UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

For the quarterly period ended September 26, 2015

or

For the transition period from                      to                      

Commission File Number: 333-142188

 

DJO Finance LLC

(Exact name of Registrant as specified in its charter)

 

 

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

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  ¨    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 whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

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

As of November 10, 2015, 100% of the issuer’s membership interests were owned by DJO Holdings LLC.

 

 

 

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DJO Finance LLC

INDEX

 

 

 

 

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PART 1 – FINANCIAL INFORMATION

 

 

Item 1. Financial Statements

DJO Finance LLC

Unaudited Condensed Consolidated Balance Sheets

(in thousands)

 

 

See accompanying Notes to Unaudited Condensed Consolidated Financial Statements.

 

 

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DJO Finance LLC

Unaudited Condensed Consolidated Statements of Operations

(in thousands)

 

 

See accompanying Notes to Unaudited Condensed Consolidated Financial Statements.

 

 

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DJO Finance LLC

Unaudited Condensed Consolidated Statements of Comprehensive Loss

(in thousands)

 

 

See accompanying Notes to Unaudited Condensed Consolidated Financial Statements.

 

 

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DJO Finance LLC

Unaudited Condensed Consolidated Statements of Deficit

(in thousands)

 

 

See accompanying Notes to Unaudited Condensed Consolidated Financial Statements.

 

 

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DJO Finance LLC

Unaudited Condensed Consolidated Statements of Cash Flows

(in thousands)

 

 

See accompanying Notes to Unaudited Condensed Consolidated Financial Statements.

 

 

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Notes to Unaudited Condensed 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.

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 15 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.

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 non-controlling 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.

Interim Reporting

The accompanying Unaudited Condensed Consolidated Financial Statements include our accounts and all voting interest entities where we exercise a controlling financial interest through the ownership of a direct or indirect majority voting interest. All significant intercompany accounts and transactions have been eliminated in consolidation. Our Unaudited Condensed Consolidated Financial Statements have been prepared in accordance with GAAP and with the instructions to Form 10–Q and Article 10 of Regulation S–X for interim financial information. Accordingly, these financial statements do not include all of the information required by GAAP or Securities and Exchange Commission (SEC) rules and regulations for complete annual financial statements. In the opinion of management, these financial statements reflect all adjustments (consisting of normal recurring adjustments) necessary for a fair presentation of the results of operations for the interim periods presented. The results of operations for any interim period are not necessarily indicative of results for the full year. These Unaudited Condensed Consolidated Financial Statements should be read in conjunction with our consolidated financial statements and notes thereto included in our Annual Report on Form 10–K for the year ended December 31, 2014.

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Recent Accounting Standards

In April 2014, the FASB issued an 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. On July 9, 2015, the FASB decided to defer the effective date of the standard. The guidance is now effective for fiscal years beginning after December 15, 2017 and interim periods within that reporting period. Early adoption is permitted as early as the original effective date of December 15, 2016. 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 to 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.

In April 2015, the FASB issued an accounting standards update related to the presentation of debt issuance costs. The standard requires that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of the debt liability, consistent with debt discounts. The guidance is effective for annual and interim periods beginning after December 15, 2015. Early application is permitted. The Company has early adopted this update and the impact is reflected in the current and prior periods presented.

In April 2015, the FASB issued an accounting standards update related to internal-use software. The standard provides guidance to clarify the customer’s accounting for fees paid in a cloud computing arrangement. The guidance is effective for annual periods and interim periods within those annual periods beginning after December 15, 2015. Adoption of this new guidance is not expected to have a material effect on the Company’s financial statements.

 

 

2. ACQUISITION

 

On June 30, 2015, our subsidiary Encore Medical, L.P., dba DJO Surgical, acquired certain assets from Zimmer Biomet Holdings, Inc., including the Biomet Cobalt™ Bone Cement, Optivac^® Cement Mixing Accessories, SoftPac™ Pouch and Discovery^® Elbow System. The purchase price consisted of a cash payment of $24.0 million and was funded through the $20.0 million delayed draw term loan from our New Senior Secured Credit Facilities (as defined below). Additional acquisition related costs were $3.4 million and are included in the Selling, general and administrative expense line item in the Consolidated Statement of Operations.  

 

The primary reason for the acquisition was to further invest in our growing Surgical Implant segment and improve our position in the orthopedic implant market. The Discovery Elbow will be our first elbow technology and builds upon our successful upper extremity portfolio and shoulder arthroplasty experience. The Cobalt products have a substantial base of customers for hip, knee, shoulder, elbow and other orthopedic implant technologies.

 

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

 

 

The purchase price allocation included $15.0 million assigned to intangible assets related to existing technology. The value of the 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 purchase price allocation also included $2.9 million assigned to intangible assets related to trademarks and trade names. The value of the 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 trademarks and trade names acquired. Additionally, the purchase price allocation included $1.8 million assigned to intangible assets related to certain customer relationships existing on the acquisition date. The value of the customer relationships was based upon an estimate of the future discounted cash flows that would be derived from those customers, after deducting contributory asset charges.

 

Goodwill represents the excess of the purchase price over fair value of tangible and identifiable intangible assets acquired. All goodwill associated with the acquisition is allocated to our Surgical Implant segment. Among the factors which resulted in goodwill for the acquisition was the opportunity to increase our revenue and expand our presence in the surgical implant market through the use of the acquired technology and customer relationships.

 

Goodwill related to this acquisition is expected to be deductible for tax purposes.

 

 

3. ACCOUNTS RECEIVABLE RESERVES

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

 

 

Our allowance for sales returns balance was $3.8 million and $3.7 million as of September 26, 2015 and September 27, 2014, respectively.

 

 

4. INVENTORIES

Inventories consist of the following (in thousands):

 

 

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

 

 

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

 

 

5. LONG-LIVED ASSETS

Goodwill

Changes in the carrying amount of goodwill for the nine months ended September 26, 2015 are presented in the table below (in thousands):

 

 

Intangible Assets

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

 

 

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Based on indication of impairment through declining sales in the second quarter of 2015, we performed an interim impairment test on goodwill, an interim impairment test on our indefinite lived trade name intangible asset of our Empi reporting unit, and an interim recoverability test on our long lived assets. We then determined that the long lived assets and the goodwill were not impaired; however, we recorded impairment charges of $4.5 million for the Empi trade name as we determined that the percentage by which the carrying value of this trade name exceeded its fair value was 18.1%. The impairment charge was included in Impairment of goodwill line item in the Consolidated Statement of Operations. This fair value measurement is categorized within Level 3 of the fair value hierarchy.

However, during the third quarter of 2015, circumstances in our Empi reporting unit continued to worsen beyond our second quarter estimates due to continuing challenges of the reimbursement environment for Empi products. As a result we performed an interim impairment test on goodwill. In performing the goodwill impairment test, we estimated the fair values of the Empi reporting unit 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 the reporting unit were based on a discrete financial forecast 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. Future cash flows were then discounted to present value. Publicly available information regarding comparable market capitalization was also considered in assessing the reasonableness of the cumulative fair value of the reporting unit estimated using the discounted cash flow methodology. We determined that the carrying value of our Empi reporting unit was in excess of its estimated fair value. As a result, we recorded impairment charges of $117.3 million for the Empi reporting unit. This impairment charge represents an estimated loss that has not yet been finalized at this time. We will continue to evaluate these estimates in our 2015 annual impairment test in the fourth quarter of 2015. The percentage by which the carrying value of the Empi reporting unit exceeded the fair value was 92.6%. The impairment charge was included in Impairment of goodwill line item in the Consolidated Statement of Operations. This fair value measurement is categorized within Level 3 of the fair value hierarchy.

