SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

(Mark One)

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2006

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 1-10670

                        HANGER ORTHOPEDIC GROUP, INC.                        
(Exact name of registrant as specified in its charter)

Delaware	84-0904275
(State or other jurisdiction of	(IRS Employer Identification No.)
incorporation or organization)

Two Bethesda Metro Center, Suite 1200, Bethesda, MD 20814
(Address of principal executive offices)                  (Zip Code)

Registrant's telephone number, including area code:

            (301) 986-0701            

____________________________________________________________________________________________________________________
Former name, former address and former fiscal year, if changed since last report.

        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

        Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one).

Large accelerated filer       Accelerated filer       Non-accelerated filer

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

        As of April 28, 2006, 21,926,176 shares of common stock, $.01 par value per share were outstanding.

HANGER ORTHOPEDIC GROUP, INC.

INDEX

Page No.

Part I.      FINANCIAL INFORMATION
Item 1.      Condensed Consolidated Financial Statements
Unaudited Condensed Consolidated Balance Sheets - March 31, 2006 and December 31, 2005	1
Unaudited Condensed Consolidated Statements of Operations for the
Three Months ended March 31, 2006 and 2005	3
Unaudited Condensed Consolidated Statements of Cash Flows for the
Three Months ended March 31, 2006 and 2005	4
Notes to Condensed Consolidated Financial Statements (Unaudited)	5
Item 2.       Management's Discussion and Analysis of Financial
Condition and Results of Operations	23
Item 3.       Quantitative and Qualitative Disclosures About Market Risk	37
Item 4.       Controls and Procedures	38
Part II.      OTHER INFORMATION
Item 1.      Legal Proceedings	39
Item 1A.   Risk Factors	39
Item 6.      Exhibits	41
SIGNATURES	42
Exhibit Index	43

HANGER ORTHOPEDIC GROUP, INC.
CONSOLIDATED BALANCE SHEETS
(Dollars in thousands, except share and per share amounts)
(Unaudited)

ASSETS	March 31, 2006		December 31, 2005
CURRENT ASSETS
Cash and cash equivalents	$	6,172	$	7,921
Accounts receivable, less allowance for doubtful accounts
of $5,402 and $4,582 in 2006 and 2005, respectively		95,552		103,200
Inventories		78,372		76,725
Prepaid expenses, other assets and income taxes receivable		15,555		6,554
Deferred income taxes		7,484		7,087
Total current assets		203,135		201,487
PROPERTY, PLANT AND EQUIPMENT
Land		1,094		1,094
Buildings		5,848		5,833
Furniture and fixtures		11,946		11,874
Machinery and equipment		24,441		23,867
Leasehold improvements		30,534		29,431
Computer and software		45,218		44,364
Total property, plant and equipment, gross		119,081		116,463
Less accumulated depreciation and amortization		76,446		72,966
Total property, plant and equipment, net		42,635		43,497
INTANGIBLE ASSETS
Excess cost over net assets acquired		445,979		445,979
Patents and other intangible assets, $9,999 in each of 2006 and 2005, less
accumulated amortization of $6,443 and $6,234 in 2006 and 2005, respectively		3,557		3,765
Total intangible assets, net		449,536		449,744
OTHER ASSETS
Debt issuance costs, net		7,649		8,142
Other assets		1,463		1,597
Total other assets		9,112		9,739
TOTAL ASSETS	$	704,418	$	704,467

The accompanying notes are an integral part of the consolidated financial statements.

1

HANGER ORTHOPEDIC GROUP, INC.
CONSOLIDATED BALANCE SHEETS
(Dollars in thousands, except share and per share amounts)
(Unaudited)

LIABILITIES, REDEEMABLE PREFERRED STOCK AND SHAREHOLDERS' EQUITY	March 31, 2006			December 31, 2005
CURRENT LIABILITIES
Current portion of long-term debt	$	4,490		$	4,466
Accounts payable		18,809			20,520
Accrued expenses		10,633			10,955
Accrued interest payable		3,499			8,320
Accrued compensation related costs		12,824			21,675
Total current liabilities		50,255			65,936
LONG-TERM LIABILITIES
Long-term debt, less current portion		386,793			373,965
Deferred income taxes		31,749			30,851
Other liabilities		7,112			6,531
Total liabilities		475,909			477,283
COMMITMENTS AND CONTINGENCIES (Refer to Note I)
PREFERRED STOCK
10% Redeemable Convertible Preferred stock, liquidation
preference $1,000 per share, 10,000,000 shares authorized,
37,881 shares issued and outstanding in 2006 and 2005		63,507			61,942
SHAREHOLDERS' EQUITY
Common stock, $.01 par value; 60,000,000 shares authorized,
22,271,022 shares and 22,227,607 shares issued and
outstanding in 2006 and 2005, respectively		223			222
Additional paid-in capital		154,226			156,346
Unearned compensation		--			(2,615	)
Retained earnings		11,209			11,945
		165,658			165,898
Treasury stock at cost (141,154 shares)		(656	)		(656	)
Total shareholders' equity		165,002			165,242
TOTAL LIABILITIES, REDEEMABLE PREFERRED STOCK
AND SHAREHOLDERS' EQUITY	$	704,418		$	704,467

The accompanying notes are an integral part of the consolidated financial statements.

2

HANGER ORTHOPEDIC GROUP, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
For the Three Months Ended March 31,
(Dollars in thousands, except share and per share amounts)
(Unaudited)

	2006			2005
Net sales	$	140,445		$	133,000
Cost of goods sold (exclusive of depreciation and amortization)		70,215			67,446
Selling, general and administrative		55,627			50,937
Depreciation and amortization		3,688			3,509
Income from operations		10,915			11,108
Interest expense		9,500			8,843
Income before taxes		1,415			2,265
Provision for income taxes		586			930
Net income		829			1,335
Preferred stock dividend and accretion		1,565			1,419
Net loss applicable to common stock	$	(736	)	$	(84	)
Basic Per Common Share Data
Net loss	$	(0.03	)	$	(0.00	)
Shares used to compute basic per common share amounts		21,837,069			21,615,850
Diluted Per Common Share Data
Net loss	$	(0.03	)	$	(0.00	)
Shares used to compute diluted per common share amounts		21,837,069			21,615,850

The accompanying notes are an integral part of the consolidated financial statements.

3

HANGER ORTHOPEDIC GROUP, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
For the Three Months Ended March 31,
(Dollars in thousands)
(Unaudited)

	2006			2005
Cash flows from operating activities:
Net income	$	829		$	1,335
Adjustments to reconcile net income to net cash used in operating activities:
Gain on disposal of assets		(57	)		--
Provision for bad debt		4,125			4,943
Provision for deferred income taxes		505			751
Depreciation and amortization		3,688			3,509
Amortization of debt issuance costs		589			644
Compensation expense on stock options and restricted stock		349			257
Amortization of terminated interest rate swaps		(127	)		(128	)
Changes in assets and liabilities, net of effects of acquired companies:
Accounts receivable		3,523			1,472
Inventories		(1,558	)		(935	)
Prepaid expenses, other assets, and income taxes receivable		(9,001	)		(3,669	)
Other assets		44			(30	)
Accounts payable		(2,268	)		(1,355	)
Accrued expenses, accrued interest payable, and income taxes payable		(5,143	)		(5,468	)
Accrued compensation related costs		(8,850	)		(20,527	)
Other liabilities		581			(658	)
Net cash used in operating activities		(12,771	)		(19,859	)
Cash flows from investing activities:
Purchase of property, plant and equipment (net of acquisitions)		(2,617	)		(1,553	)
Acquisitions and earnouts (net of cash acquired)		(154	)		(983	)
Proceeds from sale of property, plant and equipment		57			--
Net cash used in investing activities		(2,714	)		(2,536	)
Cash flows from financing activities:
Borrowings under revolving credit agreement		19,000			29,000
Repayments under revolving credit agreement		(5,000	)		(9,000	)
Repayments under term loan		(375	)		(375	)
Scheduled repayment of long-term debt		(646	)		(636	)
Increase in financing costs		(95	)		(3	)
Proceeds from issuance of Common Stock		141			118
Change in book overdraft		711			3,198
Net cash provided by financing activities		13,736			22,302
Decrease in cash and cash equivalents		(1,749	)		(93	)
Cash and cash equivalents, at beginning of period		7,921			8,351
Cash and cash equivalents, at end of period	$	6,172		$	8,258

The accompanying notes are an integral part of the consolidated financial statements.

4

HANGER ORTHOPEDIC GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOTE A – BASIS OF PRESENTATION

The unaudited interim condensed consolidated financial statements as of and for the three months ended March 31, 2006 and 2005 have been prepared by the Company pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”) for interim financial reporting. These condensed consolidated statements are unaudited and, in the opinion of management, include all adjustments (consisting of normal recurring adjustments and accruals) necessary for a fair statement for the periods presented. The year-end condensed consolidated data was derived from audited financial statements but does not include all disclosures required by accounting principles generally accepted in the United States of America (“GAAP”).

These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements of Hanger Orthopedic Group, Inc. (the “Company”) and notes thereto included in the Annual Report on Form 10-K for the year ended December 31, 2005, filed by the Company with the SEC.

NOTE B – SIGNIFICANT ACCOUNTING PRINCIPLES

Principles of Consolidation

The condensed consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All intercompany transactions and balances have been eliminated.

Use of Estimates

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

5

NOTE B – SIGNIFICANT ACCOUNTING PRINCIPLES (CONTINUED)

Stock-Based Compensation

General

The Company issues options and restricted shares of common stock under two active share-based compensation plans, one for employees and the other for the Board of Directors. At March 31, 2006, 2.0 million shares of common stock are authorized for issuance under the Company’s share-based compensation plans. Shares of common stock issued under the share-based compensation plans are released from the Company's authorized shares. Stock option and restricted share awards are granted at the fair market value of the Company’s common stock on the date of grant. Stock option awards vest over a period determined by the compensation plan, ranging from one to three years, and generally have a maximum term of ten years. Restricted shares of common stock vest over a period of time determined by the compensation plan, ranging from one to four years.

Effective January 1, 2006, the Company adopted the fair value recognition provisions of Statement of Financial Accounting Standards (“SFAS”) 123R, Share-Based Payment (“SFAS 123R”), which require companies to measure and recognize compensation expense for all share-based payments at fair value. SFAS 123R eliminates the ability to account for share-based compensation transactions using APB Opinion 25, Accounting for Stock Issued to Employees (“APB 25”) and generally requires that such transactions be accounted for using prescribed fair-value-based methods.

The Company adopted SFAS 123R using the modified prospective method allowed for in SFAS 123R. Under the modified prospective method, compensation expense related to awards granted prior to and unvested as of the adoption of SFAS 123R is calculated in accordance with SFAS 123, Accounting for Stock-Based Compensation and recognized in the statements of operations over the requisite remaining service period; compensation expense for all awards granted after the adoption of SFAS 123R is calculated according to the provision of SFAS 123R. Results for prior periods have not been restated. For the three month period ended March 31, 2006, the Company recognized $0.3 million in compensation expense, of which less than $0.1 million related to compensation expense of options. The Company calculates the fair value of stock options using the Black-Scholes model. The total value of the stock option awards is expensed ratably over the requisite service period of the employees receiving the awards. At March 31, 2006, the Company continues to evaluate the available methods for computing the windfall tax pool as required under SFAS 123R.

