UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

FORM 10-K

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

For the fiscal year ended December 31, 2004

o 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

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

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

None

Securities registered pursuant to section 12(g) of the Act:

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

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

     Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2).
     Yes þ No o

     The aggregate market value of common stock held by non-affiliates of Encore Medical Corporation as of July 3, 2004, the end of the registrant’s second fiscal quarter, was $ 198,926,559 based on a per share price of $ 6.27. As of March 1, 2005, the registrant had 52,214,205 shares of its common stock outstanding.

ENCORE MEDICAL CORPORATION
Annual Report on Form 10-K
For the year ended December 31, 2004

TABLE OF CONTENTS

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NOTE ON INCORPORATION BY REFERENCE

     Information pertaining to certain Items in Part III of this report is incorporated by reference to portions of the Company’s definitive Proxy Statement for its 2005 Annual Meeting of Stockholders to be filed within 120 days after the end of the year covered by this annual report of Form 10-K, pursuant to Regulation 14A.

FORWARD-LOOKING STATEMENTS

     This annual report on Form 10-K of Encore Medical Corporation for the year ended December 31, 2004 contains forward-looking statements, principally in the sections entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Business.” Generally, you can identify these statements because they use words like “anticipates,” “believes,” “expects,” “future,” “intends,” “plans,” and similar terms. These statements reflect only our current expectations. Although we do not make forward-looking statements unless we believe we have a reasonable basis for doing so, we cannot guarantee their accuracy, and actual results may differ materially from those we anticipated due to a number of uncertainties, many of which are unforeseen, including, among others, the risks we face as described on the following pages and elsewhere in this filing. You should not place undue reliance on these forward-looking statements, which apply only as of the date of this annual report. These forward-looking statements are within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, and are intended to be covered by the safe harbors created thereby. To the extent that such statements are not recitations of historical fact, such statements constitute forward-looking statements that, by definition, involve risks and uncertainties. In any forward-looking statement, where we express an expectation or belief as to future results or events, such expectation or belief is expressed in good faith and believed to have a reasonable basis, but there can be no assurance that the statement of expectation or belief will be achieved or accomplished.

     We believe it is important to communicate our expectations to our investors. There may be events in the future, however, that we are unable to predict accurately or over which we have no control. The risk factors listed on the following pages, as well as any cautionary language in this annual report, provide examples of risks, uncertainties and events that may cause our actual results to differ materially from the expectations we describe in our forward-looking statements. The following are factors that could cause actual results or events to differ materially from those anticipated, and include, but are not limited to: general economic, financial and business conditions; the success and costs of advertising and promotional efforts; changes in and compliance with governmental healthcare and other regulations; changes in tax laws; the ability to obtain financing for one or more acquisitions; the ability to successfully complete and integrate one or more acquisitions; technological obsolescence of one or more products; changes in product strategies; the availability of management personnel and other important employees; and the costs and effects of legal proceedings.

     The following, which are used in this annual report, are either (i) our registered trademarks or trademarks for which we have pending applications or common law rights to, or (ii) registered trademarks or pending trademarks for which we have licenses to use:

3D Matrix^®, 300PV ^TM , 911 First Response^®, ActionPatch ^® , Adapta^®, Advance Dynamic ROM ^® , Artromot ^® , Auto-Flex^®, Auto-Trac^™, B.A.T.H.^™, Cellex^™, Chattanooga^™, Chattanooga and Graphic^™ (Columbian app), Chattanooga Europe^™, Chieftain^®, Clear Cut^™, ColPaC^®, Cover-Sling^®, CPS^™, Cyclone^™, Cyclone (and design) ^™, Cyclone ACP^™, DTS^™, Dupel ^® , Dupel B.L.U.E. ^® , Dura-Stick^®, Dura-Stim^™, EMG Retrainer^®, E Encore (and design) ^™, E2 Fix^®, Empi ^® , Empi Europe ^TM , Encore^®, Encore Orthopedics (and design)^®, EPIK^®, Epix XL ^® , Epix VT ^® , ErgoBasic^™, ErgoStyle^™, ErgoWave^®, ES 2000^™, Ever Green Because It’s Our World Too^®, Excelerator^™, FlexiPAC^®, Fluido^™, Fluidotherapy^®, Focus ^® , Foundation^®, HotPac^™, Hydrocollator^®, Hydrocollator (and design)^®, Hydrocollator Colpac^®,Industry’s Choice^®, Intelect^®, Intelect Legend^™, Intellect Transport^™, Isobar^™, Kallassy Ankle Support^®, Keramos^™, Keramos (and design) ^™, Keystone^®, Linear^®, Maximum Poly^®, Mobile Bearing Knee System™, Myossage^®, Navigator^®, Nylatex^®, OptiFlex^®, OptiFlex S^™, Opti-Ice^™, Ormed ^® , Osteomill^®, Para-Care^®, PASS^™, Power Flex^®, PowerPlay^™, PresSsion^®, Pre-Vent^™, RAM^™, Quick-fit^™, Rebound^®, Rehab Med+Equip ^TM , Revelation^®, Reverse Shoulder Prosthesis^®, Reverse (stylized)^™, RSP^®, Secure-All^®, Sensaflex^™, Spinalator^®, Sports Supports^®, Sports Supports (and design) ^®, Stabilizer^™, Stamina^®, Stealth^®, Steam Pack^®, TheraTherm^®, 3DKnee^™, Triax^®, Triton^®, True/Fix^®, True/Flex^®, Tru/Lok^™, Tru-Trac^®, Turtle Neck^®, TX^®, Vectra^®, Vectra Genisys^™, Vitality^®, VitalStim^™, Warm’n Form^®, Wellness by Design^®, and WRIGHTLOCK^®.