 

Additionally, we performed an interim impairment test on our indefinite lived trade name intangible asset of our Empi reporting unit. The method of testing the indefinite lived intangible asset for impairment was consistent with our annual impairment test which is described in our 2014 Annual Report on Form 10-K filed with the SEC on February 20, 2015. We determined that the carrying value of our Empi trade name was in excess of its estimated fair value. As a result, we recorded impairment charges of $17.9 million for the Empi trade name. The percentage by which the carrying value of this trade name exceeded its fair value was 100.0%. The impairment charge was included in Impairment of intangible and other assets line item in the Consolidated Statement of Operations. This fair value measurement is categorized within Level 3 of the fair value hierarchy.

We also performed an interim recoverability test on our long lived assets related to the Empi reporting unit. We tested the recoverability of the long lived asset group to be held and used by using an undiscounted cash flow approach dependent primarily upon estimates of forecasted sales, gross margin, selling, general and administrative expenses, depreciation, income taxes, capital expenditures, working capital requirements and remaining useful lives of the primary asset. We then determined that the carrying value of the asset group was in excess of the estimated undiscounted cash flows. Accordingly, we completed the Step 2 analysis to determine the fair value of the asset group. As a result, we recorded impairment charges for the finite lived intangible assets of $29.1 million and the property, plant and equipment of $0.7 million. The impairment charges were included in Impairment of intangible and other long lived assets line item in the Consolidated Statement of Operations. This fair value measurement is categorized within Level 3 of the fair value hierarchy.

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Our definite lived intangible assets are being amortized using the straight line method over their remaining weighted average useful lives of 4.6 years for customer relationships, 8.0 years for patents and technology, 2.0 years for distributor contracts and relationships, 6.9 years for trademarks and trade names, and 1.8 years for non-compete agreements. Based on our amortizable intangible asset balance as of September 26, 2015, we estimate that amortization expense will be as follows for the next five years and thereafter (in thousands):

 

 

 

6. OTHER CURRENT LIABILITIES

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

 

 

 

7. 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. In prior periods, we have utilized 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 September 26, 2015, we did not have any outstanding foreign currency exchange forward contracts. 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 Unaudited Condensed Consolidated Statements of Operations.

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

 

 

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

 

 

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

 

 

 

8. FAIR VALUE MEASUREMENTS

Financial assets and liabilities are classified based on the lowest level of input that is significant to the fair value measurements. Our assessment of the significance of a particular input to the fair value measurements requires judgment and may affect the valuation of the assets and liabilities being measured and their placement within the fair value hierarchy.

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. 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.

As of September 26, 2015, the balance of financial assets and liabilities measured at fair value on a recurring basis was zero.

The following table presents the balances of financial assets and liabilities measured at fair value on a recurring basis as of December 31, 2014 (in thousands):

 

 

 

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9. DEBT

Debt obligations consist of the following (in thousands):

 

 

Senior Secured Credit Facilities

On May 7, 2015, we entered into (i) a $1,035.0 million new term loan facility (New Senior Secured Term Loan Facility) and (ii) a $150.0 million new asset-based revolving credit facility (New Asset-Based Revolving Credit Facility and together with the New Senior Secured Term Loan Facility, New Senior Secured Credit Facilities). In addition, the New Senior Secured Term Loan Facility provided for a $20.0 million delayed draw term loan and a $150.0 million incremental facility, subject to customary borrowing conditions and the New Asset-Based Revolving Credit Facility provides for a $50.0 million facility increase, subject to customary borrowing conditions.

A portion of the proceeds from the New Senior Secured Credit Facilities was used to repay in full all amounts due and owing under the credit agreement, dated as of November 20, 2007, as amended and restated as of March 20, 2012, as supplemented as of March 30, 2012, as amended as of December 19, 2012, as amended and supplemented as of March 21, 2013 and as further amended and supplemented as of April 8, 2014, DJOFL, DJO Holdings, Credit Suisse AG, as administrative agent, and the lenders party thereto. The full amount available under the delayed draw term loan under the New Senior Secured Credit Facilities was drawn in connection with our acquisition of certain assets from Zimmer Biomet Holdings, Inc. on June 30, 2015.

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As of September 26, 2015, the market values of our New Senior Secured Term Loan Facility and drawings under our New Asset-Based Revolving Credit Facility were $1,052.4 million and $5.0 million, respectively. We determine market value using trading prices for the New Senior Secured Credit Facilities on or near that date. This fair value measurement is categorized within Level 2 of the fair value hierarchy.

New Senior Secured Term Loan Facility

Interest Rates. Borrowings under the New Senior Secured Term Loan Facility bear interest at a rate equal to an applicable margin plus, at our option, either (a) a base rate determined by reference to the highest of (1) the prime rate determined by the Wall Street Journal, (2) the federal funds effective rate plus 0.50% and (3) the Eurodollar rate for a one-month interest period plus 1.00% or (b) the Eurodollar rate determined by reference to the ICE Benchmark Administration London Interbank Offered Rate for deposits in the U.S. dollars for the interest period relevant to each borrowing adjusted for required reserves. The applicable margin for borrowings under the New Senior Secured Term Loan Facility is 2.25% with respect to base rate borrowings and 3.25% with respect to Eurodollar borrowings. As of September 26, 2015, our weighted average interest rate for all borrowings under the New Senior Secured Credit Facilities was 4.24%.

Fees. In addition to paying interest on outstanding principal under the New Senior Secured Term Loan Facility, DJOFL as the borrower under the New Senior Secured Term Loan Facility is required to pay a delayed draw commitment fee to the delayed draw lenders under the New Senior Secured Term Loan Facility in respect of the unutilized delayed draw commitments thereunder.

Principal Payments. We are required to repay installments on the New Senior Secured Term Loan Facility in quarterly installments equal to 0.25% of the original principal amount of the New Senior Secured Term Loan Facility, with the remaining amount payable at maturity in June 2020.

Prepayments. The New Senior Secured Term Loan Facility requires us to prepay outstanding term loans (Term Loans), subject to certain exceptions, with:

The foregoing mandatory prepayments will be applied pro rata to installments of Term Loans as directed by us.

We may voluntarily repay outstanding loans under the New Senior Secured Credit Facilities at any time without premium or penalty, provided that (i) 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 and (ii) voluntary prepayments made on a date within 6 months from the date of the closing of the New Senior Secured Term Loan Facility (Closing Date) shall be subject to a prepayment premium of 1%.

Guarantee and Security. All obligations under the New Senior Secured Term Loan Facility are unconditionally guaranteed by DJO Holdings LLC 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, Credit Facility Guarantors). In addition, the New Senior Secured Term Loan Facility is secured by (i) a first priority security interest in certain of our tangible and intangible assets and those of each of the Credit Facility Guarantors and all the capital stock of, or other equity interests in, DJO Holdings and each of our and the Credit Facility Guarantors’ material direct or indirect wholly-owned restricted domestic subsidiaries and direct wholly-owned first-tier restricted foreign subsidiaries (subject to certain exceptions and qualifications) (collectively, Term Loan Collateral) and (ii) a second priority security interest in the ABL Collateral (as defined below).

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

In addition, the New Senior Secured Term Loan Facility requires 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 governing the New Senior Secured Term Loan Facility) of 5.35:1 for a trailing twelve month period commencing with the period ending September 30, 2015. The New Senior Secured Term Loan Facility also contains certain customary affirmative covenants and events of default. As of September 26, 2015, our actual senior secured first lien net leverage ratio was 3.54:1, and we were in compliance with all other applicable covenants.

New Asset-Based Revolving Credit Facility

Interest Rate. Borrowings under our New Asset-Based Revolving Credit Facility bear interest, at our option, at a rate equal to a margin over, either (a) a base rate determined by reference to the highest of (1) the administrative agent’s prime lending rate, (2) the federal funds effective rate plus 0.50% and (3) the Eurodollar rate for a one-month interest period plus 1.00% or (b) a Eurodollar rate determined by reference to the Reuters LIBOR rate for the interest period relevant to such borrowing. The margin for the New Asset-Based Revolving Credit Facility is 1.25% with respect to base rate borrowings and 2.25% with respect to Eurodollar borrowings, each subject to step-downs upon the achievement of specified excess availability thresholds.

