HANGER, INC. - FORM 10-Q - August 9, 2010

Attached files

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EX-32 - EX-32 - HANGER, INC.	a10-12895_1ex32.htm
EX-31.1 - EX-31.1 - HANGER, INC.	a10-12895_1ex31d1.htm
EX-10.7 - EX-10.7 - HANGER, INC.	a10-12895_1ex10d7.htm
EX-10.6 - EX-10.6 - HANGER, INC.	a10-12895_1ex10d6.htm
EX-10.4 - EX-10.4 - HANGER, INC.	a10-12895_1ex10d4.htm
EX-10.2 - EX-10.2 - HANGER, INC.	a10-12895_1ex10d2.htm
EX-31.2 - EX-31.2 - HANGER, INC.	a10-12895_1ex31d2.htm
EX-10.5 - EX-10.5 - HANGER, INC.	a10-12895_1ex10d5.htm
EX-10.3 - EX-10.3 - HANGER, INC.	a10-12895_1ex10d3.htm

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended June 30, 2010

OR

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 1-10670

HANGER ORTHOPEDIC GROUP, INC.

(Exact name of registrant as specified in its charter)

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

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

Registrant’s telephone number, including area code:

(301) 986-0701

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

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

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

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

Large accelerated filer o		Accelerated filer x

Non-accelerated filer o		Smaller reporting company o

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

As of July 30, 2010, 32,334,110 shares of common stock, $.01 par value per share, were outstanding.

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HANGER ORTHOPEDIC GROUP, INC.

INDEX

			Page No.

Part I.		FINANCIAL INFORMATION

Item 1.		Consolidated Financial Statements (unaudited)

	Consolidated Balance Sheets — June 30, 2010 and December 31, 2009		1

	Consolidated Income Statements for the Three and Six Months ended June 30, 2010 and 2009		3

	Consolidated Statements of Cash Flows for the Six Months ended June 30, 2010 and 2009		4

	Notes to Consolidated Financial Statements		5

Item 2.		Management’s Discussion and Analysis of Financial Condition and Results of Operations	24

Item 3.		Quantitative and Qualitative Disclosures About Market Risk	44

Item 4.		Controls and Procedures	45

Part II.		OTHER INFORMATION

Item 1A.		Risk Factors	45

Item 6.		Exhibits	46

SIGNATURES			48

Certifications of Chief Executive Officer and Chief Financial Officer

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HANGER ORTHOPEDIC GROUP, INC.

CONSOLIDATED BALANCE SHEETS

(Dollars in thousands)

(Unaudited)

	June 30,		December 31,
	2010		2009

ASSETS

CURRENT ASSETS
Cash and cash equivalents	$	72,133	$	84,558
Short-term investments	4,976		4,976
Accounts receivable, less allowance for doubtful accounts of $12,536 and $10,526 in 2010 and 2009, respectively	106,329		105,480
Inventories	95,037		91,289
Prepaid expenses, other assets, and income taxes receivable	16,397		8,380
Deferred income taxes	13,271		15,167
Total current assets	308,143		309,850

PROPERTY, PLANT AND EQUIPMENT
Land	864		864
Buildings	4,536		4,599
Furniture and fixtures	14,903		14,007
Machinery and equipment	51,685		45,803
Leasehold improvements	54,241		52,174
Computer and software	62,806		59,980
Total property, plant and equipment, gross	189,035		177,427
Less accumulated depreciation	122,351		115,116
Total property, plant and equipment, net	66,684		62,311

INTANGIBLE ASSETS
Goodwill	491,860		484,422
Patents and other intangible assets, net	7,195		7,516
Total intangible assets, net	499,055		491,938

OTHER ASSETS
Debt issuance costs, net	4,795		5,660
Other assets	3,918		5,277
Total other assets	8,713		10,937

TOTAL ASSETS	$	882,595	$	875,036

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

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HANGER ORTHOPEDIC GROUP, INC.

