10-K 1 d450869d10k.htm FORM 10-K Form 10-K
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-K

 

 

 

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

For the fiscal year ended December 31, 2012

or

 

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

For the transition period from                      to                     .

Commission file number 333-142188

 

 

DJO Finance LLC

(Exact name of Registrant as specified in its charter)

 

 

 

Delaware   20-5653965

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

1430 Decision Street

Vista, California

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

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

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

 

Title of each class

 

Name of each exchange on which registered

None   None

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

 

 

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

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes  ¨    No  x (On January 8, 2013, the registrant’s Registration Statement on Form S-4 (File No. 333-185713) was declared effective. As of that date, the registrant became subject to the filing requirements of Section 13 or 15(d) of the Exchange Act.)

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: Prior to the effectiveness of the registrant’s Registration Statement on Form S-4 (File No. 333-185713) on January 8, 2013, the registrant was a voluntary filer not subject to the filing requirements of Section 13 or 15(d) of the Exchange Act. As a voluntary filer the registrant filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the preceding 12 months (or for such shorter period that the registrant would have been required to file such reports) as if it were subject to such filing requirements). In addition, since January 8, 2013, when the registrant became subject to the filing requirements of Section 13 or 15(d) of the Exchange Act, it has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act.)

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

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

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

 

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

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

As of February 27, 2013, 100% of the issuer’s membership interests were owned by DJO Holdings LLC.

 

 

 


Table of Contents

DJO FINANCE LLC

FORM 10-K

TABLE OF CONTENTS

 

          Page
No.
 
   PART I   

Item 1.

  

Business

     3   

Item 1A.

  

Risk Factors

     24   

Item 2.

  

Properties

     40   

Item 3.

  

Legal Proceedings

     40   

Item 4.

  

Mine Safety Disclosures

     43   
   PART II   

Item 5.

  

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

     44   

Item 6.

  

Selected Financial Data

     45   

Item 7.

  

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

     46   

Item 7A.

  

Quantitative and Qualitative Disclosures About Market Risk

     62   

Item 8.

  

Financial Statements and Supplementary Data

     64   

Item 9.

  

Changes in and Disagreements With Accountants on Accounting and Financial Disclosure

     117   

Item 9A.

  

Controls and Procedures

     117   

Item 9B.

  

Other Information

     117   
   PART III   

Item 10.

  

Directors, Executive Officers and Corporate Governance

     118   

Item 11.

  

Executive Compensation

     123   

Item 12.

  

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

     137   

Item 13.

  

Certain Relationships and Related Transactions, and Director Independence

     139   

Item 14.

  

Principal Accounting Fees and Services

     140   
   PART IV   

Item 15.

  

Exhibits, Financial Statement Schedules

     142   

SIGNATURES

     150   

 

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FORWARD-LOOKING STATEMENTS

This Annual Report on Form 10-K (Annual Report) of DJO Finance LLC (DJOFL, or the Company) for the year ended December 31, 2012 contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended (the Securities Act) and Section 21E of the Securities Exchange Act of 1934, as amended (the Exchange Act), which are intended to be covered by the safe harbors created thereby. To the extent that any statements are not recitations of historical fact, such statements constitute forward-looking statements that, by definition, involve risks and uncertainties. Specifically, the sections entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Business” may contain forward-looking statements. These statements can be identified because they use words like “anticipates,” “believes,” “estimates,” “expects,” “forecasts,” “future,” “intends,” “plans,” and similar terms. These statements reflect only our current expectations. Forward-looking statements include statements concerning our plans, objectives, goals, strategies, future events, capital expenditures, future results, our competitive strengths, our business strategy, the trends in our industry and the benefits of our acquisitions.

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

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

PART  I.

ITEM 1. BUSINESS

Overview

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

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.

 

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

Operating Segments

We currently develop, manufacture and distribute our products through the following four operating segments:

Bracing and Vascular Segment

Our Bracing and Vascular segment, which generates its revenues in the United States, offers our rigid knee bracing products, orthopedic soft goods, cold therapy products, vascular systems, therapeutic 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 business, through which we maintain an inventory of soft goods and other products at healthcare facilities, primarily orthopedic practices, for immediate distribution to patients.

Recovery Sciences Segment

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

 

   

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

 

   

CMF. Our CMF business unit sells our combined magnetic field (CMF) bone growth stimulation products. We sell these products either directly to patients or to independent distributors. For products sold to patients, we arrange billing to patients and their third party payors.

 

   

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

 

   

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

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.

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.

 

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

Recent Acquisitions

On December 28, 2012, we acquired all of the outstanding shares of capital stock of Exos Corporation (Exos) for an initial payment of $31.2 million and an earn out payment of up to $10.0 million upon achievement of certain milestones and revenue targets. Exos is a medical device company focused on a thermoformable external musculoskeletal stabilization system for the treatment of fractures and other injuries requiring stabilization. Since October 2011, we have been the exclusive distributor of Exos products in most of the world.

In connection with the acquisition of Exos, we incurred $1.3 million of direct acquisition costs comprised of $0.5 million of legal and other professional fees and $0.8 million of transaction and advisory fees to Blackstone Advisory Partners L.P., and Blackstone Management Partners LLC, affiliates of our major shareholder (see Note 17 of the Notes to Consolidated Financial Statements). These costs are included in Selling, general and administrative expense in our Consolidated Statement of Operations. The acquisition was partially funded using proceeds from $25.0 million of new term loans issued on December 28, 2012 (see Note 12 of the Notes to Consolidated Financial Statements).

Our Products

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

Bracing and Vascular Segment

Our Bracing and Vascular segment generated net sales of $441.3 million, $387.9 million and $311.6 million for the years ended December 31, 2012, 2011 and 2010, respectively. The following table summarizes our Bracing and Vascular segment product categories:

 

Product Category

  

Description

Rigid bracing and soft goods

  

Soft goods

Lower extremity fracture boots

Ligament braces

Post-operative braces

Osteoarthritis braces

Ankle bracing

Shoulder, elbow and wrist braces

Back braces

Neck braces

ExosTM thermoformable braces

Cold and compression therapy

   Cold and compression therapy products

Vascular therapy

  

Vascular system pumps

Compression hosiery

Therapeutic shoes and inserts

   Therapeutic footwear and related medical and comfort products

 

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Recovery Sciences Segment

Our Recovery Sciences segment generated net sales of $334.6 million, $342.6 million and $347.1 million for the years ended December 31, 2012, 2011 and 2010, respectively. The following table summarizes our Recovery Sciences segment product categories:

 

Product Category    Description

Home electrotherapy devices

  

Transcutaneous electrical nerve stimulation (TENS)

Neuromuscular electrical stimulation (NMES)

Interferential electrical nerve stimulation

Electrodes

Clinical electrotherapy

  

TENS

NMES

Ultrasound

Laser

Light therapy

Shortwave Diathermy

Acoustic wave therapy

Electrodes

Patient care

  

Nutritional supplements

Patient safety devices

Pressure care products

Continuous passive motion devices

Dynamic splinting

Back braces

Hot, cold and compression therapy

  

Dry heat therapy

Hot/cold therapy

Paraffin wax therapy

Moist heat therapy

Cold therapy

Compression therapy

Physical therapy tables and traction products

  

Treatment tables

Traction tables

Cervical traction for home use

Lumbar traction for home use

Iontophoresis

   Needle-free transdermal drug delivery

Bone growth stimulation

  

Non-union fracture bone growth stimulation devices

Spine bone growth stimulation devices

International Segment

Our International segment generated net sales of $280.5 million, $279.3 million and $244.5 million for the years ended December 31, 2012, 2011 and 2010, respectively. The product categories for our International segment are similar to the product categories for our domestic segments except certain products are tailored to international market requirements and preferences. In addition, our International segment sells a number of product categories, none of which is individually significant, that we do not sell domestically.

 

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Surgical Implant Segment

Our Surgical Implant segment generated net sales of $73.0 million, $64.9 million and $62.7 million for the years ended December 31, 2012, 2011 and 2010, respectively. The following table summarizes our Surgical Implant segment product categories:

 

Product Category

  

Description

Knee implants

  

Primary total joint replacement

Revision total joint replacement

Unicondylar joint replacement

Hip implants

  

Primary replacement stems

Acetabular cup system

Revision joint replacement

Shoulder implants

  

Primary total joint replacement

Fracture repair system

Revision total joint replacement (including reverse shoulder)

Research and Development

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

We conduct research and development programs at our facilities in Vista, California; Austin, Texas; and Ecublens, Switzerland. We spent $27.9 million, $26.9 million, and $21.9 million in 2012, 2011 and 2010, respectively, for research and development activities.

Marketing and Sales

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

No particular customer or distributor accounted for 10% or more of product sales in any of our segments for the year ended December 31, 2012. Medicare and Medicaid together accounted for approximately 6.4% of our consolidated 2012 net sales.

Bracing and Vascular Segment

We market and sell our Bracing and Vascular segment products in several different ways. The DonJoy channel is primarily dedicated to the sale of our bracing and supports products to orthopedic surgeons, podiatrists, orthotic and prosthetic centers, hospitals, surgery centers, physical therapists, athletic trainers and other healthcare professionals. Certain DonJoy sales representatives also sell our Recovery Sciences and Vascular products. The DonJoy channel consists of mostly independent commissioned sales representatives who are employed by independent sales agents. Because the DonJoy product lines generally require customer education in the application and use of the product, DonJoy sales representatives are technical specialists who receive extensive training both from us and the agent, and use their expertise to help fit the patient with the product and assist the orthopedic professional in choosing the appropriate product to meet the patient’s needs.

 

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After a sales representative receives a product order, we generally ship and bill the product directly to the orthopedic professional, and pay a sales commission to the agent. For certain custom rigid braces and other products, we sell directly to the patient and bill a third party payor, if applicable, on behalf of the patient. We enjoy long-standing relationships with most of our agents and sales representatives. Under the arrangements with the agents, each agent is granted an exclusive geographic territory for sales of our products and is not permitted to market products, or represent competitors who sell or distribute products, that compete with our existing products. The agents receive a commission, which varies based on the type of product being sold. If an agent fails to achieve specified sales quotas, we have the right to terminate our relationship with the agent.

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

Through our Dr. Comfort business, we market and distribute our therapeutic footwear and related medical and comfort products primarily through the podiatry, home medical equipment (HME), pharmacy, and orthotic and prosthetic (O&P) channels through our sales force of direct and independent sales representatives. The compression hosiery manufactured by our ETI business unit is private labeled and sold to customers who resale the products.

Our OfficeCare business provides stock and bill arrangements for physician practices. Through OfficeCare, we maintain an inventory of bracing and supports products at approximately 1,700 orthopedic practices and other healthcare facilities for immediate distribution to patients. We then bill the patient or, if applicable, a third party payor. For certain facilities, we provide on-site technical representatives. The OfficeCare channel is managed by our DonJoy sales force.

Recovery Sciences Segment

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

 

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

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

International Segment

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

We intend to continue to expand our direct and indirect distribution capabilities in attractive foreign markets. Recent examples of our strategy to expand our international sales are our 2010 acquisition of an independent South African distributor of DonJoy products, and our 2009 acquisitions of two independent Canadian distributors of Empi and Chattanooga products and an independent Australian distributor of DonJoy products. Our 2011 acquisitions of ETI and Dr. Comfort also increased our product offerings internationally.

Surgical Implant Segment

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

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

 

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Manufacturing

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

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

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

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

Many of the component parts and raw materials we use in our manufacturing and assembly operations are available from more than one supplier and are generally available on the open market. We source some of our finished products from manufacturers in China as well as other third party manufacturers. We also currently purchase certain CPM devices from a single supply source, Medireha, which is 50% owned by us. Our distribution agreement with Medireha grants us exclusive rights to the distribution of products that Medireha manufactures. The distribution agreement also requires that we purchase a certain amount of product annually and that we seek Medireha’s approval if we choose to manufacture or distribute products that are identical or similar, or otherwise compete with the products that are the subject of the distribution agreement.

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

 

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

Intellectual Property

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

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

Competition

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

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

 

   

develop new products and innovative technologies,

 

   

obtain regulatory clearance and compliance for our products,

 

   

manufacture and sell our products cost-effectively,

 

   

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

 

   

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

 

   

protect the proprietary technology of our products and manufacturing processes,

 

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market our products,

 

   

attract and retain skilled employees and sales representatives, and

 

   

establish and maintain distribution relationships.

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

Bracing and Vascular Segment

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

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

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

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

Recovery Sciences Segment

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

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

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

International Segment

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

 

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Surgical Implant Segment

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

Government Regulation

FDA and Similar Foreign Government Regulations

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

Under the Food, Drug and Cosmetic Act, as amended, medical devices are generally classified into one of three classes depending on the degree of risk to patients using the device. Class I is the lowest risk classification. Class I devices are those for which safety and effectiveness can be assured by adherence to General Controls, which include compliance with FDA QSRs, facility and device registrations and listings, reporting of adverse medical events, and appropriate truthful and non-misleading labeling, advertising, and promotional materials. Most Class I devices are exempt from pre-market submission requirements. Some Class I devices require a pre-market notification to and clearance from FDA as set forth under § 510(k) of the Food, Drug and Cosmetic Act, as amended, also known as a “510(k)” submission. The 510(k) process is described more fully below. Class II devices are subject to General Controls, as well as pre-market demonstration of adherence to certain performance standards or other special controls as specified by the FDA. Although some Class II medical devices are exempt from 510(k) requirements, most Class II devices are subject to 510(k) review and clearance by FDA prior to marketing.

By way of a 510(k) submission, a manufacturer provides certain required information to the FDA to establish that the device is “substantially equivalent” to a device that was legally marketed prior to May 28, 1976, the date upon which the Medical Device Amendments of 1976 were enacted. A device legally marketed before May 28, 1976 is called a “pre-amendment device.” A manufacturer may also obtain marketing clearance by showing that its medical device is substantially equivalent to a commercially available “post-amendment device” which is a device cleared through the 510(k) process after May 28, 1976. Upon establishment of such substantial equivalence, the FDA may grant clearance to commercially market the device. If the FDA determines that the device, or its intended use, is not “substantially equivalent,” the FDA will automatically place the device into Class III.

A Class III device is a product that has a new intended use or is based on technology that is not substantially equivalent to a use or technology of a legally marketed device and for which the safety and effectiveness of the device cannot be assured solely by the General Controls, performance standards and special controls applied to Class I and II devices. These devices generally require clinical trials involving human subjects to assess their safety and effectiveness. A Pre-Market Application (PMA) must be submitted to and approved by the FDA before the manufacturer of a Class III product can proceed in marketing the product. The PMA process is much more extensive and takes longer than the 510(k) process. In approving a PMA application, the FDA may require

 

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additional clinical data and may also require some form of post-market surveillance or clinical study whereby the manufacturer follows certain patient groups for a number of years, making periodic reports to the FDA on the clinical status of those patients.

Our products include both pre-amendment and post-amendment Class I, II and III medical devices. All our currently marketed devices are either exempt from the FDA clearance and approval process (based on our interpretation of those regulations) or we have obtained the requisite clearances or approvals (including all modifications, amendments and changes), as appropriate, required under federal medical device law. The FDA may disagree with our conclusion that clearances or approvals were not required for specific products and may require clearances or approval for such products. In these circumstances, we may be required to cease distribution of the product, the devices may be subject to seizure by the FDA or to a voluntary or mandatory recall, and we could be subject to significant fines and penalties.

Our manufacturing processes are also required to comply with the FDA’s current Good Manufacturing Practice requirements for medical devices, which are specified in FDA QSRs. The QSRs cover the methods and documentation of the design, testing, production processes, control, quality assurance, labeling, packaging and shipping of our products. Furthermore, our facilities, records and manufacturing processes are subject to periodic unscheduled inspections by the FDA and other agencies. Failure to comply with applicable QSR or other U.S. medical device regulatory requirements could result in, among other things, warning letters, fines, injunctions, civil penalties, repairs, replacements, refunds, recalls or seizures of products, total or partial suspensions of production, refusal of the FDA to grant future pre-market clearances or PMA approvals, withdrawals or suspensions of current clearances or approvals, and criminal prosecution. We are also required to report to the FDA if our products cause or contribute to death or serious injury or malfunction in a way that would likely cause or contribute to death or serious injury were the malfunction to recur; the FDA or other agencies may require the recall of products in the event of material defects or deficiencies in design or manufacturing. The FDA can also withdraw or limit our product approvals or clearances in the event of serious unanticipated health or safety concerns.

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

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

We must obtain export certificates from the FDA before we can export certain of our products. We are also subject to extensive regulations that are similar to those of the FDA in many of the foreign countries in which we sell our products, including those in Europe, our largest foreign market. These include product standards, packaging requirements, labeling requirements, import restrictions, tariff regulations, duties and tax requirements. The regulation of our products in the European Economic Area (which consists of the twenty-seven member states of the European Union, as well as Iceland, Liechtenstein and Norway) is governed by various directives and regulations promulgated by the European Commission and national governments. Only medical devices that comply with certain conformity requirements are allowed to be marketed within the European Economic Area. In addition, the national health or social security organizations of certain countries, including certain countries outside Europe, require our products to be qualified before they can be marketed in those countries.

 

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Third Party Reimbursement

Our home therapy products, rigid knee braces, CMF products, and certain of our soft goods are generally prescribed by physicians and are eligible for third party reimbursement by government payors, such as Medicare and Medicaid, and private payors. Customer selection of our products depends, in part, on coverage of our products and whether third party payment amounts will be adequate. We believe that Medicare and other third party payors will continue to focus on measures to contain or reduce their costs through managed care and other methods. Medicare policies are important to our business because private payors often model their policies after the Medicare program’s coverage and reimbursement policies.

In recent years, Congress has enacted a number of laws that affect Medicare reimbursement for and coverage of durable medical equipment (DME), prosthetics, orthotics and supplies (DMEPOS), including many of our products. These laws have included temporary freezes or reductions in Medicare fee schedule updates. For instance, in March 2010, President Obama signed into law the Patient Protection and Affordable Care Act, which was amended by a second bill signed into law on March 30, 2010, known as the Health Care and Education Reconciliation Act (collectively referred to as the Affordable Care Act or ACA). The ACA is a sweeping measure designed to expand access to affordable health insurance, control health care spending, and improve health care quality. Several provisions of the ACA specifically impact the medical equipment industry. Among other things, the ACA eliminates the full inflation update to the DMEPOS fee schedule for the years 2011 through 2014. Instead, beginning in 2011, the ACA reduces the inflation update for DMEPOS by a “productivity adjustment” factor intended to reflect productivity gains in delivering health care services. For 2013, the update factor is 0.8% (reflecting a 1.7% inflation update that is partially offset by 0.9% “productivity adjustment”).