Fees. In addition to paying interest on outstanding principal under the New Asset-Based Revolving Credit Facility, we are required to pay a commitment fee to the lenders under the New Asset-Based Revolving Credit Facility in respect of the unutilized commitments thereunder. The initial commitment fee rate is 0.375% per annum. The commitment fee rate is subject to a step-down upon utilization of the New Asset-Based Revolving Credit Facility commitments. We are also required to pay customary letter of credit fees.

Guarantee and Security. The New Asset-Based Revolving Credit Facility is secured by a first priority security interest in personal property of DJOFL and each of the Credit Facility Guarantors consisting of accounts receivable (including related contracts and contract rights, inventory, cash, deposit accounts and securities accounts), inventory, intercompany notes and intangible assets (other than intellectual property and investment property), instruments, chattel paper, documents and commercial tort claims to the extent arising out of the foregoing, and related books and records (subject to certain exceptions and qualifications) (collectively, the ABL Collateral, and together with the Term Loan Collateral, Collateral) and a fourth priority security interest in the Term Loan Collateral.

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

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In addition, we and our restricted subsidiaries are required to maintain a minimum fixed charge coverage ratio of 1.0 to 1.0 if excess availability is less than the greater of $9.0 million or 10% of the lesser of (1) the aggregate commitments under the New Asset-Based Revolving Credit Facility and (2) the aggregate borrowing base until the 30^th consecutive day that excess availability exceeds such threshold. The New Asset-Based Revolving Credit Facility also contains certain customary affirmative covenants and events of default. As of September 26, 2015, we were in compliance with all applicable covenants.

Prior to May 7, 2015, our prior senior secured credit facilities consisted 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, supplemented as of March 30, 2012, as amended as of December 19, 2012, amended and supplemented as of March 21, 2013 and further amended and supplemented as of April 8, 2014. Effective April 8, 2014, the interest rate margins applicable to borrowings under our prior senior secured revolving credit facilities were, 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 Tranche B term loans were, at our option, either (a) the Eurodollar rate plus 325 basis points or (b) a base rate plus 325 basis points. There was a minimum LIBOR rate applicable to the Eurodollar component of interest rates on Tranche B term loans of 1.00%. The applicable margin for borrowings under the old senior secured revolving credit facilities could have been reduced, subject to our attaining certain leverage ratios.

Existing Notes:

8.125% Second Lien Notes

On May 7, 2015 we issued $1,015.0 million aggregate principal amount of 8.125% Second Lien Notes (8.125% Notes), which mature on June 15, 2021. The 8.125% Notes are jointly and severally and fully and unconditionally guaranteed on a senior secured basis by each of DJOFL’s existing and future direct and indirect wholly-owned domestic subsidiaries that guarantees any of DJOFL’s indebtedness or any indebtedness of DJOFL’s domestic subsidiaries or is an obligor under the New Senior Secured Credit Facilities.

The net proceeds of the issuance of the 8.125% Notes were used, together with borrowings under the New Senior Secured Credit Facilities and cash on hand, to satisfy and discharge our obligations under our prior note issuances (see below), repay amounts outstanding under our prior existing senior secured credit facilities and pay all related fees and expenses.

Pursuant to a second lien security agreement, the 8.125% Notes and related guarantees are secured by second-priority liens on the Term Loan Collateral and third-priority liens on the ABL Collateral, in each case subject to permitted liens.

As of September 26, 2015, the market value of the 8.125% Notes was $1,021.3 million. We determined market value using trading prices for the 8.125% Notes on or near that date. This fair value measurement is categorized within Level 2 of the fair value hierarchy.

Optional Redemption. Prior to June 15, 2018, we have the option to redeem some or all of the 8.125% Notes at a redemption price equal to 100% of the principal amount of the 8.125% Notes redeemed, plus accrued and unpaid interest to, but excluding, the redemption date, if any, plus the “make-whole” premium set forth in the indenture governing the 8.125% Notes (8.125% Indenture). On and after June 15, 2018, we have the option to redeem the 8.125% Notes, in whole or in part, at the redemption prices set forth in the 8.125% Indenture, plus accrued and unpaid interest to, but excluding, the redemption date. In addition, (i) prior to June 15, 2019, we have the option to redeem up to 15% of the aggregate principal amount of the 8.125% Notes at a redemption price equal to 103% of the aggregate principal amount thereof and/or (ii) prior to June 15, 2018, we may also redeem up to 35% of the aggregate principal amount of the 8.125% Notes at a redemption price equal to 108.125% of the aggregate principal amount thereof, in each case, using an amount not to exceed the net proceeds from certain equity offerings, plus accrued and unpaid interest to, but excluding, the redemption date.

10.75% Third Lien Notes

On May 7, 2015, we issued $298.5 million aggregate principal amount of 10.75% Third Lien Notes (10.75% Notes) which mature on April 15, 2020. The 10.75% Notes are guaranteed jointly and severally and fully and unconditionally on a secured basis by

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each of DJOFL’s existing and future direct and indirect wholly-owned domestic subsidiaries that guarantees any of DJOFL’s indebtedness or any indebtedness of DJOFL’s domestic subsidiaries or is an obligor under the New Senior Secured Credit Facilities.

The 10.75% Notes were issued in connection with our (i) private offer (Exchange Offer) to exchange our 9.75% Senior Subordinated Notes due 2017 (9.75% Notes) for the 10.75% Notes and cash and (ii) solicitation (Consent Solicitation) of consents (Consents) from registered holders of the 9.75% Notes to certain proposed amendments (Proposed Amendments) to the indenture (9.75% Indenture), dated as of October 18, 2010, by and among DJOFL, the guarantors party thereto and The Bank of New York Mellon, as trustee, governing the 9.75% Notes.

Pursuant to a third lien security agreement, the 10.75% Notes and related guarantees are secured by third-priority liens on the Term Loan Collateral and fourth-priority liens on the ABL Collateral, in each case subject to permitted liens.

As of September 26, 2015, the market value of the 10.75% Notes was $300.3 million. We determined market value using trading prices for the 10.75% Notes on or near that date. This fair value measurement is categorized within Level 2 of the fair value hierarchy.

Optional Redemption. We have the option to redeem the 10.75% Notes, in whole or in part, at any time and from time to time after May 7, 2015, at the redemption prices set forth in the Indenture governing the 10.75% Notes (10.75% Indenture), plus accrued and unpaid interest to, but excluding, the redemption date.

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 fully and unconditionally 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 New Senior Secured Credit Facilities.

On May 13, 2015, a total of $298.5 million aggregate principal of outstanding 9.75% Notes were validly tendered as part of the Exchange Offer. As of September 26, 2015, $1.5 million aggregate principal of the 9.75% Notes remains outstanding.

Optional Redemption. Under the indenture governing the 9.75% Notes (the 9.75% Indenture), we have the option to redeem some or all of the 9.75% Notes at a redemption price of 102.438% and 100% of the then outstanding principal balance at October 15, 2015 and 2016, respectively, plus accrued and unpaid interest.

Change of Control

Upon the occurrence of a change of control, DJOFL must give holders of the Notes an opportunity to sell to DJOFL some or all of their 8.125% Notes, 10.75% Notes and 9.75% Notes at a price equal to 101% of their principal amount, plus accrued and unpaid interest to the repurchase date.

Covenants

The 8.125% Indenture, the 10.75% Indenture and the 9.75% Indenture (collectively, 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 September 26, 2015, 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 credit agreement governing the Senior Secured Credit Facilities or the Indentures, at which time the lenders could elect to declare all amounts outstanding under the New 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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Prior Note Issuances:

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 were 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 our prior senior secured credit facilities.