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PART I.

Item 1. Business

Overview

     Encore Medical Corporation, a Delaware corporation, and our wholly owned subsidiaries (collectively referred to as “us,” “we,” “our,” “our company,” “the Company,” or “Encore”), is a diversified orthopedic device company with leading positions in many of the markets in which we compete. We develop, manufacture and distribute a comprehensive range of high quality orthopedic devices, including surgical implants, sports medicine equipment and products for orthopedic rehabilitation, pain management and physical therapy. We believe that with our acquisition of Empi, Inc. (“Empi”) in October 2004, we created the first orthopedic products company that provides a comprehensive continuum of products for the needs of orthopedic surgical and rehabilitation patients.

     Our products are used by orthopedic surgeons, physicians, physical and occupational therapists and other healthcare professionals to treat patients with musculoskeletal conditions resulting from degenerative diseases, deformities, and sports-related injuries, and our non-invasive medical devices and related accessories are primarily used by patients for at-home physical therapy. We categorize our products into the following product lines:

	•	Surgical Implant Products. Our surgical implant products, which are provided by our Surgical Implant Division, including reconstructive joint products, such as knee, hip, shoulder and spinal implants are used across the major segments of the orthopedic surgical market.
	•	Orthopedic Rehabilitative Products. Our orthopedic rehabilitative products, which are provided by our Orthopedic Rehabilitation Division, include electrotherapy devices and accessories used to treat pain and restore and maintain muscle function, iontophoretic devices and accessories used to treat pain, restore muscle function and deliver medication, clinical therapy tables and traction equipment, orthotics devices used to treat joint and spine conditions, and soft goods products used before and after surgery to assist in the repair and rehabilitation of soft tissue and bone and to protect against injury.

     Throughout our history, we have emphasized research and development activities designed to expand the product lines we offer. Since our inception, we have developed and obtained regulatory approval for over 100 products and product improvements. We continue to develop new products to enhance our organic growth. For example, we commercially introduced several new products in 2004, including our Keramos ceramic-on-ceramic acetabular hip implant, our Vectra Genesis electrotherapy product line, and our new orthopedic therapy laser devices, which we will market as part of our clinical electrotherapy and therapeutic ultrasound product lines. In addition, we are currently engaged in ongoing clinical trials involving our Mobile Bearing Knee system and Reverse Shoulder Prosthesis.

     We have used strategic business acquisitions to broaden our product offering and to increase our customer base. Since July 2001, we have completed several significant acquisitions that have allowed us to expand our business, access a wider range of distribution partners and sell our existing products to an expanded customer base. With the completion of these acquisitions, we believe we provide a comprehensive range of orthopedic devices, rehabilitation equipment and related products to orthopedic specialists operating in a variety of treatment settings.

     Most recently, on October 4, 2004, we acquired Empi, a manufacturer, marketer and distributor of pain management, orthopedic rehabilitation, and physical therapy products, for a total purchase price of approximately $369.8 million. The Empi acquisition expanded our product line and geographic presence to include European operations. We believe that our acquisition of Empi creates the first orthopedic company that can provide a comprehensive continuum of care for surgical and rehabilitation patients.

Industry Background

Our Market Opportunity

     Sales of orthopedic implants and devices in the United States were estimated to be approximately $8.7 billion in 2003 and are expected to grow to $17.9 billion by 2009, which represents a compounded annual growth rate of 12.5%, according to a 2004 survey conducted by Business Communications Co., Inc. We participate in the knee, hip and spinal implant, sports medicine and rehabilitation products segments of the overall orthopedic products market. Several factors are driving growth in the orthopedic products industry, including, but not limited to:

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•	Favorable demographics. An aging population is driving growth in the orthopedic products market. For example, a majority of reconstructive implants are performed on patients who are aged 65 and over. As a result of the aging of the baby boomer generation, the percentage of the U.S. population aged 65 and over is expected to grow from 12.4% in 2000 to 13.0% in 2010 and 16.3% by 2020, representing an increase of 5.2 and 14.4 million people, respectively, during these periods according to a 2004 U.S. Census Bureau projection. In addition, according to the National Center for Health Statistics of the Center for Disease Control, the average life expectancy in the United States increased from 75.8 years in 1992 to 77.3 years in 2002. As people continue to live longer lives, we believe the number of injuries requiring reconstructive implants and orthopedic rehabilitation will continue to increase.
•	Growing emphasis on physical fitness and leisure sports has led to an increase in injuries. A 2000 U.S. Consumer Product Safety Commission survey determined that from 1991 to 1998 there was a 33% increase in the number of sports-related injuries among people aged 35 to 54. We believe as people lead more active lives, the number of sports-related injuries will continue to increase, leading to a continued rise in the use of physical therapy as a treatment.
•	Improving technologies for surgical implant products. Advances in technologies and procedures have expanded the scope and applications of products competing in the orthopedic products market. For example, joint reconstruction historically has been reserved for older patients who tend to be less active and who typically place less stress on their implants. However, with new technologies that prolong the expected life of orthopedic implants and conserve patients’ existing bone, surgeons are increasingly able to perform joint reconstruction on younger and more active patients. We believe our new ceramic-on-ceramic acetabular hip implant, that we introduced in 2004, is an example of a product that will expand the market for surgical implant products to younger and more active patients. In addition to increasing unit volume, products developed from new technologies typically command a higher price compared to traditional implants.
•	Increased surgical implant replacement procedure volume. According to data compiled by Millennium Research Group of Toronto, Ontario, the U.S. hip and knee implant market grew approximately 14.5% from 2002 to 2003 to $3.4 billion. The U.S. market for spinal implants and devices in spinal surgery grew approximately 18.7% between 2003 and 2004 to over $3.3 billion. Additionally, we believe that implant replacement or revision procedures represent a growing proportion of total reconstructive procedures and typically command higher prices than other reconstructive procedures. With the average lifespan of many reconstructive joint implants estimated at 15 to 20 years, many of the implants administered in the late 1980s will be due for replacement in the near future.
•	Increased orthopedic surgical volume results in increased need for rehabilitation. The combination of factors such as an aging population, increased sports-related injuries and improvements in orthopedic surgical technologies has led to increases in the number of orthopedic surgeries performed. An increase in orthopedic surgical volume is expected to result in an increased need for rehabilitative therapy and orthopedic rehabilitation products to recover from such surgeries.
•	Shift toward at-home physical therapy. We believe the physical rehabilitation market is shifting toward home treatment alternatives. This shift has been driven by several factors, including payor cost containment efforts that seek to reduce clinic visits and to accommodate patients’ preference for therapies that can be conveniently administered at home. We believe that because many of our orthopedic rehabilitative products are designed for at-home use with an emphasis on quality, cost- effectiveness and convenience, we will be able to capitalize on this shift toward at-home physical therapy. We believe that currently only a small portion of physical therapy products are designed for at-home use and that there remains significant growth potential for the at-home physical therapy market.
•	Increasing awareness and use of non-invasive devices for treatment and rehabilitation. We believe the growing awareness and clinical acceptance by healthcare professionals and patients of the benefits of non-invasive treatment and rehabilitation products will continue to drive demand for these products. We believe that growth in sales of iontophoretic devices and electrotherapy solutions, for example, will be driven by increased awareness of the benefits of non-invasive drug delivery products over invasive delivery systems for certain joint inflammation, anesthesia delivery applications and other pain control solutions.
•	Cost containment initiatives by third-party payors. With the cost of healthcare rising in the United States and internationally, third-party payors are challenged to seek more cost-effective therapies without reducing the quality of care. We believe that some of our orthopedic rehabilitation products offer lower-cost alternatives to surgery and traditional forms of physical therapy and pain management.

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Our Competitive Strengths

          We believe we have a number of competitive strengths that will enable us to further enhance our position in the orthopedic products market.

	•	Leading market positions. We have a leadership position in many of the markets in which we compete and we believe that our products have recognized brand names with a reputation for quality, durability and reliability among healthcare professionals. Both Empi and Chattanooga Group, Inc., the company we acquired in 2002, each of which now comprise part of our Orthopedic Rehabilitation Division, have been marketing physical therapy products for over 25 years. We believe that we have a leading market share in the clinical electrotherapy, transcutaneous electrical nerve stimulation (TENS), iontophoresis, neuromuscular electrical stimulation (NMES), and orthotics markets in the United States and the continuous passive motion (CPM) device markets in the United States and Germany.
	•	Comprehensive range of surgical implant and orthopedic rehabilitation products. We offer a comprehensive range of surgical implant products, orthopedic devices, sports medicine equipment and other related products to orthopedic specialists servicing a variety of treatment settings. The breadth of our product line enables us to provide orthopedic surgeons, physical and occupational therapists, other orthopedic healthcare professionals and their patients a wide range of products to address their requirements and preferences. For example, we received Food and Drug Administration (FDA) clearance for our Keramos ceramic-on-ceramic acetabular hip implant in December 2003 and commercially introduced this product in 2004. Ceramic-on-ceramic is a new technology focused on addressing implant wear, an area of concern in the orthopedic products industry. We now offer metal-on-metal, metal combined with polyethylene and ceramic-on-ceramic acetabular hip implants, which we believe provides implant surgeons with a broad range of product choices.
	•	New product development capabilities. We have an experienced research and development team with proven expertise in the design and development of new products as well as in the enhancement of existing products with the latest technology and updated designs. We seek to develop new technologies to improve durability, performance and usability of existing products. For example, a clinical study is underway on our Reverse Shoulder Prosthesis, which is designed to overcome a barrier to shoulder replacement surgery for patients with severe rotator cuff conditions. In addition to our own research and development, we acquire, license and commercialize technologies and new product ideas from orthopedic surgeons and other orthopedic specialists. Products that we have introduced in the past two years include VitalStim (the first electrotherapy product to treat dysphagia), Action Patch (an iontophoresis product, a needle-free drug delivery system), Basix3 (a TENS electrotherapy product), Infinity (a NMES electrotherapy product), Infinity Plus (a TENS/NMES product), 3DKnee (a surgical implant product), and Keramos (a ceramic-on-ceramic acetabular hip implant).
	•	Extensive and diverse distribution network. We use multiple distribution channels to bring our products to market. For our surgical implant products, we have an independent sales representative network. For our orthopedic rehabilitation products, because of the diverse nature of our customers, we use dealers, a direct sales force, and national supply chains. As a result of the Empi acquisition, we believe that our distribution network is one of the largest in the orthopedic rehabilitation products market and provides us with a significant competitive advantage with respect to sales of our existing products and the introduction of our new orthopedic rehabilitation products.
	•	Proprietary third-party billing system. Empi has developed a third-party billing system that manages over 40,000 payor profiles including 600 national payors, which allows access to over 110 million patient lives. This billing system reduces payment cycles, improves relationships with payors, such as insurance companies and managed care organizations, and tracks patients to improve quality of care and create subsequent selling opportunities. We anticipate adding selected products from our other orthopedic rehabilitation product lines to this system and offering these products along with our at-home physical therapy products.
	•	Strong relationships with managed care organizations and national rehabilitation providers. Our market positions in our core orthopedic rehabilitation product lines and the breadth of our orthopedic rehabilitation product offerings have enabled us to secure important preferred provider and managed care contracts. We currently have contracts with over 600 managed care providers, including over 40 preferred provider arrangements with regional and national operators of physical therapy clinics.
	•	Experienced management team. Our senior management team has extensive experience in the medical device industry, with previous employers including Maxxim Medical, Stryker Corporation, Johnson & Johnson

