a second lien security agreement, the 8.75% Notes are secured by second priority liens, subject to permitted liens, on certain of our assets that secure borrowings under the senior secured credit facilities.

As of December 31, 2014, the market value of the 8.75% Notes was $344.0 million. We determined market value using trading prices for the 8.75% Notes on or near that date. This fair value measurement is categorized within Level 2 of the fair value hierarchy.

Optional Redemption. Under the agreement governing the 8.75% Notes (8.75% Indenture), prior to March 15, 2015, we have the option to redeem some or all of the 8.75% 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 March 15, 2015, we may redeem some or all of the 8.75% Notes at a redemption price of 104.375% of the then outstanding principal balance, plus accrued and unpaid interest. The redemption price decreases to 102.188% and 100% of the then outstanding principal balance at March 15, 2016 and 2017, respectively, plus accrued and unpaid interest. Additionally, from time to time, before March 15, 2015, we may redeem up to 35% of the 8.75% Notes at a redemption price equal to 108.75% of the then outstanding principal balance, plus accrued and unpaid interest, 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 8.75% Notes issued remains outstanding.

9.875% Senior Unsecured Notes

On October 1, 2012, we issued $440.0 million aggregate principal amount of new 9.875% senior unsecured notes (9.875% Notes) maturing on April 15, 2018. The 9.875% Notes are guaranteed jointly and severally and on an unsecured senior basis by each of DJOFL’s existing and future direct and indirect wholly owned domestic subsidiaries that guarantee any of DJOFL’s indebtedness or any indebtedness of DJOFL’s domestic subsidiaries or is an obligor under DJOFL’s senior secured credit facilities.

As of December 31, 2014, the market value of the 9.875% Notes was $442.2 million. We determined market value using trading prices for the 9.875% Notes on or near that date. This fair value measurement is categorized within Level 2 of the fair value hierarchy.

Optional Redemption. Under the agreement governing the 9.875% Notes (the 9.875% Indenture), prior to April 15, 2015, we have the option to redeem some or all of the 9.875% 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 April 15, 2015, we may redeem some or all of the 9.875% Notes at a redemption price of 104.938% of the then outstanding principal balance plus accrued and unpaid interest. The redemption price decreases to 102.469% and 100% of the then outstanding principal balance at April 2016 and 2017, respectively. Additionally, from time to time, before April 15, 2015, we may redeem up to 35% of the 9.875% Notes at a redemption price equal to 109.875% of the principal amount then outstanding, plus accrued and unpaid interest, 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 9.875% Notes issued remains outstanding.

 

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7.75% Senior Unsecured Notes

On April 7, 2011, we issued $300.0 million aggregate principal amount of 7.75% senior unsecured notes (7.75% Notes) maturing on April 15, 2018. The 7.75% Notes are guaranteed jointly and severally and on a senior unsecured basis by each of DJOFL’s existing and future direct and indirect wholly-owned domestic subsidiaries that guarantee any of DJOFL’s indebtedness, or any indebtedness of DJOFL’s domestic subsidiaries, or is an obligor under the senior secured credit facilities.

As of December 31, 2014, the market value of the 7.75% Notes was $286.5 million. We determined market value using trading prices for the 7.75% Notes on or near that date. This fair value measurement is categorized within Level 2 of the fair value hierarchy.

Optional Redemption. Under the agreement governing the 7.75% Notes (the 7.75% Indenture), prior to April 15, 2014, we have the option to redeem some or all of the 7.75% 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. As of April 15, 2014, we were able to redeem some or all of the 7.75% Notes at a redemption price of 105.813% of the then outstanding principal balance plus accrued and unpaid interest. The redemption price decreases to 103.875%, 101.938% and 100% of the then outstanding principal balance at April 15, 2015, 2016 and 2017, respectively.

9.75% Senior Subordinated Notes

On October 18, 2010, we issued $300.0 million aggregate principal amount of 9.75% senior subordinated notes (9.75% Notes) maturing on October 15, 2017. The 9.75% Notes are guaranteed jointly and severally and on an unsecured senior basis by each of DJOFL’s existing and future direct and indirect wholly-owned domestic subsidiaries that guarantee any of DJOFL’s indebtedness, or any indebtedness of DJOFL’s domestic subsidiaries, or is an obligor under the senior secured credit facilities.

As of December 31, 2014, the market value of the 9.75% Notes was $294.0 million. We determined market value using trading prices for the 9.75% Notes on or near that date. This fair value measurement is categorized within Level 2 of the fair value hierarchy.