Medicare payment for DMEPOS also can be impacted by the DMEPOS competitive bidding program, under which Medicare rates are based on bid amounts for certain products in designated geographic areas, rather than the Medicare fee schedule amount. Only those suppliers selected through the competitive bidding process within each designated competitive bidding area (CBA) are eligible to have their products reimbursed by Medicare. Competitive bidding went into effect January 1, 2011 in nine CBA’s and nine product categories, with reimbursement to contract suppliers averaging 32% below the Medicare DMEPOS fee schedule amount. Bidding has concluded in the second round of competitive bidding in 100 CBAs (in addition to national mail order competition for diabetic testing supplies). The Centers for Medicare & Medicaid Services (CMS) announced on January 30, 2013 that payment amounts under round two are projected to be 45% below current fee schedule prices, and payment amounts under the national mail-order program for diabetic testing supplies are projected to be reduced by 72%. While none of our products were included in the first two rounds, CMS is including TENS units in a recompetition of round one as part of a new “General Home Equipment and Related Supplies and Accessories” product category. Bidding for the new three-year contracts was conducted in late 2012, and we submitted bids to supply products in this category. Announcement of the successful bidders and contract negotiation will occur in 2013, and implementation of the contracts and prices is scheduled to take place on January 1, 2014. In addition, CMS recently released a listing of codes that it considers to be off-the-shelf (OTS) orthotics and subject to competitive bidding in the future. When our products are subject to competitive bidding, if we are not selected as a contract supplier (or subcontractor) in a particular region or if contract prices are significantly below Medicare fee schedule reimbursement levels, it could have a material adverse impact on our sales and profitability. Further, the ACA requires the Secretary to use competitive bidding payment information to adjust DMEPOS payments in areas outside of competitive bidding areas beginning in 2016. Additional reforms to Medicare and Medicaid DMEPOS payment amounts are proposed periodically. Any changes in the basis for Medicare reimbursement of our products could have a material adverse impact on our results of operations.

On June 8, 2012, CMS issued a final decision memorandum in which CMS determined that coverage for TENS for the treatment of chronic low back pain (other than chronic low back pain due to certain diseases) would not be available under Medicare unless the patient is enrolled in a clinical study meeting certain defined standards. On August 3, 2012, CMS published a National Coverage Determination and listed the diagnostic

 

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codes for TENS prescriptions that will no longer be covered under Medicare outside of a clinical study. Our Empi business unit in our Recovery Sciences Segment provides TENS devices that are prescribed for patients to use in the home (and for patients with diagnoses that fall within one of the diagnostic codes for which Medicare coverage is no longer available). As a result, this coverage decision by CMS reduces the available market for these TENS devices. In addition to eliminating a common application for TENS for Medicare beneficiaries, this coverage policy may be adopted by some or all of the private health insurers with which Empi does business. We have no plans to conduct a clinical study at this time. We have adapted our business procedures to reflect this coverage policy and have ceased billing Medicare for TENS units and supplies prescribed for the applicable diagnostic codes. While the full effect of this coverage decision will not be known for some time, it could reduce the revenue of our Empi business for Medicare billing of TENS and related supplies by an estimated $9 million to $14 million annually, and over time by a similar or greater amount if the Medicare coverage policy is adopted by private insurers. We believe Empi can offset, at least partially, the impact of these revenue losses by (i) offering these devices as self-pay items to Medicare beneficiaries, (ii) convincing private insurers that they should continue to cover TENS because of its effectiveness for chronic low back pain, its ability to reduce the use of pharmaceuticals and its favorable impact on health economics, (iii) focusing on growth initiatives related to other TENS indications for which reimbursement is available and on other Empi products and (iv) adjusting operating expenses where possible. Nevertheless, the long-term revenue and profit impact of this coverage decision could be materially adverse to the Empi business and as a result could have an adverse effect on our business and results of operations as a whole.

Medicare suppliers must meet a variety of program criteria. Medicare DMEPOS suppliers (other than certain exempted professionals) must be accredited by an approved accreditation organization as meeting DMEPOS Quality Standards adopted by CMS, including specific requirements for suppliers of custom fabricated and custom fitted orthoses and certain prosthetics. The portion of our business serving in a Medicare supplier capacity has been accredited. Most Medicare DMEPOS suppliers also must post a $50,000 surety bond from an authorized surety, with higher amounts required for certain “high-risk” suppliers. We believe we are in compliance with current surety bond requirements. If in the future we fail to maintain our Medicare accreditation status and/or do not comply with Medicare surety bond or supplier standard requirements, or if these requirements are expanded or if additional conditions for coverage or payment are adopted in the future, it could adversely impact our profits and results of operation.

The ACA imposes a new annual federal excise tax on certain medical device manufacturers and importers. Specifically, for sales on or after January 1, 2013, manufacturers, producers, and importers of taxable medical devices must pay as an excise tax 2.3% of the price for which the devices are sold. Although our position is that many of our products are exempt from the tax, some products will be subject to the tax, but we do not expect the amount of tax due to be material to our business.

The ACA also establishes new Medicare and Medicaid program integrity provisions, including expanded documentation requirements for Medicare DMEPOS orders and more stringent procedures for screening Medicare and Medicaid DMEPOS suppliers, along with broader expansion of federal fraud and abuse authorities. On February 2, 2011, CMS published a final rule implementing the ACA provider and supplier screening provisions, effective March 25, 2011. Under the final rule, DMEPOS suppliers could be subject to verification of compliance with enrollment and licensure requirements, database checks, unannounced site visits, and, for newly-enrolling suppliers, fingerprint-based criminal history record checks of law enforcement repositories. The rule also imposes application fees on providers and suppliers; authorizes CMS and states to impose moratoria on new provider enrollment to protect against a high risk of fraud; authorizes the suspension of payments pending an investigation of a credible allegation of fraud; and expands health program termination authority. There can be no assurances that the new policy will not increase compliance costs or otherwise adversely impact our results of operation.

The ACA also adds a requirement that physician orders for covered items of DME must be written by a physician and must document that a physician, a physician assistant, a nurse practitioner, or a clinical nurse specialist has had a face-to-face encounter (including through the use of telehealth) with the individual involved

 

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during the six-month period preceding such written order, or other reasonable timeframe as determined by the Secretary of Health and Human Services. On November 16, 2012, CMS published a final rule to implement this provision. The rule requires a physician to document that the physician or a physician assistant, a nurse practitioner, or a clinical nurse specialist has had a face-to-face encounter with the beneficiary within the six month period before the order is written for specified DME items, including certain of our products. This requirement applies to new orders for covered items written on or after July 1, 2013. Although we are not able to assess the full impact of the new policy at this time, it may impose new administrative burdens and could increase our costs of operation.

In addition, the ACA establishes new disclosure requirements (sometimes referred to as the Physician Payment Sunshine Act) regarding financial arrangements between medical device and supplies manufacturers and physicians, including physicians who serve as consultants. CMS has published final regulations to implement these requirements, and the recordkeeping requirements are effective August 1, 2013. Manufacturers and GPOs will be required to report the data for August through December of 2013 to CMS by March 14, 2014, and the first reports will be publicly available by September 30, 2014. The regulations require us to report annually to CMS all payments and other transfers of value to physicians and teaching hospitals for products payable under federal health care programs, as well as ownership or investments held by physicians or their family members. Failure to fully and accurately disclose transfers of value to physicians could subject us to civil monetary penalties. Several states also have enacted specific marketing and payment disclosure requirements and other states may do so in the future. Likewise, in recent years, voluntary industry guidelines have been adopted regarding device manufacturer financial arrangements with physicians and other health care professionals. We cannot determine at this time the impact, if any, of such requirements or voluntary guidelines on our relationships with surgeons, and there can be no assurances that such requirements and guidelines would not impose additional costs on us and/or adversely affect our consulting and other arrangements with surgeons.

On August 27, 2010, CMS published a final rule that, among other things, prohibits suppliers from sharing a practice location in certain circumstances, imposes new physical facility requirements on suppliers, clarifies the prohibition on the direct solicitation of Medicare beneficiaries, generally prohibits suppliers from contracting with another individual to perform licensed services, and clarifies a number of other supplier operational requirements. The rule generally is effective September 27, 2010 (although there are separate deadlines for compliance with the physical facility standards for existing suppliers with leases that expire after that date). We believe we are in compliance with the requirements of the rule.

In response to pressure from certain groups (primarily orthotists), the United States Congress and state legislatures have periodically considered proposals that limit the types of orthopedic professionals who can fit or sell our orthotic device products or who can seek reimbursement for them. Several states have adopted legislation which imposes certification or licensing requirements on the measuring, fitting and adjusting of certain orthotic devices. Although some of these state laws exempt manufacturers’ representatives, other states’ laws subject the activities of such representatives to certification or licensing requirements. The state of Texas has adopted such a licensure law without an exemption for manufacturer’s sales representatives acting under the supervision of a physician and has issued a cease and desist letter directed to the fitting activities of our sales representatives in that state. We are in communication with the Texas authorities to respond to such letter. Additional states may be considering similar legislation. Such laws could reduce the number of potential customers by restricting the activities of our sales representatives in jurisdictions where such policies are enacted. Furthermore, because the sales of orthotic devices are driven in part by the number of professionals who fit and sell them, laws that limit these activities potentially could reduce demand for these products. We may not be successful in opposing the adoption of such legislation or regulations and, therefore, such laws could have a material adverse impact on our business.

In addition, efforts have been made to establish similar certification requirements at the federal level for the Medicare program. For example, in 2000, Congress passed the Medicare, Medicaid and SCHIP Benefits Improvement and Protection Act of 2000 (BIPA). BIPA contained a provision requiring, as a condition for

 

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payment by the Medicare program, that certain certification or licensing requirements be met for individuals and suppliers furnishing certain, but not all, custom-fabricated orthotic devices. Although CMS has not implemented this requirement to date, Medicare follows state requirements in those states that require the use of an orthotist or prosthetist for furnishing of orthotics or prosthetics. We cannot predict the effect of implementation of BIPA or implementation of other such laws will have on our business.

Our business also can be impacted by changes in federal and state health care legislative and regulatory policies being adopted as a result of budgetary shortfalls. For instance, the federal Budget Control Act of 2011, as amended by the American Taxpayer Relief Act of 2012, will trigger various federal budget cuts in 2013 in the absence of additional legislation. Medicare provider payments would be subject to up to a 2 percent across-the-board reduction, generally effective for services provided beginning in April 2013. Congress and the President also could consider alternative spending reduction options, which could reduce federal spending on the Medicare and/or Medicaid programs. There can be no assurances that any such budget provisions will not have an adverse impact on our business. At the state level, these changes have included reductions in provider and supplier reimbursement levels under state Medicaid programs, including in some cases reduced reimbursement for DMEPOS items, and/or other Medicaid coverage restrictions. As states continue to face significant financial pressures, it is possible that state health policy changes will adversely affect our profitability.

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

Fraud and Abuse

We are subject to various federal and state laws and regulations pertaining to healthcare fraud and abuse. Violations of these laws are punishable by criminal and civil sanctions, including, in some instances, exclusion from participation in federal and state healthcare programs, including Medicare, Medicaid, Veterans Administration health programs and TRICARE (the health care program for active duty military, retirees and their families managed by the Department of Defense). We have no reason to believe that our operations are not in material compliance with such laws. However, because these laws and regulations are broad in scope and may change, we may be required to alter one or more of our practices to be in compliance with these laws. In addition, the occurrence of one or more violations of these laws or regulations, a challenge to our operations by a governmental authority under these laws or regulations or a change in the laws or regulations may have a material adverse impact on our financial condition and results of operations.

Anti-Kickback and Other Fraud Laws

Our operations are subject to federal and state anti-kickback laws. Certain provisions of the Social Security Act, commonly referred to as the Anti-Kickback Statute, prohibit persons from knowingly and willfully soliciting, receiving, offering or providing remuneration directly or indirectly to induce either the referral of an individual, or the furnishing, recommending, or arranging for a good or service, for which payment may be made under a federal healthcare program such as Medicare and Medicaid. The definition of remuneration has been broadly interpreted to include anything of value, including such items as gifts, discounts, waiver of payments,

 

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and providing anything at less than its fair market value. The U.S. Department of Health and Human Services (HHS) has issued regulations, commonly known as safe harbors, which set forth certain conditions, which if fully met, will assure healthcare providers and other parties that they will not be prosecuted under the Anti-Kickback Statute. Although full compliance with these provisions ensures against prosecution under the Anti-Kickback Statute, the failure of a transaction or arrangement to fit within a specific safe harbor does not necessarily mean that the transaction or arrangement is illegal or that prosecution under the Anti-Kickback Statute will be pursued. The penalties for violating the Anti-Kickback Statute include imprisonment for up to five years, fines of up to $25,000 per violation and possible exclusion from federal healthcare programs such as Medicare and Medicaid. Many states have adopted prohibitions similar to the Anti-Kickback Statute, some of which apply to the referral of patients for healthcare services reimbursed by any source, not only by the Medicare and Medicaid programs.

Our OfficeCare program is a stock and bill arrangement through which we make products and services available in the offices of physicians or other providers. In conjunction with the OfficeCare program, we may pay participating physicians a fee for rental space and support services provided by such physicians to us. In a February 2000 Special Fraud Alert, the Office of Inspector General (OIG) indicated that it may scrutinize stock and bill programs involving excessive rental payments or rental space for possible violation of the Anti-Kickback Statute, but noted that legitimate arrangements, including fair market value rental arrangements, will not be considered violations of the statute. We believe that we have structured our OfficeCare program to comply with the Anti-Kickback Statute.

HIPAA

The Health Insurance Portability and Accountability Act of 1995 (HIPAA) created two new federal crimes effective as of August 21, 1996, relating to healthcare fraud and false statements regarding healthcare matters. The healthcare fraud statute prohibits knowingly and willfully executing or attempting to execute a scheme or artifice to defraud any healthcare benefit program, including private payors. The false statements statute prohibits knowingly and willfully falsifying, concealing or covering up a material fact or making any materially false, fictitious or fraudulent statement or representation in connection with the delivery of or payment for healthcare benefits, items or services. HIPAA applies to any healthcare benefit plan, not just Medicare and Medicaid. Additionally, HIPAA granted expanded enforcement authority to HHS and the DOJ and provided enhanced resources to support the activities and responsibilities of the HHS, OIG and DOJ by authorizing large increases in funding for investigating fraud and abuse violations relating to healthcare delivery and payment. In addition, HIPAA mandates the adoption of standards for the electronic exchange of health information, as described below in greater detail under “Federal Privacy and Transaction Law and Regulations.”

Physician Self-Referral Laws

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

 

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False Claims Laws

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

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

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

In March 2006, the U.S. Attorney’s Office for the Eastern District of Wisconsin (U.S. Attorney’s Office) and the OIG (together with the U.S. Attorney’s Office, the Federal Authorities) began an investigation of Dr. Comfort, regarding allegations filed by two whistleblowers that from 2004 through 2006, Dr. Comfort sold custom diabetic shoe inserts as Medicare approved custom inserts that were not, in fact, custom as defined by Medicare because they were not created with a unique image of each foot; and Dr. Comfort sold heat moldable diabetic shoe inserts that did not comply with Medicare requirements for the inserts and did not conform to the heat moldable diabetic inserts that Dr. Comfort submitted to Medicare for coding verification, allegedly in violation of the federal False Claims Act (collectively, the Covered Conduct).

As a condition to DJO’s acquisition of Dr. Comfort in April 2011, Dr. Comfort has entered into a settlement agreement for the Covered Conduct (Settlement Agreement) with the Federal Authorities resolving alleged violations of the federal False Claims Act which were the subject of an investigation triggered by two whistleblower actions. Dr. Comfort also entered into a Corporate Integrity Agreement (CIA) with the OIG-HHS. As required by the CIA, Dr. Comfort has established a compliance program and has and will submit required reports to the OIG at least annually on the status of implementation of the requirements of the CIA and compliance activities. Although we conducted healthcare regulatory and related due diligence efforts concerning Dr. Comfort’s operations and business practices prior to our acquisition of Dr. Comfort in April, 2011, and we believe the activities that were the subject of the Covered Conduct described in the Settlement Agreement were

 

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isolated and have been addressed through Dr. Comfort’s compliance efforts, including those required by CIA, we cannot assure you that we will not identify additional healthcare regulatory issues in the future or that the Covered Conduct will not be reviewed or investigated by other parties which purchased or reimbursed products of Dr. Comfort that allegedly did not comply with Medicare requirements. Even if we cause Dr. Comfort to take corrective actions to remedy such alleged violations of healthcare regulatory laws, Dr. Comfort could be subject to certain enforcement actions, including, among other things, significant fines, suspension of approvals, seizures or recalls of products, operating restrictions and criminal prosecutions. Failure of Dr. Comfort to comply with certain obligations set forth in the CIA may result in the imposition of monetary (stipulated) penalties and/or Dr. Comfort’s exclusion from participation in the Federal health care programs. We cannot assure you that relevant governmental authorities would agree with our interpretation of Dr. Comfort’s obligations under applicable healthcare regulatory laws and under the CIA to which Dr. Comfort is subject for five years, or that Dr. Comfort has in all instances fully complied with all applicable healthcare regulatory laws. Any enforcement action could adversely affect Dr. Comfort’s business and results of operations.

Customs and Import/Export Laws and Regulations

Our business is conducted world-wide, with raw material and finished goods imported from and exported to a substantial number of countries. In particular, a significant portion of our products are manufactured in our plant in Tijuana, Mexico and imported to the United States before shipment to domestic customers or export to other countries. We are subject to customs and import/export rules in the U.S. and other countries and to requirements for payment of appropriate duties and other taxes as goods move between countries. Customs authorities monitor our shipments and payments of duties, fees and other taxes and can perform audits to confirm compliance with applicable laws and regulations. After receiving a series of inquiries from U.S. Customs and Border Protection (CBP) regarding various customs compliance issues we submitted a Prior Disclosure to CBP on January 4, 2012, in which we indicated that we may have misclassified certain imported products for tariff purposes as well as improperly imported products under the provisions of the North American Free Trade Agreement (NAFTA). We committed to CBP that we would undertake an investigation of the potential compliance issues, and if we determine that any errors exist, we will correct the impacted entries made during the five-year period included in the Prior Disclosure and pay the appropriate duties. CBP also has the authority to impose penalties for such compliance issues in certain cases. We expect to complete the investigation and submit a perfected disclosure to CBP within the next few months.

Foreign Corrupt Practices Act

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

Governmental Audits

Because we participate in governmental programs as a supplier of medical devices, our operations are subject to periodic surveys and audits by governmental entities or contractors to assure compliance with

 

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

We have also been subject to periodic audits of our compliance with other federal requirements for our facilities and related quality and manufacturing processes and have, on occasion, received FDA warning letters and other notices and have promptly implemented corrective and preventative actions.

Federal Privacy and Transaction Law and Regulations

HIPAA impacts the transmission, maintenance, use and disclosure of certain individually identifiable health information (referred to as protected health information, or PHI). Since HIPAA was enacted in 1996, numerous implementing regulations have been issued, including, but not limited to: (1) standards for the privacy of individually identifiable health information (the Privacy Rule), (2) standards to protect the confidentiality, integrity and security of electronic protected health information (the Security Rule), (3) standards for electronic transactions, (4) a standard unique national provider identifier for providers and health plans, and (5) the HHS Breach Notification Rule. We refer to these rules, as well as similar state laws applicable to our operations, as the HIPAA Rules. HHS has also issued regulations governing the enforcement of the HIPAA Rules, the violation of which potentially includes significant criminal and civil penalties. Furthermore, many states have similar laws and regulations applicable to our operations, including but not limited to state data security breach requirements.