On May 16, 2015, we redeemed the full principal amount outstanding under the 8.75% Notes, plus accrued interest, at a redemption price of 104.375%.

9.875% Senior Notes

On October 1, 2012, we issued $440.0 million aggregate principal amount of 9.875% Senior Notes (9.875% Notes) maturing on April 15, 2018. The 9.875% Notes were 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 our prior senior secured credit facilities.

On May 16, 2015, we redeemed the full principal amount outstanding under the 9.87% Notes, plus accrued interest, at a redemption price of 104.938%.

7.75% Senior Unsecured Notes

On April 7, 2011, we issued $300.0 million aggregate principal amount of 7.75% Senior Notes (7.75% Notes) maturing on April 15, 2018. The 7.75% Notes were 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 our prior senior secured credit facilities.

On May 16, 2015, we redeemed the full principal amount outstanding of the 7.75% Notes, plus accrued interest, at a redemption price of 103.875%.

Loss on Modification and Extinguishment of Debt

During the nine months ended September 26, 2015, we recognized loss on modification and extinguishment of debt of $68.3 million. The loss consists of $47.8 million in premiums related to the redemption of our 8.75% Notes, 9.875% Notes, and 7.75% Notes, $11.9 million related to the non-cash write off of unamortized debt issuance costs and original issue discount associated with the portion of our debt that was extinguished and $8.6 million of arrangement and amendment fees and other fees and expenses incurred in connection with the refinancing.

During the nine months ended September 27, 2014, we recognized a loss on modification and extinguishment of debt of $1.0 million. The loss consists of $0.4 million of arrangement and amendment fees and other fees and expenses incurred in connection with the amendment of our prior 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.

Debt Issuance Costs

As of September 26, 2015 and December 31, 2014, we had $15.4 million and $28.6 million, respectively, of unamortized debt issuance costs. In April 2015, the FASB issued an accounting standards update related to the presentation of debt issuance costs. The standard requires that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of the debt liability, consistent with debt discounts. The Company has early adopted this update and the impact is reflected in the current and prior periods presented. Therefore, debt issuance costs are reflected as direct deduction from the debt liability included in Long-term debt obligations in our Unaudited Condensed Consolidated Balance Sheets.

For the nine month period ended September 26, 2015, we capitalized $5.9 million of debt issuance costs incurred in connection with our debt refinancing. For the nine month period ended September 27, 2014, we capitalized $1.5 million of debt issuance costs incurred in connection with the amendment of our prior senior secured credit facilities.

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For the three and nine months ended September 26, 2015, amortization of debt issuance costs was $0.7 million and $4.0 million, respectively. For the three and nine months ended September 27, 2014, amortization of debt issuance costs was $2.1 million and $6.0 million, respectively. Amortization of debt issuance costs was included in Interest expense in our Unaudited Condensed Consolidated Statements of Operations for each of the periods presented.

 

 

10. INCOME TAXES

Income taxes for the interim periods presented have been included in our Unaudited Condensed Consolidated Financial Statements on the basis of an estimated annual effective tax rate, adjusted for discrete items. The income tax expense for these periods differed from the amounts which would have been recorded using the U.S. statutory tax rate due primarily to certain valuation allowances provided against deferred tax assets, the impact of nondeductible expenses, foreign taxes, deferred taxes on the assumed repatriation of foreign earnings and tax amortization of goodwill and indefinite-lived intangibles.

For the three and nine months ended September 26, 2015, we recorded income tax benefit of $7.2 million and $1.8 million on pre-tax losses of $184.9 million and $292.6 million, resulting in effective tax rates of 3.9% and 0.6%, respectively. For the three and nine months ended September 27, 2014, we recorded income tax expense of approximately $1.3 million and $10.6 million on pre-tax losses of $19.9 million and $71.9 million, resulting in negative effective tax rates of 6.3% and 14.8%, respectively. For the three months ended September 26, 2015 the Company wrote down certain Empi intangible assets which included goodwill and indefinite lived intangible assets. The total goodwill and intangible asset impairment in the quarter was $164.9 million. The impairment loss created a tax benefit which reduced tax expense by $6.8 million in the quarter.

From time to time 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 foreign jurisdictions where we are subject to tax. In addition, we do not currently recognize a tax benefit for our U.S. and state tax loss carryovers because we cannot conclude that it is more likely than not the carryovers will be available to offset future taxable income.

We record net deferred tax assets to the extent we conclude that it is more likely than not that the related deferred tax assets will be realized. In making such determination, we consider all available positive and negative evidence, including future reversals of existing taxable temporary differences, projected future taxable income, tax planning strategies and the results of recent financial operations. At this time, we cannot conclude that it is more likely than not that the benefit from certain U.S. federal and state net operating loss carryforwards will be realized. Accordingly, we have provided a valuation allowance of $29.2 million and $57.0 million for the three and nine months ended September 26, 2015, respectively, on the deferred tax assets related to the net operating loss carry forwards. If our assumptions change and we determine that it is more likely than not that we will be able to realize the deferred tax assets related to these net operating losses, reversal of the valuation allowances we have recorded against those deferred tax assets will be recognized as a reduction of income tax expense. The establishment of valuation allowances does not preclude us from utilizing our loss carryforwards or other deferred tax assets in the future and does not impact our cash resources.

We and our subsidiaries file income tax returns in the U.S. federal jurisdiction and various states and foreign jurisdictions. With few exceptions, we are no longer subject to U.S. federal, state and local, or foreign income tax examinations by tax authorities for years before 2011.

At September 26, 2015, our gross unrecognized tax benefits were $14.2 million reflecting an increase of $0.3 million from the unrecognized amount of $13.9 million at December 31, 2014. As of September 26, 2015, we have $2.5 million accrued for interest and penalties related to these unrecognized tax benefits. 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 the U.S. federal valuation allowance. We anticipate that approximately $0.4 million aggregate of unrecognized tax benefits, each of which are individually immaterial will decrease in the next twelve months due to the expiration of statutes of limitation. As of September 26, 2015, we have unrecognized various foreign and U.S. state tax benefits of approximately $5.6 million, which, if recognized, would impact our effective tax rate in future periods.

 

 

11. 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.

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Options issued under the 2007 Plan can be either incentive stock options or non-qualified stock options. The exercise price of stock options granted will not be less than 100% of the fair market value of the underlying shares on the date of grant and will expire no more than ten years from the date of grant.

In July 2015, all outstanding options granted to employees prior to 2012 were amended to modify the vesting terms of the portion of options which vested on achievement of a minimum multiple of invested capital (MOIC) from a MOIC of 2.25 for one-third of the options and a MOIC of 2.5 for one-third of the options to a single MOIC vesting component covering two-thirds of the options with the terms described below.  As amended, the options granted prior to 2012 vest as follows: (i) 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); and, (ii) two-thirds of each stock option grant will vest upon achieving MOIC 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 Market Return Options provide for vesting within a range of achievement of a MOIC multiple between 1.5 and 2.25. If Blackstone sells all or a portion of its equity interests in DJO while the Options are outstanding, then the unvested Market Return Options will vest and become exercisable as follows: 1) 25% of the options will vest and become exercisable if Blackstone realizes a MOIC of 1.5 times its equity investment in DJO; 2) 100% of the options will vest and become exercisable if Blackstone realizes a MOIC of at least 2.25 times its equity investment in DJO; and 3) if Blackstone realizes a MOIC of greater than 1.5 times its equity investment but less than 2.25 times its equity investment, then 25% of the options will vest and become exercisable and a percentage of the remaining unvested options will vest and become exercisable with such percentage equal to a fraction, the numerator of which is the actual MOIC realized by the majority shareholder, less 1.5 and the denominator of which is 0.75.

