PART I.

ITEM 1. BUSINESS

OVERVIEW

Encore Medical Corporation, a Delaware corporation, and its wholly owned subsidiaries (indivudally referred to as "us," "we," "our company," "the Company," or "Encore"), is a diversified orthopedic company that designs, manufactures and distributes a comprehensive range of high quality orthopedic devices, sports medicine equipment and other related products for the orthopedic industry. We sell our products to orthopedic surgeons, physical and occupational therapists and other orthopedic specialists who use our products to treat patients with musculoskeletal conditions resulting from degenerative diseases, deformities, traumatic events and sports related injuries. Our surgical implants are used in reconstructive surgical procedures for the knee, hip, shoulder and spine. Our soft goods and rehabilitation products are used before surgery to offset the progression of an orthopedic condition. After surgery, our rehabilitation and soft goods products are used to assist the patient in recovery and to protect against further injury. As a result, we believe our products address a wide spectrum of the orthopedic continuum of care.

We have marketed and distributed our products through our three operating divisions, our Surgical Division, our Chattanooga Group Division and our Soft Goods Division. Our Surgical Division provides implant products across all three major segments of the orthopedic surgical market, including reconstructive joint products, such as hip, knee and shoulder implants; trauma products; and spinal implants. Our Chattanooga Group Division is a leader in domestic sales of many of the products used for orthopedic rehabilitation. Our Soft Goods Division provides orthopedic soft goods that are used to assist in the repair and rehabilitation of soft tissue and bone, and protect against injury. Total revenue from all three divisions was $108.1 million in 2003 and $95.5 million in 2002. Our income from operations was $9.2 million in 2003 and $7.1 million in 2002. Beginning in 2004 our soft goods products will be marketed and distributed as part of our Chattanooga Group Division to improve operational effectiveness and focus.

Throughout our history, we have strongly emphasized research and development to expand the product line of our Surgical Division. Since our inception, we have developed and obtained regulatory approval for over 100 products and product improvements. We continue to develop internally new products to enhance our organic growth. For example, we commenced the sale of several new products in 2003, including the 3DKnee System, our data-driven design total knee replacement. In addition to a continued focus on product innovation within our Surgical Division, our Chattanooga Group Division will continue its historical pattern of investing in product development. For example, we recently began selling VitalStim, a product used for the treatment of dysphagia, a swallowing disorder, and a new line of world-class electrotherapy equipment.

We have used strategic business acquisitions to broaden our product offering and to increase our customer base. Since July 1, 2001, we have completed two significant acquisitions that have allowed us to expand our business into two new product segments of the orthopedic market — orthopedic soft goods and rehabilitation equipment — both of which complement our Surgical Division. In July 2001, we purchased the orthopedic soft goods, patient safety devices and pressure care product lines of Kimberly-Clark Corporation. In February 2002, we purchased Chattanooga Group, Inc., a provider of orthopedic rehabilitation products, which became our Chattanooga Group Division. These acquisitions provide us access to a wide range of distribution partners and allow us the opportunity to sell our existing products to an expanded customer base. With the completion of these two acquisitions, we provide a comprehensive range of orthopedic devices and related products to orthopedic specialists operating in a variety of treatment settings.

INDUSTRY BACKGROUND

The worldwide orthopedic market was estimated to be approximately $17.1 billion in 2002 with sales in the United States accounting for approximately $10.5 billion. While we participate in the overall orthopedic market, for the twelve months period ended December 31, 2003, we derived approximately 33% of our revenue from sales of our orthopedic implants through our Surgical Division. The worldwide orthopedic implant market is expected to grow from $4.6 billion in 2002 to $7.2 billion in 2009 and the number of procedures is expected to grow from 2.0 million in 2002 to 2.6 million in 2009.