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Corporation, Centerpulse Ltd., and Cholestech Corporation. Members of our senior management team have significant previous experience in identifying, completing and integrating acquired companies and business lines.

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 therapists, athletic trainers and other orthopedic specialists operating in a variety of treatment settings and for the at-home physical therapy market. To achieve this objective, we intend to:

	•	Expand our distribution channels. We intend to continue to recruit actively new sales representatives who have established relationships with orthopedic surgeons to increase market penetration and geographic coverage in the surgical implant and orthopedic rehabilitation product markets. We utilize domestic independent sales representatives for our surgical implant products. A network of over 6,000 dealers support our clinical orthopedic rehabilitation products. A direct sales force of 120 field representatives in the United States and 25 international sales representatives support our home therapy orthopedic rehabilitation products. An internal sales force of 100 domestic representatives and 30 international representatives work with patients to handle insurance and third-party reimbursement. The combination of a direct sales force, independent sales representatives, and dealers will allow us to deepen our penetration into our existing markets as well as to expand our domestic and international geographic reach.
	•	Develop and launch new products. We plan to continue to develop and launch new products through both internal development and acquisitions. In our Surgical Implant Division, we intend to continue to emphasize our reconstructive joint and spinal products and technology to continue to meet the needs of orthopedic surgeons and to cover additional types of surgical procedures. In our Orthopedic Rehabilitation Division, we intend to maintain our leadership position through continued innovation and development of our electrotherapy, patient care and other product offerings.
	•	Expand our international presence. Historically we have sold our products outside of the United States through distributors principally in Europe and Japan. As a result of the Empi acquisition, we gained the European manufacturing base, additional distribution capabilities and billing systems of Empi’s wholly owned German subsidiary, Ormed GmbH & Co. Kg, (“Ormed”). In addition, Ormed already has relationships with a significant number of orthopedic surgeons who are potential customers for our surgical implant products.
	•	Capitalize on potential synergies and cost savings opportunities. We have identified a number of areas for potential synergies and cost savings that may result from the Empi acquisition. We believe we will be able realize operating efficiencies in several areas such as manufacturing and related processes, research and development in overlapping product categories and quality control processes.
	•	Improve financial strength. While we incurred significant debt in connection with the Empi acquisition, we plan to use free cash flow that we expect to generate and, subject to market conditions, pricing and availability, the proceeds from possible sales of equity to reduce leverage and strengthen our balance sheet.
	•	Pursue strategic acquisitions. We will continue to pursue selective acquisitions of complementary businesses, technologies or product lines in the orthopedic products market that enhance, or are complementary with or related to, our product mix, sales and distribution, or manufacturing capabilities. However, we do not have any acquisition commitments or agreements at this time. We expect the sources of funds for future acquisitions may include cash generated from operations and from the issuance of debt or equity.

Our Products

          We develop, manufacture, market and distribute surgical implant and orthopedic rehabilitation devices and related products for the orthopedic products market. Our products are used primarily by orthopedic surgeons, physical and occupational therapists and other healthcare professionals who treat patients with musculoskeletal conditions resulting from degenerative diseases, deformities, and sports-related injuries. Our non-invasive medical devices and related accessories are primarily used by patients for at-home therapy. We categorize our products into two product segments: surgical implant products and orthopedic rehabilitation products.

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Surgical Implant Division

          We currently develop, manufacture and market a wide variety of orthopedic reconstructive joint 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 2004, knee products accounted for 43%, hip products accounted for 34%, and shoulder products accounted for 10% of our Surgical Implant Division sales. The following table summarizes our current Surgical Implant Division reconstructive joint products which, except as indicated, have FDA approval and which we are currently marketing:

          Spinal Implant Products. In October 2003, we began selling the Cyclone Anterior Cervical Plate, our first internally developed spine product. We are manufacturing this product, which is designed to address the growing cervical spine fusion market. Within the United States, we also distribute spinal implant products designed and manufactured by Medicrea (“Medicrea”), a French company, whose spinal implant products are used in lumbar and cervical fusion. Medicrea’s PASS Poly-Axial Spinal System consists of a lumbar pedicle screw system used to achieve fusion of the spine. In 2004, sales of spinal products accounted for approximately 8% of our total Surgical Implant Division sales, which was primarily represented by sales of Medicrea’s spinal implant products. In February 2005, we acquired substantially all assets of Osteoimplant Technology, Inc. These acquired assets included a complete line of spinal implant products. See Note 22 – “Subsequent Event”, in our notes to consolidated financial statements.

          Other Products. Sales of our trauma product line contributed the remaining 5% of the Surgical Implant Division’s 2004 sales. During the fourth quarter of 2004, we discontinued our trauma product line in order to focus our Surgical Implant Division business on the growing knee, hip, shoulder and spinal implant product lines.