In July 2015, all outstanding options granted to employees in 2012 and later years were amended to modify the MOIC vesting provision as described below. 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, as amended in July 2015, such options also provide that in the event Blackstone the same MOIC requirement described above for the Market Return Options, 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. The 2013 Adjusted EBITDA results were not met. 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 equaled or exceeded an enhanced amount of Adjusted EBITDA reflected in the 2014 financial plan. Because the required 2014 Adjusted EBITDA results were not achieved, those tranches did not vest.

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).

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). 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; and, as amended in July 2015, two-thirds of the stock option grant will vest in the same manner as the Market Return Options.

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Stock-Based Compensation

During the nine months ended September 26, 2015, the compensation committee granted 858,621 options to employees, of which 444,169 were Performance Options, 265,000 were Market Return Options, 128,331 were Time-Based Options and 21,121 were Vested Options. Additionally, the compensation committee granted 23,000 Director Performance Options to members of the Board of Directors. The weighted average grant date fair values of the Time-Based Options, the Vested Options, and the Director Options, granted during the nine months ended September 26, 2015 were $6.04, $5.27, and $6.92, respectively.

During the nine months ended September 27, 2014, the compensation committee granted 1,279,500 options to employees, of which 922,830 were Performance Options and 356,670 were Time-Based Options. The weighted average grant date fair value of the Time-Based Options granted during the nine months ended September 27, 2014 was $6.05.

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 granted:

 

 

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

 

 

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 2015. Additionally, we have not recognized expense for any of the options which have the potential to vest based on Adjusted EBITDA for 2016, 2017, and 2018 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 2014 or 2015.

In each of the periods presented above, we recognized stock-based compensation expense only for Time-Based Options granted to employees, as the performance components of the 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 Unaudited Condensed Consolidated Statements of Operations.

 

 

12. MEMBERSHIP DEFICIT

During the nine months ended September 26, 2015, DJO issued 8,848 shares of its common stock upon the net exercise of vested stock options that had been granted to an employee in 2006 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 employee exercised these Rollover Options for a total of 30,529 shares of DJO’s common stock, from which we withheld 21,681 shares to cover $0.4 million of aggregate option exercise price and income tax withholdings and issued the remaining 8,848 shares.

 

 

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13. 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 three and nine months presented, we expensed $1.75 million and $5.25 million, respectively, related to the annual monitoring fee, which is recorded as a component of Selling, general and administrative expense in the Consolidated Statements of Operations.

 

 

14. COMMITMENTS AND CONTINGENCIES

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 the relator and we understand that the other three defendants have reached settlements. The case continues against us. While we believe the case against us has no merit, we can make no assurances as to 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 has been granted without leave to amend as to the federal false claim act allegations. The Court declined jurisdiction over the remaining state claims. Relators have filed a notice of appeal.

Empi Investigation

Our subsidiary, Empi, Inc., was served with a subpoena dated May 11, 2015, issued by the Office of Inspector General (OIG) for the U.S. Department of Defense seeking a variety of documents primarily relating to the supply of home electrotherapy units and supplies by Empi to beneficiaries covered under medical insurance programs sponsored or administered by TRICARE, the Defense Health Agency and the Department of Defense. The relevant time period for these documents is from January 1, 2010 to the date of the subpoena. We are in the process of collecting and producing responsive documents to the OIG.

 

 

15. SEGMENT AND GEOGRAPHIC INFORMATION

For the periods ended September 26, 2015 and September 27, 2014, we reported our business in four operating segments: Bracing and Vascular; Recovery Sciences; Surgical Implant and International.

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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 online. The bracing and vascular products sold through the channel are principally sold under the DonJoy Performance, Bell-Horn and Doctor Comfort brands.

Recovery Sciences Segment

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

Surgical Implant Segment

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

International Segment

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

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Information regarding our reportable business segments is presented below (in thousands). 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 New Senior Secured Credit Facilities. We do not allocate assets to reportable segments because a significant portion of our assets are shared by the segments.

 

 

Geographic Area

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

 

 

 

16. SUPPLEMENTAL GUARANTOR CONDENSED CONSOLIDATING FINANCIAL STATEMENTS

DJOFL and its direct wholly-owned subsidiary, DJO Finco Inc. (DJO Finco), jointly issued the 8.125% Notes, 10.75% Notes and 9.75% Notes. DJO Finco was formed solely to act as a co-issuer of the notes, has only nominal assets and does not conduct any operations. The Indentures generally prohibit DJO Finco from holding any assets, becoming liable for any obligations or engaging in any business activity.

The 8.125% Notes are jointly and severally, fully and unconditionally guaranteed, on a senior secured basis by all of DJOFL’s domestic subsidiaries (other than the co-issuer) that are 100% owned, directly or indirectly, by DJOFL (the Guarantors). The 10.75% Notes are jointly and severally, fully and unconditionally guaranteed, on a secured basis by the Guarantors. The 9.75% Notes are jointly and severally, fully and unconditionally guaranteed, on an unsecured senior subordinated basis by the Guarantors. Our foreign subsidiaries (the Non-Guarantors) do not guarantee the notes.

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The following tables present the financial position, results of operations and cash flows of DJOFL, the Guarantors, the Non-Guarantors and certain eliminations for the periods presented.

DJO Finance LLC

Unaudited Condensed Consolidating Balance Sheets

As of September 26, 2015

(in thousands)

 

 

25

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DJO Finance LLC

Unaudited Condensed Consolidating Statements of Operations

For the Three Months Ended September 26, 2015

(in thousands)

 

 

26

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DJO Finance LLC

Unaudited Condensed Consolidating Statements of Operations

For the Nine Months Ended September 26, 2015

(in thousands)

 

 

27

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DJO Finance LLC

Unaudited Condensed Consolidating Statements of Comprehensive Loss

For the Three Months Ended September 26, 2015

(in thousands)

 

 

28

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DJO Finance LLC

Unaudited Condensed Consolidating Statements of Comprehensive Loss

For the Nine Months Ended September 26, 2015

(in thousands)

 

 

29

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DJO Finance LLC

Unaudited Condensed Consolidating Statements of Cash Flows

For the Nine Months Ended September 26, 2015

(in thousands)

 

 

30

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DJO Finance LLC

Condensed Consolidating Balance Sheets

As of December 31, 2014

(in thousands)

 

 

31

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DJO Finance LLC

Unaudited Condensed Consolidating Statements of Operations

For the Three Months Ended September 27, 2014

(in thousands)

 

 

32

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DJO Finance LLC

Unaudited Condensed Consolidating Statements of Operations

For the Nine Months Ended September 27, 2014

(in thousands)

 

 

33

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DJO Finance LLC

Unaudited Condensed Consolidating Statements of Comprehensive Loss

For the Three Months Ended September 27, 2014

(in thousands)

 

 

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DJO Finance LLC

Unaudited Condensed Consolidating Statements of Comprehensive Loss

For the Nine Months Ended September 27, 2014

(in thousands)

 

 

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DJO Finance LLC

Unaudited Condensed Consolidating Statements of Cash Flows

For the Nine Months Ended September 27, 2014

(in thousands)

 

 

 

17. SUBSEQUENT EVENTS

On October 28, 2015, we executed interest rate caps with Goldman Sachs Bank USA at a notional amount of $500.0 million and a cap rate of 1.00%. Our objective in entering this transaction is to reduce our exposure to higher interest payments on our New Senior Secured Term Loan Facility in the event of rising short term interest rates.