Orthopedic implants include reconstructive joint products such as hip, knee, and shoulder implants, all of which are expected to experience market growth over the next several years. Worldwide hip implant sales are expected to grow at a 6.2% annual growth rate from 2002 to 2009 and average selling prices are expected to increase from $2,173 in 2002 to $2,769 in 2009. Over the same time period, worldwide sales of knee implants are expected to increase by 6.9% annually with the average selling price expected to increase from $2,698 in 2002 to $3,152 in 2009, primarily due to advancements in technology. Though a smaller market opportunity, worldwide shoulder implant sales are expected to experience a 7.9% annual growth rate from $178.7 million in 2002 to $304.5 million in 2009. We participate in each of these markets.

Several factors are driving growth in the orthopedic industry, these factors include:

OUR STRATEGY 

Our objective is to strengthen our position as a provider of a comprehensive range of orthopedic devices, sports medicine equipment and related products to orthopedic surgeons, physical and occupational therapists and other orthopedic specialists operating in a variety of treatment settings. To achieve this objective, we intend to:

OUR PRODUCTS

We design, manufacture, market and distribute orthopedic devices and 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. During 2003, our Surgical Division accounted for 32.9% of total sales, our Chattanooga Group Division accounted for 53.2% of total sales and our Soft Goods Division accounted for 13.9% of total sales.

Surgical Division

We currently design, manufacture and market a wide variety of orthopedic reconstructive joint products, trauma products, spinal implant products and instruments used by surgeons to perform orthopedic surgery.

Reconstructive Joint Products.    We offer reconstructive joint products in three general areas: knees, hips and shoulders. In 2003, knee products accounted for 40.2% of our Surgical Division sales, hip products accounted for 33.9% of our Surgical Division sales, and shoulder products accounted for 8.8% of our Surgical Division sales. The following table summarizes our current Surgical Division reconstructive joint product offerings:

Trauma Products.    Our trauma products are designed to address difficult surgical requirements brought about by disease, fracture and deformity. In 2003, trauma products accounted for approximately 5.4% of our total Surgical Division sales. Our trauma products include:

Spinal Implant Products.    Within the United States we distribute spinal implant products designed and manufactured by Medicrea, a French company whose spinal implant products are used in lumbar and cervical fusion. The PASS Poly-Axial Spinal System, designed and manufactured by Medicrea, consists of a lumbar pedicle screw system used to achieve fusion of the spine. In addition, we recently introduced the Cyclone Anterior Cervical Plate used in cervical spine fusion. In 2003, sales of spinal products accounted for approximately 9.4% of our total Surgical Division sales.

Chattanooga Group Division

Our Chattanooga Group Division is a leading provider of rehabilitation products used by a variety of healthcare professionals involved in the field of physical medicine. In 2003, sales of our Chattanooga Group Division were as broken down as follows: patient care products accounted for 46.9% sales; electrotherapy products, including the new dysphagia products accounted for 31.4% of sales; physical therapy tables and traction products accounted for 14.9% of sales; and chiropractic products accounted for 6.8% of sales. The following table summarizes many of our current Chattanooga Group Division product offerings:

Soft Goods Division

Our Soft Goods Division offers orthopedic soft goods, patient safety devices and patient care products, which are used to assist in the repair and rehabilitation of soft tissue and bone, to protect patients from injury and to aid patients in their recovery from orthopedic trauma and surgery. In 2003, sales for our Soft Goods Division were broken down as follows: orthopedic soft goods products accounted for 63.4% of sales, patient safety devices accounted for 29.8% of sales, and pressure care products accounted for 6.8% of sales. The following table summarizes many of our current Soft Goods Division product offerings:

RESEARCH AND DEVELOPMENT

Our research and development programs focus on the development of new products, as well as the enhancement of existing products with the latest technology and updated designs. We are continually seeking to develop new technologies to improve durability, performance and usability of existing products. In addition to our own research and development, we receive new product and invention ideas, especially in procedure-specific areas, from orthopedic surgeons, inventors and other orthopedic specialists. For ideas that we deem promising from a clinical and commercial perspective, we seek to obtain rights to these ideas through entering into either assignment or licensing agreements. We conduct research and development programs at our facilities in Austin, Texas and Chattanooga, Tennessee.

