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FORM 10-Q

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

(Mark One)

[X]     QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 27, 2003

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: 0-26538

ENCORE MEDICAL CORPORATION
(Exact name of registrant as specified in its charter)

512-832-9500
(Registrant’s telephone number including area code)

         Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No ____

         Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).
Yes ___ No X

         Indicate the number of shares outstanding of each of the Registrant’s classes of common stock, as of the last practicable date.

Part I. Financial Information

ITEM 1. FINANCIAL STATEMENTS

Encore Medical Corporation and Subsidiaries
Consolidated Balance Sheets
As of September 27, 2003 and December 31, 2002
(in thousands, except share and per share data)
(unaudited)

See accompanying notes to unaudited consolidated financial statements.

Encore Medical Corporation and Subsidiaries
Consolidated Statements of Operations
For the three and nine months ended September 27, 2003 and September 28, 2002
(in thousands, except per share data)
(unaudited)

See accompanying notes to unaudited consolidated financial statements.

Encore Medical Corporation and Subsidiaries
Consolidated Statements of Cash Flow
For the nine months ended September 27, 2003 and September 28, 2002
(in thousands)
(unaudited)

See accompanying notes to unaudited consolidated financial statements.

ENCORE MEDICAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1.         BASIS OF PRESENTATION AND DESCRIPTION OF BUSINESS

Basis of Presentation

        The accompanying unaudited consolidated financial statements include the accounts of Encore Medical Corporation, a Delaware corporation, and its wholly owned subsidiaries (individually and collectively referred to as “us,” “we,” “our company,” “the Company,” or “Encore”). All significant intercompany balances and transactions have been eliminated in consolidation. The unaudited consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and notes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three-and-nine-month periods ended September 27, 2003, are not necessarily indicative of the results that may be expected for the year ending December 31, 2003. For further information, refer to the consolidated financial statements and footnotes thereto included in our Form 10-K dated December 31, 2002. Certain amounts in the prior period have been reclassified to conform to the current period presentation.

Description of Business

        We are a diversified orthopedic company that designs, manufactures, markets and distributes a comprehensive range of high quality orthopedic devices, sports medicine equipment and other related products for the orthopedic industry. Our products are used primarily by orthopedic surgeons, physical and occupational therapists and other orthopedic specialists who treat patients with musculoskeletal conditions resulting from degenerative diseases, deformities, traumatic events and sports-related injuries. We currently market and distribute our products through three operating divisions, our Surgical Division, our Chattanooga Group Division and our Soft Goods Division. Our Surgical Division offers reconstructive joint products, including hip, knee and shoulder implants, trauma products and spinal implants. Our Chattanooga Group Division is a leader in domestic sales of many of the orthopedic rehabilitation products in the market. Our Soft Goods Division provides orthopedic soft goods that are used to assist the patient in recovery from injury or a surgical procedure and to protect against further injury. Our three divisions enable us to reach a diverse customer base through multiple distribution channels.

        Our products are subject to regulation by the Food and Drug Administration (“FDA”) with respect to their sale in the United States, and we must, in many cases, obtain FDA authorization to market our products before they can be sold in the United States. Additionally, we are subject to similar regulations in many of the international countries in which we sell products.

2.         STOCK-BASED COMPENSATION

        We have adopted the disclosure-only provisions of SFAS No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosures” (“SFAS 148”) as well as those outlined in SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”). As permitted by SFAS 148 and SFAS 123, we continue to apply the provisions of Accounting Principles Board Opinion No. 25, “Accounting for Stock issued to Employees” and related interpretations in accounting for our plans. Accordingly, compensation cost for stock options is measured as the excess, if any, of the quoted market price of our stock at the date of the grant over the amount an employee must pay to acquire the stock. Stock based awards for non-employees are accounted for under the provisions of SFAS 123 and Emerging Issues Task Force Consensus 96-18 (“EITF 96-18”).

        Had we determined our compensation cost for all stock option grants based on their fair market value at the grant dates consistent with the method prescribed by SFAS 148 and SFAS 123, our net income (loss) and earnings (loss) per share would have been reduced (increased) to the pro forma amounts indicated below (in thousands):

        The fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model. The following weighted average assumptions were used for grants during the first nine months of 2003 and 2002:

3.         INVENTORIES

Inventories at September 27, 2003 and December 31, 2002 are as follows (in thousands):

        We establish reserves for such issues as slow moving and excess inventory, product obsolescence and valuation impairment. Our inventory reserve policy is primarily based on our products and market practices. We utilize a specific identification methodology (product rationalization), which can occur whenever there is a change in strategy. In addition, sales performance is reviewed on at least a quarterly basis to determine the amounts that should be adjusted to the existing reserve. Reserves are monitored on a quarterly basis and adjustments are made as determined by the processes referred to above. These inventory items are primarily being disposed of by scrapping or donating to charitable organizations.