The HIPAA Rules apply to “covered entities,” which includes healthcare providers who conduct certain transactions electronically, including but not limited to the electronic submission of health care claims to an insurance carrier. We also provide services to customers that are directly regulated entities under HIPAA and the HIPAA Rules, and we are required to provide satisfactory written assurances to these customers through our written agreements that we will provide our services in accordance with HIPAA and the HIPAA Rules. As such, HIPAA and the HIPAA Rules apply to certain aspects of our business. The effective dates for all of the HIPAA Rules outlined above have passed, and, as such, all of the HIPAA Rules are in effect. To the extent applicable to our operations, we believe we are currently in compliance with HIPAA and the applicable HIPAA Rules. Any failure to comply with applicable requirements could adversely affect our profitability.

On February 17, 2009, President Obama signed into law the Health Information Technology for Economic and Clinical Health Act (HITECH Act) as part of the American Recovery and Reinvestment Act. This law includes strengthened federal privacy and security provisions to protect personally-identifiable health information, such as the notification requirements set forth in the Breach Notification Rule. On January 25, 2013, the Office for Civil Rights (“OCR”) of the Department of Health and Human Services published its final rule to modify the HIPAA Privacy, Security, Breach and Enforcement Rules, including most revisions/additions made by the HITECH Act. We are still reviewing the extensive provisions of the rule, which in general appear to expand privacy and security requirements for business associates of entities that receive protected health information, increase penalties for noncompliance, and strengthen requirements for reporting of breaches, among other things. The effective date of the rule is March 23, 2013, and covered entities and business associates must comply with most of the applicable requirements by September 23, 2013. We cannot determine at this time the

 

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potential impact of the rule on our operations. There are costs and administrative burdens associated with ongoing compliance with the HIPAA Rules and similar state law requirements. Any failure to comply with current and applicable future requirements could adversely affect our profitability.

Iran Sanctions Related Disclosure

Under the Iran Threat Reduction and Syrian Human Rights Act of 2012, 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 during the period covered by the report. 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). We are not presently aware that we and our consolidated subsidiaries have knowingly engaged in any transaction or dealing reportable under Section 13(r) of the Exchange Act during the year ended December 31, 2012.

The Blackstone Group L.P., an affiliate of our major shareholder, informed us that TRW Automotive Holdings Corp., a company that may be considered one of its affiliates, included the disclosure reproduced below in its annual report on Form 10-K as filed with the SEC on February 15, 2013 as required by Section 13(r) of the Exchange Act (the “TRW Disclosure”). We have no involvement in or control over the activities of TRW Automotive Holdings Corp., any of its predecessor companies or any of its subsidiaries, and we have not independently verified or participated in the preparation of the TRW Disclosure.

TRW Disclosure:

Compliance with Government Regulations

Pursuant to Section 13(r)(1)(D)(iii) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), we note that in 2012 certain of our non-U.S. subsidiaries sold products to customers that could be affiliated with, or deemed to be acting on behalf of, the Industrial Development and Renovation Organization, which has been designated as an agency of the Government of Iran. Gross revenue attributable to such sales was approximately $8,326,000, and net profit from such sales was approximately $377,000. Although these activities were not prohibited by U.S. law at the time they were conducted, our subsidiaries have discontinued their dealings with such customers, other than limited wind-down activities (which are permissible), and we do not otherwise intend to continue or enter into any Iran-related activity.”

Employees

As of December 31, 2012, we had approximately 5,370 employees. Of these, approximately 3,900 were engaged in production and production support, approximately 100 in research and development, approximately 1,010 in sales and support, and approximately 360 in various administrative capacities including third party billing. Of these employees, approximately 2,220 were located in the United States, approximately 2,280 were located in Mexico and approximately 870 were located in various other countries, primarily in Europe. We have not experienced any strikes or work stoppages, and our management considers our relationship with our employees to be good.

Segment and Geographic Information

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

Available Information

We have made available free of charge through our website, www.DJOglobal.com, our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, other Exchange Act reports and all

 

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amendments to those reports as soon as reasonably practicable after such material is electronically filed with the Securities and Exchange Commission (SEC). This information can be found under the “Corporate Information—Investors-SEC reports” page of our website. DJO uses its website as a channel of distribution of material Company information. Financial and other material information regarding the Company is routinely posted and accessible on our website. Our SEC reports are also available free of charge on the SEC website at, www.sec.gov. Such reports can also be inspected and copied at the Public Reference Room of the SEC located at 100 F Street, N.E., Washington, D.C. 20549. Copies of such material can be obtained from the Public Reference Room of the SEC at prescribed rates. You may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. Our Code of Business Conduct and Ethics is available free of charge under the “Corporate Information—Investors-Corporate Governance” page of our website.

ITEM 1A. RISK FACTORS

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

Risks Related To Our Indebtedness

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

We are highly leveraged. As of December 31, 2012, our total indebtedness was $2,235.0 million, exclusive of net unamortized original issue discount of $2.3 million. We also had an additional $97.0 million available for borrowing under our revolving credit facility. Our high degree of leverage could have important consequences, including:

 

   

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

 

   

increasing our vulnerability to general economic and industry conditions,

 

   

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

 

   

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

 

   

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

 

   

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

 

   

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

We, and our subsidiaries, will be able to incur substantial additional indebtedness in the future. Although our senior secured credit facilities and the indentures governing the Notes (collectively, the Indentures) contain restrictions on the incurrence of additional indebtedness, these restrictions are subject to a number of significant qualifications and exceptions, and under certain circumstances, the amount of indebtedness that could be incurred in compliance with these restrictions could be substantial. If we add new borrowings to our current debt levels, the related risks that we now face could intensify. In addition, the Indentures will not prevent us from incurring obligations that do not constitute indebtedness under such Indentures.

 

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Our cash paid for interest for the years ended December 31, 2012, 2011, and 2010 was $162.6 million, $151.2 million, and $139.1 million, respectively. As of December 31, 2012, we had $865.0 million of debt subject to floating interest rates under our senior secured credit facilities, exclusive of $8.9 million of unamortized original issue discount.

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

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

 

   

incur additional indebtedness or issue certain preferred shares,

 

   

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

 

   

make certain investments,

 

   

sell certain assets,

 

   

create liens,

 

   

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

 

   

enter into certain transactions with our affiliates.

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

A breach of any of these covenants could result in a default under one or more of these agreements, including as a result of cross default provisions. Upon the occurrence of an event of default under our senior secured credit facilities, the lenders could elect to declare all amounts outstanding under our senior secured credit facilities to be immediately due and payable and terminate all commitments to extend further credit. Such actions by those lenders could cause cross defaults under our other indebtedness. If we were unable to repay those amounts, the lenders under our senior secured credit facilities could proceed against the collateral granted to them to secure that indebtedness. We have pledged substantially all of our assets as collateral under our senior secured credit facilities. If the lenders under our senior secured credit facilities accelerate the repayment of borrowings, we cannot assure you that we will have sufficient assets to repay the amounts borrowed under our senior secured credit facilities, as well as our unsecured indebtedness.

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

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

If our cash flows and capital resources are insufficient to fund our debt service obligations, we may be forced to reduce or delay investments and capital expenditures, or to sell assets, seek additional capital or restructure or refinance our indebtedness. These alternative measures could affect the operation and growth of

 

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our business and may not be successful and may not permit us to meet our scheduled debt service obligations. If our operating results and available cash are insufficient to meet our debt service obligations, we could face substantial liquidity problems and might be required to dispose of material assets or operations to meet our debt service and other obligations. In that case, we may not be able to consummate those dispositions or to obtain the proceeds that we could realize from them, and the proceeds from those dispositions may not be adequate to meet any debt service obligations then due. Additionally, our senior secured credit facilities and the Indentures limit the use of the proceeds from dispositions of assets; as a result, we may not be permitted to use the proceeds from such dispositions to satisfy all current debt service obligations.

Risks Related To Our Business

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

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

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

In the United States, Congress and CMS frequently engage in efforts to contain costs, which may result in more restrictive Medicare or Medicaid coverage, reduced reimbursement, or selective contracting for our products. As discussed under “Government Regulations—Third Party Reimbursement” in the “Business” section above, CMS recently determined that TENS for the treatment of chronic low back pain will not be covered under Medicare unless the patient is enrolled in a clinical study meeting certain defined standards. This coverage decision reduces the available market for TENS devices. If our Empi business is unsuccessful in offsetting the adverse effects of these revenue losses, the long-term revenue and profit impact of this coverage decision could be materially adverse to the Empi business and could have an adverse impact on our business and results of operations as a whole.

Medicare payment for durable medical equipment, prosthetics, orthotics and supplies (DMEPOS) also can be impacted by the DMEPOS competitive bidding program, under which Medicare rates are based on bid amounts for certain products in designated geographic areas, rather than the Medicare fee schedule amount. Only those suppliers selected through the competitive bidding process within each designated competitive bidding area (CBA) are eligible to have their products reimbursed by Medicare. See “Government Regulations—Third Party Reimbursement” in the “Business” section above. When our products become subject to competitive bidding, if we are not selected as a contract supplier (or subcontractor) in a particular region, or if contract prices are significantly below Medicare fee schedule reimbursement levels, it could have an adverse impact on our sales and profitability.

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

Our international sales also depend in part upon the coverage and eligibility for reimbursement of our products through government-sponsored healthcare payment systems and third party payors, the amount of

 

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

The continued slow and unsteady recovery of U.S. and global economies may pose additional risks and exacerbate existing risks to our business.

The continued sluggishness in the U.S. and global economy has had and may continue to have a negative impact on demand for our products, availability and reliability of vendors and third party contract manufacturers, our ability to timely collect our accounts receivable and the availability of financing for acquisitions and working capital requirements. Continued or renewed deterioration of general economic conditions in the United States and overseas could contribute to those trends remaining a problem or becoming worse.

The slowing of economic activity has affected and could continue to affect our business in a variety of ways, including the following:

 

   

loss of jobs and lack of health insurance as a result of the economic slowdown could depress demand for healthcare services and demand for our products,

 

   

weakened demand for healthcare services, reduction in the number of insured patients and lack of available credit could result in the inability of private insurers to satisfy their reimbursement obligations, lead to delays in payment or cause the insurers to increase their scrutiny of our claims,

 

   

shortage of available credit for working capital could lead customers who buy capital goods from us to curtail their purchases or have difficulty meeting payment obligations, or

 

   

problems in the credit and financial markets could limit the availability and size of alternative or additional financing for our working capital or other corporate needs and could make it more difficult and expensive to obtain waivers under or make changes to our existing credit arrangements.

Any of these risks, among others, could adversely affect our business and operating results, and the risks could become more pronounced if the problems in the U.S. and global economies and the credit and financial markets continue or become worse.

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

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

 

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

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

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

Our manufacturing processes are required to comply with the FDA’s Quality System Regulation, which covers current Good Manufacturing Practice requirements including procedures concerning (and documentation of) the design, testing, production processes, controls, quality assurance, labeling, packaging, storage and shipping of our devices. We also are subject to state requirements and licenses applicable to manufacturers of medical devices. In addition, we must engage in extensive recordkeeping and reporting and must make available our manufacturing facilities and records for periodic unscheduled inspections by governmental agencies, including the FDA, state authorities and comparable agencies in other countries. Moreover, if we fail to pass a Quality System Regulation inspection or to comply with these and other applicable regulatory requirements, we may receive a notice of a violation in the form of inspectional observations on Form FDA-483, a warning letter, or could otherwise be required to take corrective action and, in severe cases, we could suffer a disruption of our operations and manufacturing delays. If we fail to take adequate corrective actions, we could be subject to certain enforcement actions, including, among other things, significant fines, suspension of approvals, seizures or recalls of products, operating restrictions and criminal prosecutions. We cannot assure you that the FDA or other governmental authorities would agree with our interpretation of applicable regulatory requirements or that we have in all instances fully complied with all applicable requirements. Any notice or communication from the FDA regarding a failure to comply with applicable requirements could adversely affect our product sales and profitability. We have received FDA warnings letters in the past and we cannot assure you that the FDA will not take further action in the future.

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

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

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

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

 

   

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

 

   

our ability to meet the demand for our products,

 

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

 

   

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

 

   

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

 

   

the impact of any acquisitions that occur in a quarter,

 

   

the impact of any changes in generally accepted accounting principles,

 

   

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

 

   

the loss of any of our significant distributors,

 

   

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

 

   

the timing of significant orders and shipments.

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

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

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

 

   

greater financial, marketing and other resources,

 

   

more widely accepted products,

 

   

a larger number of endorsements from healthcare professionals,

 

   

a larger product portfolio,

 

   

superior ability to maintain new product flow,

 

   

greater research and development and technical capabilities,

 

   

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

 

   

stronger name recognition,

 

   

larger sales and distribution networks, and/or

 

   

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

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

 

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If we are unable to develop or license new products or product enhancements or find new applications for our existing products, we will not remain competitive.

The markets for our products are characterized by continued new product development and the obsolescence of existing products. Our future success and our ability to increase revenues and make payments on our indebtedness will depend, in part, on our ability to develop, license, acquire and distribute new and innovative products, enhance our existing products with new technology and find new applications for our existing products. However, we may not be successful in developing, licensing or introducing new products, enhancing existing products or finding new applications for our existing products. We also may not be successful in manufacturing, marketing and distributing products in a cost-effective manner, establishing relationships with marketing partners, obtaining coverage of and satisfactory reimbursement for our future products or product enhancements or obtaining required regulatory clearances and approvals in a timely fashion or at all. If we fail to keep pace with continued new product innovation or enhancement or fail to successfully commercialize our new or enhanced products, our competitive position, financial condition and results of operations could be materially adversely affected.

In addition, if any of our new or enhanced products contain undetected errors or design defects, especially when first introduced, or if new applications that we develop for existing products do not work as planned, our ability to market these and other products could be substantially delayed, and we could ultimately become subject to product liability litigation, resulting in lost revenues, potential damage to our reputation and/or delays in regulatory clearance. In addition, approval of our products or obtaining acceptance of our products by physicians, physical therapists and other healthcare professionals that recommend and prescribe our products could be adversely affected.

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

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

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

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

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

 

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In addition, legislation has been adopted, but not implemented to date, requiring that certain certification or licensing requirements be met for individuals and suppliers furnishing certain custom-fabricated orthotic devices as a condition of Medicare payment. Medicare currently follows state policies in those states that require the use of an orthotist or prosthetist for furnishing of orthotics or prosthetics. We cannot predict whether additional restrictions will be implemented at the state or federal level or the impact of such policies on our business.

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

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

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

The international scope of our operations exposes us to economic, regulatory and other risks in the countries in which we operate. We generated 24.8% of our net revenues from customers outside the United States for the year ended December 31, 2012. Doing business in foreign countries exposes us to a number of risks, including the following:

 

   

fluctuations in currency exchange rates,

 

   

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

 

   

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

 

   

difficulty in collecting accounts receivable and longer collection periods,

 

   

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

 

   

intellectual property protection difficulties,

 

   

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

 

   

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

 

   

labor disputes,

 

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

 

   

increased costs of transportation or shipping,

 

   

exposure to different approaches to treating injuries,

 

   

exposure to different legal, regulatory and political standards, and

 

   

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

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

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

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

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

Our foreign operations expose us to currency fluctuations and exchange rate risks. We are exposed to the risk of currency fluctuations between the U.S. Dollar and the Euro, Pound Sterling, Canadian Dollar, Mexican Peso, Swiss Franc, Australian Dollar, Japanese Yen, Norwegian Krone, Danish Krone, Swedish Krona, South African Rand and Tunisian Dinar. Sales denominated in foreign currencies accounted for 21.9% of our consolidated net sales for the year ended December 31, 2012, of which 15.9% were denominated in the Euro. Our exposure to fluctuations in foreign currencies arises because certain of our subsidiaries’ results are recorded in these currencies and then translated into U.S. Dollars for inclusion in our consolidated financial statements, and certain of our subsidiaries enter into purchase or sale transactions using a currency other than our functional currency. We utilize Mexican Peso (MXN) foreign exchange forward contracts to hedge a portion of our exposure to fluctuations in foreign exchange rates, as our Mexico-based manufacturing operations incur costs that are largely denominated in MXN. As of December 31, 2012, we had outstanding MXN forward contracts to purchase an aggregate U.S. dollar equivalent of $6.4 million. As we continue to distribute and manufacture our products in selected foreign countries, we expect that future sales and costs associated with our activities in these markets will continue to be denominated in the applicable foreign currencies, which could cause currency fluctuations to materially impact our operating results. Changes in currency exchange rates may adversely affect our financial condition and results of operations and may affect the comparability of our results between reporting periods.

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

 

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

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

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

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

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

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

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

We are subject to laws concerning our marketing activities in foreign countries where we conduct business. For example, within the EU, the control of unlawful marketing activities is a matter of national law in each of the member states of the EU. The member states of the EU closely monitor perceived unlawful marketing activity by companies. We could face civil, criminal and administrative sanctions if any member state determines that we have breached our obligations under its national laws. In particular, as a result of conducting business in the U.K.

 

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through our subsidiary in that country, we are, in certain circumstances, subject to the anti-corruption provisions of the U.K. Bribery Act in our activities conducted in any country in the world. Industry associations also closely monitor the activities of member companies. If these organizations or authorities name us as having breached our obligations under their regulations, rules or standards, our reputation would suffer and our business and financial condition could be adversely affected. We are also subject to the U.S. Foreign Corrupt Practices Act (the FCPA), antitrust and anti-competition laws, and similar laws in foreign countries, any violation of which could create a substantial liability for us and also cause a loss of reputation in the market. The FCPA prohibits U.S. companies and their officers, directors, employees, shareholders acting on their behalf and agents from corruptly offering, promising, authorizing or making payments, or giving anything of value, directly or indirectly, to foreign officials for the purpose of obtaining or retaining business abroad or otherwise obtaining favorable treatment. Companies must also maintain records that fairly and accurately reflect transactions and maintain an adequate system of internal accounting controls. In many countries, hospitals and clinics are government-owned and healthcare professionals employed by such hospitals and clinics, with whom we regularly interact, may meet the definition of a foreign official for purposes of the FCPA. If we are found to have violated the FCPA, we may face sanctions including fines, criminal penalties, disgorgement of profits and suspension or debarment of our ability to contract with government agencies or receive export licenses. From time to time, we may face audits or investigations by one or more domestic or foreign government agencies, compliance with which could be costly and time-consuming, and could divert our management and key personnel from our business operations. An adverse outcome under any such investigation or audit could subject us to fines or other penalties, which could adversely affect our business and financial results.

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

The OIG, the FDA and other regulatory agencies actively enforce regulations prohibiting the promotion of a medical device for a use that has not been cleared or approved by the FDA. Use of a device outside its cleared or approved indications is known as “off-label” use. Physicians may use our products for off-label uses, as the FDA does not restrict or regulate a physician’s choice of treatment within the practice of medicine. However, if the OIG or the FDA, or another regulatory agency determines that our promotional materials, training, or activities constitute improper promotion of an off-label use, the regulatory agency could request that we modify our promotional materials, training, or activities, or subject us to regulatory enforcement actions, including the issuance of a warning letter, injunction, seizure, civil fine and criminal penalties. Although our policy is to refrain from statements and activities that could be considered off-label promotion of our products, the FDA, another regulatory agency, or the U.S. Department of Justice could disagree and conclude that we have engaged in off-label promotion and, potentially, caused the submission of false claims. In addition, the off-label use of our products may increase the risk of injury to patients, and, in turn, the risk of product liability claims. Product liability claims are expensive to defend and could divert our management’s attention and result in substantial damage awards against us.