We spent approximately $5.0 million in 2003, $3.4 million in 2002, and $1.7 million in 2001 for research and development. As of December 31, 2003, our research and development department had 38 employees.

MARKETING AND SALES

Each of our three divisions has developed its own sales and distribution channels. The combination of these three divisions provides us the opportunity to sell our products to a variety of treatment settings across new and potentially complementary distribution networks.

Surgical Division

Our Surgical Division products are currently marketed and sold in the United States to hospitals and orthopedic surgeons through a network of 115 independent commissioned sales representatives who cover territories in all or part of approximately 35 states. We are actively recruiting sales agents and representatives to continue to expand the geographic areas in which we sell. Generally, our sales representatives sell either reconstructive and trauma products or spinal products. However, a few of our sales representatives sell all of these products. Sales agents are generally granted a contract with a term of one to five years. Additional representatives work for these agents. Agents are typically paid a sales commission and are eligible for bonuses if sales exceed certain preset objectives. We assign our sales agents to an exclusive sales territory. Substantially all of our sales agents agree not to sell competitive products. Typically we can terminate our agreements with sales agents prior to the expiration of our agreements only with “cause,” which includes failure to meet specified periodic sales targets. The few sales agents who are permitted to sell competitive products are terminable at will. We provide our agents with product inventories on consignment for their use in marketing our products and for filling customer orders.

Outside the United States, our surgical products are sold through distributors principally in Europe and Japan. While we previously had a distribution arrangement that covered substantially all of Europe, we terminated our relationship with that European distributor in the fourth quarter of 2000 because, based on the decline in European sales by that distributor, we determined that over time we could develop a more effective European distribution network on a country-by-country basis. In Japan, Senko Medical Trading Co. carries our total joint products and most of our trauma products while the rest of our trauma products are sold by Century Medical, Inc. During 2003, we added three new distributors in Germany, Greece, and Venezuela which began carrying our total joint products.

To a significant extent, sales of our surgical products depend on the preference of orthopedic surgeons and other sports medicine professionals. We have developed and maintained close contractual relationships with a number of widely recognized orthopedic surgeons who not only assist us with designing our products, but who also assist us in marketing our products. These orthopedic surgeons may give demonstrations utilizing our products, assist in the development of our marketing materials, participate in symposia addressing both clinical and economic aspects of our products, speak about our products at medical seminars, train other surgeons in the use and implantation of our products, and provide us with feedback on the industry’s acceptance of our products. Surgeons who assist us in designing our products are generally compensated with a royalty. Our consulting surgeons, depending on the particular services provided in support of our products, are paid consulting fees for their services. As a portion of their compensation, these surgeons may also receive stock options under our 1997 Surgeon Advisory Panel Stock Option Plan.

Chattanooga Group Division

Our rehabilitation products are currently marketed and sold through a worldwide network of over 6,000 dealers, which are managed by our internal sales people. These dealers sell Chattanooga Group Division products to a variety of healthcare professionals including physical therapists, athletic trainers, chiropractors and sports medicine physicians. Except for distributors outside of the United States, the Chattanooga Group Division does not maintain formal distribution contracts. In addition, no particular distributor accounts for more than 4.7% of Chattanooga Group Division sales. Distributors purchase products from Chattanooga Group Division at discounts ranging from 30% to 50% off the published list price. We maintain an internal marketing and sales support program to support our dealer network. This network is comprised of a group of individuals who provide dealer and end-user training, develop promotional materials, and attend over 30 trade shows each year.