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          Orthopedic Rehabilitation Division

          Our Orthopedic Rehabilitation Division is a leading provider of rehabilitation products used by a variety of healthcare professionals involved in the field of physical medicine. We also offer 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. The following table summarizes many of our current Orthopedic Rehabilitation Division products which have FDA approval and which we are currently marketing:

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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, and develop our manufacturing process to improve product performance and reduce manufacturing costs. In addition to our own research and development, we receive new product and invention ideas, especially in procedure-specific areas, from orthopedic surgeons, inventors and other orthopedic specialists. For ideas that we consider 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, Chattanooga, Tennessee, and St. Paul, Minnesota in the United States and in Umkirch and Freiburg in Germany.

          We invested approximately $7.4 million in 2004, $5.0 million in 2003, and $3.4 million in 2002 into research and development activities. As of December 31, 2004, our research and development department had 68 employees.

Marketing and Sales

          Both of our divisions have developed their own sales and distribution channels. The combination of these two divisions provides us the opportunity to sell our products to a variety of treatment settings across new and potentially complementary distribution networks. With the addition of new distribution channels for our Orthopedic Rehabilitation Division through the acquisition of Empi, we believe we will be able to increase our penetration of the marketplace, including orthopedic surgeons, physical therapists and their patients.

Surgical Implant Division

          Our Surgical Implant Division products are currently marketed and sold in the United States to hospitals and orthopedic surgeons through a network of independent commissioned sales representatives. We are recruiting sales agents and representatives to expand the geographic areas in which we sell our products. Generally, our sales representatives sell either reconstructive joint products or spinal products. However, some of our sales representatives sell both of these products. Sales agents are generally granted a contract with a term of one to five years. Sales 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 for cause, which includes failure to meet specified periodic sales targets. 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, some of our surgical implant products are sold through distributors, principally in Japan and select countries in Europe, where we are developing a limited distribution network on a country-by-country basis.

          To a significant extent, sales of our surgical implant products depend on the preference of orthopedic surgeons. We have developed and maintained close contractual relationships with a number of widely recognized orthopedic surgeons who assist us with developing our products. These orthopedic surgeons may give demonstrations using our products, speak about our products at medical seminars, train other orthopedic surgeons in the use and implantation of our products, and provide us with feedback on the acceptance of our products. We have also established relationships with consulting surgeons who perform various consulting services for us. Such services may include conducting clinical studies on various products, establishment of protocols for use of the products and participation at various symposia. Surgeons who assist us in developing our products are generally compensated with a royalty and may receive stock options under our 1997 Surgeon Advisory Panel Stock Option Plan. Our consulting surgeons are paid consulting fees for their services and may be eligible to receive stock options under such plan.

Orthopedic Rehabilitation Division

          Our rehabilitation products are currently marketed and sold three different ways. First, for our product lines sold to clinics, we primarily sell through a worldwide network of over 6,000 dealers and distributors, which are managed by our internal sales people. These dealers sell our clinical products to a variety of healthcare professionals including physical therapists, athletic trainers, chiropractors and sports medicine physicians. Except for distributors outside of the United States, we do not maintain formal distribution contracts. In addition, no particular distributor accounts for more than 5% of Orthopedic Rehabilitation Division clinical products sales. These distributors purchase products from us at discounts off the published list price. We maintain an internal marketing and sales support program to support our dealer network. This program 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.

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          Second, for our home electrotherapy devices, our primary direct customers are individual patients and physical therapy clinics (which includes hospital physical therapy departments, sports medicine clinics and pain management centers). Therapies that use our electrotherapy and orthotics products are generally prescribed to patients by a physician, such as an orthopedic surgeon. The physician will typically direct the patient to a physical therapy clinic to meet with a trained physical therapist who provides the patient with the prescribed product from our consigned inventory at the clinic. This sales process is facilitated by our relationships with third-party payors, such as managed care organizations, who ultimately pay us for the products prescribed to patients. For these reasons, we view physical therapists, physicians and third-party payors as key decision makers in product selection and patient referral for our sales of home therapy devices.

          The payor base for our home electrotherapy products is diversified with no individual payor accounting for more than 5% of net revenues for the twelve months ended December 31, 2004. Medicare and Medicaid together accounted for 2% of these net revenues. Since no individual payor accounts for more than 5% of net revenues, we believe that our exposure to an adverse reimbursement decision by any individual payor with respect to these products is limited. In the United States, in connection with these product lines, we currently have over 40 preferred provider arrangements with third-party payors and approximately 600 managed care contracts.

          Third, for certain of our orthopedic soft goods, patient safety and pressure care products, we sell primarily to hospitals through third-party distributors. These distributors generally resell our 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. 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. As members of these buying groups are not obligated to purchase our products, we expend additional resources to market our products directly to the members of these buying groups.

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 Implant Division

          Our in-house manufacturing facilities for our Surgical Implant Division include 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 Quality System Regulations (“QSR”). At present, our own manufacturing facilities provide us with the capacity to produce a majority of our Surgical Implant Division products and third-party manufacturers produce the remainder. The primary raw materials used in the manufacture of our surgical implant products are cobalt chromium alloy, stainless steel alloys, titanium alloy and ultra high molecular weight polyethylene. All Surgical Implant Division products 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 in-process inspections are conducted at various intervals in the manufacturing process. As a final step, our products pass through a “clean room” environment designed and maintained to reduce product exposure to particulate matter.