On November 10, 2015 we announced a plan to exit the Empi business. We expect the sales of Empi products to remain below the level needed to reach acceptable profitability and that the timeframe needed to assure sustainable profitability will be longer than management believes is economically justified.  The plan will result in ceasing manufacturing, selling and reimbursement billing

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activities related to Empi, largely to be completed by the end of the fourth quarter 2015. Accordingly, we expect to incur a restructuring charge in the fourth quarter ended December 31, 2015 primarily related to one-time termination benefits, costs to shut down manufacturing, and consulting services. The amount of these costs has yet to be determined.

 

 

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

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 unaudited condensed consolidated financial statements and notes thereto as well as the other financial data included elsewhere in this Quarterly Report on Form 10-Q. References to “us,” “we,” “DJOFL,” “our,” or “the Company,” refers to DJO Finance LLC and its consolidated subsidiaries.

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. The section entitled “Risk Factors” in our 2014 Annual Report on Form 10-K filed with the Securities and Exchange Commission (SEC) on February 20, 2015 describes these important risk factors that may affect our business, financial condition, results of operation, and/or liquidity. Results actually achieved may differ materially from expected results included in these statements as a result of these or other factors.

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 consist of four operating segments; Bracing and Vascular; Recovery Sciences; Surgical Implant; and International. See Note 15 to our Unaudited Condensed Consolidated Financial Statements for financial and other additional information regarding our segments.

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The following table presents 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.

 

 

Results of Operations

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

 

 

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Three Months Ended September 26, 2015 (third quarter 2015) compared to Three Months Ended September 27, 2014 (third quarter 2014)

Net Sales. Net sales for third quarter 2015 were $300.0 million, a decrease of $5.5 million compared to net sales of $305.5 million for third quarter 2014. Excluding the unfavorable impact of foreign currency exchange rates, which resulted in a decrease in net sales of $11.2 million, net sales increased by $5.7 million, or 1.9%. Net sales from acquisitions completed in third quarter 2015 were $10.0 million. The results of the Company’s non-U.S. operations are translated into U.S. dollars to report consolidated results. Based on weakening of currency exchange rates against the U.S. dollar that occurred in late 2014 and early 2015, the Company currently expects that the stronger U.S. dollar will continue to have an adverse effect on reported amounts of net sales relative to the prior year period in the remainder of 2015.

The following table sets forth our net sales by operating segment ($ in thousands):

 

 

Net sales in our Bracing and Vascular segment were $133.2 million for third quarter 2015, an increase of 3.1% compared to net sales of $129.2 million for third quarter 2014. The increase is primarily due to new account acquisition in our OfficeCare channel, an increase in third party payor billing and growth in sales of direct consumer products and vascular pumps.

 

Net sales in our Recovery Sciences segment were $59.6 million for third quarter 2015, a decrease of 19.4% from net sales of $74.0 million for third quarter 2014. The decrease was driven primarily by lower sales of Empi products. The decrease in Empi sales was due to the continued challenging coverage and reimbursement environment, changes to our business processes for Empi products and a restructuring of the Empi selling organization. The loss of sales momentum resulting from these actions had a larger impact than expected. Continued slow market conditions affecting the sale of Chattanooga rehabilitation equipment also contributed to the decrease in this segment’s net sales.

We expect that the negative sales trend for Empi products will continue as this business faces multiple coverage and reimbursement challenges, including changes in Medicare reimbursement rates established through competitive bidding which will take effect in 2016. We expect the sales of Empi products to remain below the level needed to reach acceptable profitability and that the timeframe needed to assure sustainable profitability will be longer than management believes is economically justified. Together with these facts and the related significant impairment of the goodwill, long lived and intangible assets related to the Empi reporting unit (See Note 8 to our Unaudited Condensed Consolidated Financial Statements for additional information), we have developed a plan to exit the Empi business over the next several months.

Net sales in our Surgical Implant segment were $37.7 million for third quarter 2015, an increase of 58.0% compared to net sales of $23.8 million for third quarter 2014. Sales of bone cement, which was acquired with the assets purchased from Zimmer Biomet Holdings, Inc. (“Zimmer Biomet”) in third quarter 2015, represented $10.0 million of the increase and the remainder was driven by strong sales of our existing shoulder and hip products. Knee sales increased in third quarter 2015 compared to third quarter 2014 due to new product introductions and new accounts.

Net sales in our International segment were $69.5 million for third quarter 2015, a decrease of 11.4% compared to net sales of $78.4 million for third quarter 2014. For third quarter 2015, changes in foreign currency exchange rates had a negative $11.2 million impact on year over year sales. Excluding the impact of foreign currency exchange rates, net sales in our International segment increased 2.9% compared to third quarter 2014. Growth in net sales in this segment are driven by stronger sales in direct markets, primarily Germany and Spain, and increased sales penetration in China, offset by slower sales in certain export markets due to the strength of the U.S. dollar.

Cost of Sales. Cost of sales as a percentage of net sales was constant at 40.1% for third quarter 2015 and third quarter 2014 due to the continued lower cost of manufacturing in Mexico and benefits from certain cost savings and productivity initiatives in third quarter 2015 offset by unfavorable mix.

Selling, General and Administrative (SG&A). SG&A expenses of $123.8 million for third quarter 2015 were essentially flat compared to $123.6 million in third quarter 2014, 41.3% and 40.5% of net sales, respectively. The increase as a percent of net sales resulted from acquisition and integration expenses in our Surgical Implant segment and severance payments related to cost savings

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initiatives. The increase was offset by lower bad debt, reduced marketing and selling expenses and the favorable impact of currency exchange rates.  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):

 

 

Research and Development (R&D). R&D expenses decreased to $7.7 million for third quarter 2015, from $9.2 million in third quarter 2014. As a percentage of net sales, R&D expense was 2.6% in third quarter 2015 compared to 3.0% in third quarter 2014. In 2014, the Company incurred consulting fees for testing, documentation and software implementation to enhance new product introductions and ensure FDA compliance. The Company continues to focus on the development of new products, as well as the enhancement of existing products with the latest technology and updated designs, primarily in our Bracing and Vascular and Surgical Implant segments.

Amortization of Intangible Assets. Amortization of intangible assets decreased to $22.5 million for third quarter 2015, from $23.2 million for third quarter 2014. The decrease is due to certain intangible assets reaching full amortization primarily in our patents and technology category.

Impairment of Goodwill. We determined that the carrying value of our goodwill related to the Empi reporting unit was in excess of its estimated fair value. As a result, we recorded estimated impairment charges of $117.3 million. This impairment charge represents an estimated loss that has not yet been finalized at this time. We will continue to evaluate these estimates in our 2015 annual impairment test in the fourth quarter of 2015.

Impairment of Intangible Assets. We determined that the carrying values of our Empi trade name, an indefinite lived intangible asset was in excess of its estimated fair value. Additionally, we determined that the carrying values of certain long lived assets including our finite lived intangible assets related to the Empi reporting unit were also in excess of their fair values. As a result, we recorded impairment charges of $47.7 million.

The impairment charges resulted from declining Empi sales and profitability trends due to continuing challenges of the reimbursement environment. See Note 5 to our Unaudited Condensed Consolidated Financial Statements for additional information.

Interest Expense, net. Our interest expense, net decreased to $42.1 million for third quarter 2015, from $43.2 million for third quarter 2014 due to lower weighted average interest rates on borrowings.  

Loss on Modification and Extinguishment of Debt. Loss on modification and extinguishment of debt for third quarter 2015 consists of $0.3 million of arrangement and amendment fees and other fees and expenses incurred in connection with the refinancing. Loss on modification and extinguishment of debt for third quarter 2014 consists of $0.4 million of arrangement and amendment fees and other fees and expenses incurred in connection with the amendment of our prior 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.

Other Expense, Net. Other expense, net, decreased to $3.1 million for third quarter 2015, from $3.5 million for third quarter 2014. Results for both periods presented primarily represent net realized and unrealized foreign currency translation gains and losses.