Soft Goods Division

Our Soft Goods Division products are sold primarily to hospitals through third-party distributors. These distributors include large, national third-party medical/surgical distributors such as Cardinal Health, Owens & Minor, Inc., McKesson, the Henry Schein companies and Physician Sales and Service (PSS), regional medical/surgical distributors such as The Burrows Company and Professional Hospital Supply, and medical product buying groups. These distributors generally resell the products to hospitals, hospital buying groups, integrated delivery networks, primary care networks and orthopedic physicians for use by patients. In addition, we have entered into national or regional contracts to sell our products to large healthcare providers and group purchasing organizations, such as Consorta, Concentra, Broadlane, MedAssets HSCA, Amerinet, and the United States government. Under these contracts, we provide discounted pricing to the buying groups and are designated to the members of the particular buying group as an authorized, and sometimes preferred, source for specific products. Because members of these buying groups are not obligated to purchase our products, we utilize an independent commissioned sales force to market our products directly to the members of these buying groups. Our Soft Goods Division has limited international sales to distributors in Canada, England, Puerto Rico, France, Portugal and several other countries. We leverage the sales and distribution of our Soft Goods Division products to build brand awareness and strengthen our reputation in markets targeted for the sale of higher priced Surgical Division products.

MANUFACTURING

We use both in-house manufacturing capabilities and relationships with third-party vendors to supply our products. Generally, we use third-party vendors that have special manufacturing capabilities. In addition, we use third party vendors when we believe it is appropriate based on certain factors, including our in-house capacity, lead time control, and cost control. We believe there are alternate sources for all our vendors and suppliers and believe that adequate capacity exists at our current suppliers to meet all of our anticipated needs.

Surgical Division

Our in-house capacity for our Surgical Division includes computer controlled machine tools, belting, polishing, cleaning, packaging and quality control. We obtained internationally recognized ISO 9001 qualification and the European Community Medical Device Directive “CE” certification for this division in 1996. Our U.S. manufacturing operations also comply with FDA QSR regulations. The primary raw materials used in the manufacture of our surgical products are cobalt chromium alloy, stainless steel alloys, titanium alloy and ultra high molecular weight polyethylene. All Surgical Division implants and instruments go through in-house quality control, cleaning and packaging operations. Quality control measures begin with an inspection of raw materials and castings prior to use, and pieces are inspected at various intervals in the manufacturing process. As a final step, our products pass through a “clean room” environment designed and maintained to clean our products and reduce product exposure to particulate matter and bio burden.

Chattanooga Group Division

Our Chattanooga Group Division manufactures products which account for a majority of that division’s sales in its manufacturing facilities located in Chattanooga, Tennessee. These facilities are capable of utilizing various manufacturing processes, including metal fabrication, coating, electronic assembly, mechanical assembly, wood working, sewing and a variety of others. The manufacturing facilities for our Chattanooga Group Division are ISO 9001 certified. Our U.S. manufacturing operations for rehabilitation equipment products also comply with FDA QSR regulations. We utilize Asian subcontractors to manufacture a significant amount of our electronic components.

Soft Goods Division

For our Soft Goods Division, we supply all of the raw materials and equipment necessary to make our products to a manufacturing supplier in Mexico. They in turn supply the labor component necessary to assemble and finish our soft goods products. This vendor employs the laborers and manages the assembly process, subject to the supervision of our onsite personnel. We currently have no manufacturing operations in any foreign country other than Mexico. We entered into our agreement with the manufacturer located in Acuna, Mexico, on July 1, 2001. That agreement remains in effect through June 30, 2004, and may be renewed for a term of one to three years by mutual agreement between us and the manufacturer. We pay the manufacturer based on labor hours, and we have promised to purchase from the manufacturer a minimum of $506,250 of labor per year.

AFFILIATED SURGEONS

A key aspect in our development, marketing and sale of our surgical products is the use of designing and consulting surgeons. Each major product is supported by several designing surgeons who assist us not only with the design of the product, but who also give demonstrations using the product, assist in developing marketing materials and participate at symposia addressing both clinical and economic aspects of the product. These professionals often assist the Company by, speaking about our products at medical seminars, assisting in the training of other professionals in the use and implantation of these products and providing us with feedback on the industry’s acceptance of our products. We also have established relationships with consulting surgeons who perform various consulting services for us. Such services include conducting clinical studies on various products, analysis of economic issues relating to use of the products, establishment of protocols for use of the products and participation at various symposia. The designing surgeons working on a product are compensated with a royalty, which is typically split among the group members. Consulting surgeons are also paid consulting fees for their services to us in support of our products. The designing and consulting surgeons may also receive stock options.