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

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

 

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

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

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

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

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

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

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

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

HIPAA and the HIPAA Rules impact the transmission, maintenance, use and disclosure of PHI. As such, HIPAA and the HIPAA Rules apply to certain aspects of our business. To the extent applicable to our operations, we believe

 

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we are currently in compliance with HIPAA and the applicable HIPAA Rules. There are costs and administrative burdens associated with ongoing compliance with the HIPAA Rules and similar state law requirements. Any failure to comply with current and applicable future requirements could adversely affect our profitability.

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

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

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

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

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

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

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

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

 

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

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

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

Some of our important suppliers are in China and other parts of Asia and provide predominately finished soft goods products. In the year ended December 31, 2012, we obtained 39.6% of our total purchased materials from suppliers in China and other parts of Asia. Political and economic instability and changes in government regulations in these areas could affect our ability to continue to receive materials from suppliers there. The loss of suppliers in China and other parts of Asia, any other interruption or delay in the supply of required materials or our inability to obtain these materials at acceptable prices and within a reasonable amount of time could impair our ability to meet scheduled product deliveries to our customers and could hurt our reputation and cause customers to cancel orders.

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

If our patents and other intellectual property rights do not adequately protect our products, we may lose market share to our competitors and may not be able to operate our business profitably.

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

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

 

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In addition, we also hold U.S. and foreign patents relating to a number of our components and products and have patent applications pending with respect to other components and products. We also apply for additional patents in the ordinary course of our business, as we deem appropriate. However, these precautions offer only limited protection, and our proprietary information may become known to, or be independently developed by, competitors, or our proprietary rights in intellectual property may be challenged, any of which could have a material adverse impact on our business, financial condition and results of operations. Additionally, we cannot assure you that our existing or future patents, if any, will afford us adequate protection or any competitive advantage, that any future patent applications will result in issued patents or that our patents will not be circumvented, invalidated or declared unenforceable. In addition, certain of our subsidiaries have not always taken commercially reasonable measures to protect their ownership of some of their patents. While such measures are currently employed and have been employed by us in the past, disputes may arise as to the ownership, or co-ownership, of certain of our patents. We do not consider patent protection to be a significant competitive advantage in the marketplace for electrotherapy devices. However, patent protection may be of significance with respect to our orthopedic technology.

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

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

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

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

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

A significant portion of our rehabilitation products are manufactured in a facility in Tijuana, Mexico, with a number of products for the European market manufactured in a Tunisian facility. In Vista, California we manufacture our custom rigid bracing products, which remain in the United States to facilitate quick turnaround on custom orders, vascular products, and our CMF product line. Our clinical electrotherapy devices, patient care

 

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products, physical therapy and certain CPM devices are now manufactured in our facilities located in Tijuana, Mexico, following the closure of our Chattanooga facility during the first half of 2010. Our home electrotherapy devices sold in the United States as well as some components and related accessories are manufactured at our facility in Clear Lake, South Dakota. In our Surgical Implant business, we manufacture our products in our manufacturing facility at Austin, Texas. These facilities and the manufacturing equipment we use to produce our products would be difficult to repair or replace. Our facilities may be affected by natural or man-made disasters. If one of our facilities were affected by a disaster, we would be forced to rely on third party manufacturers or shift production to another manufacturing facility. In such an event, we would face significant delays in manufacturing which would prevent us from being able to sell our products. In addition, our insurance may not be sufficient to cover all of the potential losses and may not continue to be available to us on acceptable terms, or at all.

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

Affiliates of Blackstone collectively beneficially own 97.8% of DJO’s issued and outstanding capital stock and Blackstone designees hold a majority of the seats on DJO’s board of directors. As a result, affiliates of Blackstone have control over our decisions to enter into any corporate transaction and have the ability to prevent any transaction that requires the approval of security holders regardless of whether holders of the Notes believe that any such transactions are in their own best interests. For example, affiliates of Blackstone could collectively cause us to make acquisitions that increase the amount of indebtedness or to sell assets, or could cause us to issue additional capital stock or declare dividends. So long as affiliates of Blackstone continue to directly or indirectly own a significant amount of the outstanding shares of our common stock, they will continue to be able to strongly influence or effectively control our decisions. In addition, Blackstone has no obligation to provide us with any additional debt or equity financing.

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

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

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

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

 

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ITEM 2. PROPERTIES

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

 

Location

  

Use

   Status   Lease
Termination Date
  Square Feet
(in thousands)

Vista, California

  

Corporate headquarters, operations, manufacturing facility, research and development

   Leased   August 2021   112

Tijuana, Mexico

  

Manufacturing and distribution facility

   Leased   September 2016   286

Asheboro, North Carolina

  

Manufacturing and distribution facility

   Owned   N/A   115

Indianapolis, Indiana

  

Distribution facility

   Leased   October 2016   110

Mequon, Wisconsin

  

Office, manufacturing and distribution facility

   Leased   June 2024   95

Mequon, Wisconsin

  

Warehouse and distribution facility

   Leased   October 2013   42

Shoreview, Minnesota

  

Office, operations, medical billing

   Leased   October 2018 (a)   94

Clear Lake, South Dakota

  

Manufacturing, distribution and refurbishment, and repair facility

   Owned   N/A   54

Sfax, Tunisia

  

Manufacturing facility

   Leased   December 2013   62

Austin, Texas

  

Operations and manufacturing facility, warehouse, research and development

   Leased   March 2019 (b)   53

Vista, California

  

Manufacturing facility

   Leased   December 2018   53

Arden Hills, Minnesota

  

Office and manufacturing facility

   Leased   September 2015   20

Freiburg, Germany

  

Research and development, distribution facility

   Leased   December 2014   20

Freiburg, Germany

  

Research and development, distribution facility

   Leased   November 2014   27

Mouguerre, France

  

Office and distribution facility

   Leased   October 2016   43

Mississauga, Canada

  

Office and distribution facility

   Leased   March 2015   30

Herentals, Belgium

  

Office and distribution facility

   Leased   March 2014   26

Freiburg, Germany

  

Office and distribution facility

   Leased   December 2014   23

Malmo, Sweden

  

Office and distribution facility

   Leased   March 2014   16

Guildford, United Kingdom

  

International headquarters, office, operations

   Leased   January 2015   12

Guildford, United Kingdom

  

Warehouse and distribution facility

   Leased   May 2016   12

Other various locations

  

Various

   Leased   Various   45

Hixson, Tennessee

  

Held for sale

   Owned   N/A   226

 

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

ITEM 3. LEGAL PROCEEDINGS

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

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

 

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Pain Pump Litigation

We are currently named as one of several defendants in a number of product liability lawsuits involving approximately 45 plaintiffs in U.S. cases and a lawsuit in Canada which has been granted class action status, related to a disposable drug infusion pump product (pain pump) manufactured by two third party manufacturers that we distributed through our Bracing and Vascular segment. We sold pumps manufactured by one manufacturer from 1999 to 2003 and then sold pumps manufactured by a second manufacturer from 2003 to 2009. We discontinued our sale of these products in the second quarter of 2009. These cases have been brought against the manufacturers and certain distributors of these pumps. All of these lawsuits allege that the use of these pumps with certain anesthetics for prolonged periods after certain shoulder surgeries has resulted in cartilage damage to the plaintiffs. Many of the lawsuits which have been filed in the past five years have named multiple pain pump manufacturers and distributors without having established which manufacturer manufactured or sold the pump in issue. In the past three years, we have been dismissed from approximately 400 cases when product identification was later established showing that we did not sell the pump in issue. In the past three years, we have entered into settlements with plaintiffs in approximately 75 pain pump lawsuits. Of these, we have settled approximately 45 cases in joint settlements involving our first manufacturer and we have settled approximately 30 cases involving our second manufacturer.

Indemnity Claims Related to Pain Pump Claims

We have sought indemnity and tendered the defense of the pain pump cases to the two manufacturers who supplied these pumps to us, to their products liability carriers and to our products liability carriers. These lawsuits are about equally divided between the two manufacturers. Both manufacturers have rejected our tenders of indemnity. The base policy for one of the manufacturers contributed to our defense, but that policy has been exhausted by defense costs and settlements, as has a second policy of that manufacturer. This manufacturer has ceased operations, has little assets and no additional insurance coverage. We have asserted indemnification rights against the successor to this manufacturer and are pursuing claims against the manufacturer, its owners and its successor. This manufacturer has asserted a counterclaim for indemnity against us, alleging that we are responsible for any liability incurred by the manufacturer in connection with our sale of pain pumps supplied by this manufacturer. The base policy for the other manufacturer has been exhausted and the excess liability carriers for that manufacturer have not accepted coverage for us and are not expected to provide for our defense. We and this manufacturer have been cooperating in jointly negotiating settlements of those lawsuits in which both parties are named. Our products liability carriers have accepted coverage of these cases, subject to a reservation of the right to deny coverage for customary matters, including punitive damages and off-label promotion. In August 2010, one of our excess carriers for the period ending July 1, 2010 and for the supplemental extended reporting period (SERP) discussed below, which is insuring $10 million in excess of $25 million, informed us that it has reserved its right to rescind the policy based on an alleged failure by us and our insurance broker to disclose material information regarding the pain pump claims prior to the binding of coverage by this carrier. We disagree with this allegation and are seeking to resolve the issue with this carrier.

Pain Pump-Related HIPAA Subpoena

In August 2010, we were served with a subpoena under HIPAA seeking numerous documents related to our activities involving the pain pumps discussed above. The subpoena, which was issued by the United States Attorney’s Office for the Central District of California, refers to a criminal investigation by the DOJ and the FDA of Federal health care offenses. We have produced documents that are responsive to the subpoena. We believe that our actions related to our prior distribution of these pain pumps have been in compliance with applicable legal standards.

Pain Pump Investigation—U.S. Attorney’s Office for the Western District of Missouri

In January 2012, we became aware of a civil investigation by the United States Attorney’s Office for the Western District of Missouri regarding the sale and marketing of pain pump devices by manufacturers and distributors. The investigation relates to whether manufacturers and distributors caused false claims to be filed

 

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with government payors as a result of alleged off-label promotion of the pain pumps. We deny that we improperly promoted the pain pump devices and believe that our marketing and sales activities were in compliance with applicable legal standards.

Cold Therapy Litigation

Since mid-2010, we have been named in nine multi-plaintiff lawsuits involving a total of 210 plaintiffs, alleging that the plaintiffs had been injured following use of certain cold therapy products manufactured by the Company. The complaints are not specific as to the nature of the injuries, but allege various product liability theories, including inadequate warnings regarding the risks associated with the use of cold therapy and failure to incorporate certain safety features into the design. No specific dollar amounts of damages are alleged and as of December 31, 2012, we cannot estimate a range of potential loss. These cases have been included in a coordinated proceeding in San Diego Superior Court with a similar number of cases filed against one of our competitors. Nine of the plaintiffs included in the cases filed against us have been selected as the first cases to be tried, of which four of these “bellwether” cases are scheduled for trial commencing in July 2013. Discovery is proceeding on these bellwether cases.

Our Product Liability Insurance Coverage

We maintain product liability insurance that is subject to annual renewal. Our current policy covers claims reported between July 1, 2012 and June 30, 2013. This policy excludes coverage for claims related to both pain pump products and cold therapy products. As described below, we have other insurance which provides coverage for these excluded products. For the current policy year, we maintain coverage limits (together with excess policies) of up to $50 million, with deductibles of $500,000 per claim for claims relating to invasive products (principally our surgical implant products) and $50,000 per claim for claims relating to all other covered products, with an aggregate self-insured retention of $2 million. Starting with the 2010-2011 policy period, our products liability policy excluded claims related to pain pump products. We purchased supplemental extended reporting period (SERP) coverage for the $80 million limit product liability policy that expired on June 30, 2010, and this supplemental coverage allows us to report pain pump claims for an additional five years beyond the end of that policy period. Except for the additional excess coverage mentioned below, this SERP coverage does not provide additional limits to the aggregate $80 million limits on the 2009-2010 policy but it does provide that these limits will remain available for pain pump claims reported for an extended period of time. We also purchased additional coverage of $25 million in excess of the $80 million limits with a five year reporting period. Thus, the SERP coverage for current and future pain pump claims has a total limit of $105 million (less amounts paid for claims reported to date). Starting with the 2011-2012 policy period, our primary products liability coverage excluded claims related to cold therapy products. Concurrently with the exclusion of our cold therapy products from the 2011-2012 primary policy, we purchased SERP coverage for cold therapy product claims for injuries alleged to have occurred prior to July 1, 2011. This SERP allows us to report such cold therapy claims under our expired 2010-2011 policy which had total limits of $50 million. At that time, we also purchased separate primary and excess policies providing for a total of $5 million of coverage for claims related to cold therapy products arising from injuries alleged to have occurred after June 30, 2011, with a deductible of $250,000 per claim and an aggregate deductible of $3 million. We continued this $5 million in coverage on similar terms for the policy period commencing July 1, 2012. We believe we have adequate insurance coverage for our product liability claims.

BGS Qui Tam Action

On April 15, 2009, we became aware of a qui tam action filed in Federal Court in Boston, Massachusetts in March 2005 and amended in December 2007 and May 2010 that names us as a defendant along with each of the other companies that manufactures and sells external bone growth stimulators. This case is captioned United States ex rel. Beirman v. Orthofix International, N.V., et al., Civil Action No. 05-10557 (D. Mass.). The case was sealed when originally filed and unsealed in March 2009. The plaintiff, or relator, alleges that the defendants

 

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have engaged in Medicare fraud and violated Federal and state false claims acts from the time of the original introduction of the devices by each defendant to the present by seeking reimbursement for bone growth stimulators as a purchased item rather than a rental item. The relator also alleges that the defendants are engaged in other marketing practices constituting violations of the Federal and various state anti-kickback statutes. The case is proceeding to the discovery phase. The government has decided not to intervene in the case at this time. We can make no assurance as to the resources that will be needed to respond to this case or the final outcome of such action.

ITEM 4. MINE SAFETY DISCLOSURES

None.

 

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PART II.

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

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

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

During the year ended December 31, 2011, DJO sold 192,959 shares of its common stock at $16.46 per share, consisting of 157,959 shares purchased by our new chief executive officer, and 35,000 shares purchased by a former member of management. Net proceeds from these sales were $3.2 million.

During the year ended December 31, 2010, DJO sold 93,128 shares of its common stock at $16.46 per share to certain employees, directors and independent sales agents. Net proceeds from these sales were $1.5 million.

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

As of February 27, 2013, there were 24 holders of DJO’s common stock.

 

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ITEM 6. SELECTED FINANCIAL DATA

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

 

     Year Ended December 31,  

($ in thousands)

   2012     2011     2010     2009     2008  

Statement of Operations Data (1) (2):

          

Net sales

   $ 1,129,420      $ 1,074,770      $ 965,973      $ 946,126      $ 948,469   

Gross profit

     685,500        656,632        620,703        607,407        598,292   

Loss from continuing operations (3)

     (118,368     (213,587     (51,675     (49,391     (97,683

Net loss attributable to DJOFL (3)

     (119,150     (214,469     (52,532     (50,433     (97,786

Other Financial Data (2):

          

Depreciation and amortization

     127,459        121,151        103,519        105,150        122,447   

Balance Sheet Data (at period end):

          

Cash and cash equivalents

   $ 31,223      $ 38,169      $ 38,132      $ 44,611      $ 30,483   

Total assets

     2,862,723        2,894,860        2,779,790        2,850,179        2,940,130   

Long-term debt, net of current portion

     2,223,816        2,159,091        1,816,291        1,796,944        1,832,044   

DJOFL membership equity

     182,092        295,813        504,139        555,860        598,366   

 

(1) For additional information about our acquisitions in the past three years, see Note 3 of the Notes to Consolidated Financial Statements included in Part II, Item 8, herein.
(2) We sold our Empi Therapy Solutions catalog business on June 12, 2009 and its results have been excluded from continuing operations for all periods presented.
(3) Results for the years ended December 31, 2012, 2011 and 2009 include aggregate goodwill and intangible asset impairment charges of $7.4 million, $141.0 million and $7.0 million, respectively.

 

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

Forward Looking Statements

The following management’s discussion and analysis contains “forward looking statements” within the meaning of Section 27A of the Securities Act and Section 21E of the Exchange Act that represent our expectations or beliefs concerning future events, including, but not limited to, statements regarding growth in sales of our products, profit margins and the sufficiency of our cash flow for future liquidity and capital resource needs. These forward-looking statements are further qualified by important factors that could cause actual results to differ materially from those in the forward-looking statements. These factors are described in Item 1A, Risk Factors, noted above. Results actually achieved may differ materially from expected results included in these statements as a result of these or other factors.

Introduction

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

Overview of Business

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

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

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

Operating Segments

We currently develop, manufacture and distribute our products through the following four operating segments:

Bracing and Vascular Segment

Our Bracing and Vascular segment, which generates its revenues in the United States, offers our rigid knee bracing products, orthopedic soft goods, cold therapy products, vascular systems, therapeutic 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 business, through which we maintain an inventory of soft goods and other products at healthcare facilities, primarily orthopedic practices, for immediate distribution to patients.

 

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Recovery Sciences Segment

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

 

   

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

 

   

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

 

   

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

 

   

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

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.

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.

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

Recent Acquisitions

Acquisitions

On December 28, 2012, we acquired all of the outstanding shares of capital stock of Exos Corporation (Exos) for an initial payment of $31.2 million plus a future earn out payment of up to $10.0 million upon achievement of certain milestones. Exos is a medical device company focused on a thermoformable external musculoskeletal stabilization systems for the treatment of fractures and other injuries requiring stabilization. Since October 2011, we have been the exclusive distributor of Exos products in most of the world.

In connection with the acquisition of Exos, we incurred $1.3 million of direct acquisition costs comprised of $0.5 million of legal and other professional fees and $0.8 million of transaction and advisory fees to Blackstone Advisory Partners L.P., and Blackstone Management Partners LLC, affiliates of our major shareholder (see Note 17 of the Notes to Consolidated Financial Statements). These costs are included in Selling, general and administrative expense in our Consolidated Statement of Operations. The acquisition was partially funded using proceeds from $25.0 million of new term loans issued on December 28, 2012 (see Note 12 of the Notes to Consolidated Financial Statements).

 

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On April 7, 2011, we acquired all of the LLC membership interests of Rikco International, LLC, D/B/A Dr. Comfort (Dr. Comfort). Dr. Comfort is a provider of therapeutic footwear, which serves the diabetes care market in podiatry practices, orthotic and prosthetic centers, home medical equipment providers and independent pharmacies.

On March 10, 2011, we acquired substantially all of the assets of Circle City Medical, Inc. (Circle City or Bell-Horn). Circle City markets orthopedic soft goods and medical compression therapy products to independent pharmacies and home healthcare dealers.

On January 4, 2011, we acquired all of the outstanding shares of capital stock of Elastic Therapy, Inc. (ETI), a designer and manufacturer of private label medical compression therapy products used to treat and prevent a wide range of venous disorders.

See Note 3 of the Notes to Consolidated Financial Statements included in Part II, Item 8, herein for additional information regarding our acquisitions.