CONSOLIDATED BALANCE SHEETS

(Dollars in thousands)

(Unaudited)

	June 30,			December 31,
	2010			2009

LIABILITIES AND SHAREHOLDERS’ EQUITY

CURRENT LIABILITIES
Current portion of long-term debt	$	9,025		$	8,835
Accounts payable	24,381			27,552
Accrued expenses	15,795			19,223
Accrued interest payable	1,748			1,776
Accrued compensation related costs	26,482			35,800
Total current liabilities	77,431			93,186

LONG-TERM LIABILITIES
Long-term debt, less current portion	400,149			401,637
Deferred income taxes	40,906			37,973
Other liabilities	25,699			26,347
Total liabilities	544,185			559,143

COMMITMENTS AND CONTINGENCIES (Note H)

SHAREHOLDERS’ EQUITY
Common stock, $.01 par value; 60,000,000 shares authorized, 33,627,945 and 32,992,674 shares issued in 2010 and 2009, respectively	336			330
Additional paid-in capital	240,694			233,111
Accumulated other comprehensive loss	(1,892		)	(3,056		)
Retained earnings	99,928			86,164
	339,066			316,549
Treasury stock at cost (141,154 shares)	(656		)	(656		)
Total shareholders’ equity	338,410			315,893

TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY	$	882,595		$	875,036

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

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HANGER ORTHOPEDIC GROUP, INC.

CONSOLIDATED INCOME STATEMENTS

For the Three and Six Months Ended June 30,

(Dollars in thousands, except share and per share amounts)

(Unaudited)

	Three Months Ended				Six Months Ended
	June 30,				June 30,
	2010		2009		2010		2009

Net sales	$	205,808	$	193,523	$	384,124	$	362,670
Cost of goods sold - materials	62,753		58,848		116,403		109,897
Personnel costs	70,552		65,748		139,321		129,807
Other operating expenses	40,710		40,963		76,025		75,416
Relocation expenses	4,185		—		6,244		—
Depreciation and amortization	4,460		3,808		8,771		8,264
Income from operations	23,148		24,156		37,360		39,286

Interest expense	7,506		7,428		15,048		15,035
Income before taxes	15,642		16,728		22,312		24,251

Provision for income taxes	5,880		6,692		8,548		9,700
Net income	$	9,762	$	10,036	$	13,764	$	14,551

Basic Per Common Share Data
Net income	$	0.30	$	0.32	$	0.43	$	0.47
Shares used to compute basic per common share amounts	32,032,265		31,250,047		31,957,007		31,105,742

Diluted Per Common Share Data
Net income	$	0.30	$	0.31	$	0.42	$	0.46
Shares used to compute diluted per common share amounts	32,831,310		32,019,843		32,750,873		31,924,652

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

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HANGER ORTHOPEDIC GROUP, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

For the Six Months Ended June 30,

(Dollars in thousands)

(Unaudited)

	2010			2009

Cash flows from operating activities:
Net income	$	13,764		14,551

Adjustments to reconcile net income to net cash provided by operating activities:
Unrealized gain on interest rate swap	—			(167		)
Loss (gain) on disposal of assets and auction rate securities	232			(127		)
Provision for bad debts	8,142			8,865
Provision for income taxes	4,052			424
Depreciation and amortization	8,771			8,264
Amortization of debt issuance costs	911			911
Compensation expense on stock options and restricted stock	4,356			3,473
Changes in assets and liabilities, net of effects of acquired companies:
Accounts receivable	(7,685		)	(6,365		)
Inventories	(3,510		)	(565		)
Prepaid expenses, other current assets, and income taxes receivable	(8,278		)	1,902
Other assets	(51		)	64
Accounts payable	(2,747		)	(4,105		)
Accrued expenses and accrued interest payable	(2,298		)	617
Accrued compensation related costs	(9,340		)	(8,541		)
Other liabilities	1,161			1,559
Net cash provided by operating activities	7,480			20,760