INTELLECTUAL PROPERTY

We hold numerous United States and foreign patents covering a wide range of our products. We own a majority of these patents and have licensed rights to the remainder, either on an exclusive or non-exclusive basis. The quantity of intellectual property we own significantly increased as a result of our acquisition of Chattanooga Group, Inc. and our purchase of our orthopedic soft goods product lines from Kimberly-Clark Corporation. We have over 50 trademarks registered in the United States, a number of which are also registered in countries around the world, such as China, Japan, Australia, Germany, Switzerland, Austria, and/or other countries in the European Community. We also assert ownership of numerous unregistered trademarks, some of which have been submitted for registration in the United States and foreign countries. In the future, we will apply for such additional patents and trademarks as we deem appropriate. However, we cannot guarantee whether our existing or future patents, if any, will afford adequate protection, whether any existing patent applications will result in issued patents, or whether our patents will be circumvented or invalidated.

Additionally, we seek to protect our non-patented know-how, trade secrets, processes and other proprietary confidential information, through a variety of methods, including having our employees and consultants sign invention assignment agreements and confidentiality agreements and having our independent sales agents and distributors sign confidentiality agreements. However, these methods may not provide us with adequate protection. Because many of our products are regulated, proprietary information created during our development of a new or improved product may have to be disclosed to the FDA or another U.S. or foreign regulatory agency in order to have the lawful right to market such product. Our proprietary information may also become known to, or be independently developed by, our competitors, or our proprietary rights in intellectual property may be challenged, any of which could have a material adverse effect on our business, financial condition and results of operations.

We have distribution rights to certain products that are manufactured by others and hold both exclusive and nonexclusive licenses under third party patents and trade secrets that cover some of our existing products and products under development. As of December 31, 2003, sales from these distribution agreements and licenses represent a small portion of our overall sales.

There can be no assurance that the validity of any of the patents or other intellectual property owned by or licensed to us would be upheld if challenged by others in litigation. Due to these and other risks described previously, we do not rely solely on our patents and other intellectual property to maintain our competitive position. We believe that development of new products and improvement of existing ones is and will continue to be more important than having our products covered by patents in maintaining our competitive position.

COMPETITION

The market for orthopedic products is highly competitive and somewhat fragmented. Some of our competitors, either alone or in conjunction with their respective parent corporate groups, have research and development, sales, marketing and manufacturing capabilities that are larger than ours, which could provide those companies with a competitive advantage over our company. Recently, product pricing has become increasingly important as a competitive factor, particularly due to governmental and third-party payors’ adoption of prospective payment systems.

Due to the prior success of our Surgical Division and the market leadership of our Chattanooga Group Division, our history of innovative product development, and the extensive experience of our management team, we believe we are capable of effectively competing in the orthopedic market in the future. Further, the comprehensive range of products we offer enables us to reach a diverse customer base and to utilize multiple distribution channels in an attempt to fuel our growth across the orthopedic market. Further, our recent acquisitions in the rehabilitation area, continue to fuel name recognition of our company and our products.

Surgical Division

The market for orthopedic products similar to those produced by our Surgical Division is dominated by a number of large companies, including Biomet, Inc., DePuy, Inc. (a Johnson & Johnson company), Medtronic, Inc., Smith & Nephew, Stryker Corporation, and Zimmer Holdings, Inc. Our Surgical Division also faces competition from companies in size similar to ours, such as Wright Medical Technology, Inc. and Exactech Inc.

Many of our larger competitors offer a wider range of products than those offered by our Surgical Division, and many of their products have the endorsement of leading orthopedic surgeons. Due to recent advances, new technologies and product concepts have been introduced into the orthopedic market at an increasingly rapid rate. Often, new technologies and product concepts are introduced before the previous technologies and concepts have been fully integrated into the orthopedic market. Due to the increasing costs of research and development related to these recent advances, many of our competitors have entered into various agreements and joint ventures with each other, which may allow them to develop innovative products while sharing the research and development costs. As a result, our competitors who enter into such agreements may have a competitive advantage over our Surgical Division. It is the opinion of our management that this evolution in our industry of high technology products will continue for the foreseeable future.