Prior to January 1, 2006, the Company accounted for stock-based awards under the measurement and recognition provisions of APB 25. Under APB 25, stock options granted at the fair market value of the underlying stock required no recognition of compensation cost. However, the Company disclosed the pro-forma effect on net income of recognizing compensation cost, as required by SFAS 123 and SFAS 148, Accounting for Stock-Based Compensation – Transition and Disclosure.

6

NOTE B – SIGNIFICANT ACCOUNTING PRINCIPLES (CONTINUED)

Stock-Based Compensation (continued)

General (continued)

The following table illustrates the effect on net loss applicable to common stock and loss per share if the Company had applied fair value recognition to stock-based employee compensation for all awards in the prior year period:

	Three Months Ended March 31, 2005
(In thousands, except per share amounts)
Net loss applicable to common stock, as reported	$ (84	)
Add: stock-based employee compensation expense related to
restricted shares of common stock, net of related tax effects,
included in net income as reported	152
Deduct: total stock-based employee compensation
expense determined under the fair value method for all
awards, net of related tax effects	(560	)
Pro forma net loss applicable to common stock	$ (492	)
Loss per share:
Basic - as reported	$ (0.00	)
Basic - pro forma	(0.02	)
Diluted - as reported	(0.00	)
Diluted - pro forma	(0.02	)

The adoption of SFAS 123R reduced income from operations, income before income tax expense, and net income for the three months ended March 31, 2006 by less than $0.1 million. Additionally, upon adoption the Company eliminated the balance of Unearned Compensation, on the Consolidated Balance Sheets, to Additional Paid-in-Capital.

7

NOTE B – SIGNIFICANT ACCOUNTING PRINCIPLES (CONTINUED)

Stock-Based Compensation (continued)

Options

A summary of the stock option activity for the three month period ended March 31, 2006 is as follows:

	Employee Plans					Director Plans					Non-Qualified Awards
(In thousands, except per share and weighted average price amounts)	Shares			Weighted Average Price		Shares			Weighted Average Price		Shares		Weighted Average Price
Outstanding at December 31, 2005		2,576,050		$	10.24		198,411		$	9.83		406,000	$	5.95
Granted		--			--		--			--		--		--
Terminated		(14,865	)		8.62		--			--		--		--
Exercised		(43,415	)		2.58		(5,000	)		5.88		--		--
Outstanding at March 31, 2006		2,517,770		$	10.38		193,411		$	9.93		406,000	$	5.95
Aggregate intrinsic value at March 31, 2006	$	26,161				$	1,921				$	2,415
Weighted average remaining contractual term (years)		8.3					8.4					8.5

The intrinsic value of options exercised during the three months ended March 31, 2006 was $0.1 million. Options exercisable under the Company’s share-based compensation plans at March 31, 2006 were 3.0 million shares with a weighted average exercise price of $13.30, an average remaining contractual term of 8.4 years, and an aggregate intrinsic value of $29.8 million. Cash received by the Company related to the exercise of options during the three month period ended March 31, 2006 amounted to $0.1 million. As of March 31, 2006, total unrecognized compensation cost related to stock option awards was approximately $0.1 million and the related weighted-average period over which it is expected to be recognized is approximately 1.3 years.

The fair value of these options was estimated at the date of grant using a Black-Scholes option pricing model with the following weighted average assumptions:

	Three Months Ended March 31, 2005
Expected term (years)		4.5
Volatility factor		82	%
Risk free interest rate		3.9	%
Dividend yield		0.0	%
Fair value	$	5.25

The expected term of options is an average of the contractual terms and historical data. The expected stock price volatility is based on historical data of the Company’s common stock performance. The risk-free interest rate is based on an average of the U.S. 5-year Treasury Bill rate. The Company did not grant any options during the three months ended March 31, 2006.

8

NOTE B – SIGNIFICANT ACCOUNTING PRINCIPLES (CONTINUED)

Stock-Based Compensation (continued)

Restricted Shares of Common Stock

A summary of the activity of restricted shares of common for the three month period ended March 31, 2006 is as follows:

	Employee Plans					Director Plans
	Shares			Weighted Average Grant Date Fair Value		Shares		Weighted Average Grant Date Fair Value
Nonvested at December 31, 2005		383,000		$	8.28		28,571	$	5.18
Granted		--			--		--		--
Vested		(67,625	)		6.59		--		--
Forfeited		--			--		--		--
Nonvested at March 31, 2006		315,375		$	8.64		28,571	$	5.18

During the three-month period ended March 31, 2006, 67,625 restricted shares of common stock, with an intrinsic value of $0.4 million, became fully vested. As of March 31, 2006, total unrecognized compensation cost related to restricted shares of common stock was approximately $2.9 million and the related weighted-average period over which it is expected to be recognized is approximately 2.1 years.

Segment Information

The Company applies a “management” approach to disclosure of segment information. The management approach designates the internal organization that is used by management for making operating decisions and assessing performance as the basis of the Company’s reportable segments. The description of the Company’s reportable segments and the disclosure of segment information are presented in Note L.

New Accounting Standards

In February 2006, the FASB issued SFAS 155, Accounting for Certain Hybrid Financial Instruments. SFAS 155 amends SFAS 133, Accounting for Derivative Instruments and Hedging Activities and SFAS 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. The provisions of SFAS 155 allow for the fair value remeasurement of hybrid financial instruments that contain embedded derivatives that otherwise would require bifurcation and eliminates the interim guidance that provides that beneficial interests in securitized financial assets are not subject to the provisions of SFAS 133. Additionally, SFAS 155 eliminates SFAS 140’s restriction on qualifying special-purpose entities of holding derivative financial instruments that pertain to a beneficial interest other than another derivative financial instrument. SFAS 155 is effective for all financial instruments acquired or issued after fiscal years beginning after September 15, 2006. The Company believes the adoption of SFAS 155 will not have an impact on its financial statements.

In March 2006, the FASB issued SFAS 156, Accounting for Servicing of Financial Assets, amending SFAS 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. SFAS 156 permits entities the choice between either the amortization method or the fair value measurement method for valuing separately recognized servicing assets and liabilities. SFAS 156 is effective for fiscal years beginning after September 15, 2006; early adoption is permitted as of the beginning of an entity’s fiscal year, provided the entity has not yet issued financial statements for any interim period of that fiscal year. The Company believes the adoption of SFAS 156 will not have an impact on its financial statements.

9

NOTE C — SUPPLEMENTAL CASH FLOW FINANCIAL INFORMATION

The supplemental disclosure requirements for the statements of cash flows are as follows:

	Three Months Ended March 31,
(In thousands)	2006			2005
Cash paid during the period for:
Interest	$	13,939		$	13,166
Income taxes		3,251			724
Non-cash financing and investing activities:
Preferred stock dividends declared and accretion	$	1,565		$	1,419
Issuance of notes in connection with acquisitions		--			485
(Cancellation) issuance of restricted shares of common stock		(32	)		1,838

NOTE D — GOODWILL AND OTHER INTANGIBLE ASSETS

The activity related to goodwill for the three month period ended March 31, 2006 is as follows:

(In thousands)	Patient-Care Centers		Distribution		Total
Balance at December 31, 2005	$	417,596	$	28,383	$	445,979
Additions due to acquisitions		--		--		--
Additions due to earn-outs		--		--		--
Balance at March 31, 2006	$	417,596	$	28,383	$	445,979

NOTE E – ACQUISITIONS

The Company did not have any acquisitions during the three month period ended March 31, 2006. During the three month period ended March 31, 2005, the Company acquired one orthotics and prosthetics company that operated a total of three patient-care centers for which it paid an aggregate of $1.7 million.

The Company accounts for its acquisitions using the purchase method of accounting. The results of operations for these acquisitions are included in the Company’s results of operations from their date of acquisition. Pro forma results would not be materially different.

In connection with acquisitions, the Company occasionally agrees to make earnout payments if future earnings targets are reached. Earnouts are defined in the purchase agreement and are accrued based on earnout targets for the following quarter being attained. These estimates are adjusted in the actual quarter the payment is made. The Company made earnout payments of $0.2 million during the three month period ended March 31, 2006. During the three month period ended March 31, 2005, the Company did not make any earnout payments. The Company accounts for these amounts as additional purchase price, resulting in an increase in excess cost

10

NOTE E – ACQUISITIONS (CONTINUED)

over net assets acquired. The Company estimates that it may pay up to $1.4 million related to earnout provisions in future periods.

NOTE F – INVENTORY

Inventories, which are recorded at the lower of cost or market using the first-in, first-out method were as follows:

(In thousands)	March 31, 2006		December 31, 2005
Raw materials	$	35,524	$	31,796
Work-in-process		26,443		26,409
Finished goods		16,405		18,520
	$	78,372	$	76,725

NOTE G – LONG TERM DEBT

Long-term debt consists of the following:

(In thousands)	2006			2005
Revolving Credit Facility	$	19,000		$	5,000
10 3/8% Senior Notes due 2009 (1)		201,478			201,605
11 1/4% Senior Subordinated Notes due 2009		15,562			15,562
Term Loan		146,250			146,625
Subordinated seller notes, non-collateralized, net of unamortized discount
with principal and interest payable in either monthly, quarterly or annual
installments at effective interest rates ranging from 6.0% to 10.8%, maturing
through December 2011		8,993			9,639
		391,283			378,431
Less current portion		(4,490	)		(4,466	)
	$	386,793		$	373,965

(1)     At March 31, 2006 and December 31, 2005, the outstanding amount includes $1.5 million and $1.6 million, respectively, of interest rate swap termination income to be recognized, as a reduction of interest expense, using the effective interest method, over the remaining life of the Senior Notes.

The Company’s availability under the Revolving Credit Facility is calculated based on its last-twelve-months EBITDA, as defined in the debt agreement. At March 31, 2006, the Company had $40.3 million available under the Revolving Credit Facility, net of $2.2 million of standby letters of credit.

11

NOTE H – RESTRUCTURING

The activity related to the restructuring reserve during the three month period ended March 31, 2006 is as follows:

(In thousands)	Lease Termination and other Exit Costs			Total Restructuring Reserve
2001 Restructuring Reserve
Balance at December 31, 2005	$	220		$	220
Spending		(64	)		(64	)
Balance at March 31, 2006		156			156
2004 Restructuring Reserve
Balance at December 31, 2005		161			161
Spending		(31	)		(31	)
Balance at March 31, 2006		130			130
2001 and 2004 Restructuring Reserves	$	286		$	286

2001 Restructuring Reserve

During 2001, as a result of the initiatives associated with the Company’s performance improvement plan developed in conjunction with AlixPartners, LLC (formerly Jay Alix & Associates, Inc.), the Company recorded approximately $4.5 million in restructuring and asset impairment costs. The plan called for the closure of certain facilities and the termination of approximately 135 employees.