Cash flows from investing activities:
Purchase of property, plant and equipment (net of acquisitions)	(13,740		)	(6,097		)
Acquisitions and contingent purchase price (net of cash acquired)	(6,784		)	(2,347		)
Proceeds from sale of property, plant and equipment	2			303
Proceeds from sale of auction rate securities	1,518			—
Net cash used in investing activities	(19,004		)	(8,141		)

Cash flows from financing activities:
Repayment of long-term debt	(2,914		)	(1,126		)
Proceeds from issuance of common stock	2,013			2,871
Proceeds on UBS buy-back securities	—			3,600
Net cash (used in) provided by financing activities	(901		)	5,345

(Decrease) increase in cash and cash equivalents	(12,425		)	17,964
Cash and cash equivalents, at beginning of period	84,558			58,413
Cash and cash equivalents, at end of period	$	72,133		$	76,377

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

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HANGER ORTHOPEDIC GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE A — BASIS OF PRESENTATION

The unaudited interim consolidated financial statements as of and for the three and six months ended June 30, 2010 and 2009 have been prepared by Hanger Orthopedic Group, Inc. (the “Company”) pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”) for interim financial reporting. These consolidated statements are unaudited and, in the opinion of management, include all adjustments (consisting of normal recurring adjustments and accruals) necessary for a fair statement for the periods presented. The year-end consolidated data was derived from audited financial statements but does not include all disclosures required by accounting principles generally accepted in the United States of America (“GAAP”). Certain information and footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted. The results of operations for the three and six months ended June 30, 2010 are not necessarily indicative of the results to be expected for the full fiscal year.

These consolidated financial statements should be read in conjunction with the consolidated financial statements of the Company and notes thereto included in the Annual Report on Form 10-K for the year ended December 31, 2009, filed by the Company with the SEC.

NOTE B — SIGNIFICANT ACCOUNTING POLICIES

Principles of Consolidation

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

Use of Estimates

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

Cash and Cash Equivalents

The Company considers all highly liquid investments with original maturities of three months or less at the date of purchase to be cash equivalents. At various times throughout the year, the Company maintains cash balances in excess of Federal Deposit Insurance Corporation limits.

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NOTE B - SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

Inventories

Inventories, which consist principally of raw materials, work in process and finished goods, are stated at the lower of cost or market using the first-in, first-out method. For its patient-care centers segment, the Company calculates cost of goods sold-materials in accordance with the gross profit method for all reporting periods. The Company bases the estimates used in applying the gross profit method on the actual results of the most recently completed fiscal year and other factors, such as a change in the sales mix or changes in the trend of purchases. Cost of goods sold-materials during the interim periods are reconciled and adjusted when the annual physical inventory is taken. The Company treats these adjustments as changes in accounting estimates.

For its distribution segment, a perpetual inventory is maintained. Management adjusts the reserve for inventory obsolescence whenever the facts and circumstances indicate that the carrying cost of certain inventory items is in excess of its market price. Shipping and handling activities are reported as part of cost of goods sold-materials.

Fair Value

Effective January 1, 2008, the Company adopted the authoritative guidance for fair value measurements and disclosures, which establishes a framework for measuring fair value and requires enhanced disclosures about fair value measurements. The authoritative guidance requires disclosure about how fair value is determined for assets and liabilities and establishes a hierarchy by which these assets and liabilities must be grouped, based on significant levels of inputs as follows:

Level 1 quoted prices in active markets for identical assets or liabilities;

Level 2 quoted prices in active markets for similar assets and liabilities and inputs that are observable for the asset or liability;

Level 3 unobservable inputs, such as discounted cash flow models and valuations.

The determination of where assets and liabilities fall within this hierarchy is based upon the lowest level of input that is significant to the fair value measurement.

Effective January 1, 2008, the Company adopted the authoritative guidance regarding the option to fair value financial assets and liabilities that permits entities to choose to measure many financial instruments and certain other items at fair value that are not currently required to be measured at fair value. Unrealized gains and losses on items for which the fair value option has been elected are reported in earnings.