Orthopedic Rehabilitation Division

          Our Orthopedic Rehabilitation Division manufactures its products in two primary locations. Products which are clinical in nature, such as electrotherapy devices, patient care products and physical therapy and chiropractic treatment tables, are made in our manufacturing facilities located in Chattanooga, Tennessee. These facilities are capable of using various manufacturing processes, including metal fabrication, coating, electronic assembly, mechanical assembly, wood working, sewing and a variety of others. These manufacturing facilities are ISO 9001 certified and also comply with FDA QSR requirements.

          We manufacture our home electrotherapy and dynamic ROM orthotic devices, as well as some components and related accessories, at our Clear Lake, South Dakota facility. Manufacturing activities at the Clear Lake facility include electronic and mechanical assembly, electrode fabrication and assembly and fabric sewing processes. Our products are comprised of a variety of components including die cast metal parts, injection-molded plastic parts, printed circuit boards,

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electronic components, batteries and battery chargers, lead wires, electrodes and other components. Parts for these components are purchased from outside suppliers and are, in some instances, manufactured on a custom basis.

          For orthopedic soft goods, patient safety and pressure care products, we purchase some of these products already manufactured. However, most of these products are manufactured by a vendor in Mexico that we supply with all of the raw materials and equipment necessary to make these products. This vendor supplies the labor component necessary to assemble and finish these products and manages the assembly process, subject to the supervision of our onsite personnel. Our agreement with this vendor, located in Acuna, Mexico, remains in effect through June 30, 2006, may be renewed for a term of one to three years by mutual agreement, and requires us to purchase a minimum amount of labor per year.

          Many of the component parts and raw materials we use in our manufacturing and assembly operations are available from more than one supplier. However, several component parts and accessory products are currently purchased from a single supply source. Medireha GmbH, which is 50% owned by us, is our single source supplier for certain passive motion devices. Our distribution agreement with Medireha grants us exclusive rights to the distribution of products that Medireha manufactures. The distribution agreement, which expires on June 30, 2007, also provides that we are required to purchase a certain amount of product annually.

Intellectual Property

          We hold 102 United States and foreign patents covering a wide range of our products and have filed applications on an additional 14 patents. We own most of these patents and have licensed rights to the remainder, either on an exclusive or non-exclusive basis. In addition, certain of our issued patents are currently licensed to third parties on a non-exclusive basis. We have numerous trademarks registered in the United States, a number of which are also registered in countries around the world. We also assert ownership of numerous unregistered trademarks, some of which have been submitted for registration in the United States and foreign countries. In the future, we will apply for such additional patents and trademarks as we deem appropriate.

          Additionally, we seek to protect our non-patented know-how, trade secrets, processes and other proprietary confidential information, through a variety of methods, including having our 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. For 2004, sales from these distribution agreements and licenses represent less than 5% of our overall sales. However, if any of the distribution agreements were terminated or if we lost any of these licenses, we would not be able to manufacture or sell related products, which could have an adverse affect on our future business, financial condition and results of operations.

          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 to our competitive position than solely having our products covered by patents.

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 greater than ours, which could provide those companies with a competitive advantage over us. Recently, product pricing has become increasingly important as a competitive factor, particularly due to governmental and third-party payors’ adoption of prospective payment systems. Although we believe that the design and quality of our products compare favorably with those of our competitors, should we be unable to offer products with the latest technological advances at competitive prices, our ability to compete successfully with our competitors could be materially and adversely affected.

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          Due to our sales history, our history of product development and the experience of our management team, we believe we are capable of effectively competing in the orthopedic products market in the future. Further, the comprehensive range of products we offer enables us to reach a diverse customer base and to use multiple distribution channels in an attempt to fuel our growth across the orthopedic products market. In addition, the acquisition of the various companies and product lines which now comprise our Orthopedic Rehabilitation Division continues to improve the name recognition of our company and our products.

Surgical Implant Division

          The market for orthopedic products similar to those produced by our Surgical Implant Division is dominated by a number of large companies, including Biomet, Inc., DePuy, Inc. (a Johnson & Johnson company), Medtronic, Inc., Smith & Nephew plc, Stryker Corporation and Zimmer Holdings, Inc. Our Surgical Implant Division also faces competition from companies similar in size 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 Implant Division and many of their products have the endorsement of leading orthopedic surgeons. New technologies and product concepts have been introduced into the surgical implant 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 surgical implant 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 Implant Division. We believe that this evolution in our market will continue for the foreseeable future.

Orthopedic Rehabilitation Division

          Our competitors include large corporations and companies that are part of corporate groups that have significantly greater financial, marketing and other resources than we do. The primary competitors of our Orthopedic Rehabilitation Division in the rehabilitation market are Dynatronics Corporation, Mettler Electronics Corporation, Richmar Corporation, AbilityOne Products Corp., a wholly owned subsidiary of Patterson Dental Company, Enraf-Nonius and Acorn Engineering. The physical therapy products market is highly competitive and fragmented. The competitors in the CPM market include several multi-product companies with significant market share and numerous smaller niche competitors. In the United States, our primary competitors in the TENS and NMES markets are Compex Technologies, Inc. and International Rehabilitation Sciences, Inc. Our primary competitor in the iontophoresis market is IOMED, Inc., and our primary competitors in the orthotics market are Dynasplint Systems, Inc., Ultraflex Systems, Inc. and Saunders Group, Inc. In Europe, our primary competitors in the TENS and NMES markets are Schwa-Medico GmbH and BMR Neurotech, Inc., and our primary competitors in the orthotics market are Bauerfeind Orthopadie GmbH & Co. KG, dj Orthopedics, Inc. and Aircast, Inc. Our primary competitors in the soft good products segment include DeRoyal Industries, Inc., dj Orthopedics, Inc., and Zimmer Holdings, Inc. Competition in these product markets is primarily based on the quality and technical features of products, product pricing and contractual arrangements with third-party payors and national accounts.