As of December 31, 2002, all properties had been vacated, all of the employees had been terminated and all corresponding payments under the severance initiative had been made. As of March 31, 2006, the remaining reserve of $0.2 million is adequate to provide for the lease costs which are expected to be paid through October 2012.

2004 Restructuring Reserve

During the first quarter of 2004, the Company adopted a restructuring plan as a result of acquiring an O&P company. The restructuring plan includes estimated expenses of $0.7 million related to the closure/merger of nine facilities and the payment of severance costs to 20 terminated employees.

As of December 31, 2005, all of the nine patient-care centers had been closed/merged and approximately $0.3 million in lease costs were paid, and the employment of 11 employees had been terminated and $0.1 million of severance payments had been paid. During 2005, the Company reversed the remaining balance of restructuring accrual related to severance payments as a result of the associated employees continuing their employment with the Company. Approximately $0.1 million of lease payments are expected to be paid through April 2008.

12

NOTE I – COMMITMENTS AND CONTINGENT LIABILITIES

Contingencies

The Company is subject to legal proceedings and claims which arise in the ordinary course of its business, including additional payments under business purchase agreements. In the opinion of management, the amount of ultimate liability, if any, with respect to these actions will not have a materially adverse effect on the financial position, liquidity or results of operations of the Company.

On June 15, 2004, the Company announced that an employee at its patient-care center in West Hempstead, New York alleged in a television news story aired on June 14, 2004 that there were instances of billing discrepancies at that facility.

On June 18, 2004, the Company announced that on June 17, 2004, the Audit Committee of the Company’s Board of Directors had engaged the law firm of McDermott, Will & Emery LLP to serve as independent counsel to the Audit committee and to conduct an independent investigation of the allegations. The scope of that independent investigation was expanded to cover certain of the Company’s other patient-care centers and included consideration of some of the allegations made in the Amended Complaint recently filed in the class actions discussed below. On June 17, 2004, the U.S. Attorney’s Office for the Eastern District of New York subpoenaed records of the Company regarding various billing activities and locations. In addition, the Company also announced on June 18, 2004 that the Securities and Exchange Commission had commenced an informal inquiry into the matter. The Company is cooperating with the regulatory authorities.

While the Audit Committee’s investigation will not be complete until all regulatory authorities have indicated that their inquiries are complete, the Audit Committee’s independent counsel made a presentation to the Audit Committee in September 2005. Management believes that any billing discrepancies are likely to be primarily at the West Hempstead patient-care center. Furthermore, management does not believe the resolution of the matters raised by the allegations will have a materially adverse effect on the Company’s financial statements. The West Hempstead facility generated $0.2 million and $0.7 million in net sales during the three month period ended March 31, 2006 and the year ended 2005, respectively, or less than 0.5% of the Company’s net sales, for each period.

It should be noted that additional regulatory inquiries or issues may be raised relating to the Company’s billing activities at other locations. No assurance can be given that the final results of the regulatory agencies’ inquiries will be consistent with the results to date or that any discrepancies identified during the ongoing regulatory review will not have a material adverse effect on the Company’s financial statements.

Between June 22, 2004 and July 1, 2004, five putative securities class action complaints were filed against the Company, four in the Eastern District of New York, Twist Partners v. Hanger Orthopedic Group, Inc., et al., No. 1:04-cv-02585 (filed 06/22/2004, E.D.N.Y); Shapiro v. Hanger Orthopedic Group, Inc., et al., No. 1:04-cv-02681 (filed 06/28/2004, E.D.N.Y.); Imperato v. Hanger Orthopedic Group, Inc., No. 1:04-cv-02736 (filed 06/30/2004, E.D.N.Y.); Walters v. Hanger Orthopedic Group, Inc., et al., No. 1:04-cv-02826 (filed 07/01/2004, E.D.N.Y.); and one in the Eastern District of Virginia, Browne v. Hanger Orthopedic Group, Inc., et al., No. 1:04-cv-715 (filed 06/23/2004, E.D. Va.). The

13

NOTE I – COMMITMENTS AND CONTINGENT LIABILITIES (CONTINUED)

Contingencies (continued)

complaints asserted that the Company’s reported revenues were inflated through certain billing improprieties at one of the Company’s facilities. The plaintiffs in Browne subsequently dismissed their complaint without prejudice, and the four remaining cases were consolidated into a single action in the Eastern District of New York encaptioned In re Hanger Orthopedic Group, Inc. Securities Litigation, No. 1:04-cv-2585 (the “Consolidated Securities Class Action”). On February 15, 2005, the lead plaintiffs in the Consolidated Securities Class Action filed a Consolidated Amended Complaint (the “Amended Complaint”). The Amended Complaint asserts that the Company’s reported revenues were inflated through certain billing improprieties at some of the Company’s facilities. In addition, the Amended Complaint asserts that the Company violated the federal securities laws in connection with a restatement announced by the Company on August 16, 2004, restating certain of the Company’s financial statements during 2001 through the first quarter of 2004. The Amended Complaint purports to allege violations of Section 10(b) of the Securities Exchange Act of 1934 (the “Exchange Act”) and Rule 10b-5 promulgated thereunder, as well as violations of Section 20(a) of the Exchange Act by certain of the Company’s executives as “controlling persons” of the Company. On February 28, 2006, the court granted the Company’s motion to transfer the Consolidated Securities Class Action to the District of Maryland. The Company has filed a motion to dismiss the Amended Complaint.

The Company believes that the class action allegations of fraudulent conduct by the Company’s executive directors and officers are without merit and it intends to vigorously defend the suits. The claims have been reported to the Company’s insurance carrier.

On March 17, 2005, a derivative action was filed against the Company and its directors in the Circuit Court for Montgomery County, Maryland. The lawsuit which is encaptioned James Elgas v. Ivan Sabel, et al, Civil No. 259940-V, largely repeats the billing allegations made in the consolidated amended complaint filed by the plaintiffs in In re Hanger Orthopedic Group, Inc. Securities Litigation, discussed above. On that basis, the Elgas complaint alleges that Hanger’s directors breached their fiduciary duties to the Company. The plaintiff purports to seek monetary damages and unspecified equitable relief, on behalf of the Company, against the Company’s directors. The Company and the individual defendants filed motions to dismiss the suit for failure to state a claim and for failure to comply with the demand requirement under Delaware law. At a hearing on August 12, 2005, the Circuit Court granted the defendants’ motion to dismiss for failure to comply with the demand requirement, granting the plaintiff leave to amend within 90 days. The plaintiff filed an amended complaint, and the defendants again moved to dismiss the suit for failure to state a claim and for failure to comply with the demand requirement. The Company understands that the plaintiff has sold his shares of the Company’s common stock and has agreed to dismissal of the action.

14

NOTE I – COMMITMENTS AND CONTINGENT LIABILITIES (CONTINUED)

Contingencies (continued)

On September 8, 2005, a derivative action was filed against the Company and certain of its current and former directors in the United States District Court for the Eastern District of New York. The lawsuit, which is encaptioned Green Meadows Partners, LLP v. Ivan R. Sabel, et al, No. CV 05 4259 (E.D.N.Y.), also largely repeats the allegations made in the consolidated amended complaint filed by the plaintiffs in In re Hanger Orthopedic Group, Inc. Securities Litigation, discussed above. On that basis, the Green Meadows Partners complaint purports to assert claims against the individual defendants, on behalf of the Company, for contribution in connection with the In re Hanger Orthopedic Group, Inc. Securities Litigation matter; forfeiture of certain bonuses and other incentive-based or equity-based compensation pursuant to Section 304; breach of fiduciary duty; unjust enrichment; and “abuse of control.” The Complaint seeks unspecified compensatory damages, restitution and disgorgement, injunctive relief, and award of attorneys’ fees and costs. The defendants have not yet filed their response to the Green Meadows Partners Complaint. After the transfer of the Consolidated Securities Class Action to the District of Maryland, the parties agreed to the transfer of the Green Meadows Partners case to the District of Maryland and to stay the case pending the outcome of the defendants’ motion to dismiss the Consolidated Securities Class Action case.

Guarantees and Indemnifications

In the ordinary course of its business, the Company may enter into service agreements with service providers in which it agrees to indemnify or limit the service provider against certain losses and liabilities arising from the service provider’s performance of the agreement. The Company has reviewed its existing contracts containing indemnification or clauses of guarantees and does not believe that its liability under such agreements will result in any material liability.

15

NOTE J – NET INCOME (LOSS) PER COMMON SHARE

Basic per common share amounts are computed using the weighted average number of common shares outstanding during the period. Diluted per common share amounts are computed using the weighted average number of common shares outstanding during the period and dilutive potential common shares. Dilutive potential common shares consist of stock options, restricted shares, and Redeemable Convertible Preferred Stock and are calculated using the treasury stock method.

Net loss per share is computed as follows:

	Three Months Ended March 31,
(In thousands, except share and per share data)	2006			2005
Net income	$	829		$	1,335
Less preferred stock dividends declared and accretion		1,565			1,419
Net loss applicable to common stock	$	(736	)	$	(84	)
Shares of common stock outstanding used to compute basic
per common share amounts		21,837,069			21,615,850
Effect of dilutive options		--			--
Shares used to compute dilutive per common share amounts (1)		21,837,069			21,615,850
Basic loss per share applicable to common stock	$	(0.03	)	$	(0.00	)
Diluted loss per share applicable to common stock		(0.03	)		(0.00	)

(1)     For 2006 and 2005, excludes the effect of the conversion of the Redeemable Convertible Preferred Stock as it is considered anti-dilutive. For 2006 and 2005, options to purchase 1,687,065 and 1,956,301 shares of common stock, respectively, are not included in the computation of diluted income per share as these options are anti-dilutive.

16

NOTE K – SUPPLEMENTAL EXECUTIVE RETIREMENT PLAN

The Company’s unfunded noncontributory defined benefit plan (the “Plan”) covers certain senior executives, is administered by the Company and calls for annual payments upon retirement based on years of service and final average salary. Net periodic benefit expense is actuarially determined.

The change in Plan’s net benefit obligation is as follows:

(In thousands)
Benefit obligation at December 31, 2005	$	3,624
Service cost		505
Interest cost		52
Amortization of (gain) loss		--
Benefit obligation at March 31, 2006	$	4,181

At March 31, 2006, the Company has accrued approximately $4.2 million in benefit obligations related to the Plan.

NOTE L – SEGMENT AND RELATED INFORMATION

The Company has identified two reportable segments in which it operates based on the products and services it provides. The Company evaluates segment performance and allocates resources based on the segments’ income from operations.