4.         INTANGIBLE ASSETS

Intangible assets consists of the following (in thousands) as of September 27, 2003:

Intangibles consisted of the following (in thousands) as of December 31, 2002:

    During the nine months ended September 27, 2003, we disposed of $52,000 of intangible assets. Amortization expense for the nine months ended September 27, 2003 and September 28, 2002 was $747,000 and $823,000,respectively.

    Estimated amortization expense for the three months ended December 31, 2003 and the next five years is as follows (in thousands):

      For three months ended December 31, 2003       $200
      For year ended December 31, 2004                     $700
      For year ended December 31, 2005                     $600
      For year ended December 31, 2006                     $500
      For year ended December 31, 2007                     $500
      For year ended December 31, 2008                     $500

    Our amortizable assets will continue to be amortized over their remaining useful lives ranging from 1 to 40 years.

5.         LONG-TERM DEBT

Long-term debt (including capital lease obligations) consists of the following (dollars in thousands):

        The debt agreements related to the $25,000,000 credit facility and the $24,000,000 senior subordinated notes payable contain warranties and covenants and require maintenance of certain financial ratios. Default on any warranty or covenant could affect the ability to borrow under the agreements and, if not waived or corrected, could accelerate the maturity of any borrowings outstanding under the applicable agreement. As of the date of this report, we are in compliance with all debt covenants and warranties.

        We repaid in full the $25,000,000 credit facility and the $24,000,000 senior subordinated notes payable during the quarter ended September 27, 2003 in conjunction with the public offering we completed on August 11, 2003. See Note 6 for additional detail regarding the public offering. In connection with the repayment, these debt agreements were amended and restated effective September 26, 2003 to reflect, among other things, lower interest rates, removal of the term notes from the senior credit facility, adjustment of the required Borrowing Base, and adjustment of the warranties and covenants.

        In connection with the original $24,000,000 senior subordinated notes payable, we granted a warrant to purchase through February 8, 2009 up to an aggregate of 2,198,614 shares of our common stock at a purchase price of $0.01 per share. This warrant was originally valued at $6,596,000 and recorded as a reduction of long-term debt on the balance sheet. The expense related to this warrant was amortized to interest expense beginning February 8, 2002 using the original term of the note agreement (five years). In connection with the repayment of this original debt, we expensed the remaining balance of this warrant during the quarter ended September 27, 2003.

        Under the terms of the original agreement pursuant to which the senior subordinated notes were issued (the “Note Agreement”), because we failed to generate $16.5 million of earnings before interest, taxes, depreciation, and amortization, for the period commencing March 31, 2002 and ending on March 29, 2003, we had the right to prepay without penalty up to $6 million of the aggregate principal amount. On August 14, 2003, we exercised our right to prepay without penalty up to $6 million of the aggregate principal amount of senior subordinated notes. Because we exercised this right, the lender conveyed warrants to purchase 549,653 shares of our common stock to three related entities, Galen Partners III, L.P., Galen Partners International III, L.P. and Galen Employee Fund III, L.P. (collectively, the “Galen Entities”).

        Additionally, the Galen Entities and the lender entered into an agreement (the “Agreement”) to evidence certain obligations included in the original $24,000,000 senior subordinated notes payable. As an inducement for the Galen Entities to enter into the Agreement, we granted to the Galen Entities an option (the “Option”) dated as of February 8, 2002 to acquire up to the number of shares of common stock of the Company which have a value equal to $6 million, at an exercise price equal to the greater of $3.50 per share or one-half of the trailing ten-day average closing price of the common stock on the date of exercise. The Option expired unexercised on August 15, 2003. The Option was originally valued at $1,308,000 and recorded as an other asset on the balance sheet. It was amortized to interest expense over the life of the option (eighteen months). As of September 27, 2003, the Option is fully amortized.

6.         CAPITAL STOCK

        On August 11, 2003 we sold a total of 10,637,500 shares of our common stock at $4.00 per share in a public offering. This offering generated total gross proceeds of approximately $42.6 million, and we used the net offering proceeds of approximately $39.0 million to repay $25.9 million indebtedness under our senior subordinated notes payable to CapitalSource Finance LLC, $2.0 million of the term loan debt under our senior credit facility with Bank of America, $10.6 million to repay our outstanding indebtedness under our Bank of America revolving credit facility, and the remainder for general corporate purposes. See Note 5 for additional information.

        In conjunction with the public offering, all 131,603 shares of our Series A Preferred Stock were converted into 13,160,300 shares of common stock effective August 11, 2003.

7.         EARNINGS PER SHARE

        The reconciliation of the denominators used to calculate the basic and diluted earnings (loss) per share for the periods ended September 27, 2003 and September 28, 2002, respectively, are as follows (in thousands):