Optional Redemption. Under the agreement governing the 9.75% Notes (the 9.75% Indenture), prior to October 15, 2013, we have the option to redeem some or all of the 9.75% 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. As of October 15, 2014, we were able to redeem some or all of the 9.75% Notes at a redemption price 104.875% of the then outstanding principal balance, plus accrued and unpaid interest. The redemption price decreases to 102.438% and 100% of the then outstanding principal balance at October 15, 2015 and 2016, respectively.

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 its 8.75% Notes, 9.875% Notes, 7.75% Notes, and 9.75% Notes (collectively, the Notes), DJOFL will be required to make an offer to repurchase all of the Notes at 101% of the then outstanding principal balance, plus accrued and unpaid interest.

Covenants

The 8.75% Indenture, the 9.75% Indenture, the 9.875% Indenture and the 7.75% Indenture (collectively, the Indentures) each contain covenants limiting, among other things, our and our restricted subsidiaries’ ability to (i) 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, (ii) make certain investments, (iii) sell certain assets, (iv) create liens on certain assets to secure debt, (v) consolidate, merge, sell or otherwise dispose of all or substantially all of our assets, (vi) enter into certain transactions with affiliates, or (vii) designate our subsidiaries as unrestricted subsidiaries. As of December 31, 2014, we were in compliance with all applicable covenants.

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 covenants. A breach of any of these covenants in the future could result in a default under the Agreement or the Indentures, at which time the lenders could elect to declare all amounts outstanding under the senior secured credit facilities to be immediately due and payable. Any such acceleration would also result in a default under the Indentures.

 

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At December 31, 2014, the aggregate amounts of annual principal maturities of long-term debt for the next five years and thereafter are as follows (in thousands):

 

Years Ending December 31,

      

2015

   $ 8,975   

2016

     8,912   

2017

     1,183,736   

2018

     1,070,000   

2019

     —    
  

 

 

 
   $ 2,271,623   
  

 

 

 

Loss on Modification and Extinguishment of Debt

During the year ended December 31, 2014, we recognized a loss on modification and extinguishment of debt of $0.9 million. The loss consists of $0.3 million of arrangement and amendment fees and other fees and expenses incurred in connection with the amendment of our senior secured credit facilities and $0.6 million related to the non-cash write off of unamortized debt issuance costs and original issue discount associated with the portion of our original term loans which were extinguished.

During the year ended December 31, 2013, we recognized a loss on modification and extinguishment of debt of $1.1 million. The loss consists of $0.9 million of arrangement and amendment fees and other fees and expenses incurred in connection with the amendment of our senior secured credit facilities and $0.2 million related to the non-cash write off of unamortized debt issuance costs and original issue discount associated with the portion of our original term loans which were extinguished.

Debt Issuance Costs

As of December 31, 2014 and December 31, 2013, we had $28.6 million and $35.7 million, respectively, of unamortized debt issuance costs, which are included in Other assets in our Consolidated Balance Sheets. For each of the years ended December 31, 2014 and 2013, we capitalized $1.5 million of debt issuance costs incurred in connection with the amendment of our senior secured credit facilities.

For the years ended December 31, 2014, 2013 and 2012 amortization of debt issuance costs was $8.1 million, $7.3 million and $8.9 million, respectively. Amortization of debt issuance costs was included in Interest expense in our Consolidated Statements of Operations for each of the periods presented.

13. MEMBERSHIP DEFICIT

During the year ended December 31, 2014, DJO issued 115,693 shares of its common stock upon the net exercise of vested stock options that had been granted to two former members of DJO’s Board of Directors in 2006 and to employees in 2007 in exchange for options that had previously been granted in the predecessor company to DJO (“Rollover Options”). Our stock incentive plan permits participants to exercise stock options using a net exercise method. In a net exercise, we withhold from the total number of shares that otherwise would be issued to a participant upon exercise of the stock option such number of shares having a fair market value at the time of exercise equal to the aggregate option exercise price and applicable income tax withholdings, and remit the remaining shares to the participant. The two former directors and employees exercised these Rollover Options for a total of 507,088 shares of DJO’s common stock, from which we withheld 391,395 shares to cover $6.5 million of aggregate option exercise price and income tax withholdings and issued the remaining 115,693 shares.

Additionally, during the year ended December 31, 2014, DJO issued 6,447 shares of its common stock upon the exercise of stock options. Net proceeds from the share sales were contributed by DJO to us, and are included in Member capital in our Consolidated Balance Sheet as of December 31, 2014.

During the year ended December 31, 2013, DJO issued 72,151 shares of common stock upon the net exercise of Rollover Options. During the year ended December 31, 2013, the net exercise method was employed by the participants to exercise Rollover Options to acquire 221,057 shares of our common stock; we withheld 148,906 of the shares subject to the Rollover Options to cover $2.5 million of aggregate option exercise price and income tax withholdings and issued the remaining 72,151 shares to the participants.