The reportable segments are: (i) patient-care centers and (ii) distribution. The reportable segments are described further below:

Patient-Care Centers – This segment consists of the Company’s owned and operated patient-care centers, fabrication centers of O&P components, Innovative Neurotronics, Inc. (“IN, Inc.”) and Linkia, LLC (“Linkia”). The patient-care centers provide services to design and fit O&P devices to patients. These centers also instruct patients in the use, care and maintenance of the devices. Fabrication centers are involved in the fabrication of O&P components for both the O&P industry and the Company’s own patient-care centers. IN, Inc. specializes in bringing emerging MyoOrthotics Technologies® to the O&P market. MyoOrthotics Technologies represents the merging of orthotic technologies with electrical stimulation. Linkia is a national managed-care agent for O&P services and a patient referral clearing house.

Distribution – This segment distributes O&P products and components to both the O&P industry and the Company’s own patient-care practices.

The accounting policies of the segments are the same as those described in the summary of “Significant Accounting Policies” in Note B to the condensed consolidated financial statements.

17

NOTE L – SEGMENT AND RELATED INFORMATION (CONTINUED)

Summarized financial information concerning the Company’s reportable segments is shown in the following table. Intersegment sales mainly include sales of O&P components from the distribution segment to the patient-care centers segment and were made at prices which approximate market values.

(In thousands)	Patient-Care Center			Distribution		Other			Total
Three Months Ended March 31, 2006
Net sales
Customers	$	127,260		$	13,185	$	--		$	140,445
Intersegments		--			24,223		(24,223	)		--
Depreciation and amortization		3,198			76		414			3,688
Income (loss) from operations		13,991			4,667		(7,743	)		10,915
Interest (income) expense		(1,575	)		1,727		9,348			9,500
Income before taxes and extraordinary items		15,566			2,940		(17,091	)		1,415
Total assets		587,166			79,941		37,311			704,418
Capital expenditures		2,186			32		399			2,617
Three Months Ended March 31, 2005
Net sales
Customers	$	122,836		$	10,164	$	--		$	133,000
Intersegments		--			16,621		(16,621	)		--
Depreciation and amortization		3,038			75		396			3,509
Income (loss) from operations		14,219			3,266		(6,377	)		11,108
Interest (income) expense		(1,558	)		1,732		8,669			8,843
Income before taxes and extraordinary items		15,778			1,534		(15,047	)		2,265
Total assets		568,063			70,962		62,562			701,587
Capital expenditures		1,382			23		148			1,553

NOTE M – CONSOLIDATING FINANCIAL INFORMATION

The Company’s Revolving Credit Facility, Senior Notes, Senior Subordinated Notes, and Term Loan are guaranteed fully, jointly and severally, and unconditionally by all of the Company’s current and future domestic subsidiaries. The following are summarized Condensed Consolidating Balance Sheets as of March 31, 2006 and December 31, 2005, Condensed Statements of Operations for the three month periods ended March 31, 2006 and 2005 and Condensed Cash Flows for the three month periods ended March 31, 2006 and 2005 of the Company, segregating the parent company (Hanger Orthopedic Group, Inc.) and its guarantor subsidiaries, as each of the Company’s subsidiaries is wholly-owned.

18

NOTE M – CONSOLIDATING FINANCIAL INFORMATION (CONTINUED)

BALANCE SHEET - March 31, 2006	Hanger Orthopedic Group (Parent Company)			Guarantor Subsidiaries			Consolidating Adjustments			Consolidated Totals
(In thousands)
ASSETS
Cash and cash equivalents	$	1,995		$	4,177		$	--		$	6,172
Accounts receivable		--			95,552			--			95,552
Inventories		--			78,372			--			78,372
Prepaid expenses, other assets and income taxes receivable		7,680			7,875			--			15,555
Intercompany receivable		414,242			--			(414,242	)		--
Deferred income taxes		7,484			--			--			7,484
Total current assets		431,401			185,976			(414,242	)		203,135
Property, plant and equipment, net		5,248			37,387			--			42,635
Intangible assets, net		--			449,536			--			449,536
Investment in subsidiaries		224,668			--			(224,668	)		--
Other assets		7,907			1,205			--			9,112
Total assets	$	669,224		$	674,104		$	(638,910	)	$	704,418
LIABILITIES, REDEEMABLE PREFERRED STOCK
AND SHAREHOLDERS' EQUITY
Current portion of long-term debt	$	1,500		$	2,990		$	--		$	4,490
Accounts payable		2,560			16,249			--			18,809
Accrued expenses		7,359			3,274			--			10,633
Accrued interest payable		3,422			77			--			3,499
Accrued compensation related costs		1,698			11,126			--			12,824
Income taxes payable		2,952			(2,952	)		--			--
Total current liabilities		19,491			30,764			--			50,255
Long-term debt, less current portion		380,790			6,003			--			386,793
Deferred income taxes		36,611			(4,862	)		--			31,749
Intercompany payable		--			414,242			(414,242	)		--
Other liabilities		3,823			3,289			--			7,112
Total liabilities		440,715			449,436			(414,242	)		475,909
Redeemable preferred stock		63,507			--			--			63,507
Common stock		223			35			(35	)		223
Additional paid-in capital		154,226			7,460			(7,460	)		154,226
Retained earnings		11,209			217,713			(217,713	)		11,209
Treasury stock		(656	)		(540	)		540			(656	)
Total shareholders' equity		165,002			224,668			(224,668	)		165,002
Total liabilities, redeemable preferred stock
and shareholders' equity	$	669,224		$	674,104		$	(638,910	)	$	704,418

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NOTE M – CONSOLIDATING FINANCIAL INFORMATION (CONTINUED)

BALANCE SHEET - December 31, 2005	Hanger Orthopedic Group (Parent Company)			Guarantor Subsidiaries			Consolidating Adjustments			Consolidated Totals
(In thousands)
ASSETS
Cash and cash equivalents	$	3,120		$	4,801		$	--		$	7,921
Accounts receivable		--			103,200			--			103,200
Inventories		--			76,725			--			76,725
Prepaid expenses, other assets and income taxes receivable		1,520			5,034			--			6,554
Intercompany receivable		425,211			--			(425,211	)		--
Deferred income taxes		7,087			--			--			7,087
Total current assets		436,938			189,760			(425,211	)		201,487
Property, plant and equipment, net		5,263			38,234			--			43,497
Intangible assets, net		--			449,744			--			449,744
Investment in subsidiaries		206,163			--			(206,163	)		--
Other assets		8,400			1,339			--			9,739
Total assets	$	656,764		$	679,077		$	(631,374	)	$	704,467
LIABILITIES, REDEEMABLE PREFERRED STOCK
AND SHAREHOLDERS' EQUITY
Current portion of long-term debt	$	1,500		$	2,966		$	--		$	4,466
Accounts payable		2,534			17,986			--			20,520
Accrued expenses		7,096			3,859			--			10,955
Accrued interest payable		8,257			63			--			8,320
Accrued compensation related costs		1,485			20,190			--			21,675
Total current liabilities		20,872			45,064			--			65,936
Long-term debt, less current portion		367,292			6,673			--			373,965
Deferred income taxes		35,713			(4,862	)		--			30,851
Income taxes payable		2,418			(2,418	)		--			--
Intercompany payable		--			425,211			(425,211	)		--
Other liabilities		3,285			3,246			--			6,531
Total liabilities		429,580			472,914			(425,211	)		477,283
Redeemable preferred stock		61,942			--			--			61,942
Common stock		222			35			(35	)		222
Additional paid-in capital		156,346			7,460			(7,460	)		156,346
Unearned compensation		(2,615	)		--			--			(2,615	)
Retained earnings		11,945			199,208			(199,208	)		11,945
Treasury stock		(656	)		(540	)		540			(656	)
Total shareholders' equity		165,242			206,163			(206,163	)		165,242
Total liabilities, redeemable preferred stock
and shareholders' equity	$	656,764		$	679,077		$	(631,374	)	$	704,467

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NOTE M – CONSOLIDATING FINANCIAL INFORMATION (CONTINUED)

STATEMENT OF OPERATIONS Three Months Ended March 31, 2006 (In Thousands)	Hanger Orthopedic Group (Parent Company)			Guarantor Subsidiaries		Consolidating Adjustments			Consolidated Totals
Net sales	$	--		$	140,445	$	--		$	140,445
Cost of goods sold (exclusive of depreciation and amortization)		--			70,215		--			70,215
Selling, general and administrative		7,328			48,299		--			55,627
Depreciation and amortization		414			3,274		--			3,688
(Loss) income from operations		(7,742	)		18,657		--			10,915
Interest expense, net		9,348			152		--			9,500
Equity in earnings of subsidiaries		18,505			--		(18,505	)		--
Income before taxes		1,415			18,505		(18,505	)		1,415
Provision for income taxes		586			--		--			586
Net income	$	829		$	18,505	$	(18,505	)	$	829
STATEMENT OF OPERATIONS Three Months Ended March 31, 2005 (In Thousands)	Hanger Orthopedic Group (Parent Company)			Guarantor Subsidiaries		Consolidating Adjustments			Consolidated Totals
Net sales	$	--		$	133,000	$	--		$	133,000
Cost of goods sold (exclusive of depreciation and amortization)		--			67,446		--			67,446
Selling, general and administrative		5,981			44,956		--			50,937
Depreciation and amortization		396			3,113		--			3,509
(Loss) income from operations		(6,377	)		17,485		--			11,108
Interest expense, net		8,669			174		--			8,843
Equity in earnings of subsidiaries		17,311			--		(17,311	)		--
Income before taxes		2,265			17,311		(17,311	)		2,265
Provision for income taxes		930			--		--			930
Net income	$	1,335		$	17,311	$	(17,311	)	$	1,335

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NOTE M – CONSOLIDATING FINANCIAL INFORMATION (CONTINUED)