Results of Operations

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

 

     Year Ended December 31,  
     2012     2011     2010  

Net sales

   $ 1,129,420        100.0   $ 1,074,770        100.0   $ 965,973        100.0

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

     443,920        39.3        418,138        38.9        345,270        35.7   
  

 

 

     

 

 

     

 

 

   

Gross profit

     685,500        60.7        656,632        61.1        620,703        64.3   

Operating expenses:

            

Selling, general and administrative

     460,065        40.7        487,084        45.3        433,408        44.9   

Research and development

     27,877        2.5        26,850        2.5        21,892        2.3   

Amortization of intangible assets

     97,243        8.6        93,957        8.7        77,523        8.0   

Impairment of goodwill and intangible assets

     7,397        0.7        141,006        13.1        —          0.0   
  

 

 

     

 

 

     

 

 

   
     592,582        52.5        748,897        69.7        532,823        55.9   
  

 

 

     

 

 

     

 

 

   

Operating income (loss)

     92,918        8.2        (92,265     (8.6     87,880        9.1   

Other (expense) income:

            

Interest expense

     (183,055     (16.1     (169,332     (15.8     (155,181     (16.1

Interest income

     201        0.0        345        0.0        310        0.0   

Loss on modification and extinguishment of debt

     (36,889     (3.3     (2,065     (0.2     (19,798     (2.0

Other income (expense), net

     3,553        0.3        (2,814     (0.3     859        0.1   
  

 

 

     

 

 

     

 

 

   
     (216,190     (19.1     (173,866     (16.2     (173,810     (18.0
  

 

 

     

 

 

     

 

 

   

Loss from continuing operations before income taxes

     (123,272     (10.9     (266,131     (24.8     (85,930     (8.9

Income tax benefit

     4,904        0.5        52,544        4.9        34,255        3.5   
  

 

 

     

 

 

     

 

 

   

Net loss

     (118,368     (10.4     (213,587     (19.9     (51,675     (5.3

Net income attributable to noncontrolling interests

     (782     (0.1     (882     (0.1     (857     (0.1
  

 

 

     

 

 

     

 

 

   

Net loss attributable to DJOFL

   $ (119,150     (10.5 )%    $ (214,469     (20.0 )%    $ (52,532     (5.4 )% 
  

 

 

     

 

 

     

 

 

   

 

(1) Cost of sales is exclusive of amortization of intangible assets of $38,355, $38,668 and $36,343 for the years ended December 31, 2012, 2011 and 2010, respectively.

 

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Year Ended December 31, 2012 (2012) Compared to Year Ended December 31, 2011 (2011)

Net Sales. Our net sales for 2012 were $1,129.4 million, compared to net sales of $1,074.8 million for 2011, representing a 5.1% increase year over year. This increase was driven primarily by sales of our new products, sales from businesses acquired in 2011 and improving sales execution, partially offset by unfavorable changes in foreign currency exchange rates during 2012 as compared to foreign currency exchange rates in 2011. Excluding the impact of the changes in foreign currency exchange rates in 2012 (constant currency) of $15.3 million, and including pre-acquisition sales in 2011 of $20.7 million, pro forma net sales in constant currency increased by $49.3 million, or 4.5%, to $1,144.7 million for 2012 from $1,095.4 million for 2011.

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

 

     2012      % of Net
Sales
    2011      % of Net
Sales
    Increase
(Decrease)
    % Increase
(Decrease)
 

Bracing and Vascular

   $ 441,256         39.1   $ 387,928         36.1   $ 53,328        13.7

Recovery Sciences

     334,649         29.6        342,599         31.9        (7,950     (2.3

International

     280,535         24.8        279,299         26.0        1,236        0.4   

Surgical Implant

     72,980         6.5        64,944         6.0        8,036        12.4   
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

   
   $ 1,129,420         100.0   $ 1,074,770         100.0   $ 54,650        5.1
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

   

Net sales in our Bracing and Vascular segment were $441.3 million for 2012, increasing 13.7% from net sales of $387.9 million for 2011. Our Bracing and Vascular segment benefited from sales of new products, sales from businesses acquired in 2011 and improving sales execution. Including the impact of pre-acquisition sales in 2011 of $20.0 million, pro forma net sales in this segment increased by $33.3 million, or 8.2%, from $408.0 million in 2011 to $441.3 million in 2012.

Net sales in our Recovery Sciences segment were $334.6 million for 2012, decreasing 2.3% from net sales of $342.6 million for 2011. The decrease was primarily driven by changes in reimbursement for certain products in our Empi business unit and by slow market conditions for the capital equipment sold by our Chattanooga business unit.

Net sales in our International segment were $280.5 million for 2012, increasing 0.4% from net sales of $279.3 million for 2011. Excluding the impact of the changes in foreign currency exchange rates in 2012 of $15.3 million, and including pre-acquisition sales in 2011 of $0.7 million, pro forma net sales in constant currency in this segment increased by $15.9 million, or 5.7%, to $295.8 in 2012 from $279.9 million in 2011. Our International segment benefited from increased market penetration, sales of new products, sales from businesses acquired in 2011 and improving sales execution, partially offset by the impact of changes in foreign currency exchange rates.

Net sales in our Surgical Implant segment were $73.0 million for 2012, increasing 12.4% from net sales of $64.9 million for 2011. The increase was driven by strong sales of our shoulder products as well as sales of new products and strong sales execution.

Gross Profit. Consolidated gross profit as a percentage of net sales was 60.7% for 2012, compared to 61.1% for 2011.

Gross profit in our Bracing and Vascular segment as a percentage of net sales was 51.2% for 2012, compared to 52.4% for 2011. The decrease was primarily due to a lower margin mix of products sold and pricing pressure on certain product lines.

Gross profit in our Recovery Sciences segment as a percentage of net sales remained fairly consistent at 75.7% for 2012, compared to 75.6% for 2011.

 

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Gross profit in our International segment as a percentage of net sales decreased to 55.3% for 2012, from 57.7% for 2011. The decrease was primarily driven by a lower margin mix of products sold, pricing pressure in certain markets and changes in foreign currency exchange rates.

Gross profit in our Surgical Implant segment as a percentage of net sales increased to 74.9% for 2012, compared to 72.2% for 2011. The increase was driven by a higher margin mix of products sold.

Selling, General and Administrative (SG&A). SG&A expenses decreased to $460.1 million for 2012, from $487.1 million in 2011. As a percentage of net sales, SG&A expenses decreased to 40.7% in 2012 from 45.3% in 2011. Our SG&A expenses for both years were impacted by non-recurring charges, including significant amounts related to our global ERP implementation and other amounts related to restructuring activities and acquisitions. We incurred the following SG&A expenses in connection with such activities during the periods presented:

 

     Year Ended December 31,  

(in thousands)

       2012              2011      

Integration charges:

     

Commercial and global business unit reorganization and integration

   $ 6,042         11,258   

Acquisition related expenses and integration

     2,277         8,487   

CEO transition

     183         4,270   

Litigation and regulatory costs and settlements, net

     11,247         6,971   

Other non-recurring items

     3,150         3,342   

ERP implementation and other automation projects

     4,905         24,083   

Impairment of fixed assets and assets held for sale

     975         7,116   
  

 

 

    

 

 

 
   $ 28,779       $ 65,527   
  

 

 

    

 

 

 

Research and Development (R&D). R&D expenses were $27.9 million for 2012 and $26.9 million for 2011, remaining consistent at 2.5% of net sales in both years.

Amortization of Intangible Assets. Amortization of intangible assets was $97.2 million in 2012 and $94.0 million for 2011. The increase is attributable to intangible assets acquired through our 2011 acquisitions.

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

In the fourth quarter of 2011, we determined that the carrying values of goodwill and intangible assets related to our Empi and Surgical Implant reporting units were in excess of their estimated fair values. As a result, we recorded goodwill impairment charges for the Empi and Surgical Implant reporting units of $76.7 million and $47.4 million, respectively. Additionally, in the fourth quarter of 2011, we determined that the carrying value of our Empi trade name was in excess of its estimated fair value, and recorded an impairment charge of $16.9 million.

Interest Expense. Our interest expense was $183.1 million for 2012 and $169.3 million for 2011. The increase is primarily due to an increase in the total amount of outstanding borrowings in 2012 as compared to 2011.

 

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Loss on Modification and Extinguishment of Debt. Loss on modification and extinguishment of debt for year ended December 31, 2012 consists of $17.3 million in premiums related to the repurchase or redemption of our 10.875% Senior unsecured notes and $12.7 million related to the non-cash write off of unamortized debt issuance costs related to the 10.875% Senior unsecured notes, net of $2.5 million related to the non-cash write off of unamortized original issue premium associated with the 10.875% Senior unsecured notes, $8.6 million of arrangement and amendment fees and other fees and expenses incurred in connection with the March 2012 amendment of our senior secured credit facilities and $0.8 million related to the non-cash write off of unamortized debt issuance costs and original issue discount associated with a portion of our original term loans which were extinguished. Loss on modification of debt for the twelve months ended December 31, 2011 is comprised of arrangement and lender consent fees associated with the February 2011 amendment of our original senior secured credit facilities.

Other Income (Expense), Net. Other income (expense), net was $3.6 million for 2012 and $(2.8) million for 2011. Results for both periods presented primarily represent net realized and unrealized foreign currency translation gains and losses.

Income Tax (Provision) Benefit. We recorded an income tax benefit of $4.9 million on a pre-tax loss of $123.3 million, resulting in an effective tax rate of 4.0% in 2012. In 2011 we recorded a tax benefit of $52.5 million on a pre-tax loss of $266.1 million, resulting in an effective tax rate of 19.7%. The change in our effective tax rates from 2011 to 2012 primarily relates to U.S federal and state valuation allowances provided against deferred tax assets beginning in the first quarter of 2012 and differences in our projected annualized effective tax rates for each year.

Year Ended December 31, 2011 (2011) Compared to Year Ended December 31, 2010 (2010)

Net Sales. Our net sales for 2011 were $1,074.8 million, compared to net sales of $966.0 million for 2010, representing an 11.3% increase year over year. This increase was driven primarily by sales from our 2011 acquisitions of Dr. Comfort, ETI and Circle City and favorable changes in foreign currency exchange rates during 2011 as compared to foreign currency exchange rates in 2010. Excluding the impact of the changes in foreign currency exchange rates in 2011 (constant currency) of $11.8 million, and including the pre-acquisition sales in 2011 and 2010 of $20.7 million and $104.8 million, respectively, pro forma net sales in constant currency increased by $12.9 million, or 1.2%, to $1,083.7 million for 2011 from $1,070.8 million for 2010.

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

 

     2011      % of Net
Sales
    2010      % of Net
Sales
    Increase
(Decrease)
    % Increase
(Decrease)
 

Bracing and Vascular

   $ 387,928         36.1   $ 311,620         32.3   $ 76,308        24.5

Recovery Sciences

     342,599         31.9        347,139         35.9        (4,540     (1.3

International

     279,299         26.0        244,493         25.3        34,806        14.2   

Surgical Implant

     64,944         6.0        62,721         6.5        2,223        3.5   
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

   
   $ 1,074,770         100.0   $ 965,973         100.0   $ 108,797        11.3
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

   

Net sales in our Bracing and Vascular segment were $387.9 million for 2011 and $311.6 million for 2010. The increase was primarily due to $75.6 million of net sales attributable to our newly acquired Dr. Comfort, ETI and Circle City businesses. Including the impact of pre-acquisition sales in 2011 and 2010 of $20.0 million and $92.5 million, respectively, pro forma net sales in this segment increased by $3.8 million, or 0.9%, from $404.1 million in 2010 to $407.9 million in 2011.

Net sales in our Recovery Sciences segment were $342.6 million for 2011 and $347.1 million for 2010. The decrease was primarily attributable to decreased sales at our Empi business unit due primarily to certain reimbursement price changes.

 

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Net sales in our International segment were $279.3 million for 2011 and $244.5 million for 2010. The increase was driven primarily by $10.5 million of net sales from our newly acquired Dr. Comfort and ETI businesses, sales of new products, and the favorable impact of foreign exchange rates in effect during 2011 as compared to 2010, which increased net sales by $11.8 million. Excluding the impact of foreign currency exchange rates in 2011 of $11.8 million, and including pre-acquisition sales in 2011 and 2010 of $0.7 million and $12.2 million, respectively, pro forma net sales in constant currency in this segment increased by $11.5 million, or 4.5%, from $256.7 million in 2010 to $268.2 million in 2011.

Net sales in our Surgical Implant segment were $64.9 million for 2011 and $62.7 million for 2010. The increase was driven by strong sales of our Reverse Shoulder products as well as our newly launched Turon shoulder product, offset by decreases in sales of hip and knee products.

Gross Profit. Consolidated gross profit as a percentage of net sales was 61.1% for 2011 and 64.3% for 2010. The decrease was driven by several factors including the impact of sales from our acquired businesses which have lower margins, reduced average selling prices of certain of our products and purchase accounting adjustments related to the fair market value step-up of acquired inventory. These decreases were partially offset by the favorable impact of a $4.2 million adjustment made by the Company to reduce deferred gross profit from intercompany sales of inventory.

Gross profit in our Bracing and Vascular segment as a percentage of net sales was 52.4% for 2011 and 54.8% for 2010. The decrease was primarily due to a lower margin mix of products sold, including sales from our recently acquired businesses.

Gross profit in our Recovery Sciences segment as a percentage of net sales was 75.6% for 2011 and 76.4% for 2010. The decrease was primarily due to reduced average selling prices of certain products, primarily in our Empi business unit.

Gross profit in our International segment as a percentage of net sales was 57.7% for 2011 and 58.7% for 2010. The decrease was primarily driven by a lower margin mix of products sold, including sales from our recently acquired Dr. Comfort and ETI businesses and changes in foreign currency exchange rates.

Gross profit in our Surgical Implant segment as a percentage of net sales was 72.2% for 2011 and 73.4% for 2010.

Selling, General and Administrative (SG&A). SG&A expenses were $487.1 million for 2011 and $433.4 million in 2010. As a percentage of net sales, SG&A expenses increased slightly to 45.3% in 2011 from 44.9% in 2010. Our SG&A expenses for both years were impacted by non-recurring charges, including significant amounts related to our global ERP implementation and other amounts related to restructuring activities and acquisitions. We incurred the following SG&A expenses in connection with such activities during the periods presented:

 

     Year Ended December 31,  

(in thousands)

       2011              2010      

Integration charges:

     

Commercial and global business unit reorganization and integration

     11,258         18,837   

Acquisition related expenses and integration

     8,487         —     

CEO transition

     4,270         —     

Litigation and regulatory costs and settlements, net

     6,971         7,561   

Other non-recurring items

     3,342         11,138   

ERP implementation and other automation projects

     24,083         16,916   

Impairment of fixed assets and assets held for sale

     7,116         —     
  

 

 

    

 

 

 
   $ 65,527       $ 54,452   
  

 

 

    

 

 

 

 

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Research and Development (R&D). R&D expenses were $26.9 million for 2011 and $21.9 million for 2010, increasing to 2.5% of net sales in 2011 from 2.3% of net sales in 2010. R&D expense for the year ended December 31, 2011 included $0.9 million related to the write off of an abandoned product under development in our Surgical Implant segment.

Amortization of Intangible Assets. Amortization of intangible assets was $94.0 million in 2011 and $77.5 million for 2010. The increase is attributable to intangible assets acquired with our 2011 acquisitions.

Impairment of Goodwill and Intangible Assets. During the year ended December 31, 2011 we determined that the carrying values of our Empi and Surgical Implant reporting units were in excess of its estimated fair values. As a result, we recorded aggregate goodwill impairment charges of $124.1 million consisting of $76.7 million for the Empi reporting unit and $47.4 million for the Surgical Implant reporting unit. In addition, during the year ended December 31, 2011 we recorded intangible asset impairment charges of $16.9 million, related to our Empi trade name. There were no goodwill or intangible asset impairment charges recognized during 2010.

Interest Expense. Our interest expense was $169.3 million for 2011 and $155.2 million for 2010. The impact of an increase in the total amount of outstanding borrowings was partially offset by lower weighted average interest rates on outstanding borrowings. For 2010, interest expense included $4.5 million of accelerated amortization of debt discount and issuance costs related to certain prepayments of our term loans.

Loss on Modification and Extinguishment of Debt. In 2011, we recognized $2.1 million of arrangement and lender consent fees related to amendments to our original senior secured credit facilities. In 2010, we recognized a loss on extinguishment of debt of $19.8 million, including $13.0 million of premiums, $4.3 million for a non-cash write-off of unamortized debt issuance costs and $1.4 million of fees and expenses associated with the redemption of our $200 million of 11.75% senior subordinated notes in October 2010, and $1.1 million of fees and expenses related to the prepayment of $101.5 million of our term loan in January 2010.

Other Income (Expense), Net. Other income (expense), net was $(2.8) million for 2011 and $0.9 million for 2010. Results for both periods presented primarily represent net realized and unrealized foreign currency translation gains and losses.

Income Tax Benefit. We recorded an income tax benefit of $52.5 million on a pre-tax loss of $266.1 million, resulting in an effective tax rate of 19.7% in 2011. In 2010 we recorded a tax benefit of $34.3 million on a pre-tax loss of $85.9 million, resulting in an effective tax rate of 39.9%. Income tax benefit for both years is net of tax expense related to foreign operations, deferred taxes on the assumed repatriation of foreign earnings, and other non-deductible items.

Recent Accounting Pronouncements

In May 2011, the FASB issued guidance to amend the requirements related to fair value measurement which changes the wording used to describe many requirements in GAAP for measuring fair value and for disclosing information about fair value measurements. Additionally, the amendments clarify the FASB’s intent about the application of existing fair value measurement requirements. The amended guidance was effective for interim and annual periods beginning after December 15, 2011 and was applied prospectively. The Company adopted this guidance during the first quarter of fiscal year 2012. Adoption of this guidance did not have a material impact on the Company’s consolidated financial statements.

In June 2011, the FASB issued guidance to amend the presentation of comprehensive income to allow an entity the option to present the total of comprehensive income, the components of net income and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. In both choices, an entity is required to present each component of net income along with total net income, each component of other comprehensive income along with a total for other comprehensive income and a total amount for comprehensive income. The guidance eliminates the option

 

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to present the components of other comprehensive income as part of the statement of changes in stockholders’ equity. The amended guidance was effective for interim and annual periods beginning after December 15, 2011, and was applied retrospectively. The Company adopted this guidance during the first quarter of fiscal year 2012. Adoption of this guidance did not have a material impact on the Company’s consolidated financial statements.

In July 2012, the FASB issued an accounting standard update regarding testing of intangible assets for impairment. This standard update allows companies the option to perform a qualitative assessment to determine whether it is more likely than not that an indefinite lived intangible asset is impaired. An entity is not required to calculate the fair value of an indefinite-lived intangible asset and perform the quantitative impairment test unless the entity determines that it is more likely than not the asset is impaired. We will adopt this standard update during the first quarter of 2013. The adoption of this standard is not expected to have a significant impact on the Company’s consolidated financial statements.

Liquidity and Capital Resources

As of December 31, 2012, our primary sources of liquidity consisted of cash and cash equivalents totaling $31.2 million and $97.0 million of available borrowings under our revolving credit facility, as described below. Working capital at December 31, 2012 was $217.2 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 in the future. 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.