Income Tax Provision. For each quarter we record our tax provision so that the year to date tax provision reflects our latest estimated annual effective tax rate plus adjustments for quarter-to-date discrete items. In third quarter 2015, we recorded income tax benefit of $7.2 million on pre-tax losses of $184.9 million, resulting in an effective tax rate of 3.9%. For third quarter 2014, we recorded income tax expense of $1.3 million on pre-tax losses of $19.9 million, resulting in a negative effective tax rate of 6.3%.

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From time to time 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 foreign jurisdictions where we are subject to tax. In addition, we do not currently recognize a tax benefit for our U.S. and state tax loss carryovers because we cannot conclude that it is more likely than not the carryovers will be available to offset future taxable income.

Nine Months Ended September 26, 2015 (nine months 2015) compared to Nine Months Ended September 27, 2014 (nine months 2014)

Net Sales. Net sales for nine months 2015 were $890.9 million, compared to net sales of $902.1 million for nine months 2014, a 1.2% decrease year over year. Excluding the unfavorable impact of foreign currency exchange rates, which resulted in a decrease in net sales of $37.3 million, net sales increased by $26.1 million, or 2.9%, to $928.2 million for nine months 2015. Net sales from acquisitions completed in nine months 2015 were $10.0 million. The results of the Company’s non-U.S. operations are translated into U.S. dollars to report consolidated results. Based on weakening of currency exchange rates against the U.S. dollar that occurred in late 2014 and early 2015, the Company currently expects that the stronger U.S. dollar will continue to have an adverse effect on reported amounts of net sales relative to the prior year period in the remainder of 2015.

The following table sets forth our net sales by operating segment ($ in thousands):

 

 

Net sales in our Bracing and Vascular segment were $383.3 million for nine months 2015, an increase of 4.4% from net sales of $367.0 million for nine months 2014. The increase is primarily due to new account acquisition in our OfficeCare channel, an increase in third party payor billing and growth in sales of direct consumer products and vascular pumps.

Net sales in our Recovery Sciences segment were $197.8 million for nine months 2015, a decrease of 9.6% from net sales of $218.8 million for nine months 2014. The decrease was driven primarily by lower sales of Empi products. The decrease in Empi sales was due to the continued challenging coverage and reimbursement environment, changes to our business processes for Empi products and a restructuring of the Empi selling organization.  The loss of sales momentum resulting from these actions had a larger impact than expected.

We expect that the negative sales trend for Empi products will continue as this business faces multiple coverage and reimbursement challenges, including changes in Medicare reimbursement rates established through competitive bidding which will take effect in 2016. We expect the sales of Empi products to remain below the level needed to reach acceptable profitability and that the timeframe needed to assure sustainable profitability will be longer than management believes is economically justified. Together with these facts and the related significant impairment of the goodwill, long lived and intangible assets related to the Empi reporting unit (See Note 8 to our Unaudited Condensed Consolidated Financial Statements for additional information), we have developed a plan to exit the Empi business over the next several months.

Net sales in our Surgical Implant segment were $92.6 million for nine months 2015, an increase of 27.2% from net sales of $72.8 million for nine months 2014. The increase was driven by sales of bone cement, which was acquired with the assets purchased from Zimmer Biomet in third quarter 2015, and strong sales of shoulder and hip products. Knee sales increased during nine months 2015 compared to nine months 2014 due to new product introductions and gaining new accounts.

Net sales in our International segment were $217.2 million for nine months 2015, a decrease of 10.8% from net sales of $243.5 million for nine months 2014. In constant currency, excluding an unfavorable impact of $37.3 million related to changes in foreign exchange rates in effect during nine months 2015 compared to the rates in effect in nine months 2014, net sales increased 4.5% for nine months 2015 compared to nine months 2014. Growth in net sales in this segment is being driven by stronger sales in direct markets, primarily Germany and Spain, and increased sales penetration in emerging markets.

Cost of Sales. As a percentage of net sales, cost of sales decreased to 39.8% for nine months 2015, compared to 40.5% for nine months 2014 mainly due to lower cost of manufacturing in Mexico and benefits from cost savings and productivity initiatives.

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Selling, General and Administrative (SG&A). SG&A expenses decreased to $362.6 million for nine months 2015, from $375.0 million in nine months 2014. As a percentage of sales, SG&A expenses decreased to 40.7% for nine months 2015, compared to 41.6% for nine months 2014. The decrease was mainly driven by lower bad debt, lower selling and marketing expenses and a reduction in reorganization and integration costs primarily related to information technology projects.  The decrease was offset by acquisition and related integrations costs in our Surgical Implant segment.

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):

 

 

Research and Development (R&D). R&D expenses decreased to $25.4 million for nine months 2015, from $28.5 million in nine months 2014. As a percentage of sales, R&D expense decreased to 2.8% in nine months 2015 from 3.2% in nine months 2014. In 2014 the company incurred consulting fees for testing, documentation and software implementation to enhance new product introductions and ensure FDA compliance. The company continues to focus on the development of new products, as well as the enhancement of existing products with the latest technology and updated designs, primarily our Bracing and Vascular and Surgical Implant segments.

Amortization of Intangible Assets. Amortization of intangible assets decreased to $66.7 million for nine months 2015, from $70.3 million for nine months 2014. The decrease is due to certain intangible assets reaching full amortization primarily in our patents and technology category. This impairment charge represents an estimated loss that has not yet been finalized at this time. We will continue to evaluate these estimates in our 2015 annual impairment test in the fourth quarter of 2015.

Impairment of Goodwill. We determined that the carrying value of our goodwill related to the Empi reporting unit was in excess of its estimated fair value. As a result, we recorded estimated impairment charges of $117.3 million.

Impairment of Intangible Assets. We determined that the carrying values of our Empi trade name, an indefinite lived intangible asset was in excess of its estimated fair value. Additionally, we determined that the carrying values of certain long lived assets including our finite lived intangible assets related to the Empi reporting unit were also in excess of their fair values. As a result, we recorded impairment charges of $52.2 million.

The impairment charges resulted from declining Empi sales and profitability trends due to continuing challenges of the reimbursement environment. See Note 5 to our Unaudited Condensed Consolidated Financial Statements for additional information.

Interest Expense, net. Our interest expense, net was constant at $129.5 million for nine months 2015 compared to $130.5 million for nine months 2014.

Loss on Modification and Extinguishment of Debt. Loss on modification and extinguishment of debt for nine months 2015 consists of $47.8 million in premiums related to the redemption of our 8.75% Notes, 9.875% Notes and 7.75% Notes, $11.9 million related to the non-cash write off of unamortized debt issuance costs and original issue discount associated with the portion of our debt that was extinguished and $8.6 million of arrangement and amendment fees and other fees and expenses incurred in connection with the refinancing. Loss on modification and extinguishment of debt for nine months 2014 consists of $0.4 million of arrangement and amendment fees and other fees and expenses incurred in connection with the amendment of our prior 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.

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Other Expense, Net. Other expense, net, increased to expense of $6.4 million for nine months 2015, from $2.9 million for nine months 2014. Results for both periods presented primarily represent net realized and unrealized foreign currency translation gains and losses.

Income Tax Provision. We record our tax provision so that the year to date tax provision reflects our latest estimated annual effective tax rate plus adjustments for year-to-date discrete items. For nine months 2015, we recorded an income tax benefit of $1.8 million on a pre-tax loss of $292.6 million, resulting in an effective tax rate of 0.6%. For nine months 2014, we recorded income tax expense of $10.6 million on pre-tax losses of $71.9 million, resulting in a negative effective tax rate of 14.8%. Given the relationship between fixed dollar tax items, the impact of the valuation allowance against our deferred tax assets, and pre-tax financial results, the projected annual effective tax rate can change materially from quarter to quarter and year to year.

From time to time 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 U.S. and state tax loss carryovers because we cannot conclude that it is more likely than not they will offset future taxable income.