STATEMENTS OF CASH FLOWS Three Months Ended March 31, 2006 (In thousands)	Hanger Orthopedic Group (Parent Company)			Guarantor Subsidiaries			Consolidating Adjustments		Consolidated Totals
Cash flows from operating activities:
Net cash (used in) provided by operating activities	$	(15,108	)	$	2,337		$	--	$	(12,771	)
Cash flows from investing activities:
Purchase of property, plant and equipment		(399	)		(2,218	)		--		(2,617	)
Acquisitions and earnouts		--			(154	)		--		(154	)
Proceeds from sale of property, plant and equipment		--			57			--		57
Net cash used in investing activities		(399	)		(2,315	)		--		(2,714	)
Cash flows from financing activities:
Borrowings under revolving credit agreement		19,000			--			--		19,000
Repayments under revolving credit agreement		(5,000	)		--			--		(5,000	)
Repayments under term loan		(375	)		--			--		(375	)
Scheduled repayment of long-term debt		--			(646	)		--		(646	)
Increase in financing costs		(95	)		--			--		(95	)
Proceeds from issuance of Common Stock		141			--			--		141
Change in book overdraft		711			--			--		711
Net cash provided by (used in) financing activities		14,382			(646	)		--		13,736
Net decrease in cash and cash equivalents		(1,125	)		(624	)		--		(1,749	)
Cash and cash equivalents, at beginning of period		3,120			4,801			--		7,921
Cash and cash equivalents, at end of period	$	1,995		$	4,177		$	--	$	6,172
STATEMENTS OF CASH FLOWS Three Months Ended March 31, 2005 (In thousands)	Hanger Orthopedic Group (Parent Company)			Guarantor Subsidiaries			Consolidating Adjustments		Consolidated Totals
Cash flows from operating activities:
Net cash (used in) provided by operating activities	$	(23,984	)	$	4,125		$	--	$	(19,859	)
Cash flows from investing activities:
Purchase of property, plant and equipment		(148	)		(1,405	)		--		(1,553	)
Acquisitions and earnouts		--			(983	)		--		(983	)
Net cash provided by (used in) investing activities		(148	)		(2,388	)		--		(2,536	)
Cash flows from financing activities:
Borrowings under revolving credit agreement		29,000			--			--		29,000
Repayments under revolving credit agreement		(9,000	)		--			--		(9,000	)
Repayments under term loan		(375	)		--			--		(375	)
Scheduled repayment of long-term debt		--			(636	)		--		(636	)
Increase in financing costs		(3	)		--			--		(3	)
Proceeds from issuance of Common Stock		118			--			--		118
Change in book overdraft		1,162			2,036			--		3,198
Net cash used in financing activities		20,902			1,400			--		22,302
Net (decrease) increase in cash and cash equivalents		(3,230	)		3,137			--		(93	)
Cash and cash equivalents, at beginning of period		3,466			4,885			--		8,351
Cash and cash equivalents, at end of period	$	236		$	8,022		$	--	$	8,258

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ITEM 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

Overview

The following is a discussion of our results of operations and financial position for the periods described below. This discussion should be read in conjunction with the Condensed Consolidated Financial Statements included in this report.

Business Overview

General

We are the largest owner and operator of orthotic and prosthetic (“O&P”) patient-care centers in the United States. Through our wholly-owned subsidiary, Southern Prosthetic Supply, Inc. (“SPS”), we are also the largest distributor of branded and private label O&P devices and components in the United States, all of which are manufactured by third parties. We also create products, through our wholly-owned subsidiary Innovative Neurotronics, Inc. (“IN, Inc.”), for sale in our patient-care centers and through a sales force, to patients who have had a loss of mobility due to strokes, multiple sclerosis or other similar conditions. Another subsidiary, Linkia, LLC (“Linkia”), develops programs to manage all aspects of O&P patient care for large private payors.

We have increased our net sales during the past two years principally through acquisitions, increased distribution revenues, sales generated by the two national contracts signed by our Linkia subsidiary and by opening new patient-care centers. We strive to improve our local market position to enhance operating efficiencies and generate economies of scale. We generally acquire small and medium-sized O&P patient care businesses and open new patient-care centers to achieve greater density in our existing markets.

Patient Care

In our orthotics business, we design, fabricate, fit and maintain a wide range of standard and custom-made braces and other devices (such as spinal, knee and sports-medicine braces) that provide external support to patients suffering from musculoskeletal disorders, such as ailments of the back, extremities or joints and injuries from sports or other activities. In our prosthetics business, we design, fabricate, fit and maintain custom-made artificial limbs for patients who are without limbs as a result of traumatic injuries, vascular diseases, diabetes, cancer or congenital disorders. O&P devices are increasingly technologically advanced and are custom-designed to add functionality and comfort to patients’ lives, shorten the rehabilitation process and lower the cost of rehabilitation.

At March 31, 2006, we operated 621 O&P patient-care centers (“patient-care centers”) in 45 states and the District of Columbia and employed in excess of 1,000 revenue-generating O&P practitioners (“practitioners”). Patients are referred to our local patient-care centers directly by physicians as a result of our reputation with them or through our agreements with managed care providers. Practitioners, technicians and office administrators staff our patient-care centers. Our practitioners generally design and fit patients with, and the technicians fabricate, O&P devices as prescribed by the referring physician. Following the initial design, fabrication and fitting of our O&P devices, our technicians conduct regular, periodic maintenance of O&P devices as needed. Our practitioners are also responsible for managing and operating our patient-care centers and are compensated, in part, based on their success in managing costs and collecting accounts receivable. We provide centralized administrative, marketing and materials management services to take advantage of economies of scale and to increase the time practitioners have to provide patient care. In areas where we have multiple patient-care centers, we also utilize shared fabrication facilities where technicians fabricate devices for practitioners in that area.

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Distribution

Our distribution segment, SPS, is the largest distributor in the O&P market with a dedicated sales force and current product catalogue. SPS purchases and distributes O&P products to our patient-care centers as well as independent O&P providers. SPS maintains three distribution sites throughout the U.S. to facilitate prompt shipping.

Products

In 2004, the Company formed a new subsidiary, IN, Inc. Specializing in the field of functional electrical stimulation, IN, Inc. identifies emerging MyoOrthotics Technologies® developed at research centers and universities throughout the world that use neuromuscular stimulation to improve the functionality of an impaired limb. MyoOrthotics Technologies represents the merging of orthotic technologies with electrical stimulation. Working with the inventors, IN, Inc. advances the design and manufacturing, as well as the regulatory and clinical aspects of the technology, and then introduces the devices to the marketplace through a variety of distribution channels. While IN, Inc. has not yet generated sales, its first product, the WalkAide System, has received FDA approval and will be released for sale during the second quarter of 2006.

Provider Network Management

Linkia, the first provider network management service company dedicated solely to serving the O&P market, was created in 2003 and is dedicated to managing the O&P services of national insurance companies. Linkia partners with healthcare insurance companies by securing national and regional contracts to manage the O&P networks of those companies. In 2004, Linkia entered into its first contract and in September 2005, Linkia signed an agreement with CIGNA HealthCare which will cover nine million beneficiaries. We will continue the deployment of Linkia and although it is too early to assess the overall success of this effort, we expect the Linkia contracts to begin impacting sales in the second half of fiscal 2006, as the CIGNA contract is phased in on a geographic basis.

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Industry Overview

We estimate the O&P patient care market in the United States represented approximately $2.5 billion in revenues in 2005, of which we accounted for approximately 21%. The O&P patient care services market is highly fragmented and is characterized by local, independent O&P businesses, with the majority generally having a single facility with annual revenues of less than $1.0 million. According to the most recent American Orthotic and Prosthetic Association study, which was conducted in 1999, there are an estimated 3,300 certified prosthestists and/or orthotists and approximately 2,800 O&P patient-care centers in the United States. We do not believe that any of our patient care competitors account for a market share of more than 2% of the country’s total estimated O&P patient care services revenue.

The care of O&P patients is part of a continuum of rehabilitation services including diagnosis, treatment and prevention of future injury. This continuum involves the integration of several medical disciplines that begins with the attending physician’s diagnosis. A patient’s course of treatment is generally determined by an orthopedic surgeon, vascular surgeon or physiatrist, who writes a prescription and refers the patient to an O&P patient care services provider for treatment. A practitioner then, using the prescription, consults with both the referring physician and the patient to formulate the design of an orthotic or prosthetic device to meet the patient’s needs.

The O&P industry is characterized by stable, recurring revenues, primarily resulting from the need for periodic replacement and modification of O&P devices. Based on our experience, the average replacement time for orthotic devices is one to three years, while the average replacement time for prosthetic devices is three to five years. There is also an attendant need for continuing O&P patient care services. In addition to the inherent need for periodic replacement and modification of O&P devices and continuing care, we expect the demand for O&P services will continue to grow as a result of several key trends, including:

Aging U.S. Population. The growth rate of the over-65 age group is nearly triple that of the under-65 age group. There is a direct correlation between age and the onset of diabetes and vascular disease, which is the leading cause of amputations. With broader medical insurance coverage, increasing disposable income, longer life expectancy, greater mobility expectations and improved technology of O&P devices, we believe the elderly will increasingly seek orthopedic rehabilitation services and products.

Growing Physical Health Consciousness. The emphasis on physical fitness, leisure sports and conditioning, such as running and aerobics, is growing, which has led to increased injuries requiring orthopedic rehabilitative services and products. These trends are evidenced by the increasing demand for new devices that provide support for injuries, prevent further or new injuries or enhance physical performance.

Increased Efforts to Reduce Healthcare Costs. O&P services and devices have enabled patients to become ambulatory more quickly after receiving medical treatment in the hospital. We believe that significant cost savings can be achieved through the early use of O&P services and products. The provision of O&P services and products in many cases reduces the need for more expensive treatments, thus representing a cost savings to third-party payors.

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Advancing Technology. The range and effectiveness of treatment options for patients requiring O&P services have increased in connection with the technological sophistication of O&P devices. Advances in design technology and lighter, stronger and more cosmetically acceptable materials have enabled patients to replace older O&P devices with new O&P products that provide greater comfort, protection and patient acceptability. As a result, treatment can be more effective or of shorter duration, giving the patient greater mobility and a more active lifestyle. Advancing technology has also increased the prevalence and visibility of O&P devices in many sports, including skiing, running and tennis.

Competitive Strengths

The combination of the following competitive strengths will help us in growing our business through an increase in our net sales, net income and market share:

• Leading market position, with an approximate 21% share of total industry revenues and operations in 45 states and the District of Columbia, in an otherwise fragmented industry;

• National scale of operations, which has better enabled us to:

- establish our brand name and generate economies of scale;

- implement best practices throughout the country;

- utilize shared fabrication facilities;

- contract with national and regional managed care entities;

- identify, test and deploy emerging technology; and

- increase our influence on, and input into, regulatory trends;

• Distribution of, and purchasing power for, O&P components and finished O&P products, which enables us to:

- negotiate greater purchasing discounts from manufacturers and freight providers;

- reduce patient-care center inventory levels and improve inventory turns through centralized purchasing control;

- quickly access prefabricated and finished O&P products;

- promote the usage by our patient-care centers of clinically appropriate products that also enhance our profit margins;

- engage in co-marketing and O&P product development programs with suppliers; and

- expand the non-Hanger client base of our distribution segment;

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• Development of leading-edge technology for sale in our practices and through distributors;

• Full O&P product offering, with a balanced mix between orthotics services and products and prosthetics services and products;

• Practitioner compensation plans that financially reward practitioners for their efficient management of accounts receivable collections, labor, materials, and other costs, and encourages cooperation among our practitioners within the same local market area;

• Proven ability to rapidly incorporate technological advances in the fitting and fabrication of O&P devices;

• History of successful integration of small and medium-sized O&P business acquisitions, including 84 O&P businesses since 1992, with purchase prices ranging from less than $100,000 to $50 million and representing over 298 patient-care centers;

• Highly trained practitioners, whom we provide with the highest level of continuing education and training through programs designed to inform them of the latest technological developments in the O&P industry, and our certification program located at the University of Connecticut; and

• Experienced and committed management team.