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

 

     2012     2011     2010  

Cash provided by operating activities

   $ 44,619      $ 23,605      $ 25,594   

Cash used in investing activities

     (63,965     (358,662     (30,195

Cash provided by financing activities

     11,953        334,290        413   

Effect of exchange rate changes on cash and cash equivalents

     447        804        (2,291
  

 

 

   

 

 

   

 

 

 

Net (decrease) increase in cash and cash equivalents

   $ (6,946   $ 37      $ (6,479
  

 

 

   

 

 

   

 

 

 

Cash Flows

Operating activities provided $44.6 million, $23.6 million and $25.6 million of cash for 2012, 2011 and 2010, respectively. Cash provided by operating activities for all years presented primarily represented our net loss, adjusted for non-cash expenses. For 2012, 2011 and 2010, cash paid for interest was $162.6 million, $151.2 million, and $139.1 million, respectively.

Investing activities used $64.0 million, $358.7 million and $30.2 million of cash for 2012, 2011, and 2010 respectively. Cash used in investing activities for 2012 primarily consisted of purchases of property and equipment of $33.0 million and cash paid for acquisitions of $30.0 million, net of cash acquired. Cash used in investing activities for 2011 primarily consisted of $317.7 million of net cash paid for acquisitions and $39.4 million of cash paid for purchases of property and equipment. Cash used in investing activities for 2010 primarily consisted of $27.2 million of purchases of property and equipment and $2.0 million related to acquisitions.

 

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Financing activities provided $12.0 million, $334.3 million and $0.4 million of cash for 2012, 2011 and 2010, respectively. Cash provided by financing activities in 2012 consisted of proceeds from borrowings under our senior secured credit facilities and our new 8.75% Notes, offset by repayments of our original senior secured credit facilities and our 10.875% Notes and the payment of $55.9 million of debt issuance, modification and extinguishment costs. During 2012, we received an investment of $2.0 million from DJO, our indirect parent, related to proceeds from the sale of common stock. Cash provided by financing activities in 2011 was primarily related to net proceeds from our issuance of $300.0 million aggregate principal of 7.75% Notes and net borrowings from our revolving credit facility, which together with cash on hand were used to fund acquisitions. In connection with the issuance of our $300.0 million aggregate principal of 7.75% Notes, we paid $7.7 million in debt issuance costs. During 2011, we received an investment of $3.2 million from DJO, related to proceeds from the sale of common stock. During 2010, cash provided by financing activities primarily consisted of cash received from issuances of $100.0 million aggregate principal of 10.875% Notes, and $300.0 million aggregate principal of 9.75% Notes, offset by cash paid for the redemption of our $200.0 million aggregate principal of 11.75% Notes, prepayments of $182.5 million of term loans under the senior secured credit facilities, and payment of $10.3 million of capitalized debt issuance costs in connection with the issuance and registered exchange offer of our $100.0 million 10.875% Notes and the issuance of our $300.0 million of 9.75% Notes. During 2010 we received an investment of $1.5 million from DJO, related to proceeds from the sale of common stock.

Indebtedness

As of December 31, 2012, we had $2,235.0 million in aggregate indebtedness outstanding, exclusive of a net unamortized original issue discount of $2.3 million. The principal amount and carrying value of our debt was as follows for December 31, 2012 and 2011:

 

     December 31,
2012
     December 31,
2011
 
     Principal
Amount
     Carrying
Value
     Principal
Amount
     Carrying
Value
 

Senior secured credit facilities:

           

Revolving credit facility

   $ 3,000       $ 3,000       $ 51,000       $ 51,000   

Term loans

     862,021         853,165         843,027         838,591   
  

 

 

    

 

 

    

 

 

    

 

 

 
     865,021         856,165         894,027         889,591   

Note financing:

           

8.75% second priority senior secured notes

     330,000         336,509         —           —     

10.875% senior unsecured notes

     —           —           675,000         678,282   

9.875% senior unsecured notes

     440,000         440,000         —           —     

7.75% senior unsecured notes

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

9.75% senior subordinated notes

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

 

 

    

 

 

    

 

 

    

 

 

 
     1,370,000         1,376,509         1,275,000         1,278,282   

Capital leases

     —           —           38         38   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total indebtedness

   $ 2,235,021       $ 2,232,674       $ 2,169,065       $ 2,167,911   
  

 

 

    

 

 

    

 

 

    

 

 

 

Senior Secured Credit Facilities. Term Loans outstanding under our senior secured credit facilities at December 31, 2012 consist of $385.5 million of term loans that were amended in March 2012 to extend the final maturity date to November 1, 2016 (“extended term loans”) and $476.5 million of new term loans which mature on September 15, 2017. Of the $100 million total revolving credit facility which matures on March 15, 2017, $3.0 million was outstanding as of December 31, 2012.

The interest rate margins applicable to borrowings under the revolving credit facility are, at our option, either (a) the Eurodollar rate, plus 475 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 375 basis points. The interest rate margins applicable to the extended term loans and the new term loans are, at our option, either (a) the Eurodollar rate plus 500 basis points or (b) a base rate plus 400 basis

 

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points. There is a minimum LIBOR rate of 1.25% applicable to the Eurodollar component of interest rates on the new term loan borrowings. The applicable margin for borrowings under the senior secured credit facilities may be reduced, subject to our attaining certain leverage ratios. As of December 31, 2012, our weighted average interest rate for all borrowings under the senior secured credit facilities was 5.78%.

We are required to pay annual payments in equal quarterly installments on the extended term loans in an amount equal to 1.00% of the funded total principal amount through September 2016, with any remaining amount payable in full at maturity in November 2016. We are required to pay annual payments in equal quarterly installments on the new term loans in an amount equal to 1.00% of the funded total principal amount through June 2017, with any remaining amount payable in full at maturity in September 2017.

Note Financing. Our note financing matures at various dates in 2016 and 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 12 of the Notes to Consolidated Financial Statements included in Part II, Item 8, herein for additional information regarding our indebtedness.

Certain Covenants and Related Compliance. Pursuant to the terms of the credit agreement relating to the senior secured credit facilities, we are required to maintain a maximum senior secured first lien leverage ratio of consolidated first lien net debt to Adjusted EBITDA of 4.25:1 for the trailing twelve months ended December 31, 2012. Adjusted EBITDA is defined as net income (loss) attributable to DJOFL, plus interest expense, net, income tax (provision) benefit and depreciation and amortization, further adjusted for certain non-cash items, non-recurring items and other adjustment items, as permitted in calculating covenant compliance under our senior secured credit facilities and the Indentures governing our 8.75% Notes, 9.875% Notes, 7.75% Notes and 9.75% Notes (collectively, the Notes). Adjusted EBITDA is a material component of these covenants. As of December 31, 2012, our actual senior secured first lien leverage ratio was within the required ratio at 3.01:1.

Adjusted EBITDA should not be considered as an alternative to net income or other performance measures presented in accordance with GAAP, or as an alternative to cash flow from operations as a measure of our liquidity. Adjusted EBITDA does not represent net income (loss) or cash flow from operations as those terms are defined by GAAP and does not necessarily indicate whether cash flows will be sufficient to fund cash needs. In particular, the definition of Adjusted EBITDA in the Indentures and our senior secured credit facilities allows us to add back certain non-cash, extraordinary, unusual or non-recurring charges that are deducted in calculating net loss. However, these are expenses that may recur, vary greatly and are difficult to predict. While Adjusted EBITDA and similar measures are frequently used as measures of operations and the ability to meet debt service requirements, Adjusted EBITDA is not necessarily comparable to other similarly titled captions of other companies due to the potential inconsistencies in the method of calculation.

Under the Indentures governing the Notes, our ability to incur additional debt, subject to specified exceptions, is tied to either improving the ratio of our Adjusted EBITDA to fixed charges or having this ratio be at least 2.00:1 on a pro forma basis after giving effect to such incurrence. Additionally, our ability to make certain restricted payments is also tied to having an Adjusted EBITDA to fixed charges ratio of at least 2.00:1 on a pro forma basis, as defined, subject to specified exceptions. Our ratio of Adjusted EBITDA to fixed charges for the twelve months ended December 31, 2012, measured on that date, was 1.56:1. Notwithstanding these limitations, the aggregate amount of term loan increases and revolving commitment increases shall not exceed the greater of (i) $150.0 million and (ii) the additional aggregate amount of secured indebtedness which would be permitted to be incurred as of any date of determination (assuming for this purpose that the full amount of any revolving credit increase had been utilized as of such date) such that, after giving pro forma effect to such incurrence (and any other transactions consummated on such date), the senior secured leverage ratio for the immediately preceding test period would not be greater than 4.25:1. 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.

 

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The following is a summary of our covenant requirements and pro forma ratios as of December 31, 2012:

 

     Covenant
Requirements
     Actual Ratios  

Senior Secured Credit Facilities

     

Maximum ratio of consolidated net senior secured first lien debt to Adjusted EBITDA

     4.25:1         3.01:1   

Notes

     

Minimum ratio of Adjusted EBITDA to fixed charges required to incur additional debt pursuant to ratio provision, pro forma

     2.00:1         1.56:1   

As described above, our senior secured credit facilities and the Indentures governing the Notes represent significant components of our capital structure. Under our senior secured credit facilities, we are required to maintain specified senior secured first lien leverage ratios, which become more restrictive over time, and which are 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 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, many of which are beyond our control, and we cannot assure you that we will meet those covenants. A breach of any of these covenants in the future could result in a default under our senior secured credit facilities and the Indentures, at which time the lenders could elect to declare all amounts outstanding under our senior secured credit facilities to be immediately due and payable. Any such acceleration would also result in a default under the Indentures.

The following table provides a reconciliation from our net loss to Adjusted EBITDA for the years ended December 21, 2012, 2011, and 2010. The terms and related calculations are defined in the credit agreement relating to our senior secured credit facilities and the Indentures.

 

     (unaudited)  
     Year Ended December 31,  

(in thousands)

   2012     2011     2010  

Net loss attributable to DJO Finance LLC

   $ (119,150   $ (214,469   $ (52,532

Interest expense, net

     182,854        168,987        154,871   

Income tax benefit

     (4,904     (52,544     (34,255

Depreciation and amortization

     127,459        121,251        103,519   

Non-cash charges (a)

     10,742        163,918        3,460   

Non-recurring and integration charges (b)

     32,584        63,717        60,175   

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

     41,400        13,393        27,112   
  

 

 

   

 

 

   

 

 

 
     270,985        264,253        262,350   

Permitted pro forma adjustments (d)

      

Pre-acquisition Adjusted EBITDA

     1,590        7,873        332   

Future cost savings

     1,396        5,905        —     
  

 

 

   

 

 

   

 

 

 

Adjusted EBITDA

   $ 273,971      $ 278,031      $ 262,682   
  

 

 

   

 

 

   

 

 

 

 

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

 

     Year Ended December 31,  

(in thousands)

   2012      2011      2010  

Stock compensation expense

   $ 2,339       $ 2,701       $ 1,888   

Impairment of goodwill and intangible assets

     7,397         141,006         —     

Impairment of fixed assets and assets held for sale

     975         7,466         1,147   

Purchase accounting adjustments

     —           12,336         —     

Loss on disposal of assets, net

     31         409         425   
  

 

 

    

 

 

    

 

 

 

Total non-cash items

   $ 10,742       $ 163,918       $ 3,460   
  

 

 

    

 

 

    

 

 

 

 

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

 

     Year Ended December 31,  

(in thousands)

   2012      2011      2010  

Integration charges:

        

Commercial sales and global business unit reorganization and integration

   $ 7,025       $ 12,228       $ 9,392   

Acquisition related expenses and integration (1)

     3,020         8,661         8,936   

CEO transition

     183         4,270         —     

Litigation and regulatory costs and settlements, net (2)

     12,582         6,971         7,561   

Other non-recurring items

     4,129         3,342         17,370   

ERP implementation and other automation projects

     5,645         28,245         16,916   
  

 

 

    

 

 

    

 

 

 

Total non-recurring and integration charges

   $ 32,584       $ 63,717       $ 60,175   
  

 

 

    

 

 

    

 

 

 

 

  (1) Consists of direct acquisition costs and integration expenses related to the Exos, Dr. Comfort, Elastic Therapy, Inc. (ETI) and Circle City acquisitions and costs related to potential acquisitions.
  (2) For the year ended December 31, 2012, litigation and regulatory costs and settlements includes $2.8 million of estimated costs to complete a post-market surveillance study required by the FDA related to our discontinued metal-on-metal hip implant products, $4.7 million related to ongoing product liability issues related to our discontinued pain pump products, a $1.3 million judgment related to a French litigation matter we intend to appeal and $3.8 million related to other litigation.

 

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

 

     For the Year Ended December 31,  

(in thousands)

   2012     2011      2010  

Blackstone monitoring fee

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

Noncontrolling interests

     781        882         857   

Loss on modification and extinguishment of debt (1)

     36,889        2,065         19,798   

Other (2)

     (3,270     3,446         (543
  

 

 

   

 

 

    

 

 

 

Total other adjustment items before permitted pro forma adjustments

   $ 41,400      $ 13,393       $ 27,112   
  

 

 

   

 

 

    

 

 

 

 

  (1) Loss on modification and extinguishment of debt for year ended December 31, 2012 consists of $17.3 million in premiums related to the repurchase or redemption of our 10.875% Senior unsecured notes and $12.7 million related to the non-cash write off of unamortized debt issuance costs related to the 10.875% Senior unsecured notes, net of $2.5 million related to the non-cash write off of unamortized original issue premium associated with the 10.875% Senior unsecured notes, $8.6 million of arrangement and amendment fees and other fees and expenses incurred in connection with the March 2012 amendment of our original senior secured credit facilities and $0.8 million related to the non-cash write off of unamortized debt issuance costs and original issue discount associated with a portion of our
  term loans which were extinguished. Loss on modification of debt for the twelve months ended
  December 31, 2011 is comprised of arrangement and lender consent fees associated with the February 2011 amendment of our original senior secured credit facilities.

 

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  (2) Other adjustments consist primarily of net realized and unrealized foreign currency transaction gains and losses.

 

(d) Permitted pro forma adjustments include:
   

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

   

Future cost savings for the year ended December 31, 2012 included $0.6 for Dr. Comfort, $0.3 for Circle City, $0.2 for Exos and $0.3 for ETI. Future cost savings for the year ended December 31, 2011 included $2.8 million for Dr. Comfort, $2.1 million for ETI and $1.0 million for Circle City.

Contractual Commitments

As of December 31, 2012, our consolidated contractual commitments are as follows (in thousands):

 

     Payment due:  
     Total      2013      2014-2015      2016-2017      Thereafter  

Long-term debt obligations

   $ 2,235,021       $ 8,858       $ 17,716       $ 1,138,447       $ 1,070,000   

Interest payments (1)

     837,157         175,894         350,768         285,025         25,470   

Operating lease obligations

     67,097         13,072         22,382         14,711         16,932   

Purchase obligations

     122,747         70,851         23,896         14,000         14,000   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 
   $ 3,262,022       $ 268,675       $ 414,762       $ 1,452,183       $ 1,126,402   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

(1) $1,370.0 million principal amount of long-term debt is subject to fixed interest rates and $865.0 million of principal amount of long-term debt is subject to a floating interest rate. Interest payments for the floating rate debt were determined using an average assumed effective interest rate of 5.9%, which is equal to the average assumed effective interest rate for the term loans under the senior secured credit facilities over the remainder of their term.

As of December 31, 2012, we had entered into purchase commitments for inventory, capital expenditures and other services totaling $73.7 million in the ordinary course of business. In addition, under the amended transaction and monitoring fee agreement entered into in November 2007, the purchase obligations shown above include DJO’s obligation to pay a $7.0 million annual monitoring fee to Blackstone Management Partners V L.L.C. through 2019. See Item 13. “Certain Relationships and Related Transactions and Director Independence” for a more detailed description of the monitoring fee agreement.

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

Critical Accounting Policies and Estimates

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

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

 

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

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

We maintain provisions for estimated contractual allowances for reimbursement amounts from our third party payor customers based on negotiated contracts and historical experience for non-contracted payors. We report these allowances as reductions to our gross revenue. We estimate the amount of the reduction based on historical experience and invoices generated in the period, and we consider the impact of new contract terms or modifications of existing arrangements with our customers. We have contracts with certain third party payors for our third party reimbursement billings, which call for specified reductions in reimbursement of billed amounts based upon contractual reimbursement rates. For the years ended December 31, 2012, 2011, and 2010, we reserved for and reduced gross revenues from third party payors by estimated contractual allowances of 35%, 33%, and 32%; respectively.

Our reserve for doubtful accounts is based upon estimated losses from customers who are billed directly and the portion of third party reimbursement billings that ultimately become the financial responsibility of the end user patients. Direct-billed customers represented approximately 72%, 71% and 67% of our net revenues for the year ended December 31, 2012, 2011 and 2010, respectively. Direct-billed customers represented approximately 70% and 71% of our net accounts receivable at December 31, 2012 and 2011, respectively. We experienced write-offs related to direct-billed customers of less than 1% of related net revenues in each of the years ended December 31, 2012, 2011, and 2010.

Our third party reimbursement customers including insurance companies, managed care companies and certain governmental payors, such as Medicare, include all of our OfficeCare customers, most of our Empi customers, and certain other customers of our Recovery Sciences and Bracing and Vascular segments. Our third party payor customers represented approximately 28%, 29% and 33% of our net revenues for the years ended December 31, 2012, 2011 and 2010, respectively. Third party payor customers represented approximately 30% and 29%, respectively, of our net accounts receivable at December 31, 2012 and 2011. For the years ended December 31, 2012, 2011, and 2010, we estimate bad debt expense to be approximately 4%, 5% and 6%, respectively, of gross revenues from these third party reimbursement customers. If the financial condition of our customers were to deteriorate resulting in an impairment of their ability to make payments or if third party payors were to deny claims for late filings, incomplete information or other reasons, additional provisions may be required. Additions to this reserve are reflected as selling, general and administrative expense in our consolidated statements of operations.

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

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

Our reserve for rental credit recognizes a timing difference between billing for a sale and processing a rental credit associated with some of our rehabilitation devices. Many insurance providers require patients to rent our rehabilitation devices for a period of one to three months prior to purchase. If the patient has a long-term need for the device, these insurance companies may authorize purchase of the device after such time period. When the device is purchased, most providers require that rental payments previously made on the device be credited toward the purchase price. These credits are processed at the time the payment is received for the purchase of the

 

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device, which creates a time lag between billing for a sale and processing the rental credit. Our rental credit reserve estimates unprocessed rental credits based on the number of devices converted to purchase. The reserve is calculated by first assessing the number of our products being rented during the relevant period and our historical conversion rate of rentals to sales, and then reducing our revenue by the applicable amount. We provide for these reserves by reducing our gross revenue. The cost to refurbish rented products is expensed as incurred to cost of sales in our consolidated statements of operations.