Additionally, during the year ended December 31, 2013, we entered into an agreement to repurchase Rollover Options from our former chief financial officer, upon her departure, which cancelled vested Rollover Options for 313,681 shares of common stock held by her. The $2.0 million amount to be paid represents the excess of the fair market value of the shares over the exercise price of the options. This amount is included as a reduction to Member capital in our Consolidated Balance Sheet as of December 31, 2013.

 

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During the year ended December 31, 2012, DJO sold 121,506 shares of its common stock at $16.46 per share, consisting of 60,753 shares purchased by the new Chairman of its Board of Directors, and 60,753 shares purchased by another new member of the Board of Directors. Additionally, DJO issued 18,622 shares of its common stock upon the exercise of stock options. Net proceeds of $2.0 million from the share sales were contributed by DJO to us, and are included in Member capital in our Consolidated Balance Sheet as of December 31, 2012.

The proceeds from the DJO sales of shares were used for working capital purposes. All such sales were subject to execution of a stockholder agreement including certain rights and restrictions (See Note 17).

14. STOCK OPTION PLANS AND STOCK-BASED COMPENSATION

Stock Option Plan

We have one active equity compensation plan, the DJO 2007 Incentive Stock Plan (2007 Plan) under which we are authorized to grant awards of restricted and unrestricted stock, options, and other stock-based awards based on the shares of common stock of our indirect parent, DJO, subject to adjustment in certain events. The total number of shares available to grant under the 2007 plan is 10,575,529.

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.

Options granted prior to 2012 vest as follows: one-third of each stock option grant vests over a specified period of time contingent solely upon the awardees’ continued employment with us (Time-Based Options). Another one-third of each stock option grant will vest upon achieving a minimum return of money on invested capital (MOIC), as defined, with respect to Blackstone’s aggregate investment in DJO’s capital stock, to be achieved by Blackstone following a liquidation of all or a portion of its investment in DJO’s capital stock (Market Return Options). The final one-third of each stock option grant will vest based upon achieving an increased minimum return of MOIC, as defined, with respect to Blackstone’s aggregate investment in DJO’s capital stock, to be achieved by Blackstone following a liquidation of all or a portion of its investment in DJO’s capital stock (Enhanced Market Return Options).

Options granted to employees in 2012 vest in four equal installments beginning in 2012 and for each of the three calendar years following 2012, with each such installment vesting only if the final reported financial results for such year show that the Adjusted EBITDA for such year equaled or exceeded the Adjusted EBITDA amount in the financial plan approved by DJO’s Board of Directors for such year (Performance Options). In the event that the Adjusted EBITDA in any of such four years falls short of the amount of Adjusted EBITDA in the financial plan for that year, the installment that did not therefore vest at the end of such year shall be eligible for subsequent vesting at the end of the four year vesting period if the cumulative Adjusted EBITDA for such four years equals or exceeds the cumulative Adjusted EBITDA in the financial plans for such four years and the Adjusted EBITDA in the fourth vesting year equals or exceeds the Adjusted EBITDA in the financial plan for such year. In addition, in the event Blackstone achieves a minimum return of MOIC with respect to Blackstone’s aggregate investment in DJO’s capital stock following a liquidation of all or a portion of its investment in DJO’s capital stock, any unvested installments from prior years and all installments for future years shall thereupon vest.

In February 2013, 310,000 options previously granted to new employees in 2012 were amended to convert one-third of such options into Time-Based Options, with the remaining two-thirds continuing to be Performance Options. Additionally, all 2012 Performance Options were amended to allow for vesting of the 2012 Adjusted EBITDA tranche if the 2013 Adjusted EBITDA results equal or exceed an enhanced amount of Adjusted EBITDA over the amount reflected in the 2013 financial plan. Options granted in 2013 and 2014 to existing employees had the same terms as the Performance Options described above and options granted to new employees in 2013 and 2014 had the same terms as the options amended in February 2013.

In December 2013 and December 2014, options were granted to employees following the net exercise of their Rollover Options which were scheduled to expire in December 2013 and December 2014, respectively. These new options were fully vested on the date of grant and have a term of ten years (“Vested Options”).

In February 2014, all 2012 and 2013 Performance Options were amended to allow for vesting of the 2012 and 2013 Adjusted EBITDA tranches if the 2014 Adjusted EBITDA results equal or exceed an enhanced amount of Adjusted EBITDA reflected in the 2014 financial plan.

Except for options granted to the Chairman of the Board and two other board members as described below, options are typically granted annually to members of our Board of Directors who are not affiliates of Blackstone (referred to as Director Service Options).