Effective January 1, 2009, the Company adopted the authoritative guidance for fair value measurements and disclosures for all non-financial assets and liabilities, except those that are

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NOTE B - SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

Fair Value (continued)

recognized or disclosed at fair value in the financial statements on a recurring basis. As of June 30, 2010, there has been no impact to the Company’s consolidated financial statements related to the application of fair value measurements and disclosures guidance for non-financial assets and liabilities.

The following is a listing of the Company’s assets and liabilities measured at fair value on a recurring basis and where they are classified within the hierarchy as of June 30, 2010 and December 31, 2009, respectively:

	June 30, 2010 (unaudited)								December 31, 2009 (unaudited)
(in thousands)	Level 1		Level 2		Level 3		Total		Level 1		Level 2		Level 3		Total
Assets
Marketable Securities
Money market funds	$	48,088	$	—	$	—	$	48,088	$	78,590	$	—	$	—	$	78,590

Trading Securities
Auction rate securities	—		—		4,657		4,657		—		—		4,660		4,660
Rights on auction rate securities	—		—		319		319		—		—		315		315

Available-for-sale debt securities
Auction rate securities	—		—		—		—		—		—		1,387		1,387

	$	48,088	$	—	$	4,976	$	53,064	$	78,590	$	—	$	6,362	$	84,952

(in thousands)	Level 1		Level 2		Level 3		Total		Level 1		Level 2		Level 3		Total
Derivatives
Interest rate swaps	$	—	$	3,629	$	—	$	3,629	$	—	$	5,256	$	—	$	5,256

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NOTE B - SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

Fair Value (continued)

During the six months ended June 30, 2010 and, 2009, assets and liabilities that were measured at fair value using Level 3 inputs had the following activity:

	Fair Value Measurements
	Using Significant Unobservable Inputs
	(Level 3)
For the six months ended June 30, 2010	Auction Rate Securities			Rights		Total
Balance as of December 31, 2009	$	6,047		$	315	$	6,362
Total unrealized losses
Included in earnings	(185		)	4		(181		)
Included in accumulated other comprehensive loss	313			—		313
Settlements	(1,518		)	—		(1,518		)
Transfers in and/or out of Level 3	—			—		—
Balance as of June 30, 2010 (unaudited)	$	4,657		$	319	$	4,976

For the six months ended June 30, 2009	Auction Rate Securities			Rights			Total
Balance as of December 31, 2008	$	5,465		$	1,006		$	6,471
Total unrealized losses
Included in earnings	659			(651		)	8
Included in accumulated other comprehensive loss	(289		)	—			(289		)
Purchases, issuances, and settlements	—			—			—
Transfers in and/or out of Level 3	—			—			—
Balance as of June 30, 2009 (unaudited)	$	5,835		$	355		$	6,190

Investments: Trading securities consist of auction rate securities accounted for in accordance with authoritative guidance for investments in debt and equity securities. Trading securities are reported at fair value with unrealized gains and losses included in earnings. Securities purchased to be held for indeterminate periods of time and not intended at the time of purchase to be held until maturity are classified as available-for-sale securities with any unrealized gains and losses reported as a separate component of accumulated other comprehensive loss on our consolidated balance sheets. The Company’s Management continually evaluates whether any marketable investments have been impaired and, if so, whether such impairment is temporary or other than temporary.

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NOTE B - SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

Fair Value (continued)

Deferrable Interest Notes (“Primus ARS”). ARS are securities that are structured with short-term interest rate reset dates which generally occur every 28 days and are linked to LIBOR. At the reset date, investors can attempt to sell via auction or continue to hold the securities at par. The Company’s ARS are reported at fair value.

The fair values of our ARS were estimated through use of discounted cash flow models. These models consider, among other things, the timing of expected future successful auctions, collateralization of underlying security investments and the credit worthiness of the issuer. Since these inputs are not observable in an active market, they are classified as Level 3 inputs under the fair value accounting rules discussed above under “Fair Value”.