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 development, testing, labeling, manufacturing, promotion, distribution and marketing of medical devices to ensure that medical products distributed in the United States are safe and effective for their intended uses. The FDA also regulates the export of medical devices manufactured in the United States to international markets. Our medical devices are subject to such FDA regulation.

          Under the Food, Drug and Cosmetic Act, as amended, medical devices are classified into one of three classes depending on the degree of risk to patients using the device. Class I devices are those for which safety and effectiveness can be assured by adherence to General Controls, which include compliance with FDA QSRs, facility and device registrations and listings, reporting of adverse medical events, and appropriate truthful and non-misleading labeling, advertising and promotional materials. Some Class I devices also require pre-market review and clearance by the FDA through the Pre-market Notification 510(k) 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 Pre-market Notification 510(k) procedure. In the 510(k) procedure, the manufacturer submits certain required information to the FDA in order to establish that the device is “substantially equivalent” to a device that was legally marketed prior to May 28, 1976, the date upon which the Medical Device Amendments of 1976 were enacted, or to another similar commercially available device subsequently cleared through the 510(k) process. Upon establishment of such substantial equivalent, the FDA may grant clearance to

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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 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 technology for which the safety and effectiveness of the device cannot be assured solely by the General Controls, performance standards and special controls applied to Class I and II devices. These devices generally require clinical trials involving human subjects to assess their safety and effectiveness. These clinical trials are subject to regulation by the FDA and if federal funds are involved or if an investigator or site has signed a federal assurance, by the National Institute of Health and by the Office of Human Subject Protection. 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) 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) submission to the FDA. Only a small percentage of 510(k)s require clinical data to support the application. Investigational use is also required to evaluate clinically certain modifications or new intended uses of legally marketed devices. An approved IDE permits a device to be shipped lawfully for the purpose of conducting investigations of the device without complying with certain other requirements of the Food, Drug and Cosmetic Act that would generally 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. A 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 require additional clinical data and 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 are either exempt from FDA clearance and approval process (based on our interpretation of those regulations) or have obtained the requisite clearance or approvals (including all modifications, amendments and changes), or pre-market clearances or approvals, as appropriate, required under federal medical device law.

          Our manufacturing processes are also required to comply with QSR requirements 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 and 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.

          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. We have also implemented policies and procedures allowing us to position ourselves for the changing international regulatory environment. The ISO 9000 series of standards has been developed as an internationally recognized set of guidelines that are aimed at ensuring the design and manufacture of quality products. A company that passes an ISO audit and obtains ISO registration becomes internationally recognized as well run and functioning under a competent quality system. In certain foreign markets, it may be necessary or advantageous to obtain ISO 9000 series certification, which is in some ways analogous to compliance with the FDA’s QSR requirements. The European Community promulgated rules requiring medical products to receive a CE mark by mid-1998. A CE mark is an international symbol of adherence to certain standards and compliance with applicable European medical device requirements. ISO 9000 series certification is one of the prerequisites for CE marking for most of our products. ISO 9001 is the highest level of ISO certification, covering both the quality system for manufacturing, as well as the quality system for product design controls. We have received an ISO 9001 certification and “CE” certification for our products. In 2002 the ISO 9001 standard was revised. This scheduled five year revision was mandated by the ISO committee. These revisions

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became final in July 2003 and are now the universally accepted Quality System standard for medical devices. There is a three-year transition period from the time these new provisions became final. We expect to be certified to those standards prior to the deadline in mid-year 2006.

Third-Party Reimbursement

          Our home-therapy products generally are prescribed by physicians and are eligible for third-party reimbursement by government payors, such as Medicare and Medicaid, and private payors. An important consideration is whether third-party payment amounts will be adequate, since this is a factor in customers’ selection of our products. We believe that third-party payors will continue to focus on measures to contain or reduce their costs through managed care and other efforts. Medicare policies are important to our business because third-party payors often model their policies after the Medicare program’s coverage and reimbursement policies. Further, during 2004, approximately 2% of our direct billings were from Medicare and Medicaid revenues.

          Healthcare reform legislation in the Medicare area has focused on containing healthcare spending. On December 8, 2003, President Bush signed into law the Medicare Prescription Drug, Improvement, and Modernization Act of 2003, or Medicare Modernization Act. This legislation provides for revisions to payment methodologies and other standards for durable medical equipment and orthotic devices under the Medicare program. First, beginning in 2004 and continuing through 2008, the payment amounts for durable medical equipment will no longer be increased on an annual basis. This payment freeze also affects orthotic devices beginning in 2004 and continuing through 2006. Second, beginning in 2007, a competitive bidding program will be phased in to replace the existing fee schedule payment methodology. Off-the-shelf orthotic devices and other non-Class III devices, including TENS devices, will be subject to the program. The competitive bidding program will begin in 2007 in 10 high population metropolitan statistical areas and in 2009 will be expanded to 80 metropolitan statistical areas (and additional areas thereafter). Payments in regions not subject to competitive bidding may also be adjusted using payment information from regions subject to competitive bidding. Third, supplier quality standards are to be established which will be applied by independent accreditation organizations. Fourth, clinical conditions for payment will be established for certain products.