 

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The Director Service Options vest in increments of 33 1/3% per year on each of the first through third anniversary dates of the grant date, contingent upon the optionee’s continued service as a director. The options granted to the Chairman of the Board and the two other board members vest as follows: one-third of the stock option grant vests in increments of 33 1/3% per year on each of the first through third anniversary dates from the grant date contingent upon the optionee’s continued service as a director; one-third of the stock option grant will vest in the same manner as the Market Return Options; and one-third of the stock option grant will vest in the same manner as the Enhanced Market Return Options.

Stock-Based Compensation

During the year ended December 31, 2014, the compensation committee granted 1,747,268 options to employees, of which 1,221,162 were Performance Options, 498,338 were Time-Based Options and 27,768 were Vested Options. The weighted average grant date fair values of the Time-Based Options and the Vested Options granted during the year ended December 31, 2014 were $6.05 and $5.28, respectively.

During the year ended December 31, 2013, the compensation committee granted 1,082,397 options to employees, of which 768,677 were Performance Options, 243,323 were Time-Based Options and 70,397 were 2013 Vested Options. Additionally, the compensation committee granted 100,000 options to one board member and 13,800 Director Service Options to certain members of the Board of Directors. The weighted average grant date fair values of the Time-Based Options, the 2013 Vested Options and the Director Service Options granted during the year ended December 31, 2013 were $5.99, $5.23 and $6.02, respectively.

During the year ended December 31, 2012, we granted 2,482,100 Performance Options to employees, 303,767 options to DJO’s Chairman of the Board, 100,000 to one other board member, and 18,400 Director Service Options to certain members of our Board of Directors. The weighted average grant date fair value of the Performance Options and the Director Service Options granted during the year ended December 31, 2012 was $6.09.

The fair value of each option award is estimated on the date of grant, or modification, using the Black-Scholes option pricing model for service based awards, and a binomial model for market based awards. In estimating fair value for options issued under the 2007 Plan, expected volatility was based 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 method. 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 stock options for periods within the expected term of the option is based on the U.S. Treasury yield bond curve in effect on the date of grant.

The following table summarizes certain assumptions we used to estimate the fair value of the Time-Based Options, the Vested Options and the Director Service Options of stock options granted during the years ended December 31, 2014, 2013, and 2012:

 

     Year Ended December 31,  
     2014     2013     2012  

Expected volatility

     31.7-33.4     33.4-35.1     35.3-37.7

Risk-free interest rate

     1.7-2.2     0.7-2.0     0.8-1.5

Expected term until exercise

     5.0-6.4        5.0-6.3        6.1-6.2   

Expected dividend yield

     0.0     0.0     0.0

We recorded non-cash stock-based compensation expense during the periods presented as follows (in thousands):

 

     Year Ended December 31,  
     2014      2013      2012  

Cost of goods sold

   $ 82       $ 52       $ 78   

Operating expenses:

        

Selling, general and administrative

     1,782         2,049         2,206   

Research and development

     5         54         55   
  

 

 

    

 

 

    

 

 

 
   $ 1,869       $ 2,155       $ 2,339   
  

 

 

    

 

 

    

 

 

 

We have determined that it is not probable that we will meet the Adjusted EBITDA targets related to the Performance Options granted. As such, we did not recognize expense for any of the options which had the potential to vest in 2014. Additionally, we have not recognized expense for any of the options which have the potential to vest based on Adjusted EBITDA for 2015, 2016 and 2017,

 

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as some of these targets have not yet been established and we are unable to assess the probability of achieving such targets. Accordingly, we recognized stock-based compensation expense only for the Time-Based Options, the Vested Options and the Director Service Options granted in 2013 or 2014.

In each of the periods presented above, for the options granted prior to 2012, we recognized stock-based compensation expense only for Time-Based Options granted to employees, as the performance components of the Market Return and Enhanced Market Return Options are not deemed probable at this time.

Stock based compensation expense for options granted to non-employees was not significant to the Company for all periods presented, and was included in Selling, general and administrative expense in our Consolidated Statements of Operations.