Chattanooga Group Division

While in many rehabilitation market segments, the Chattanooga Group Division holds a leading market share position, its primary competitors in the rehabilitation marketplace are Dynatronics Corporation, Mettler Electronics Corporation, Richmar Corporation, Ability One Products Corp., (a wholly owned subsidiary of Patterson Dental Company), Enraf-Nonius B.V., and Acorn Engineering Company.

Soft Goods Division

Competitors in the soft good products segment of the orthopedic market include DeRoyal Industries, Inc., dj Orthopedics, Inc., and Zimmer Holdings, Inc. Competition in the patient safety product segment includes DeRoyal Industries, Inc. and the Posey Company.

GOVERNMENT REGULATION

Our products are subject to rigorous government agency regulation in the United States and certain other countries. In the United States, the FDA regulates the testing, labeling, manufacturing and marketing of medical devices to ensure that medical products distributed in the United States are safe and effective for their intended uses. The FDA also regulates the export of medical devices manufactured in the United States to international markets. Most of our medical devices are subject to such FDA regulation.

Under the Food, Drug and Cosmetic Act, as amended, medical devices are classified into one of three classes depending on the degree of risk imparted to patients by the medical device. Class I devices are those for which safety and effectiveness can be assured by adherence to General Controls, which include compliance with Quality System Regulations (“QSRs”), facility and device registrations and listings, reporting of adverse medical events, and appropriate truthful and non-misleading labeling, advertising and promotional materials. Some Class I devices also require pre-market review and clearance by the FDA through the 510(k) Pre-market Notification process described below. Class II devices are subject to General Controls, as well as pre-market demonstration of adherence to certain performance standards or other special controls as specified by the FDA. Pre-market review and clearance by the FDA is accomplished through the 510(k) Pre-market Notification procedure. In the 510(k) Pre-market Notification procedure, the manufacturer submits appropriate information to the FDA in a Pre-market Notification submission. If the FDA determines that the device is “substantially equivalent” to a device that was legally marketed prior to May 28, 1976, the date upon which the Medical Device Amendments of 1976 were enacted, or to another similar commercially available device subsequently cleared through the 510(k) Pre-market Notification process, it will grant clearance to commercially market the device. It generally takes three to six months from the date of submission to obtain clearance of a 510(k) Pre-market Notification submission, but the process may take longer. If the FDA determines that the device, or its “labeled” intended use, is not “substantially equivalent,” the FDA will automatically place the device into Class III.

A Class III product is a product that has a wholly new intended use or is based on advances in technology for which the device’s safety and effectiveness cannot be assured solely by the General Controls, performance standards and special controls applied to Class I and II devices. These devices often require formal clinical investigation studies to assess their safety and effectiveness. A Pre-market Approval (“PMA”) from the FDA is required before the manufacturer of a Class III product can proceed in marketing the product. The PMA process is much more extensive than the 510(k) Pre-market Notification process. In order to obtain a PMA, Class III devices, or a particular intended use of any such device, must generally undergo clinical trials pursuant to an application submitted by the manufacturer for an Investigational Device Exemption (“IDE”). An IDE allows the investigational device to be used in a clinical study in order to collect safety and effectiveness data required to support a PMA application or a 510(k) Pre-market Notification submission to the FDA. Only a small percentage of 510(k)Pre-market Notification submissions require clinical data to support the application. Investigational use also includes clinical evaluation of certain modifications or new intended uses of legally marketed devices. All clinical evaluations of investigational devices, unless exempt, must have an approved IDE before the study is initiated. An approved IDE permits a device to be shipped lawfully for the purpose of conducting investigations of the device without complying with other requirements of the Food, Drug and Cosmetic Act that would apply to devices in commercial distribution.