Inventory Reserves

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

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

Goodwill and Intangible Assets

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

In performing our 2012 goodwill impairment test, we estimated the fair values of our reporting units using the income approach which includes the discounted cash flow method and the market approach which includes the use of market multiples. The discounted cash flows for each reporting unit were based on discrete financial forecasts developed by management for planning purposes, and required significant judgment with respect to forecasted sales, gross margin, selling, general and administrative expenses, depreciation, income taxes, capital expenditures, working capital requirements and the selection and use of an appropriate discount rate. For purposes of calculating the discounted cash flows of our reporting units, we used estimated revenue growth rates averaging between 2% and 10% for the discrete forecast period. Cash flows beyond the discrete forecasts were estimated using a terminal value calculation, which incorporated historical and forecasted financial trends for each identified reporting unit and considered long-term earnings growth rates for publicly traded peer companies. Future cash flows were then discounted to present value at discount rates ranging from 9.6% to 11.2%, and terminal value growth rates of 3%. Publicly available information regarding comparable market capitalization was also considered in assessing the reasonableness of the cumulative fair values of our reporting units estimated using the discounted cash flow methodology. We determined that the fair value of the six reporting units with goodwill assigned to them exceeds their carrying value. As such, we determined that the goodwill of our reporting units was not impaired.

In 2012, we began the process of changing the trade name used for our German operations from Ormed to DJO to be consistent with our global strategy. In conjunction with this change, we revised our assumption as to the useful life of the Ormed trade name intangible asset, which resulted in changing the remaining estimated life of the asset from indefinite to three years. These changes triggered an impairment review of the intangible asset. Based on the application of a differential cash flow method, whereby an investor would be willing to pay a price

 

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equal to the present value of the incremental cash flows attributable to the economic benefit derived from defending the trade name in the market, we determined that the carrying amount of the asset was in excess of its estimated fair value. As a result, we recorded an impairment charge of $7.4 million, which is included in the Impairment of goodwill and intangible assets line item in the Consolidated Statements of Operations.

Additionally, in the fourth quarter of 2012 we tested for impairment, our remaining indefinite lived intangible assets, consisting of trade names. This test work compares the fair value of the asset with its carrying amount. To determine the fair value we applied the relief from royalty (RFR) method. Under the RFR method, the value of the trade name is determined by calculating the present value of the after-tax cost savings associated with owning the asset and therefore not being required to pay royalties for its use during the asset’s indefinite life. Significant judgments inherent in this analysis include the selection of appropriate discount rates, estimating future cash flows and the identification of appropriate terminal growth rate assumptions. Discount rate assumptions are based on an assessment of the risk inherent in the projected future cash generated by the respective intangible assets. Also subject to judgment are assumptions about royalty rates, which are based on the estimated rates at which similar brands and trademarks are being licensed in the marketplace. We determined that the fair value of these trade names exceed their carrying value. As such, we determined that these indefinite lived intangible assets are not impaired.

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

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

Deferred Tax Asset Valuation Allowance

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

Our gross deferred tax asset balance was $243.0 million at December 31, 2012 and is primarily related to reserves for accounts receivable and inventory, accrued expenses, and net operating loss carryforwards (see Note 15 of the notes to Consolidated Financial Statements included in Part II, Item 8, herein). As of December 31, 2012, we maintained a valuation allowance of $43.8 million due to uncertainties related to our ability to realize certain deferred tax assets. The valuation allowance maintained is primarily related to net operating loss carryforwards of certain international subsidiaries, and certain domestic net operating loss and capital loss carryforwards not expected to be realized.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

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

Interest Rate Risk

Our primary exposure is to changing interest rates. We have historically managed our interest rate risk by including components of both fixed and variable debt in our capital structure. For our fixed rate debt, interest rate

 

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changes may affect the market value of the debt, but do not impact our earnings or cash flow. Conversely, for our variable rate debt, interest rate changes generally do not affect the fair market value of the debt, but do impact future earnings and cash flow, assuming other factors are constant. As of December 31, 2012, we have $1,370.0 million of aggregate fixed rate notes and $865.0 million of borrowings under the senior secured credit facilities which bear interest at floating rates based on the Eurodollar rate, as defined. A hypothetical 1% increase in variable interest rates for the floating rate borrowings under our of the senior secured credit facilities would have impacted our earnings and cash flow for the year ended December 31, 2012, by $3.9 million. As of December 31, 2012, $476.5 million of our new term loans are subject to a 1.25% minimum LIBOR rate and would not have impacted our earnings and cash flows due to a hypothetical 1% increase in the LIBOR rate during the year ended December 31, 2012. We may use derivative financial instruments where appropriate to manage our interest rate risk. However, as a matter of policy, we do not enter into derivative or other financial investments for trading or speculative purposes.

Foreign Currency Risk

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

For the year ended December 31, 2012, sales denominated in foreign currencies accounted for 21.9% of our consolidated net sales, of which 15.9% were denominated in the Euro. In addition, our exposure to fluctuations in foreign currencies arises because certain of our subsidiaries enter into purchase or sale transactions using a currency other than its functional currency. Accordingly, our future results could be materially impacted by changes in foreign exchange rates or other factors. Occasionally, we seek to reduce the potential impact of currency fluctuations on our business through hedging transactions. During the year ended December 31, 2012, we utilized MXN foreign exchange forward contracts to hedge a portion of our exposure to fluctuations in foreign exchange rates, as our Mexico-based manufacturing operations incur costs that are largely denominated in MXN (see Note 10 of the notes to the audited consolidated financial statements included in Part II, Item 8, herein). These foreign exchange forward contracts expire weekly throughout fiscal year 2013.

 

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ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

DJO Finance LLC

Annual Report on Form 10-K

For the year ended December 31, 2012

INDEX TO AUDITED CONSOLIDATED FINANCIAL STATEMENTS

 

     Page No.  

Consolidated Financial Statements:

  

Report of Independent Registered Public Accounting Firm

     65   

Consolidated Balance Sheets at December 31, 2012 and 2011

     66   

Consolidated Statements of Operations for the Years Ended December 31, 2012, 2011 and 2010

     67   

Consolidated Statements of Comprehensive Loss for the Years Ended December 31,  2012, 2011 and 2010

     68   

Consolidated Statements of Equity for the Years Ended December 31, 2012, 2011 and 2010

     69   

Consolidated Statements of Cash Flows for the Years Ended December 31, 2012, 2011 and 2010

     70   

Notes to Consolidated Financial Statements

     71   

 

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Managers of DJO Finance LLC

We have audited the accompanying consolidated balance sheets of DJO Finance LLC as of December 31, 2012 and 2011, and the related consolidated statements of operations, comprehensive loss, equity and cash flows for each of the three years in the period ended December 31, 2012. Our audits also included the financial statement schedule listed in the Index at Item 15(a). These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.

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

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of DJO Finance LLC at December 31, 2012 and 2011 and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2012, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.

/s/ ERNST & YOUNG LLP

San Diego, California

February 27, 2013

 

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DJO Finance LLC

Consolidated Balance Sheets

(in thousands)

 

     December 31,  
     2012     2011  
Assets     

Current assets:

    

Cash and cash equivalents

   $ 31,223      $ 38,169   

Accounts receivable, net

     166,742        158,982   

Inventories, net

     156,315        128,699   

Deferred tax assets, net

     33,283        43,458   

Prepaid expenses and other current assets

     18,073        18,791   
  

 

 

   

 

 

 

Total current assets

     405,636        388,099   

Property and equipment, net

     107,035        107,108   

Goodwill

     1,249,305        1,228,778   

Intangible assets, net

     1,055,531        1,132,694   

Other assets

     45,216        38,181   
  

 

 

   

 

 

 

Total assets

   $ 2,862,723      $ 2,894,860   
  

 

 

   

 

 

 
Liabilities and Equity     

Current liabilities:

    

Accounts payable

   $ 54,294      $ 57,926   

Accrued interest

     31,653        20,928   

Current portion of debt and capital lease obligations

     8,858        8,820   

Other current liabilities

     93,640        81,771   
  

 

 

   

 

 

 

Total current liabilities

     188,445        169,445   

Long-term debt and capital lease obligations

     2,223,816        2,159,091   

Deferred tax liabilities, net

     241,202        252,194   

Other long-term liabilities

     24,850        16,174   
  

 

 

   

 

 

 

Total liabilities

     2,678,313        2,596,904   
  

 

 

   

 

 

 

Commitments and contingencies

    

Equity:

    

DJO Finance LLC membership equity:

    

Member capital

     839,234        834,871   

Accumulated deficit

     (658,426     (539,276

Accumulated other comprehensive income

     1,284        218   
  

 

 

   

 

 

 

Total membership equity

     182,092        295,813   

Noncontrolling interests

     2,318        2,143   
  

 

 

   

 

 

 

Total equity

     184,410        297,956   
  

 

 

   

 

 

 

Total liabilities and equity

   $ 2,862,723      $ 2,894,860   
  

 

 

   

 

 

 

See accompanying Notes to Consolidated Financial Statements.

 

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DJO Finance LLC

Consolidated Statements of Operations

(in thousands)

 

     Year ended December 31,  
     2012     2011     2010  

Net sales

   $ 1,129,420      $ 1,074,770      $ 965,973   

Cost of sales (exclusive of amortization of intangible assets of $38,355, $38,668 and $36,343 for the year ended December 31, 2012, 2011 and 2010, respectively)

     443,920        418,138        345,270   
  

 

 

   

 

 

   

 

 

 

Gross profit

     685,500        656,632        620,703   

Operating expenses:

      

Selling, general and administrative

     460,065        487,084        433,408   

Research and development

     27,877        26,850        21,892   

Amortization of intangible assets

     97,243        93,957        77,523   

Impairment of goodwill and intangible assets

     7,397        141,006        —     
  

 

 

   

 

 

   

 

 

 
     592,582        748,897        532,823   
  

 

 

   

 

 

   

 

 

 

Operating income (loss)

     92,918        (92,265     87,880   

Other income (expense):

      

Interest expense

     (183,055     (169,332     (155,181

Interest income

     201        345        310   

Loss on modification and extinguishment of debt

     (36,889     (2,065     (19,798

Other income (expense), net

     3,553        (2,814     859   
  

 

 

   

 

 

   

 

 

 
     (216,190     (173,866     (173,810
  

 

 

   

 

 

   

 

 

 

Loss before income taxes

     (123,272     (266,131     (85,930

Income tax benefit

     4,904        52,544        34,255   
  

 

 

   

 

 

   

 

 

 

Net loss

     (118,368     (213,587     (51,675

Net income attributable to noncontrolling interests

     (782     (882     (857
  

 

 

   

 

 

   

 

 

 

Net loss attributable to DJO Finance LLC

   $ (119,150   $ (214,469   $ (52,532
  

 

 

   

 

 

   

 

 

 

See accompanying Notes to Consolidated Financial Statements.

 

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DJO Finance LLC

Consolidated Statements of Comprehensive Loss

(in thousands)

 

     Year Ended December 31,  
     2012     2011     2010  

Net loss

   $ (118,368   $ (213,587   $ (51,675

Other comprehensive income (loss), net of taxes:

      

Foreign currency translation adjustments, net of tax (provision) benefit of $(1,386), $1,681 and $942 for the year ended December 31, 2012, 2011, and 2010, respectively

     1,108        (1,896     (5,435

Unrealized loss on cash flow hedges, net of tax benefit of $175, and $2,965 for the year ended December 31, 2011, and 2010, respectively

     —          (272     (4,708

Reclassification adjustment for losses on cash flow hedges included in net loss, net of tax provision of $2,773 and $4,764 for the year ended December 31, 2011, and 2010, respectively

     —          4,381        7,448   
  

 

 

   

 

 

   

 

 

 

Other comprehensive income (loss)

     1,108        2,213        (2,695
  

 

 

   

 

 

   

 

 

 

Comprehensive loss

     (117,260     (211,374     (54,370

Comprehensive income attributable to noncontrolling interests

     (824     (829     (728
  

 

 

   

 

 

   

 

 

 

Comprehensive loss attributable to DJO Finance LLC

   $ (118,084   $ (212,203   $ (55,098
  

 

 

   

 

 

   

 

 

 

See accompanying Notes to Consolidated Financial Statements.

 

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DJO Finance LLC

Consolidated Statements of Equity

(in thousands)

 

    DJO Finance LLC              
    Member
capital
    Accumulated
Deficit
    Accumulated
other
comprehensive
income (loss)
    Total
membership
equity
    Noncontrolling
interests
    Total
equity
 

Balance at December 31, 2009

  $ 827,617      $ (272,275   $ 518      $ 555,860      $ 2,509      $ 558,369   

Net (loss) income

    —          (52,532     —          (52,532     857        (51,675

Other comprehensive loss, net of taxes

    —          —          (2,566     (2,566     (129     (2,695

Investment by parent

    1,489        —          —          1,489        —          1,489   

Stock-based compensation

    1,888        —          —          1,888        —          1,888   

Dividend paid by subsidiary to owners of noncontrolling interests

    —          —          —          —          (557     (557
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance at December 31, 2010

    830,994        (324,807     (2,048     504,139        2,680        506,819   

Net (loss) income

    —          (214,469     —          (214,469     882        (213,587

Other comprehensive income (loss), net of taxes

    —          —          2,266        2,266        (53     2,213   

Investment by parent

    3,176        —          —          3,176        —          3,176   

Stock-based compensation

    2,701        —          —          2,701        —          2,701   

Cancellation of vested options

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

Dividend paid by subsidiary to owners of noncontrolling interests

    —          —          —          —          (1,366     (1,366
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance at December 31, 2011

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

Net (loss) income

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

Other comprehensive income, net of taxes

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

Investment by parent

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

Stock-based compensation

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

Exercise of indirect parent stock options

    24        —          —          24        —          24   

Dividend paid by subsidiary to owners of noncontrolling interests

    —          —          —          —          (649     (649
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance at December 31, 2012

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

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

See accompanying Notes to Consolidated Financial Statements.

 

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DJO Finance LLC

Consolidated Statements of Cash Flows

(in thousands)

 

    Year Ended December 31,  
    2012     2011     2010  

Cash Flows From Operating Activities:

     

Net loss

  $ (118,368   $ (213,587   $ (51,675

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

     

Depreciation

    30,216        27,294        25,996   

Amortization of intangible assets

    97,243        93,957        77,523   

Amortization of debt issuance costs and non-cash interest expense

    9,732        8,476        13,272   

Stock-based compensation expense

    2,339        2,701        1,888   

Impairment of goodwill and intangible assets

    7,397        141,006        —     

Loss on disposal of assets, net of depreciation and adjustments

    1,686        4,385        2,067   

Deferred income tax benefit

    (11,581     (60,620     (39,687

Provisions for doubtful accounts and sales returns

    22,226        31,673        33,077   

Inventory reserves

    6,350        7,706        6,596   

Loss on modification and extinguishment of debt

    36,889        —          19,798   

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

     

Accounts receivable

    (29,490     (32,231     (33,105

Inventories

    (28,287     (13,190     (13,908

Prepaid expenses and other assets

    1,313        8,435        (4,837

Accrued interest

    10,723        5,351        4,610   

Accounts payable and other current liabilities

    6,231        12,249        (16,021
 

 

 

   

 

 

   

 

 

 

Net cash provided by operating activities

    44,619        23,605        25,594   
 

 

 

   

 

 

   

 

 

 

Cash Flows From Investing Activities:

     

Purchases of property and equipment

    (32,950     (39,397     (27,247

Cash paid in connection with acquisitions, net of cash acquired

    (29,909     (317,669     (2,045

Other investing activities, net

    (1,106     (1,596     (903
 

 

 

   

 

 

   

 

 

 

Net cash used in investing activities

    (63,965     (358,662     (30,195
 

 

 

   

 

 

   

 

 

 

Cash Flows From Financing Activities:

     

Proceeds from issuance of debt

    1,342,450        439,000        447,130   

Repayments of debt and capital lease obligations

    (1,276,045     (96,826     (437,367

Payment of debt issuance, modification and extinguishment costs

    (55,827     (7,694     (10,282

Investment by parent

    2,000        3,176        1,489   

Cash paid in connection with the cancellation of vested options

    —          (2,000     —     

Dividend paid by subsidiary to owners of noncontrolling interests

    (649     (1,366     (557

Exercise of indirect parent stock options

    24        —          —     
 

 

 

   

 

 

   

 

 

 

Net cash provided by financing activities

    11,953        334,290        413   
 

 

 

   

 

 

   

 

 

 

Effect of exchange rate changes on cash and cash equivalents

    447        804        (2,291
 

 

 

   

 

 

   

 

 

 

Net (decrease) increase in cash and cash equivalents

    (6,946     37        (6,479

Cash and cash equivalents, beginning of year

    38,169        38,132        44,611   
 

 

 

   

 

 

   

 

 

 

Cash and cash equivalents, end of year

  $ 31,223      $ 38,169      $ 38,132   
 

 

 

   

 

 

   

 

 

 

Supplemental disclosures of cash flow information:

     

Cash paid for interest

  $ 162,579      $ 151,207      $ 139,095   

Cash paid (refunded) for taxes, net

  $ 4,704      $ (956   $ 4,515   

Non-cash investing and financing activities:

     

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

  $ —        $ —        $ 1,934   

See accompanying Notes to Consolidated Financial Statements.

 

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Notes to Consolidated Financial Statements

 

1. ORGANIZATION AND BASIS OF PRESENTATION

Organization and Business

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

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

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 therapy equipment. Our Surgical Implant segment offers a comprehensive suite of reconstructive joint products for the knee, hip and shoulder. Our International segment offers all of our products to customers outside the United States. See Note 18 for additional information about our reportable segments.

Use of Estimates

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

Basis of Presentation

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

The accompanying 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.

 

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Reclassifications and prior period adjustments

Certain reclassifications have been made to prior year amounts to conform to the current year presentation.

 

2. SIGNIFICANT ACCOUNTING POLICIES

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

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

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

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

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

Software Developed For Internal Use. Software is stated at cost less accumulated amortization and is amortized on a straight-line basis over estimated useful lives ranging from three to ten years. We capitalize costs of internally developed software during the development stage, including external consulting costs, cost of software licenses, and internal payroll and payroll-related costs for employees who are directly associated with a software project. Software assets are reviewed for impairment when events or circumstances indicate that the carrying value may not be recoverable. Upgrades and enhancements are capitalized if they result in added functionality. Amortization expense related to internally developed software was $1.9 million, $2.4 million and $1.0 million for the years ended December 31, 2012, 2011 and 2010, respectively.

In 2008, we began implementing a new ERP system to replace six legacy accounting and finance systems and numerous other software systems with a single-entry ERP system that will be used by most of our businesses. During the year ended December 31, 2011, we determined that certain capitalized ERP assets would not be used and we recorded an impairment charge of $7.1 million which is included in selling and general administrative expense in our consolidated statement of operations. As of December 31, 2012 and 2011, we had $12.4 million and $17.4 million respectively, of unamortized internally developed software costs included within property and equipment in our consolidated balance sheets.

 

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

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

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

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

 

     Year Ended December 31,  
     2012     2011     2010  

Balance, beginning of year

   $ 1,756      $ 2,222      $ 1,936   

Amount charged to expense for estimated warranty costs

     338        105        1,283   

Deductions for actual costs incurred

     (606     (571     (997
  

 

 

   

 

 

   

 

 

 

Balance, end of year

   $ 1,488      $ 1,756      $ 2,222   
  

 

 

   

 

 

   

 

 

 

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

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

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

We record revenues from sales or our surgical implant products when the products are used in a surgical procedure (implanted in a patient). We include amounts billed to customers for freight in revenue.