A summary of option activity under the 2007 Plan is presented below:

 

     Number of
Shares
     Weighted-
Average

Exercise Price
     Weighted-
Average
Remaining
Contractual Term
(Years)
     Aggregate
Intrinsic
Value
 

Outstanding at December 31, 2013

     9,017,290       $ 15.79         6.1       $ 6,133,210   

Granted

     1,747,268       $ 16.46         

Exercised

     (513,535    $ 10.89         

Forfeited or expired

     (1,011,857    $ 16.44         
  

 

 

          

Outstanding at December 31, 2014

  9,239,166    $ 16.11      6.3    $ 3,197,576   
  

 

 

          

Vested or expected to vest at December 31, 2014

  5,793,957    $ 15.91      5.5    $ 3,197,576   
  

 

 

          

Exercisable at December 31, 2014

  2,496,422    $ 15.18      3.6    $ 3,197,576   
  

 

 

          

The Company’s stock incentive plan permits optionees to exercise stock options using a net exercise method. In a net exercise, the Company withholds from the total number of shares that otherwise would be issued to an optionee upon exercise of the stock option such number of shares having a fair market value at the time of exercise equal to the option exercise price and applicable income tax withholdings and remits the remaining shares to the optionee.

The following table provides information regarding the use of the net exercise method during the periods presented:

 

     Year Ended December 31,  
     2014      2013  

Options exercised

     507,088         221,057   

Shares withheld

     391,395         148,906   
  

 

 

    

 

 

 

Shares issued

  115,693      72,151   
  

 

 

    

 

 

 

Average market value per share withheld

$ 16.46    $ 16.46   
  

 

 

    

 

 

 

Aggregate market value of shares withheld (in thousands)

$ 6,442    $ 2,451   
  

 

 

    

 

 

 

As of December 31, 2014, total unrecognized stock-based compensation expense related to unvested stock options granted under the 2007 Plan, excluding options subject to the performance components of the Market Return and Enhanced Market Return Options, was $2.0 million, net of expected forfeitures. We anticipate this expense to be recognized over a weighted-average period of approximately four years. Compensation expense associated with the Market Return and Enhanced Market Return Options granted under the 2007 Plan, with the exception of those that were issued in connection with a modification, will be recognized only to the extent achievement of the performance components are deemed probable.

 

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15. INCOME TAXES

The components of loss before income tax provision (benefit) consist of the following (in thousands):

 

     Year Ended December 31,  
     2014     2013     2012  

U.S. operations

   $ (94,111   $ (206,769   $ (137,268

Foreign operations

     17,439        17,323        13,996   
  

 

 

   

 

 

   

 

 

 
   $ (76,672   $ (189,446   $ (123,272
  

 

 

   

 

 

   

 

 

 

The income tax provision (benefit) consists of the following (in thousands):

 

     Year Ended December 31,  
     2014     2013     2012  

Current income taxes:

      

U.S. federal

   $ (309   $ 1,135      $ (1,205

U.S. state

     852        870        1,347   

Foreign

     5,989        6,373        6,330   
  

 

 

   

 

 

   

 

 

 

Total current income taxes

     6,532        8,378        6,472   
  

 

 

   

 

 

   

 

 

 

Deferred income taxes:

      

U.S. federal

     8,676        7,460        (3,558

U.S. state

     (307     (2,154     (5,751

Foreign

     (2,011     (568     (2,067
  

 

 

   

 

 

   

 

 

 

Total deferred income taxes

     6,358        4,738        (11,376
  

 

 

   

 

 

   

 

 

 

Total income tax provision (benefit)

   $ 12,890      $ 13,116      $ (4,904
  

 

 

   

 

 

   

 

 

 

The difference between the income tax provision (benefit) derived by applying the U.S. federal statutory income tax rate of 35% and the recognized income tax provision (benefit) is as follows (in thousands):

 

     Year Ended December 31,  
     2014     2013     2012  

Income tax provision (benefit) derived by applying the U.S. federal statutory income tax rate to loss before income taxes

   $ (26,835   $ (66,306   $ (43,145

Add (deduct) the effect of:

      

State tax benefit, net

     (2,476     (3,323     (4,275

Change in state effective tax rates

     (722     (992     (639

Foreign earnings repatriation

     (1,646     2,678        3,199   

Unrecognized tax benefits

     949        2,216        (7,723

Goodwill impairment

     —          33,687        —     

Prepaid tax asset impairment

     (1     229        5,479   

Valuation allowance

     40,692        50,516        38,845   

Research tax credit

     (618     (1,249     —     

Equity compensation benefit

     —          (2,864     —     

Permanent differences and other, net

     3,547        (1,476     3,355   
  

 

 

   

 

 

   

 

 

 
   $ 12,890      $ 13,116      $ (4,904
  

 

 

   

 

 

   

 

 

 

 

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The components of deferred income tax assets and liabilities are as follows (in thousands):

 

     December 31,
2014
     December 31,
2013
 

Deferred tax assets:

     

Net operating loss carryforwards

   $ 214,319       $ 202,387   

Receivables reserve

     26,709         23,878   

Other

     39,284         38,766   
  

 

 

    

 

 

 

Gross deferred tax assets

  280,312      265,031   

Valuation allowance

  (137,520   (94,741
  

 