When a manufacturer believes that sufficient pre-clinical and clinical data have been generated to substantiate the safety and efficacy of the new device or new intended use, it may submit a PMA application to the FDA. An FDA review of a PMA application generally takes one to two years from the date the PMA application is accepted for filing, but the process may take significantly longer. In approving a PMA application, the FDA may also require some form of post-market surveillance whereby the manufacturer follows certain patient groups for a number of years, making periodic reports to the FDA on the clinical status of those patients. This helps to ensure that the long-term safety and effectiveness of the device are adequately monitored for adverse events. Most pre-amendment devices (those marketed prior to the enactment of the Medical Device Amendment of 1976) are, in general, exempt from such PMA requirements, as are Class I and Class II devices.

Our products include both pre-amendment and post-amendment Class I, II and III medical devices. All currently marketed devices hold the relevant exemptions or pre-market clearances or approvals, as appropriate, required under federal medical device law.

Our manufacturing processes are also required to comply with QSR regulations that cover the methods and documentation of the design, testing, production, control, quality assurance, labeling, packaging and shipping of our products. Further, our facilities, records and manufacturing processes are subject to periodic unscheduled inspections by the FDA or other agencies. Failure to comply with applicable U.S. medical device regulatory requirements could result in, among other things, warning letters, fines, injunctions, civil penalties, repairs, replacements, refunds, recalls or seizures of products, total or partial suspensions of production, refusal of the FDA to grant future pre-market clearances or approvals, withdrawals or suspensions of current clearances or approvals and criminal prosecution. Currently, we have no adverse regulatory compliance issues or actions pending with the FDA, and no FDA QSR audits conducted at our facilities have resulted in any adverse compliance enforcement actions.

We must obtain export certificates from the FDA before we can export certain of our products and are subject to regulations in many of the foreign countries in which we sell our products. These include product standards, packaging requirements, labeling requirements, import restrictions, tariff regulations, duties and tax requirements. Many of the regulations applicable to our devices and products in such countries are similar to those of the FDA. The national health or social security organizations of certain countries require our products to be qualified before they can be marketed in those countries. To date, we have not experienced any difficulty in complying with these regulations.

We have implemented policies and procedures allowing us to position ourselves for the changing international regulatory environment. The ISO 9001 and ISO 13485 standards have been developed as internationally recognized guidelines that are aimed at ensuring the design and manufacture of quality products. A company that passes an ISO audit and obtains ISO certification becomes internationally recognized as operating under a competent quality system. A “CE” mark is a European system of adherence to the European Medical Device Directive. The European Community promulgaged rules requiring medical products to receive a CE Mark by mid 1998. The Surgical Division and the Chattanooga Group Division have received ISO 9001 and ISO 13485 certification and thereby are allowed to place a “CE” mark on our products.

Certain provisions of the Social Security Act, commonly known as the “Medicare Fraud and Abuse Statute,” prohibit entities, such as ours, from offering, paying, soliciting or receiving any form of remuneration in return for the referral of Medicare or state health program patients or patient care opportunities, or in return for the recommendation, arrangement, purchase, lease or order of items or services that are covered by Medicare or state health programs. Violation of this statute is a felony, punishable by fines of up to $25,000 per violation and imprisonment of up to five years. In addition, the U.S. Department of Health and Human Services may impose civil penalties excluding violators from participation in Medicare or state health programs. Many states have adopted similar prohibitions against payments intended to induce referrals of Medicaid and other third-party payor patients.

Subject to certain exemptions, federal physician self-referral legislation prohibits a physician or a member of his immediate family from referring Medicare or Medicaid patients to an entity providing “designated health services” in which the physician has an ownership or investment interest, or with which the physician has entered into a compensation arrangement. Penalties for violations include a prohibition on payment by these government programs and civil penalties of as much as $15,000 for each referral in violation of the statute and $100,000 for participation in a “circumvention scheme.”

EMPLOYEES

As of December 31, 2003, we had approximately 450 employees. Our workforce is not unionized. We have not experienced any strikes or work stoppages and our management considers our relationship with our employees to be good.