          On February 11, 2003, the Centers for Medicare and Medicaid Services, or CMS, made effective an interim final regulation implementing “inherent reasonableness” authority, which allows the agency and contractors to adjust payment amounts by up to 15% per year for certain items and services when the existing payment amount is determined to be grossly excessive or grossly deficient. The regulation lists factors that may be used by CMS and its contractors to determine whether an existing reimbursement rate is grossly excessive or grossly deficient and to determine a realistic and equitable payment amount. CMS may make a larger adjustment each year if it undertakes prescribed procedures. The regulation remains in effect after the Medicare Modernization Act, although the use of inherent reasonableness authority is precluded for payment amounts established under competitive bidding. We do not know what impact inherent reasonableness and competitive bidding will have on us or the reimbursement of our products.

Fraud and Abuse

          We are subject to various federal and state laws and regulations pertaining to healthcare fraud and abuse. Violations of these laws are punishable by criminal and civil sanctions, including, in some instances, exclusion from participation in federal and state healthcare programs, including Medicare, Medicaid, Veterans Administration health programs and TRICARE. We have never been challenged by a governmental authority under any of these laws and have no reason to believe that our operations are not in material compliance with such laws. However, because of the broad scope of these laws and that these laws and regulations may change, there can be no assurance that we would not be required to alter one or more of our practices to be in compliance with these laws. In addition, there can be no assurance that the occurrence of one or more violations of these laws or regulations, or the challenge of our operations by a governmental authority under these laws or that a change in the laws or regulations would not result in a material adverse effect on our financial condition and results of operations.

Anti-Kickback and Fraud Laws

          Our operations are subject to federal and state anti-kickback laws. Certain provisions of the Social Security Act, commonly referred to as the Anti-Kickback Statute, prohibit persons from knowingly and willfully soliciting, receiving, offering or providing remuneration directly or indirectly to induce either the referral of an individual, or the furnishing, recommending, or arranging for a good or service, for which payment may be made under a federal healthcare program such as Medicare and Medicaid. The definition of “remuneration” has been broadly interpreted to include anything of value, including such items as gifts, discounts, waiver of payments, and providing anything at less than its fair market value. The U.S. Department of Health and Human Services, or HHS, has issued regulations, commonly known as safe harbors, that set forth certain provisions which, if fully met, will assure healthcare providers and other parties that they will

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not be prosecuted under the Medicare Fraud and Abuse Statute. Although full compliance with these provisions ensures against prosecution under the Medicare Fraud and Abuse Statute, the failure of a transaction or arrangement to fit within a specific safe harbor does not necessarily mean that the transaction or arrangement is illegal or that prosecution under the Medicare Fraud and Abuse Statute will be pursued. The penalties for violating the Medicare Fraud and Abuse Statute include imprisonment for up to five years, fines of up to $25,000 per violation and possible exclusion from federal healthcare programs such as Medicare and Medicaid. Many states have adopted prohibitions similar to the Medicare Fraud and Abuse Statute, some of which apply to the referral of patients for healthcare services reimbursed by any source, not only by the Medicare and Medicaid programs.

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

Physician Self-Referral Laws

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

False Claims Laws

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

Governmental Audits

          Because we participate in governmental programs as a supplier of medical devices, our operations are subject to periodic surveys and audits by governmental entities or contractors to assure compliance with Medicare and Medicaid standards and requirements. To maintain our billing privileges, we are required to comply with certain supplier standards, including, by way of example, licensure and documentation requirements for our claims submissions. From time to time in the ordinary course of business, we, like other healthcare companies, are audited by or receive claims documentation requests from governmental entities, which may identify certain deficiencies based on our alleged failure to comply with applicable supplier standards or other requirements. We review and assess such audits or reports and attempt to take appropriate corrective action. We also are subject to surveys of our physical location for compliance with supplier

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standards. The failure to effect corrective action to address identified deficiencies, or to obtain, renew or maintain any of the required regulatory approvals, certifications or licenses could adversely affect our business, results of operations or financial condition and could result in our inability to offer our products and services to patients insured by the programs.

          We have not been subject to any governmental audits or claims documentation requests that have resulted in the identification of any currently existing material deficiencies.

Federal Privacy and Transaction Law and Regulations

          Other federal legislation requires major changes in the transmission and retention of health information by us. HIPAA mandates, among other things, the adoption of standards for the electronic exchange of health information that may require significant and costly changes to current practices. Sanctions for failure to comply with HIPAA include civil and criminal penalties. HHS has released three rules to date mandating the use of new standards with respect to certain healthcare transactions and health information. The first rule requires the use of uniform standards for common healthcare transactions, including healthcare claims information, plan eligibility, referral certification and authorization, claims status, plan enrollment and disenrollment, payment and remittance advice, plan premium payments, and coordination of benefits. The second rule released by HHS imposes new standards relating to the privacy of individually identifiable health information. These standards not only require our compliance with rules governing the use and disclosure of protected health information, but they also require us to obtain satisfactory assurances through written business associate agreements that any business associate of ours to whom such information is disclosed will safeguard the information. The third rule released by HHS establishes minimum standards for the security of electronic health information. We were required to comply with the transaction standards by October 16, 2003 and the privacy standards by April 14, 2003, and are required to comply with the security standards by April 21, 2005.

Employees

          As of December 31, 2004, we had approximately 1,255 employees. Of these, 442 were engaged in production and production support, 68 in research and development, 438 in sales and support, and 307 in various administrative capacities including third-party billing staff. Of these employees 1,096 were located in the United States and 159 were located in Germany. 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.”

Our substantial level of indebtedness could adversely affect our financial condition and prevent us from fulfilling our obligations.

          We have a substantial amount of indebtedness that requires significant interest payments, including our outstanding 9³/4% Senior Subordinated Notes due 2012 (the “notes”). Our substantial level of indebtedness could have important consequences to us, including the following:

&