On November 4, 2008, the Company agreed to accept Auction Rate Security Rights (“the Rights”) related to the Indiana ARS from UBS offered through a prospectus filed on October 7, 2008. The Rights permit the Company to sell, or put, the Indiana ARS back to UBS at par value of $5.0 million, at any time during the period from June 30, 2010 through July 2, 2012 and to obtain a credit line from UBS collateralized by the ARS. The Company elected to classify the Rights and our investments in the Indiana ARS as trading securities in accordance with the authoritative guidance for accounting for investments in debt and equity securities. As of June 30, 2010 and December 31, 2009, the Company determined the fair value of the Rights was $0.3 million and the fair value of the ARS was $4.7 million. The change in the fair value of the Rights and the ARS for the six months ended June 30, 2010 are reflected as components of earnings.

In May of 2010, the Company sold its investment in the Primus ARS for $1.5 million in cash proceeds. The Company recognized a loss on the sale of the auction rate securities of $0.2 million, which is the difference between the amortized cost basis of $1.7 million and the cash proceeds of $1.5 million received from the sale of the Primus ARS. The loss was reported in other expense on the Company’s income statement.

On July 1, 2010, the Company exercised its right to put the ARS back to UBS at par value of $5.0 million. The $5.0 proceeds were received on July 1, 2010. As part of the settlement, the Company closed out a $3.6 million line of credit with UBS that the Company obtained as part of the buyback agreement originally executed in November 2008, with net cash proceeds of approximately $1.4 million.

Interest Rate Swaps: The Company utilizes interest rate swaps to manage its exposures to interest rate risk associated with the Company’s variable rate borrowings. The authoritative guidance for derivatives and hedging requires companies to recognize all derivative instruments as either assets or liabilities at fair value in the Company’s consolidated balance sheets. In accordance with the authoritative guidance, the Company designates the interest rate swaps as cash flow hedges of variable-rate borrowings. For derivative instruments that are designated and qualify as a cash flow hedge, the effective portion of the gain or loss on the derivative is reported as a component of accumulated

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NOTE B - SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

Fair Value (continued)

other comprehensive loss and reclassified into earnings in the same period or periods during which the hedged transaction affects earnings. Gains and losses on the derivative representing hedge ineffectiveness are recognized in earnings.

In May 2008, the Company entered into two interest rate swap agreements under which $150.0 million of the Company’s variable rate term loans were converted to a fixed rate of 5.4%. The fair value of each interest rate swap is an estimate of the present value of the expected future cash flows the Company is to receive under the applicable interest rate swap agreement. The valuation models used to determine the fair value of the interest rate swaps are based upon the forward yield curve of one month LIBOR (Level 2 inputs), the hedged interest rate, and other factors including counterparty credit risk. The agreements, which expire April 2011, qualify as cash flow hedges in accordance with the authoritative guidance for derivatives and hedging for the three and six months ended June 30, 2010. The Company’s interest rate swaps qualified for hedge accounting, so any adjustments in fair value related to the effective portion of the interest rate swaps were not required to be recognized through the income statement.

Since their inception, the fair value of the interest rate swaps has declined to $3.6 million. Of the decline, $3.1 million related to the effective portion of the interest rate swaps and was reported as a component of accumulated other comprehensive loss on our consolidated balance sheets. The total liability, $3.6 million, is reported in accrued expenses on the Company’s consolidated balance sheet as of June 30, 2010. As of December 31, 2009, liabilities from the interest rate swap were $5.3 million, with $4.4 million reported in accrued expenses, with the remainder reported in other liabilities. Of the $5.3 million in liabilities reported as of December 31, 2009, $4.8 million related to the effective portion of the interest rate swaps and was reported as a component of accumulated other comprehensive loss on our consolidated balance sheets.