RISK FACTORS

You should carefully consider the following risk factors, in addition to the other information contained in this annual report. Investing in our common stock involves a high degree of risk and you may lose part or all of your investment in our shares. Please read the section on “Forward Looking Statements.”

We have a history of net losses and may not be profitable in the future.

We have had a history of net losses. For the year ended December 31, 2003, we incurred a net loss of approximately $2.5 million, which included approximately $7.7 million ($5.5 million after tax) in prepayment penalties and unamortized warrant and debt issuances costs associated with prepayment of our outstanding debt. For the year ended December 31, 2002 our net income was $6,000. Our net income for the year ended December 31, 2001 was $548,000, excluding a $3.7 million charge resulting from the issuance of 132,353 shares of our Series A Preferred Stock on June 12, 2001. We incurred a net loss of $3.2 million attributable to our common stock for the year ended December 31, 2001. We cannot assure you that we will not continue to incur net losses for the foreseeable future, which could cause our stock price to decline and adversely affect our ability to finance our business in the future. For additional information, you should read the discussion under “Item 7: Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

If we fail to compete successfully against our competitors, our sales and operating results may be negatively affected and we may not achieve future growth.

The markets for our products are highly competitive. The market for our Surgical Division products is dominated by a small number of large companies. In each of our other divisions, there are both large and small companies with which we compete. We may not be able to meet the prices offered by our competitors or offer products similar to or more desirable than those offered by our competitors. Many of our competitors have:

The factors set forth above may be material to our ability to develop and sell our products. Our failure to compete effectively in developing and selling our products would have an adverse effect on our results of operations.

Our future success requires the continued development or licensing of new products and the enhancement of existing products.

The market for orthopedic devices and related products is characterized by new product development and corresponding obsolescence of existing products. Our competitors may develop new medical procedures, technology or products that are more effective than our current technology or products or that render our technology or products obsolete or uncompetitive, which could have a material adverse effect on us. We may not be able to develop successful new products or enhance existing products, obtain regulatory clearances and approval of such products, market such products in a commercially viable manner or gain market acceptance for such products. The failure to develop or license and market new products and product enhancements could materially and adversely affect our competitive position, which could cause a significant decline in our sales and profitability.

We rely on independent sales agents and third-party distributors to market and sell most of our products. If we fail to establish new sales and distribution relationships or maintain our existing relationships, or if our independent sales agents and third-party distributors fail to commit sufficient resources or are otherwise ineffective in selling our products, our results of operations and future growth will be adversely impacted.

Our success depends largely upon marketing arrangements with our independent sales agents and distributors. These persons may terminate their relationships with us or devote insufficient sales efforts to our products. We do not control the efforts these persons make to sell our products. Our failure to attract and retain skilled independent sales agents and distributors would have an adverse effect on our results of operations.

We anticipate that a significant portion of the growth in our Surgical Division will require affiliating with additional sales agents. We will face significant challenges and risks in training, managing and retaining additional qualified sales and marketing agents. We may not be able to retain a sufficient number of additional qualified personnel to create increased demand for our products. If we are unable to grow effectively our sales and marketing team to sell our orthopedic devices and related products, our growth may be negatively affected.

Our quarterly operating results are subject to substantial fluctuations, and you should not rely on them as an indication of our future results.

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

Our quarterly sales and operating results have varied significantly in the past three years primarily as a result of our July 2001 acquisition of the assets which now comprise our Soft Goods Division and our acquisition of Chattanooga Group, Inc. in February 2002. We believe that quarterly sales and operating results may vary significantly in the future. Period-to-period comparisons of our results of operations are not necessarily meaningful and should not be relied upon as indications of future performance. We cannot assure you that our sales will increase or be sustained in future periods or that we will be profitable in any future period. Any shortfalls in sales or earnings in any given period from levels expected by securities or industry analysts could have an immediate and significant adverse effect on the trading price of our common stock, and any other of our securities which we may issue in the future.