 

    

 

 

 

Net deferred tax assets

  142,792      170,290   
  

 

 

    

 

 

 

Deferred tax liabilities:

Intangible assets

  (343,370   (362,950

Foreign earnings repatriation

  (13,012   (14,092

Other

  (3,987   (7,038
  

 

 

    

 

 

 

Gross deferred tax liabilities

  (360,369   (384,080
  

 

 

    

 

 

 

Net deferred tax liabilities

$ (217,577 $ (213,790
  

 

 

    

 

 

 

At December 31, 2014, we maintain federal and state net operating loss carryforwards of $563.1 million and $336.5 million respectively, which expire over a period of 1 to 20 years. Our foreign net operating loss carryforwards of $2.8 million generally are not subject to expiration dates, unless we trigger certain events.

At December 31, 2014 and 2013 we had gross deferred tax assets of $280.3 million and $265.0 million, respectively, which we reduced by valuation allowances of $137.5 million and $94.7 million, respectively.

We do not intend to permanently reinvest the earnings of foreign operations. Accordingly, we recorded a deferred tax (income) expense of $(0.6) million, $1.8 million and $2.5 million for the years ended December 31, 2014, 2013 and 2012, respectively, for unrepatriated foreign earnings in those years.

We file income tax returns in U.S. federal, state and foreign jurisdictions. With few exceptions, we are no longer subject to income tax examinations by tax authorities for years before 2009.

A reconciliation of the beginning and ending amount of gross unrecognized tax benefits is as follows (in thousands):

 

     Year Ended December 31,  
     2014      2013      2012  

Balance, beginning of year

   $ 14,469       $ 12,342       $ 19,443   

Additions based on tax positions related to current year

     1,502         1,531         817   

Additions for tax positions related to prior years

     354         975         892   

Reductions for tax positions of prior years

     —           —           —     

Reduction due to lapse of statute of limitations

     (709      (379      (990

Reductions for settlements of tax positions

     (1,711      —           (7,820
  

 

 

    

 

 

    

 

 

 

Balance, end of year

$ 13,905    $ 14,469    $ 12,342   
  

 

 

    

 

 

    

 

 

 

To the extent all or a portion of our gross unrecognized tax benefits are recognized in the future, no U.S. federal tax benefit for related state income tax deductions would result due to the existence of a U.S. federal valuation allowance. We anticipate that approximately $0.6 million of uncertain tax positions, each of which are individually immaterial, will decrease in the next twelve months due to the expiration of the statutes of limitations. We have various unrecognized tax benefits totaling approximately $5.2 million, which, if recognized, would impact our effective tax rate in future periods. We recognized interest and penalties of $0.4 million, $0.5 million and $0.3 million in the years ended December 31, 2014, 2013 and 2012, respectively, which was included as a component of income tax benefit in our Consolidated Statements of Operations. As of December 31, 2014 and 2013, we have $2.3 million and $2.6 million, respectively, accrued for interest and penalties.

 

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16. COMMITMENTS AND CONTINGENCIES

Operating Leases. We lease building space, manufacturing facilities and equipment under non-cancelable operating lease agreements that expire at various dates. We record rent incentives as deferred rent and amortize as reductions to lease expense over the lease term. The aggregate minimum rental commitments under non-cancelable leases for the next five years and thereafter, as of December 31, 2014, are as follows (in thousands):

 

Years Ending December 31,

      

2015

   $ 17,374   

2016

     15,645   

2017

     9,698   

2018

     8,966   

2019

     7,352   

Thereafter

     14,219   
  

 

 

 
   $ 73,254   
  

 

 

 

Rental expense under operating leases totaled $17.4 million, $17.6 million, and $16.4 million for the years ended December 31, 2014, 2013, and 2012, respectively. Scheduled increases in rent expense are amortized on a straight line basis over the life of the lease.

Pain Pump Litigation

Over the past 7 years, we have been named in numerous product liability lawsuits involving our prior distribution of a disposable drug infusion pump product (pain pump) manufactured by two third-party manufacturers that was distributed through our Bracing and Vascular segment. We currently are a defendant in two U.S. cases and a lawsuit in Canada which has been granted class action status for a class of approximately 45 claimants. 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. All of these lawsuits allege that the use of these pumps with certain anesthetics for prolonged periods after certain shoulder surgeries or, less commonly, knee surgeries, has resulted in cartilage damage to the plaintiffs. In the past four years, we have entered into settlements with plaintiffs in approximately 140 pain pump lawsuits. Except for the payment by the Company of policy deductibles or self-insured retentions, our products liability carriers in three policy periods have paid the defense costs and settlements related to these claims, subject to reservation of rights to deny coverage for customary matters, including punitive damages and off-label promotion. The range of potential loss for these claims is not estimable, although we believe we have adequate insurance coverage for such claims. As of December 31, 2014, we have accrued $0.7 million for unpaid settlements in this case, and a corresponding receivable as all of the settlements will be paid by our product liability carriers.