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

Advertising Costs. We expense advertising costs as they are incurred. For the years ended December 31, 2012, 2011 and 2010, advertising costs were $18.7 million, $17.1 million and $10.4 million, respectively.

 

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Shipping and Handling Expenses. Shipping and handling expenses are included within cost of sales in our consolidated statements of operations.

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

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

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

Transactions denominated in currencies other than our or our subsidiaries’ functional currencies are recorded based on exchange rates at the time such transactions arise. Changes in exchange rates with respect to amounts recorded in our consolidated balance sheets related to such transactions result in transaction gains and losses that are reflected in our consolidated statements of operations as either unrealized (based on the applicable period end translation) or realized (upon settlement of the transactions). For the years ended December 31, 2012, 2011 and 2010, foreign transaction gains (losses) were $3.6 million, $(2.8) million and $0.6 million, respectively.

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

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

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

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

 

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Concentration of Credit Risk. We sell the majority of our products in the United States to orthopedic professionals, hospitals, distributors, specialty dealers, insurance companies, managed care companies and certain governmental payors such as Medicare. International sales comprised 24.8%, 26.0%, and 25.3% of our net sales for the years ended December 31, 2012, 2011, and 2010, respectively. International sales are generated from a diverse group of customers through our wholly owned subsidiaries and certain independent distributors. Credit is extended based on an evaluation of the customer’s financial condition and generally collateral is not required. We provide a reserve for estimated bad debts. Management reviews and revises its estimates for credit losses from time to time and such credit losses have generally been within management’s estimates. In each of the years ended December 31, 2012, 2011 and 2010, we had no individual customer or distributor that accounted for 10% or more of our total annual net sales.

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

Recent Accounting Standards. In May 2011, the FASB issued guidance to amend the requirements related to fair value measurement which changes the wording used to describe many requirements in GAAP for measuring fair value and for disclosing information about fair value measurements. Additionally, the amendments clarify the FASB’s intent about the application of existing fair value measurement requirements. The amended guidance was effective for interim and annual periods beginning after December 15, 2011 and was applied prospectively. The Company adopted this guidance during the first quarter of fiscal year 2012. Adoption of this guidance did not have a material impact on the Company’s Consolidated Financial Statements.

In June 2011, the FASB issued guidance to amend the presentation of comprehensive income to allow an entity the option to present the total of comprehensive income, the components of net income and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. In both choices, an entity is required to present each component of net income along with total net income, each component of other comprehensive income along with a total for other comprehensive income and a total amount for comprehensive income. The guidance eliminates the option to present the components of other comprehensive income as part of the statement of changes in stockholders’ equity. The amended guidance was effective for interim and annual periods beginning after December 15, 2011, and was applied retrospectively. The Company adopted this guidance during the first quarter of fiscal year 2012. Adoption of this guidance did not have a material impact on the Company’s consolidated financial statements.

In July 2012, the FASB issued an accounting standard update regarding testing of intangible assets for impairment. This standard update allows companies the option to perform a qualitative assessment to determine whether it is more likely than not that an indefinite lived intangible asset is impaired. An entity is not required to calculate the fair value of an indefinite-lived intangible asset and perform the quantitative impairment test unless the entity determines that it is more likely than not the asset is impaired. We will adopt this standard update during the first quarter of 2013. The adoption of this standard is not expected to have a significant impact on the Company’s consolidated financial statements.

 

3. ACQUISITIONS

On December 28, 2012, we acquired all of the outstanding shares of capital stock of Exos Corporation (Exos) for a total purchase price of $40.6 million. The purchase price consisted of a cash payment of $31.2 million, settlement of the existing distributor agreement with Exos at a fair value of $1.2 million and $8.2 million for the fair value of contingent consideration. Of the initial cash payment, $3.0 million was withheld from the closing date payment and was paid to a third party escrow agent to secure the indemnity obligations of the seller.

The $10.0 million contingent consideration was measured at a fair value of $8.2 million based on the probability weighted estimate of approximately 95% for the achievement of milestones and budgeted 2013 Exos

 

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product line revenues. The fair value of the expected payment was then calculated using as 13% discount rate as the contingent consideration is to be paid in April 2014. This fair value measurement is categorized within Level 3 of the fair value hierarchy.

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

During 2011, we made the following acquisitions, all of which are included in our Bracing and Vascular segment (with the exception of the international activities of Dr. Comfort and ETI, which are included in our International segment):

On April 7, 2011, we acquired all of the LLC membership interests of Rikco International, LLC, d/b/a Dr. Comfort (Dr. Comfort), for a total purchase price of $257.5 million. Dr. Comfort is a provider of therapeutic footwear, which serves the diabetes care market in podiatry practices, orthotic and prosthetic centers, home medical equipment providers and independent pharmacies. In connection with the acquisition of Dr. Comfort, we incurred $11.3 million of direct acquisition costs comprised of $2.2 million in legal and other professional fees, $4.1 million of bridge financing fees and $5.0 million in transaction and advisory fees to Blackstone Advisory Partners L.P., an affiliate of our major shareholder (see Note 17). These costs are included in selling, general and administrative expense in our Consolidated Statement of Operations. The acquisition was funded using proceeds from $300.0 million of new 7.75% senior notes (7.75% Notes) issued in April 2011 (see Note 12).

On March 10, 2011, we acquired substantially all of the assets of Circle City Medical, Inc. (Circle City or Bell-Horn). Circle City markets orthopedic soft goods and medical compression therapy products to independent pharmacies and home healthcare dealers. The purchase price was $11.7 million, of which $1.3 million was withheld from the closing date payment and was paid to a third party escrow agent to secure the indemnity obligations of the seller. No claims were made and the holdback was paid in March 2012. An additional $1.3 million was deposited into escrow for the retention of a key employee and is being recognized as compensation expense over the retention period of 24 months. Direct acquisition costs associated with the Circle City acquisition of $0.1 million are included in selling, general and administrative expense in our Consolidated Statement of Operations. We financed the acquisition with cash on hand and a draw of $7.0 million on our revolving line of credit. Up to an additional $2.0 million may be earned by the sole shareholder of Circle City as a royalty payment based on future sales of a specific product line over the next six years. This potential royalty payment was evaluated separately from the acquisition of the assets and liabilities of Circle City, and the royalty payments will be expensed as they are earned. For the year ended December 31, 2012, royalty payments made to the seller for sales of this product line were not significant to the Company.

On February 4, 2011, we purchased certain assets of an e-commerce business (BetterBraces.com), which offers various bracing, cold therapy and electrotherapy products, for total consideration of $3.0 million. Of the total purchase price, $1.8 million was paid in cash at closing, $0.4 million was offset against accounts receivable due from the seller, $0.5 million was retained to fully repay outstanding principal and accrued interest due from the seller under a revolving convertible promissory note, and $0.3 million was paid to the seller in February 2012 following expiration of an indemnification hold back period. The acquisition was financed using cash on hand.

On January 4, 2011, we acquired all of the outstanding shares of capital stock of Elastic Therapy, Inc. (ETI), a designer and manufacturer of private label medical compression therapy products used to treat and prevent a wide range of venous disorders. The purchase price was $46.4 million, of which $3.6 million was deposited in escrow for up to one year to fund potential indemnity of claims. No claims were made and the holdback was paid

 

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in January 2012. An additional $1.0 million was deposited in escrow for the retention of certain key employees and was fully paid in installments six months, nine months and twelve months after the closing date. This retention amount was expensed over the period it was earned. Direct acquisition costs associated with the ETI acquisition of $0.3 million are included in selling, general and administrative expense in our Consolidated Statement of Operations. The acquisition was financed using cash on hand and a draw of $35.0 million on our revolving line of credit.

On September 20, 2010, we acquired certain assets and contractual rights from our independent South African distributor for total consideration of $1.9 million, which included holdbacks of $0.3 million related primarily to potential indemnification claims. We have withheld this payment pending resolution of certain post-closing adjustments.

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

 

(in thousands):

   Exos     Dr. Comfort     Circle City     BetterBraces.
com
     ETI     DJO South
Africa
 

Cash

   $ 1,282      $ 59      $ —        $ —         $ 817      $ —     

Accounts receivable

     1,138        9,187        572        —           3,690        —     

Inventory

     1,754        27,241        1,736        —           2,133        435   

Other current assets

     105        2,108        —          —           1,542        —     

Property and equipment

     584        2,183        —          —           7,230        310   

Other non-current assets

     12        1,607        —          —           394        —     

Liabilities assumed

     (474     (10,854     (406     —           (1,876     —     

Deferred tax liabilities

     (9,137     (15,111     —          —           (9,609     —     

Identifiable intangible assets (1):

             

Customer relationships

     —          72,100        3,700        75         13,400        1,103   

Technology

     24,200        7,000        —          1,120         6,000        —     

Non-compete

     1,900        1,200        200        185         1,600        —     

Trademarks and trade names

     1,000        22,200        1,400        50         —          —     

Goodwill (2)

     18,211        138,548        4,469        1,570         21,085        64   
  

 

 

   

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

Total purchase price

   $ 40,575      $ 257,468      $ 11,671      $ 3,000       $ 46,406      $ 1,912   
  

 

 

   

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

 

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

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

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

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

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

 

(2)

Goodwill represents the excess purchase price over the fair value of the identifiable net assets acquired. Among the factors which resulted in the recognition of goodwill for Exos was improved our margins on the sale of Exos products and being able to control the rights to future products developed by Exos. Among the factors which resulted in the recognition of goodwill for Dr. Comfort was expanded product offerings and increased markets. Among the factors which resulted in the recognition of goodwill for ETI was expanded

 

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  product offerings and vertically integrated products which had been purchased from a third party manufacturer. Among the factors which resulted in the recognition of goodwill for Circle City were expected cost savings from consolidation of warehouse facilities and reduction of redundant general and administrative expenses. Among the factors which resulted in the recognition of goodwill for BetterBraces.com were expected cost savings resulting from distribution efficiencies and from reduction of redundant general and administrative expenses.

Goodwill related to our Circle City and BetterBraces.com acquisitions is expected to be deductible for tax purposes.

The results of operations attributable to each acquisition are included in our condensed consolidated financial statements from the date of acquisition. The pro forma financial results presented below (in thousands) give effect to the acquisitions of Exos, Dr. Comfort, ETI and Circle City, as if such acquisitions had been completed as of the beginning of fiscal year 2011. The pro forma results presented include amortization charges for acquired intangible assets, elimination of intercompany transactions, adjustments for the increased fair value of acquired inventory, additional interest expense and related tax effects. These pro forma results are not necessarily indicative of the operating results that would have been achieved had these acquisitions occurred on such date.

 

     Year Ended December 31,  
     2012     2011  

Net sales

   $ 1,129,626      $ 1,095,467   
  

 

 

   

 

 

 

Net loss attributable to DJOFL

   $ (120,877   $ (225,420
  

 

 

   

 

 

 

Due to the December 28, 2012 acquisition date, our Consolidated Statement of Operations includes no activity attributable to Exos for the year ended December 31, 2012, except for the direct costs incurred to complete the acquisition.

 

4. ACCOUNTS RECEIVABLE RESERVES

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

 

     Year Ended December 31,  
     2012     2011     2010  

Balance, beginning of year

   $ 38,315      $ 53,076      $ 48,306   

Provision for doubtful accounts and sales returns

     22,226        31,673        33,077   

Write-offs, net of recoveries

     (31,347     (46,434     (28,307
  

 

 

   

 

 

   

 

 

 

Balance, end of year

   $ 29,194      $ 38,315      $ 53,076   
  

 

 

   

 

 

   

 

 

 

 

5. INVENTORIES

Inventories consist of the following (in thousands):

 

     December 31,
2012
    December 31,
2011
     

Components and raw materials

   $ 50,619      $ 50,322     

Work in process

     4,563        4,681     

Finished goods

     94,683        60,839     

Inventory held on consignment

     23,763        27,003     
  

 

 

   

 

 

   
     173,628        142,845     

Inventory reserves

     (17,313     (14,146  
  

 

 

   

 

 

   
   $ 156,315      $ 128,699     
  

 

 

   

 

 

   

 

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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):

 

     Year Ended December 31,  
     2012     2011     2010  

Balance, beginning of year

   $ 14,146      $ 12,853      $ 13,063   

Provision charged to costs of sales

     6,350        7,706        6,596   

Write-offs, net of recoveries

     (3,183     (6,413     (6,806
  

 

 

   

 

 

   

 

 

 

Balance, end of year

   $ 17,313      $ 14,146      $ 12,853   
  

 

 

   

 

 

   

 

 

 

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

 

6. PROPERTY AND EQUIPMENT, NET

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

 

     December 31,
2012
    December 31,
2011
    Depreciable lives
(years)

Land

   $ 266      $ 266      Indefinite

Buildings and improvements

     26,802        22,646      3 to 25

Equipment

     105,351        92,816      2 to 7

Software

     31,270        29,314      3 to 10

Furniture and fixtures

     23,441        17,335      3 to 8

Surgical implant instrumentation

     46,504        40,739      5

Construction in progress

     8,196        8,753      N/A
  

 

 

   

 

 

   
     241,830        211,869     

Accumulated depreciation and amortization

     (134,795     (104,761  
  

 

 

   

 

 

   

Property and equipment, net

   $ 107,035      $ 107,108     
  

 

 

   

 

 

   

Depreciation and amortization expense relating to property and equipment (including equipment under capital leases) was $30.2 million, $27.3 million, and $26.0 million for the years ended December 31, 2012, 2011, and 2010, respectively.

 

7. LONG-LIVED ASSETS

Goodwill

Changes in the carrying amount of goodwill are presented in the table below (in thousands):

 

     Year Ended December 31,      
     2012      2011      

Balance, beginning of year

   $ 1,228,778       $ 1,188,887     

Acquisitions (see Note 3)

     18,211         165,672     

Impairment of goodwill

     —           (124,106  

Foreign currency translation

     2,316         (1,675  
  

 

 

    

 

 

   

Balance, end of year

   $ 1,249,305       $ 1,228,778     
  

 

 

    

 

 

   

In performing our 2012 goodwill impairment test, we estimated the fair values of our reporting units using the income approach which includes the discounted cash flow method and the market approach which includes the use of market multiples. These fair value measurements are categorized within Level 3 of the fair value hierarchy. The discounted cash flows for each reporting unit were based on discrete financial forecasts developed by management for planning purposes, and required significant judgment with respect to forecasted sales, gross

 

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margin, selling, general and administrative expenses, depreciation, income taxes, capital expenditures, working capital requirements and the selection and use of an appropriate discount rate. For purposes of calculating the discounted cash flows of our reporting units, we used estimated revenue growth rates averaging between 2% and 10% for the discrete forecast period. Cash flows beyond the discrete forecasts were estimated using a terminal value calculation, which incorporated historical and forecasted financial trends for each identified reporting unit and considered long-term earnings growth rates for publicly traded peer companies. Future cash flows were then discounted to present value at discount rates ranging from 9.6% to 11.2%, and terminal value growth rates of 3%. Publicly available information regarding comparable market capitalization was also considered in assessing the reasonableness of the cumulative fair values of our reporting units estimated using the discounted cash flow methodology. We determined that the fair value of the six reporting units with goodwill assigned to them exceeds their carrying value. As such, we determined that the goodwill of our reporting units was not impaired.

In the fourth quarter of 2011, we determined that the carrying values of our Empi and Surgical Implant reporting units were in excess of their estimated fair values. As a result, we recorded goodwill impairment charges for the Empi and Surgical Implant reporting units of $76.7 million and $47.4 million, respectively. These impairment charges were included in impairment of goodwill and intangible assets in our Consolidated Statement of Operations. The goodwill impairment in our Empi reporting unit in 2011 resulted primarily from reductions in our projected operating results due to unfavorable decisions made by certain third party payors related to insurance pricing for certain products sold by the Empi business. The goodwill impairment in our Surgical Implant reporting unit in 2011 resulted primarily from reductions in our projected operating results and estimated future cash flows for the business. For all other reporting units, estimated fair values at December 31, 2011 exceeded carrying values.

Intangible Assets

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

 

December 31, 2012

   Gross Carrying
Amount
     Accumulated
Amortization
    Intangible
Assets, Net
 

Definite lived intangible assets:

       

Customer relationships

   $ 570,221       $ (236,228   $ 333,993   

Patents and technology

     485,675         (195,099     290,576   

Trademarks and trade names

     25,773         (4,248     21,525   

Distributor contracts and relationships

     3,662         (1,659     2,003   

Non-compete agreements

     5,547         (1,722     3,825   
  

 

 

    

 

 

   

 

 

 
   $ 1,090,878       $ (438,956     651,922   
  

 

 

    

 

 

   

Indefinite lived intangible assets:

       

Trademarks and trade names

          403,609   
       

 

 

 

Net identifiable intangible assets

        $ 1,055,531   
       

 

 

 

 

December 31, 2011

   Gross Carrying
Amount
     Accumulated
Amortization
    Intangible
Assets, Net
 

Definite lived intangible assets:

       

Customer relationships

   $ 569,528       $ (181,396   $ 388,132   

Patents and technology

     460,624         (156,290     304,334   

Trademarks and trade names

     23,650         (1,807     21,843   

Distributor contracts and relationships

     5,089         (1,206     3,883   

Non-compete agreements

     3,636         (883     2,753   
  

 

 

    

 

 

   

 

 

 
   $ 1,062,527       $ (341,582     720,945   
  

 

 

    

 

 

   

Indefinite lived intangible assets:

       

Trademarks and trade names

          411,749   
       

 

 

 

Net identifiable intangible assets

        $ 1,132,694   
       

 

 

 

 

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In 2012, we began the process of changing the trade name used for our German operations from Ormed to DJO to be consistent with our global strategy. In conjunction with this change, we revised our assumption as to the useful life of the Ormed trade name intangible asset, which resulted in changing the remaining estimated life of the asset from indefinite to three years. These changes triggered an impairment review of the intangible asset. Based on the application of a differential cash flow method, whereby an investor would be willing to pay a price equal to the present value of the incremental cash flows attributable to the economic benefit derived from defending the trade name in the market, we determined that the carrying amount of the asset was in excess of its estimated fair value. As a result, we recorded an impairment charge of $7.4 million, which is included in the Impairment of goodwill and intangible assets line item in the Consolidated Statements of Operations. This fair value measurement is categorized within Level 3 of the fair value hierarchy.

Additionally, in the fourth quarter of 2012 we tested for impairment, our remaining indefinite lived intangible assets, consisting of trade names. This test work compares the fair value of the asset with its carrying amount. To determine the fair value we applied the relief from royalty (RFR) method. Under the RFR method, the value of the trade name is determined by calculating the present value of the after-tax cost savings associated with owning the asset and therefore not being required to pay royalties for its use during the asset’s indefinite life. Significant judgments inherent in this analysis include the selection of appropriate discount rates, estimating future cash flows and the identification of appropriate terminal growth rate assumptions. Discount rate assumptions are based on an assessment of the risk inherent in the projected future cash generated by the respective intangible assets. Also subject to judgment are assumptions about royalty rates, which are based on the estimated rates at which similar brands and trademarks are being licensed in the marketplace. We determined that the fair value of these trade names exceed their carrying value. As such, we determined that these indefinite lived intangible assets are not impaired. This fair value measurement is categorized within Level 3 of the fair value hierarchy.