Business Strategy

Our goal is to continue to provide superior patient care and to be the most cost-efficient, full service, national O&P operator. The key elements of our strategy to achieve this goal are to:

• improve our performance by:

- developing and deploying new processes to improve the productivity of our practitioners;

- continuing periodic patient evaluations to gauge patients’ device and service satisfaction;

- improving the utilization and efficiency of administrative and corporate support services;

- enhancing margins through continued consolidation of vendors and product offering; and

- leveraging our market share to increase sales and enter into more competitive payor contracts;

• increase our market share and net sales by:

- continued marketing of Linkia products to regional and national providers;

- contracting with national and regional managed care providers who we believe select us as a preferred O&P provider because of our reputation, national reach, density of our patient-care centers in certain markets and our ability to help reduce administrative expenses;

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- increasing our volume of business through enhanced comprehensive marketing programs aimed at referring physicians and patients, such as our Patient Evaluation Clinics program, which reminds patients to have their devices serviced or replaced and informs them of technological improvements of which they can take advantage; and our “People in Motion” program which introduces potential patients to the latest O&P technology; and

- expansion of the breadth of products being offered out of our patient-care centers;

• develop businesses that provide services and products to the broader rehabilitation and post-surgical healthcare areas as demonstrated by our emerging venture called TotalCare;

• continue to create, license or patent and market devices based on new cutting edge technology. We anticipate bringing new technology to the market through our IN, Inc. product line. The first new product, the WalkAide System, will be available for sale during the second quarter of 2006;

• provide our practitioners with the training necessary to utilize existing technology for different patient service facets, such as the use of our Insignia scanning system for burns and cranial helmets;

• selectively acquire small and medium-sized O&P patient care service businesses and open satellite patient-care centers primarily to expand our presence within an existing market and secondarily to enter into new markets; and

• provide our practitioners with:

- career development and increased compensation opportunities;

- a wide array of O&P products from which to choose;

- administrative and corporate support services that enable them to focus their time on providing superior patient care; and

- selective application of new technology to improve patient care.

Critical Accounting Estimates

Our analysis and discussion of our financial condition and results of operations are based upon our Consolidated Financial Statements that have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. GAAP provides the framework from which to make these estimates, assumptions, adjustments, and disclosures. We have chosen accounting policies within GAAP that management believes are appropriate to accurately and fairly report our operating results and financial position in a consistent manner. Management regularly assesses these policies in light of current and forecasted economic conditions. Our significant accounting policies are stated in Note B to the Consolidated Financial Statements in our Annual Report on Form 10-K for the year ended December 31, 2005. We believe the following accounting policies are critical to understanding the results of operations and affect the more significant judgments and estimates used in the preparation of the Consolidated Financial Statements.

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• Revenue Recognition: Revenues on the sale of orthotic and prosthetic devices and associated services to patients are recorded when the device is accepted by the patient, provided that (i) delivery has occurred or services have been rendered; (ii) persuasive evidence of an arrangement exists; (iii) the sales price is fixed or determinable; and (iv) collectibility is reasonably assured. Revenues on the sale of orthotic and prosthetic devices to customers by our distribution segment are recorded upon the shipment of products, in accordance with the terms of the invoice, net of merchandise returns received and the amount established for anticipated returns. Discounted sales are recorded at net realizable value. Deferred revenue represents prepaid tuition and fees received from students enrolled in our practitioner education program.

Revenue at our patient-care centers segment is recorded net of all governmental adjustments, contractual adjustments and discounts. We employ a systematic process to ensure that our sales are recorded at net realizable value and that any required adjustments are recorded on a timely basis. The contracting module of our centralized, computerized billing system is designed to record revenue at net realizable value based on our contract with the patient’s insurance company. Updated billing information is received periodically from payors and is uploaded into our centralized contract module and then disseminated to all patient-care centers electronically.

The following represents the composition of our patient-care segment’s accounts receivable balance by payor at March 31, 2006:

	(In thousands)
Commercial, private pay and other	$	59,023
Medicaid		13,468
Medicare		18,546
VA		1,318
	$	92,355

We completed the rollout of OPS in the second quarter of 2005, prior to which we were unable to develop reports to determine the composition of our accounts receivable by payor. Additionally, we will endeavor to develop reports to determine the composition of our allowance for doubtful accounts by payor. The composition of our accounts receivable and allowance for doubtful accounts by payor will not be comparable until the third quarter of 2006.

Disallowed sales generally relate to billings to payors with whom we do not have a formal contract. In these situations we record the sale at usual and customary rates and simultaneously record a disallowed sale to reduce the sale to net value, based on our historical experience with the payor in question. Disallowed sales may also result if the payor rejects or adjusts certain billing codes. Billing codes are frequently updated within our industry. As soon as updates are received, we reflect the change in our centralized billing system.

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As part of our preauthorization process with payors, we validate our ability to bill the payor for the service we are providing before we deliver the device. Subsequent to billing for our devices and services, there may be problems with pre-authorization or with other insurance coverage issues with payors. If there has been a lapse in coverage, the patient is financially responsible for the charges related to the devices and services received. If we do not collect from the patient, we record bad debt expense. Occasionally, a portion of a bill is rejected by a payor due to a coding error on our part and we are prevented from pursuing payment from the patient due to the terms of our contract with the insurance company. We appeal these types of decisions and are generally successful. This activity is factored into our methodology to determine the estimate for the allowance for doubtful accounts. We immediately record, as a reduction of sales, a disallowed sale for any claims that we know we will not recover and adjust our future estimates accordingly.

Certain accounts receivable may be uncollectible, even if properly pre-authorized and billed. Regardless of the balance, accounts receivable amounts are periodically evaluated to assess collectibility. In addition to the actual bad debt expense recognized during collection activities, we estimate the amount of potential bad debt expense that may occur in the future. This estimate is based upon our historical experience as well as a review of our receivable balances. On a quarterly basis, we evaluate cash collections, accounts receivable balances and write-off activity to assess the adequacy of our allowance for doubtful accounts. Additionally, a company-wide evaluation of collectibility of receivable balances older than 180 days is performed at least semi-annually, the results of which are used in the next allowance analysis. In these detailed reviews, the account’s net realizable value is estimated after considering the customer’s payment history, past efforts to collect on the balance and the outstanding balance, and a specific reserve is recorded if needed. From time to time, the Company may outsource the collection of such accounts to outsourced agencies after internal collection efforts are exhausted. In the cases when valid accounts receivable cannot be collected, the uncollectible account is written off to bad debt expense.

• Inventories: Inventories, which consist principally of raw materials, work-in-process and finished goods, are stated at the lower of cost or market using the first-in, first-out method. At our patient-care centers segment, we calculate cost of goods sold in accordance with the gross profit method for all reporting periods. We base the estimates used in applying the gross profit method on the actual results of the most recently completed fiscal year and other factors, such as sales mix and purchasing trends among other factors, affecting cost of goods sold during the current reporting periods. Estimated cost of goods sold during the period is adjusted when the annual physical inventory is taken. We treat these adjustments as changes in accounting estimates. At our distribution segment, a perpetual inventory is maintained. Management adjusts our reserve for inventory obsolescence whenever the facts and circumstances indicate that the carrying cost of certain inventory items is in excess of its market price. Shipping and handling costs are included in cost of goods sold.

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• Property, Plant and Equipment: We record property, plant and equipment at cost. Equipment acquired under capital leases is recorded at the lower of fair market value or the present value of the future lease payments. The cost and related accumulated depreciation of assets sold, retired or otherwise disposed of are removed from the respective accounts, and any resulting gains or losses are included in the Consolidated Statements of Operations. Depreciation is computed for financial reporting purposes using the straight-line method over the estimated useful lives of the related assets as follows:

Furniture and fixtures	5 years
Machinery and equipment	5 years
Computers and software	5 years
Buildings	10 to 40 years
Assets under capital leases	Shorter of asset life or term of lease
Leasehold improvements	Shorter of asset life or term of lease

We capitalize internally developed computer software costs incurred during the application development stage in accordance with Statement of Position 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use.

• Goodwill and Other Intangible Assets: Excess cost over net assets acquired (“Goodwill”) represents the excess of purchase price over the value assigned to net identifiable assets of purchased businesses. We assess goodwill for impairment when events or circumstances indicate that the carrying value may not be recoverable, or, at a minimum, annually in the Company’s fourth quarter. Any impairment would be recognized by a charge to operating results and a reduction in the carrying value of the intangible asset.

Non-compete agreements are recorded based on agreements entered into by us and are amortized, using the straight-line method, over their terms ranging from five to seven years. Other definite-lived intangible assets are recorded at cost and are amortized, using the straight-line method, over their estimated useful lives of up to 16 years. Whenever the facts and circumstances indicate that the carrying amounts of these intangibles may not be recoverable, management reviews and assesses the future cash flows expected to be generated from the related intangible for possible impairment. Any impairment would be recognized as a charge to operating results and a reduction in the carrying value of the intangible assets.

• Deferred Tax Assets (Liabilities): We account for certain income and expense items differently for financial accounting purposes than for income tax purposes. Deferred income tax assets or liabilities are provided in recognition of these temporary differences. We recognize deferred tax assets if it is more likely than not the assets will be realized in future years. We are required to estimate our income taxes in each of the jurisdictions in which we operate. This process requires us to estimate our actual current tax exposure and assess the temporary differences resulting from differing treatment of items, such as the deductibility of certain intangible assets, for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included within our consolidated balance sheet. We must then assess the likelihood that our deferred tax assets will be recovered from future taxable income. To the extent we believe the recovery is not likely, we must establish a valuation allowance, which will continually be assessed. After having determined that we will be able to begin utilizing a significant portion of the deferred tax assets, the valuation allowance may be reversed, resulting in a benefit to the statement of operations in some future period.

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• Stock-Based Compensation. Stock-based compensation is accounted for using the grant-date fair value method. Compensation expense is recognized ratably over the service period.

• Supplemental Executive Retirement Plan. Benefit costs and liabilities balances are calculated based on certain assumptions including benefits earned, discount rates, interest costs, mortality rates and other factors. Actual results that differ from the assumptions are accumulated and amortized over future periods, affecting the recorded obligation and expense in future periods. The following assumptions were used in the calculation of the net benefit cost and obligation at March 31, 2006:

Discount Rate	5.5	%
Average rate of increase in compensation	3.0	%

We believe the assumptions used are appropriate, however, changes in assumptions or differences in actual experience may affect our benefit obligation and future expenses.

New Accounting Guidance

Effective January 1, 2006, we adopted the fair value recognition provisions of Statement of Financial Accounting Standards (“SFAS”) 123R, Share-Based Payment (“SFAS 123R”), which require companies to measure and recognize compensation expense for all share-based payments at fair value. SFAS 123R eliminates the ability to account for share-based compensation transactions using APB Opinion 25, Accounting for Stock Issued to Employees (“APB 25”) and generally requires that such transactions be accounted for using prescribed fair-value-based methods.