Fair Value of Financial Instruments

The carrying value of the Company’s short-term financial instruments, such as receivables and payables, approximate their fair values, based on the short-term maturities of these instruments. The carrying value of the Company’s long-term debt, excluding the Senior Notes, approximates fair value based on rates currently available to the Company for debt with similar terms and remaining maturities. The fair value of the Senior Notes, at June 30, 2010, was $182.2 million, as compared to the carrying value of $175.0 million at that date. The fair values of the Senior Notes were based on quoted market prices at June 30, 2010.

Revenue Recognition

Revenues in our patient care centers are derived from the sale of orthotic and prosthetic (“O&P”) devices and the maintenance and repair of existing devices. The sale of O&P devices includes the design, fabrication, assembly, fitting and delivery of a wide range of braces, limbs and other

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NOTE B - SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

Revenue Recognition (continued)

devices. Revenues from the sale of these devices are recorded when (i) acceptance by and delivery to the patient has occurred; (ii) persuasive evidence of an arrangement exists and there are no further obligations to the patients; (iii) the sales price is fixed or determinable; and (iv) collectibility is reasonably assured. Revenues from maintenance and repairs are recognized when the service is provided. Revenues from the sale of O&P devices to customers by our distribution segment are recorded upon the shipment of products, in accordance with the terms of the invoice, net of merchandise returns received and the amount established for anticipated returns. Discounted sales are recorded at net realizable value.

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

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

As part of the Company’s preauthorization process with payors, it validates its ability to bill the payor, if applicable, for the service provided before the delivery of the device. Subsequent to billing for devices and services, there may be problems with pre-authorization or with other insurance coverage issues with payors. If there has been a lapse in coverage, the patient is financially responsible for the charges related to the devices and services received. If the Company is unable to collect from the patient, a bad debt expense is recognized.

Occasionally, a portion of a bill is rejected by a payor due to a coding error on the Company’s part and the Company is prevented from pursuing payment from the patient due to the terms of its contract with the insurance company. The Company appeals these types of decisions and is generally successful. This activity is factored into the Company’s methodology of determining the estimate for the allowance for doubtful accounts. The Company recognizes, as reduction of sales, a disallowed sale for any claims that it believes will not be recovered and adjusts future estimates accordingly.

Certain accounts receivable may be uncollectible, even if properly pre-authorized and billed. Regardless of the balance, accounts receivable amounts are periodically evaluated to assess

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NOTE B - SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

Revenue Recognition (continued)

collectibility. In addition to the actual bad debt expense recognized during collection activities, the Company estimates the amount of potential bad debt expense that may occur in the future. This estimate is based upon historical experience as well as a review of the receivable balances.

On a quarterly basis, the Company evaluates cash collections, accounts receivable balances and write-off activity to assess the adequacy of the allowance for doubtful accounts. Additionally, a Company-wide evaluation of collectibility of receivable balances older than 180 days is performed at least semi-annually, the results of which are used in the next allowance analysis. In these detailed reviews, the account’s net realizable value is estimated after considering the customer’s payment history, past efforts to collect on the balance and the outstanding balance, and a specific reserve is recorded if needed. From time to time, the Company may outsource the collection of such accounts to outsourced agencies after internal collection efforts are exhausted. In the cases when valid accounts receivable cannot be collected, the uncollectible account is written off to bad debt expense.

Segment Information

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

Income Taxes

The Company applies the authoritative guidance for accounting for uncertainty in income taxes. Over the next 12 months the Company may recognize gross tax affected unrecognized tax benefits of up to $1.0 million, of which $0.4 million is expected to impact the effective tax rate, due to the pending expiration of the period of limitations for assessing tax deficiencies for certain income tax returns. The Company recognizes interest accrued and penalties related to unrecognized tax benefits as a component of income tax expense. Total penalties and interest accrued as of June 30, 2010 is $0.1 million. The Company files numerous consolidated and separate income tax returns in the United States Federal jurisdiction and in many state jurisdictions. The Company is no longer subject to US Federal income tax examinations for years before 2006 and with few exceptions is no longer subject to state and local income tax examinations by tax authorities for years before 2005.