Liquidity and Capital Resources

As of September 26, 2015, our primary sources of liquidity consisted of cash and cash equivalents totaling $56.7 million and our $150 million revolving credit facility, of which $144.5 million was available. Our revolving credit balance was $5.0 million as of September 26, 2015 and we have provided a $0.5 million letter of credit related to collateral requirements under our product liability insurance policy. Working capital at September 26, 2015 was $244.4 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.

Cash Flows

A summary of our cash flow activity is presented below (in thousands):

 

 

Operating activities provided $63.7 million and $47.1 million of cash in nine months 2015 and nine months 2014, respectively. The increase was driven by higher operating income before non-cash expenses and changes in working capital which largely consisted of cash inflows from accounts receivable due to better collections and timing of interest payments and accounts payable.  For nine months 2015 and nine months 2014, cash paid for interest was $95.6 million and $104.0 million, respectively.

Investing activities used $54.6 million and $47.1 million of cash for nine months 2015 and nine months 2014, respectively. Cash used in investing activities for nine months 2015 was for purchases of property and equipment primarily for the acquisition of certain surgical assets from Zimmer Biomet, consigned surgical instruments and vascular system pumps used as rental units, IT automation technology and manufacturing equipment for new products and more efficient production. Cash used in investing activities for nine months 2014 primarily consisted of $41.5 million for purchases of property and equipment primarily for consigned surgical instruments, information technology and manufacturing equipment and $4.6 million related to the acquisition of Speetec.

Financing activities provided cash of $16.5 million and used cash of $1.9 million in nine months 2015 and nine months 2014, respectively. Cash provided by financing activities in the nine months 2015 consisted of proceeds from the borrowings related to the refinancing of our debt, offset by the repayments of our prior senior secured credit facilities and our 8.75% Notes, 9.875% Notes and

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7.75% Notes. Cash used in financing activities in nine months 2014 consisted of proceeds from the borrowings under our prior revolving credit facility and our prior senior secured credit facility, offset by payments of the prior senior secured credit facility, 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.

Indebtedness

The principal amount and carrying value of our debt, exclusive of debt issuance costs and net unamortized original issue discount of $44.1 million, was as follows for September 26, 2015 (in thousands):

 

 

Senior Secured Credit Facilities. Our senior secured credit facilities at September 26, 2015 consisted of $1,055.0 million of senior secured term loan facility (including a $20.2 million delayed draw term loan facility) and a $150.0 million senior secured revolving credit facility, which mature on June 7, 2020 (collectively, the senior secured credit facilities). Our revolving credit balance was $5.0 million at September 26, 2015 and we have provided a $0.5 million letter of credit related to collateral requirements under our product liability insurance policy.

The interest rate margins applicable to borrowings under the senior secured revolving credit facility are, at our option, either (a) a base rate determined by reference to the highest of (1) the prime rate determined by the Wall Street Journal, (2) the federal funds effective rate plus 0.50% and (3) the Eurodollar rate for a one-month interest period plus 1.00% or (b) the Eurodollar rate determined by reference to the ICE Benchmark Administration London Interbank Offered Rate for deposits in the U.S. dollars for the interest period relevant to each borrowing adjusted for required reserves. The applicable margin for borrowings under the New senior secured term loan facility is 2.25% with respect to base rate borrowings and 3.25% with respect to Eurodollar borrowings. As of September 26, 2015, our weighted average interest rate for all borrowings under the senior secured credit facilities was 4.24%.

We are required to repay installments on the term loans in quarterly installments equal to 0.25% of the original principal amount of the term loans, with the remaining amount payable at maturity in June 2020.

Note Financing. Our outstanding notes mature at various dates in 2020 and 2021, with $1.5 million of our 9.75% Senior Notes remaining outstanding due in 2017. 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 9 to our Unaudited Condensed 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 senior secured first lien net debt to Adjusted EBITDA of 5.35:1 for a trailing twelve months commencing with the period ended September 30, 2015. 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

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compliance under our senior secured credit facilities and the indentures governing our 8.125% Notes, 10.75% Notes and 9.75% Notes (collectively, the “Indentures” and the “Notes”). Adjusted EBITDA is a material component of these covenants. As of September 26, 2015, our actual senior secured first lien leverage ratio was within the required ratio at 3.54:1. 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, 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 September 26, 2015, 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 5.35:1. 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 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 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.

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The following table provides a reconciliation from our net loss to Adjusted EBITDA for the three and nine months ended September 26, 2015 and September 27, 2014 and the twelve months ended September 26, 2015 (in thousands). The terms and related calculations are defined in the credit agreement relating to our senior secured credit facilities and the Indentures.

 

 

 

 

 

 

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ITEM 3. 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 September 26, 2015, we have $1,315.0 million of aggregate fixed rate notes and $1,060.0 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 nine months ended September 26, 2015 by $1.6 million. As of September 26, 2015, our term loans are subject to a 1.00% minimum LIBOR rate which is higher than the actual LIBOR rate of 0.20% as of September 26, 2015. Accordingly, a hypothetical 100 basis point increase in the LIBOR rate during the nine months ended September 26, 2015 would have increased the rate applicable to our variable debt by only 0.20%. 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.

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For the three and nine months ended September 26, 2015, sales denominated in foreign currencies accounted for 21.0% and 22.0% of our consolidated net sales, respectively, of which 14.3% and 15.4% 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.

 

 

ITEM 4. CONTROLS AND PROCEDURES

Disclosure Controls and Procedures

We maintain disclosure controls and procedures (as the term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) that are designed to ensure that information required to be disclosed in our Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.

Any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives. Under the supervision and with the participation of our management, including our Chief Executive Officer and our Chief Financial Officer, we conducted an evaluation of the effectiveness of our disclosure controls and procedures as of the end of the quarter covered by this report. Based on this evaluation and subject to the foregoing, our Chief Executive Officer and our Chief Financial Officer concluded that, as of the end of the quarter covered by this report, the design and operation of our disclosure controls and procedures were effective to accomplish their objectives at a reasonable assurance level.

Changes in Internal Control over Financial Reporting

There has been no change in the Company’s internal control over financial reporting (as that term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the quarter covered by this report that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

 

 

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PART II – OTHER INFORMATION

 

 

ITEM 1. 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. There have been no material developments in the Legal Proceedings discussed in our Annual Report on Form 10-K for the fiscal year ended December 31, 2014 and in our Quarterly Reports on Form 10-Q for the fiscal quarters ended March 28, 2015 and June 27, 2015.

 

 

ITEM 1A. RISK FACTORS

For a discussion of the Company’s potential risks or uncertainties, please see Part I, Item IA, of the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2014 filed with the SEC on February 20, 2015. There have been no material changes to the risk factors disclosed in such Form 10-K.

 

 

ITEM 5. OTHER INFORMATION

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 quarter ended September 26, 2015.

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 (the “portfolio companies”), may be deemed to be our affiliates. Since the filing of the Company’s Form 10-Q for the quarter ended June 27, 2015, two such portfolio companies have included information in their respective periodic reports filed with the SEC regarding activities 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 those filings.

Exit of the Empi Business

On November 10, 2015 we announced a plan to exit the Empi business. We expect the sales of Empi products to remain below the level needed to reach acceptable profitability and that the timeframe needed to assure sustainable profitability will be longer than management believes is economically justified.  The plan will result in ceasing manufacturing, selling and reimbursement billing activities related to Empi, largely to be completed by the end of the fourth quarter 2015. Accordingly, we expect to incur a restructuring charge in the fourth quarter ended December 31, 2015 primarily related to one-time termination benefits, costs to shut down manufacturing, and consulting services. The amount of these costs has yet to be determined.

 

 

 

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ITEM 6. EXHIBITS

(a) Exhibits

 

 

 

 

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SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

 

 

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