Prior to January 1, 2006, we accounted for stock-based awards under the measurement and recognition provisions of APB 25. Under APB 25, stock options granted at the fair market value of the underlying stock required no recognition of compensation cost. However, we disclosed the pro-forma effect on net income of recognizing compensation cost, as required by SFAS 123, Accounting for Stock-Based Compensation and SFAS 148, Accounting for Stock-Based Compensation – Transition and Disclosure.

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Given our recent trend of compensating certain of our employees with restricted shares of common stock instead of options, and in anticipation of the implementation of SFAS 123R, during the second quarter 2005 we accelerated the vesting of 1.2 million non-director stock options which had a grant price in excess of the market value of the underlying common stock. These options had grant prices ranging from $6.02 to $16.81 and vesting periods through January, 3, 2009. The compensation expense related to this acceleration was $3.3 million which was reflected, net of tax, in our 2005 pro-forma net income calculation.

We adopted SFAS 123R using the modified prospective method allowed for in SFAS 123R. Under the modified prospective method, compensation expense related to awards granted prior to and unvested as of the adoption of SFAS 123R is calculated in accordance with SFAS 123 and recognized in the statements of operations over the requisite remaining service period; compensation expense for all awards granted after the adoption of SFAS 123R is calculated according to the provision of SFAS 123R. Results for prior periods have not been restated. For the three month period ended March 31, 2006, we recognized $0.3 million in compensation expense, of which less than $0.1 million related to compensation expense of options.

The adoption of SFAS 123R reduced income from operations, income before income tax expense, and net income for the three months ended March 31, 2006 by less than $0.1 million. Additionally, effective January 1, 2006, we eliminated the balance of Unearned Compensation, on the Consolidated Balance Sheets, to Additional Paid-in-Capital.

As of March 31, 2006, total unrecognized compensation cost related to stock option awards was approximately $0.1 million and the related weighted-average period over which it is expected to be recognized is approximately 1.3 years. Total unrecognized compensation cost related to restricted shares of common stock was approximately $2.9 million as of March 31, 2006 and the weighted-average period over which it is expected to be recognized is approximately 2.1 years.

In February 2006, the FASB issued SFAS 155, Accounting for Certain Hybrid Financial Instruments. SFAS 155 amends SFAS 133, Accounting for Derivative Instruments and Hedging Activities and SFAS 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. The provisions of SFAS 155 allow for the fair value remeasurement of hybrid financial instruments that contain embedded derivatives that otherwise would require bifurcation and eliminates the interim guidance that provides that beneficial interests in securitized financial assets are not subject to the provisions of SFAS 133. Additionally, SFAS 155 eliminates SFAS 140’s restriction on qualifying special-purpose entities of holding derivative financial instruments that pertain to a beneficial interest other than another derivative financial instrument. SFAS 155 is effective for all financial instruments acquired or issued after fiscal years beginning after September 15, 2006. We believe the adoption of SFAS 155 will not have an impact on our financial statements.

In March 2006, the FASB issued SFAS 156, Accounting for Servicing of Financial Assets, amending SFAS 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. SFAS 156 permits entities the choice between either the amortization method or the fair value measurement method for valuing separately recognized servicing assets and liabilities. SFAS 156 is effective for fiscal years beginning after September 15, 2006; early adoption is permitted as of the beginning of an entity’s fiscal year, provided the entity has not yet issued financial statements for any interim period of that fiscal year. We believe the adoption of SFAS 156 will not have an impact on our financial statements.

Results of Operations

The following table sets forth, for the periods indicated, certain items from our Condensed Consolidated Statements of Operations and their percentage of our net sales:

	Three Months Ended March 31,
	2006			2005
Net sales		100	.0%		100	.0%
Cost of goods sold		50	.0		50	.7
Selling, general and administrative		39	.6		38	.3
Depreciation and amortization		2	.6		2	.6
Income from operations		7	.8		8	.4
Interest expense, net		6	.8		6	.7
Income before taxes		1	.0		1	.7
Provision for income taxes		0	.4		0	.7
Net income		0	.6		1	.0

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Three Months Ended March 31, 2006 Compared to the Three Months Ended March 31, 2005

Net Sales. Net sales for the three months ended March 31, 2006 were $140.4 million, an increase of $7.4 million, or 5.6%, versus net sales of $133.0 million for the three months ended March 31, 2005. The sales increase was the result of a $4.8 million, or 3.9%, same-center sales growth and a $3.2 million, or 30.7%, increase in external sales of our distribution segment, offset by a $0.4 million decline as a result of practices that closed, including those in New Orleans.

Cost of Goods Sold. Cost of goods sold for the three months ended March 31, 2006 was $70.2 million, an increase of $2.8 million, or 4.2%, over $67.4 million for the same period in the prior year. The increase was the result of the increased sales volume at our patient-care centers and our distribution segment. Cost of goods sold as a percentage of net sales decreased to 50.0% in 2006 from 50.7% in 2005 as a result of labor and purchasing efficiencies.

Selling, General and Administrative. Selling, general and administrative expenses for the three months ended March 31, 2006 increased by $4.7 million to $55.6 million, or 39.6% of net sales from $50.9 million, or 38.3% of net sales, for the three months ended March 31, 2005. The increase was principally due to the following: (i) $0.9 million invested in Linkia and IN, Inc. growth strategies; (ii) $0.8 million increase in labor, related to one extra business day in the first quarter of 2006 compared to 2005; (iii) $0.8 million related to nonrecurring expenses associated with a combination of personnel changes and Sarbanes-Oxley Act consulting; and (iv) $0.7 million increase in variable compensation due to the strong collections during the quarter. The balance of the increase resulted from inflationary increases in fixed costs such as labor and rent which were offset by cost savings principally in advertising and bad debt expense.

Depreciation and Amortization. Depreciation and amortization for the three months ended March 31, 2006 was $3.7 million versus $3.5 million for the three months ended March 31, 2005. This increase was primarily due to the depreciation of computer related assets and amortization of leasehold improvements.

Income from Operations. As a result of the above, income from operations for the three months ended March 31, 2006 was $10.9 million compared to $11.1 million for the three months ended March 31, 2005. Income from operations, as a percentage of net sales, decreased to 7.8% for the three months ended March 31, 2006 versus 8.4% for the prior year’s comparable period.

Interest Expense, Net. Interest expense in the three months ended March 31, 2006 increased to $9.5 million compared to $8.8 million in the three months ended March 31, 2005 due to higher variable interest rates in the first quarter of 2006.

Income Taxes. Income tax provision of $0.6 million was recognized for the three months ended March 31, 2006 compared to $0.9 million for the same period of the prior year. The change in the income tax provision was primarily the result of lower income from operations. The effective tax rate for the three months ended March 31, 2006 was 41.4% compared to 41.1% for the three months ended March 31, 2005. The effective tax rate for the three month periods ended March 31, 2006 and 2005 consists principally of the federal statutory tax rate of 35.0% and state income taxes.

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Net Income. As a result of the above, we recorded net income of $0.8 million for the three months ended March 31, 2006, compared to net income of $1.3 million for the same period in the prior year.

Restructuring and Integration Costs

The following summarizes the components of the restructuring reserve and the remaining balances:

	Lease Termination and other Exit Costs			Total Restructuring Reserve
(In thousands)
2001 Restructuring Reserve
Balance at December 31, 2005	$	220		$	220
Spending		(64	)		(64	)
Balance at March 31, 2006		156			156
2004 Restructuring Reserve
Balance at December 31, 2005		161			161
Spending		(31	)		(31	)
Balance at March 31, 2006		130			130
2001 and 2004 Restructuring Reserves	$	286		$	286

2001 Restructuring Reserve

During 2001, as a result of the initiatives associated with our performance improvement plan developed in conjunction with AlixPartners, LLC (formerly Jay Alix & Associates, Inc.), we recorded approximately $4.5 million in restructuring and asset impairment costs. The plan called for the closure of certain facilities and the termination of approximately 135 employees.

As of December 31, 2002, all properties had been vacated, all of the employees had been terminated and all corresponding payments under the severance initiative had been made. As of March 31, 2006, the remaining reserve of $0.2 million is adequate to provide for the lease costs which are expected to be paid through October 2012.

2004 Restructuring Reserve

During the first quarter of 2004, we adopted a restructuring plan as a result of acquiring an O&P company. The restructuring plan includes estimated expenses of $0.7 million related to the closure/merger of nine facilities and the payment of severance costs to 20 terminated employees.

As of December 31, 2005, all of the nine patient-care centers had been closed/merged and approximately $0.3 million in lease costs were paid, and the employment of 11 employees had been terminated and $0.1 million of severance payments had been paid. During 2005, we reversed the remaining balance of restructuring accrual related to severance payments as a result of the associated employees continuing their employment with the Company. Approximately $0.1 million of lease payments are expected to be paid through April 2008.

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Financial Condition, Liquidity, and Capital Resources

Our working capital at March 31, 2006 was $152.9 million compared to $135.6 million at December 31, 2005. Working capital increased principally as a result of the payment of year-end incentive compensation and interest on the Senior Notes and the Revolving Credit Facility which is payable semi-annually and quarterly, respectively. Days sales outstanding (“DSO”), which is the number of days between the billing for our O&P services and the date of our receipt of payment thereof, for the three months ended March 31, 2006, decreased to 59 days, compared to 65 days for the same period last year. The decrease in DSO is due to a continued effort at our patient-care centers to target collections as well as the implementation of electronic billing. Our ratio of current assets to current liabilities was 4.0 to 1 at March 31, 2006 compared to 3.1 to 1 at December 31, 2005. At March 31, 2006 the company’s availability under its Revolving Credit Facility was $40.3 million, net of $2.2 million of standby letters of credit.

Net cash used in operating activities for the three months ended March 31, 2006 was $12.8 million, compared to $19.9 million for the three months ended March 31, 2005. During the Company’s first quarter of 2006, operating cash flows were impacted by the payout of incentive compensation and scheduled interest payments. The use of cash was funded by draws on the Company’s Revolving Credit Facility.

Net cash used in investing activities was $2.7 million for the three months ended March 31, 2006, versus $2.5 million for the same period in the prior year. Cash used in investing activities was principally related to the purchase of computer related assets and leasehold improvements.

Net cash provided by financing activities was $13.7 million for the three months ended March 31, 2006, compared to $22.3 million for the three months ended March 31, 2005. The decrease in cash provided by financing activities was primarily due to decreased borrowings under the Revolving Credit Facility. Borrowings under the Revolving Credit Facility were used primarily to fund the payout of incentive compensation and the purchases of fixed assets.

The Revolving Credit Facility and the Term Loan require compliance with various covenants, including a minimum consolidated interest coverage ratio, a maximum total leverage ratio, a maximum senior secured leverage ratio and a minimum fixed charge ratio, as well as other covenants. We assess, on a quarterly basis, our compliance with these covenants and monitor any matters critical to continue our compliance. At March 31, 2006, we are in compliance with these covenants.