New Accounting Guidance

In January 2010, the FASB issued additional authoritative guidance for fair value measurements and disclosures. This includes the disclosure of significant transfers in and out of Level 1 and 2

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NOTE B - SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

New Accounting Guidance (continued)

measurements and describing the reasons for the transfers, reporting of information separately for purchases, sales, issuances, and settlements within Level 3 measurements, level of disaggregation, and input and valuation techniques. The additional authoritative guidance, except for the reporting of information within Level 3 measurements was effective January 1, 2010. The adoption of the additional guidance on January 1, 2010 did not have a material impact on the Company’s consolidated financial statements. The additional authoritative guidance for the reporting of activity for purchases, sales, issuances, and settlements within Level 3 measurements is effective January 1, 2011. The Company believes the impact of the additional authoritative guidance for fair value measurements and disclosures for Level 3 measurements will not have a material impact on the Company’s consolidated financial statements.

NOTE C - SUPPLEMENTAL CASH FLOW FINANCIAL INFORMATION

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

	Six Months Ended
	June 30,
(In thousands)	2010		2009
	(Unaudited)		(Unaudited)
Cash paid during the period for:
Interest	$	14,188	$	14,739
Income taxes	$	10,048	$	7,098

Non-cash financing and investing activities:
Non-cash property, plant and equipment purchases	$	5,709	$	—
Unrealized loss on auction rate securities	$	—	$	(174	)
Unrealized gain on interest rate swaps	$	976	$	579
Issuance of notes in connection with acquistions	$	2,000	$	1,631
Issuance of restricted shares of common stock	$	9,181	$	1,484

NOTE D — ACQUISITIONS

Effective January 1, 2009, the Company adopted the revised authoritative guidance for business combinations, which provides revised guidance to improve the relevance, representational faithfulness, and comparability of the information that a reporting entity provides in its financial reports about a business combination and its effects.

During the six months ended June 30, 2010, the Company acquired one entity consisting of three new patient care centers for a purchase price of $7.7 million, consisting of $5.7 million in cash, $2.0 million in promissory notes, and $1.4 million in contingent consideration payable within the next two years. The Company recorded approximately $7.1 million of goodwill and incurred

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NOTE D — ACQUISITIONS (CONTINUED)

approximately $0.04 million of transaction costs related to this acquisition. Pro forma results would not be materially different.

During the six months ended June 30, 2009 the Company acquired two entities consisting of five patient care centers for an aggregate purchase price of $3.9 million, consisting of $2.2 million in cash, $0.9 million in promissory notes, and $0.8 million in contingent consideration payable within the next two years. The Company recorded approximately $3.5 million of goodwill and incurred approximately $0.1 million of transaction costs related to these acquisitions. The results of operations for these acquisitions are included in the Company’s results of operations from the date of acquisition. Pro forma results would not be materially different.

In connection with contingent consideration agreements with acquisitions completed prior to adoption of the revised authoritative guidance for business combinations becoming effective, the Company made payments of $1.0 million and $0.8 million during the six months ended June 30, 2010 and 2009, respectively. The Company has accounted for these amounts as additional purchase price, resulting in an increase in goodwill. The Company estimates that it may pay up to a total of $7.3 million related to contingent consideration provisions of acquisitions in future periods. Of the $7.3 million, $3.7 million is related to acquisitions completed after adoption of the revised authoritative guidance.

NOTE E - GOODWILL

The Company determined that it has two reporting units with goodwill, which are the same as its reportable segments: (i) patient-care centers and (ii) distribution. The Company completes its annual goodwill impairment analysis in October. The fair value of the Company’s reporting units are primarily determined based on the income approach and considers the market and cost approach.