Lawsuit by Insurance Carrier

In December 2013, one of our product liability insurance carriers, Ironshore Specialty Ins. Co. filed a complaint in the U.S. District Court for the Southern District of California, which seeks (a) either (i) rescission of an insurance policy (the “Policy”) purchased by the Company from the plaintiff and repayment by the Company of all amounts allegedly paid under the Policy, approximately $10 million, less premiums paid by the Company for the Policy, or, in the alternative, (ii) reformation of the Policy to exclude coverage for pain pump claims and repayment by the Company of all amounts allegedly paid under the Policy for such claims, in an unspecified amount; and/or (b) damages and other relief in an unspecified amount for alleged fraud and negligent misrepresentation based on an alleged failure by the Company and/or the involved Policy producers to disclose alleged material information while applying for the Policy. While we believe this case is without merit, we have brought third-party indemnification claims against our insurance broker and a wholesale broker who were involved in securing the Policy. The carrier under our directors and officers liability policy has agreed to reimburse defense costs incurred in this matter, subject to reservation of rights to deny coverage for customary matters. A tentative settlement has been reached in this case, which if completed will result in a dismissal of the lawsuit and complete resolution of this matter.

Cold Therapy Litigation

DJO was named in nine multi-plaintiff lawsuits involving a total of 172 plaintiffs which alleged that the plaintiffs had been injured following use of certain cold therapy products manufactured by DJO. The complaints alleged 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 were alleged in the complaints. These cases were included in a

 

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coordinated proceeding in San Diego Superior Court with a similar number of cases filed against one of our competitors. The first of these cases was tried and ended with a deadlocked jury, resulting in no verdict and a declaration of a mistrial; therefore, the range of potential loss for these claims was not estimable at that time. In October 2014, the company reached a settlement agreement with plaintiffs’ counsel that effectively resolves all of the claims. The settlement amount was paid by our product liability carriers. As such, there was no impact to the financial results.

State Licensing Subpoenas

In July 2013 and October 2014, we were served with subpoenas under the Health Insurance Portability and Accountability Act (HIPAA) seeking documents relating to the fitting of custom-fabricated or custom-fitted orthoses in the States of New Jersey, Washington and Texas. The subpoenas were issued by the United States Attorney’s Office for the District of New Jersey in connection with an investigation of compliance with professional licensing statutes in those states relating to the practice of orthotics. We responded to the first subpoena, and are in the process of responding to the second subpoena.

BGS Qui Tam Action

We are a defendant in a qui tam action filed in Federal Court in Boston, Massachusetts, captioned United States, ex rel. Bierman v. Orthofix International, N.V. et al., in which the relator, or whistleblower, names us and each other company engaged in the external bone growth stimulator industry as defendants. The case was filed under seal in March 2005 and unsealed in March 2009, during which time the government investigated the claims made by relator and decided not to intervene in the case. The government continued its investigation of DJO for several years following the unsealing of the case but did not ultimately bring any criminal or civil charges against us relating to the investigation. The 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 bone growth stimulation devices by each defendant to the present by seeking reimbursement for such devices as purchased items rather than rental items. The relator also alleges that the defendants are engaged in other marketing practices constituting violations of the federal and various state false claim and anti-kickback statutes. Orthofix International, N.V. has settled with both the government and the relator, and the case continues against the remaining defendants, with the relator pressing for discovery after years of inactivity on the case. While we believe the case against us has no merit, we can make no assurances as to the resources that will be needed to respond to this matter or the final outcome of the case.

California Qui Tam Action

On October 11, 2013, we were served with a summons and complaint related to a qui tam action filed in U.S. District Court in Los Angeles, California in August 2012 and amended in December 2012 that names us as a defendant along with each of the other companies that manufactures and sells external bone growth stimulators for spinal applications. The case is captioned United States of America, et al.ex re. Doris Modglin and Russ Milko, v. DJO Global, Inc., DJO, LLC, DJO Finance LLC, Orthofix, Inc., Biomet, Inc., and EBI, LP., Case No. CV12-7152-MMM (JCGx) (C.D. Cal.). The plaintiffs, or relators, allege that the defendants have violated federal and state false claim acts by seeking reimbursement for bone growth stimulators for uses outside of the FDA approved indications for use for such products. The plaintiffs are seeking treble damages alleged to have been sustained by the U.S. and the states, penalties and attorney’s fees and costs. The federal government and all of the named states have declined to intervene in this case. We filed a motion to dismiss the second amended complaint, which motion was granted with leave to amend. Relators then filed a third amended complaint and we filed a motion to dismiss the third amended complaint and that motion is pending. We believe that this lawsuit is without merit and intend to vigorously defend this case.