We believe that, based on current levels of operations and anticipated growth, cash generated from operations, together with other available sources of liquidity, including borrowings available under the Revolving Credit Facility, will be sufficient for at least the next twelve months to fund anticipated capital expenditures and make required payments of principal and interest on our debt, including payments due on our outstanding debt. In addition, we continually evaluate potential acquisitions and expect to fund such acquisitions from our available sources of liquidity, as discussed above. We are limited to $8.0 million in acquisitions in fiscal 2006 by the terms of the Revolving Credit Facility.

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The following table sets forth our contractual obligations and commercial commitments as of March 31, 2006:

	Payments Due by Period
	2006		2007		2008		2009		2010		Thereafter		Total
(In thousands)
Long-term debt	$	3,445	$	4,584	$	3,844	$	377,539	$	211	$	182	$	389,805
Interest payments on long-term debt		33,833		37,306		36,987		21,954		20		8		130,108
Operating leases		24,224		21,746		17,148		12,003		5,712		4,268		85,101
Capital leases		122		154		74		23		--		--		373
Other long-term obligations (1)		857		416		232		276		12,746		720		15,247
Total contractual cash obligations	$	62,481	$	64,206	$	58,285	$	411,795	$	18,689	$	5,178	$	620,634

(1)     Other long-term obligations consist primarily of amounts related to our Supplemental Executive Retirement Plan, earnout payments and payments under the restructuring plans.

Market Risk

We are exposed to the market risk that is associated with changes in interest rates. At March 31, 2006, all our outstanding debt, with the exception of the Revolving Credit Facility and the Term Loan, is subject to a fixed interest rate. (See Item 3 below.)

Forward Looking Statements

This report contains forward-looking statements setting forth our beliefs or expectations relating to future revenues, contracts and operations, as well as the results of an internal investigation and certain legal proceedings. Actual results may differ materially from projected or expected results due to changes in the demand for our O&P products and services, uncertainties relating to the results of operations or recently acquired O&P patient-care centers, our ability to enter into and derive benefits from managed-care contracts, our ability to successfully attract and retain qualified O&P practitioners, federal laws governing the health-care industry, uncertainties inherent in incomplete investigations and legal proceedings, governmental policies affecting O&P operations and other risks and uncertainties generally affecting the health-care industry. Readers are cautioned not to put undue reliance on forward-looking statements. We disclaim any intent or obligation to publicly update these forward-looking statements, whether as a result of new information, future events or otherwise.

ITEM 3. Quantitative and Qualitative Disclosures about Market Risk

We have existing obligations relating to our Senior Notes, Senior Subordinated Notes, Term Loan, Subordinated Seller Notes, and Redeemable Convertible Preferred Stock. As of March 31, 2006, we have cash flow exposure to the changing interest rate on the Term Loan and Revolving Credit Facility. The other obligations have fixed interest or dividend rates.

We have a $75.0 million revolving credit facility, with an outstanding balance of $19.0 million at March 31, 2006, as discussed in Note G to our Condensed Consolidated Financial Statements. The rates at which interest accrues under the entire outstanding balance are variable.

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In addition, in the normal course of business, we are exposed to fluctuations in interest rates. From time to time, we execute LIBOR contracts to fix interest rate exposure for specific periods of time. At March 31, 2006, we had one contract outstanding which fixed LIBOR at 8.8% and is set to expire on May 9, 2006.

Presented below is an analysis of our financial instruments as of March 31, 2006 that are sensitive to changes in interest rates. The table demonstrates the change in estimated annual cash flow related to the outstanding balance under the Term Loan and the Revolving Credit Facility, calculated for an instantaneous parallel shift in interest rates, plus or minus 50 basis points (“BPS”), 100 BPS, and 150 BPS.

Cash Flow Risk	Annual Interest Expense Given an Interest Rate Decrease of X Basis Points						No Changes		Annual Interest Expense Given an Interest Rate Increase of X Basis Points
(In thousands)	(150 BPS)		(100 BPS)		(50 BPS)				50 BPS		100 BPS		150 BPS
Term Loan	$	10,573	$	11,304	$	12,035	$	12,767	$	13,498	$	14,229	$	14,960
Revolving Credit Facility		1,541		1,636		1,731		1,826		1,921		2,016		2,111
	$	12,114	$	12,940	$	13,766	$	14,593	$	15,419	$	16,245	$	17,071

ITEM 4. Controls and Procedures

Disclosure Controls and Procedures

The Company’s disclosure controls and procedures are designed to provide reasonable assurance that information required to be disclosed by it in its periodic reports filed with the Securities and Exchange Commission is recorded, processed, summarized and reported, within the time periods specified in the Commission’s rules and forms. Based on an evaluation of the Company’s disclosure controls and procedures conducted by the Company’s Chief Executive Officer and Chief Financial Officer, such officers concluded that the Company’s disclosure controls and procedures were effective as of March 31, 2006.

Change in Internal Control Over Financial Reporting

In accordance with Rule 13a-15(d) under the Securities Exchange Act of 1934, management, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer determined that there was no change in the Company’s internal control over financial reporting that occurred during the quarter ended March 31, 2006, that has materially effected, or is reasonably likely to materially effect, the Company’s internal control over financial reporting.

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Part II. Other Information

ITEM 1. Legal Proceedings

For a description of certain legal proceedings, refer to the disclosure set forth in Note I (“Commitments and Contingent Liabilities”) in Part I, Item 1 (“Condensed Consolidated Financial Statements”).

The Company is also party to various legal proceedings that are ordinary and incidental to its business. Management does not expect that any legal proceedings currently pending will have a material adverse impact on the Company’s financial statements.

ITEM 1A. Risk Factors

Item 1A (“Risk Factors”) of the Company’s Annual Report on Form 10-K for the year ended December 31, 2005 sets forth information relating to important risks and uncertainties that could materially adversely affect the Company’s business, financial condition or operating results. Those risk factors continue to be relevant to an understanding of the Company’s business, financial condition and operating results. Certain of those risk factors have been updated in this Form 10-Q to provide updated information, as set forth below. References to “we,” “our” and “us” in these risk factors refer to the Company.

We incurred net losses for the years ended December 31, 2004 and could incur net losses in the future.

We incurred a net loss of $23.4 million for the year ended December 31, 2004 primarily as a result of the recognition of $45.8 million in non-cash charges related to goodwill impairment. For the three months ended March 31, 2006 and the year ended December 31, 2005, we generated net income of $0.8 million and $17.8 million, respectively. We cannot assure that we will not incur net losses in the future.

Changes in government reimbursement levels could adversely affect our net sales, cash flows and profitability.

We derived 41.5% and 44.8% of our net sales for the three months ended March 31, 2006 and 2005, respectively, from reimbursements for O&P services and products from programs administered by Medicare, Medicaid and the U.S. Veterans Administration. Each of these programs sets maximum reimbursement levels for O&P services and products. If these agencies reduce reimbursement levels for O&P services and products in the future, our net sales could substantially decline. In addition, the percentage of our net sales derived from these sources may increase as the portion of the U.S. population over age 65 continues to grow, making us more vulnerable to maximum reimbursement level reductions by these organizations. Reduced government reimbursement levels could result in reduced private payor reimbursement levels because fee schedules of certain third-party payors are indexed to Medicare. Furthermore, the healthcare industry is experiencing a trend towards cost containment as government and other third-party payors seek to impose lower reimbursement rates and negotiate reduced contract rates with service providers. This trend could adversely affect our net sales. Medicare provides for reimbursement for O&P products and services based on prices set forth in fee schedules for ten regional service areas. Additionally, if the U.S. Congress were to legislate modifications to the Medicare fee schedules, our net sales from Medicare and other payors could be adversely and materially affected. We cannot predict whether any such modifications to the fee schedules will be enacted or what the final form of any modifications might be. In November 2003, Congress legislated a three-year freeze on Medicare reimbursement levels beginning January 1, 2004 on all O&P services. The effect of this legislation has been a downward pressure on our income from operations. We have, however, initiated certain purchasing and efficiency programs which we believe will minimize such effects.

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On April 24, 2006, the Centers for Medicare & Medicaid Services announced a proposed rule that would call for a competitive bidding program for certain covered prosthetic and orthotic equipment as required by the Medicare Modernization Act of 2003. We cannot now identify the impact of such proposed rule on us.

If we cannot collect our accounts receivable and effectively manage our inventory, our business, results of operations, financial condition and ability to satisfy our obligations under our indebtedness could be adversely affected.

As of March 31, 2006 and December 31, 2005, our accounts receivable over 120 days represented approximately 21.5% and 20.4% of total accounts receivable outstanding in each period, respectively. If we cannot collect our accounts receivable, our business, results of operations, financial condition and ability to satisfy our obligations under our indebtedness could be adversely affected. In addition, our principal means of control with respect to accounting for inventory and costs of goods sold is a physical inventory conducted on an annual basis. This accepted method of accounting controls and procedures may result in an understatement or overstatement, as the case may be, of inventory between our annual physical inventories. We did not record a book-to-physical inventory adjustment as a result of our October 1, 2005 inventory count. Because our income from operations percentage is based on our inventory levels, adjustments to inventory during interim periods following our physical inventory could adversely affect our results of operations and financial condition.

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ITEM 6. Exhibits

(a) Exhibits.   The following exhibits are filed herewith:

Exhibit No. Document

10.1 Second Amended and Restated Employment Agreement, effective as of January 1, 2005, by and between Ivan R. Sabel and the Company.

10.2 Second Amended and Restated Employment Agreement, effective as of January 1, 2005, by and between Thomas F. Kirk and the Company.

10.3 Second Amended and Restated Employment Agreement, effective as of January 1, 2005, by and between Richmond L. Taylor and the Company.

10.4 Second Amended and Restated Employment Agreement, effective as of January 1, 2005, by and between George E. McHenry and the Company.

31.1 Written Statement of the Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2 Written Statement of the Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32 Written Statement of the Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

	HANGER ORTHOPEDIC GROUP, INC.
Dated: May 1, 2006	/s/ Ivan R. Sabel
	Ivan R. Sabel, CPO
	Chairman and Chief Executive Officer
	(Principal Executive Officer)
Dated: May 1, 2006	/s/ George E. McHenry
	George E. McHenry
	Executive Vice President and
	Chief Financial Officer
	(Principal Financial Officer)
Dated: May 1, 2006	/s/ Thomas C. Hofmeister
	Thomas C. Hofmeister
	Vice President of Finance
	(Chief Accounting Officer)

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Exhibit Index

Exhibit No. Document

10.1 Second Amended and Restated Employment Agreement, effective as of January 1, 2005, by and between Ivan R. Sabel and the Company.

10.2 Second Amended and Restated Employment Agreement, effective as of January 1, 2005, by and between Thomas F. Kirk and the Company.

10.3 Second Amended and Restated Employment Agreement, effective as of January 1, 2005, by and between Richmond L. Taylor and the Company.

10.4 Second Amended and Restated Employment Agreement, effective as of January 1, 2005, by and between George E. McHenry and the Company.

31.1 Written Statement of the Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

31.2 Written Statement of the Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

32 Written Statement of the Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

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