17. RELATED PARTY TRANSACTIONS

Blackstone Management Partners LLC (BMP) has agreed to provide 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 DJO and BMP may mutually determine. DJO 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 DJO, a sale of all or substantially all of DJO’s assets or an initial public offering of common stock of DJO, 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 years presented, we expensed $7.0 million related to the annual monitoring fee, which is recorded as a component of Selling, general and administrative expense in the Consolidated Statements of Operations.

18. SEGMENT AND GEOGRAPHIC INFORMATION

For the years ended December 31, 2014, 2013 and 2012, we reported our business in four operating segments: Bracing and Vascular; Recovery Sciences; Surgical Implant and International.

Bracing and Vascular Segment

Our Bracing and Vascular segment, which generates its revenues in the United States, offers our rigid knee bracing products, orthopedic soft goods, cold therapy products, vascular systems, therapeutic shoes and inserts and compression therapy products, primarily under the DonJoy, ProCare, Aircast, Dr. Comfort, Bell-Horn and Exos brands. This segment also includes our OfficeCare channel, through which we maintain an inventory of soft goods and other products at healthcare facilities, primarily orthopedic practices, for immediate distribution to patients. The Bracing and Vascular segment primarily sells its products to orthopedic and sports medicine professionals, hospitals, podiatry practices, orthotic and prosthetic centers, home medical equipment providers and independent pharmacies. In 2014 we expanded our consumer channel to focus on marketing, selling and distributing our products, including bracing and vascular products, to professional and consumer retail customers and on-line. The bracing and vascular products sold through the channel will principally be sold under the DonJoy Performance, Bell-Horn and Doctor Comfort brands.

 

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Recovery Sciences Segment

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

 

    Empi. Our Empi channel 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.

 

    CMF. Our CMF channel 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 channel offers products in the clinical rehabilitation market in the category 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.

 

    Consumer. Our consumer channel offers professional and consumer retail customers our Compex electrostimulation device, which is used in training programs to aid 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.

Information regarding our reportable business segments is presented below (in thousands). Segment results exclude the impact of amortization and impairment of goodwill and intangible assets, certain general corporate expenses, and charges related to various integration activities, as defined by management. 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 in the senior secured credit facilities. We do not allocate assets to reportable segments because a significant portion of our assets are shared by the segments.

 

     Year Ended December 31,  
     2014      2013      2012  

Net sales:

        

Bracing and Vascular

   $ 504,590       $ 476,492       $ 444,444   

Recovery Sciences

     299,122         312,783         331,461   

Surgical Implant

     100,139         87,088         72,980   

International

     325,315         299,094         280,535   
  

 

 

    

 

 

    

 

 

 
$ 1,229,166    $ 1,175,457    $ 1,129,420   
  

 

 

    

 

 

    

 

 

 

Operating income (loss):

Bracing and Vascular

$ 102,933    $ 86,447    $ 87,694   

Recovery Sciences

  84,322      83,028      90,353   

Surgical Implant

  12,712      8,669      6,747   

International

  62,304      57,515      54,442   

Expenses not allocated to segments and eliminations

  (158,520   (245,217   (146,318
  

 

 

    

 

 

    

 

 

 
$ 103,751    $ (9,558 $ 92,918   
  

 

 

    

 

 

    

 

 

 

 

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Table of Contents

Geographic Area

Following are our net sales by geographic area (in thousands):

 

     Year Ended December 31,  
     2014      2013      2012  

United States

   $ 903,851       $ 876,363       $ 848,885   

Other Europe, Middle East, and Africa

     156,339         139,252         135,030   

Germany

     91,754         88,236         84,527   

Australia and Asia Pacific

     39,990         35,025         26,786   

Canada

     26,481         27,035         24,588   

Latin America

     10,751         9,546         9,604   
  

 

 

    

 

 

    

 

 

 
$ 1,229,166    $ 1,175,457    $ 1,129,420   
  

 

 

    

 

 

    

 

 

 

Net sales are attributed to countries based on location of customer. In each of the years ended December 31, 2014, 2013 and 2012, no individual customer or distributor accounted for 10% or more of total annual net sales.

Following are our long-lived assets by geographic area (in thousands):

 

     December 31,
2014
     December 31,
2013
 

United States

   $ 136,490       $ 130,498   

International

     16,470         16,830   
  

 

 

    

 

 

 
$