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NOTE E — GOODWILL (CONTINUED)

The activity related to goodwill for the six months ended June 30, 2010 and 2009 are as follows:

	Patient-Care Centers							Distribution
(In thousands)	Goodwill		Accumulated Impairment Loss			Net		Goodwill		Total
Balance at December 31, 2009	$	491,842	$	(45,808	)	$	446,034	$	38,388	$	484,422
Additions due to acquisitions	6,453		—			6,453		—		6,453
Additions due to contingent considerations	985		—			985		—		985
Balance at June 30, 2010 (unaudited)	$	499,280	$	(45,808	)	$	453,472	$	38,388	$	491,860

	Patient-Care Centers							Distribution
(In thousands)	Goodwill		Accumulated Impairment Loss			Net		Goodwill		Total
Balance at December 31, 2008	$	477,831	$	(45,808	)	$	432,023	$	38,388	$	470,411
Additions due to acquisitions	5,345		—			5,345		—		5,345
Additions due to contingent considerations	83		—			83		—		83
Balance at June 30, 2009 (unaudited)	$	483,259	$	(45,808	)	$	437,451	$	38,388	$	475,839

NOTE F — INVENTORIES

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

	June 30,		December 31,
(In thousands)	2010		2009
	(Unaudited)		(Unaudited)
Raw materials	$	34,983	$	34,157
Work-in-process	42,607		38,814
Finished goods	17,447		18,318
	$	95,037	$	91,289

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NOTE G — LONG TERM DEBT

Long-term debt consists of the following:

	June 30,			December 31,
(In thousands)	2010			2009
	(Unaudited)			(Unaudited)
Line of Credit	$	3,657		$	3,628
Term Loan	220,800			221,956
10 1/4% Senior Notes due 2014	175,000			175,000
Subordinated seller notes, non-collateralized, net of unamortized discount with principal and interest payable in either monthly, quarterly or annual installments at effective interest rates ranging from 3.00% to 7.00%, maturing through October 2014	9,717			9,888
	409,174			410,472
Less current portion	(9,025		)	(8,835		)
	$	400,149		$	401,637

Revolving Credit Facility

The $75.0 million Revolving Credit Facility (the “Facility”) matures on May 26, 2011 and bears interest, at the Company’s option, at LIBOR plus 2.75% or a Base Rate (as defined in the credit agreement) plus 1.75%. The obligations under the Facility are guaranteed by the Company’s subsidiaries and are secured by a first priority perfected interest in the Company’s subsidiaries’ shares, all of the Company’s assets and all the assets of the Company’s subsidiaries. The Company was notified by Lehman Commercial Paper, Inc. (“LCPI”), a subsidiary of Lehman Brothers Holdings, Inc. (“Lehman”) that they were unable to continue their commitment under the Facility. LCPI’s total commitment was $17.8 million of our total $75.0 million dollar facility. On October 23, 2009, Barclays Bank PLC replaced $10.0 million of the $17.8 million defaulted Lehman commitment under the Facility. The Facility requires compliance with various covenants including but not limited to a maximum total leverage ratio of 6.5 times EBITDA (as defined in the credit agreement) and a maximum annual capital expenditures limit of $50.0 million, plus an unused portion of such amount from the previous fiscal year. As of June 30, 2010, the Company was in compliance with all such covenants and had $63.5 million available under the Facility, net of LCPI’s remaining $7.8 million commitment and $3.7 million of outstanding letters of credit.

Line of Credit

On April 6, 2009, the Company obtained a collateralized line of credit from UBS in conjunction with the Rights agreement. The credit line is collateralized by our Indiana ARS and allows the Company to borrow up to the fair market value of the ARS not to exceed its $5.0 million par value. As of June 30, 2010, the Company has drawn $3.6 million, which is the maximum currently allowed under the agreement. The credit line has no net cost to the Company as it bears interest in the amount equal to the income on the ARS. On July 1, 2010, the Company closed the $3.6 million line of credit with UBS in conjunction with settling the Rights agreement.

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NOTE G — LONG TERM DEBT (CONTINUED)

Term Loan

The $230.0 million Term Loan matures on May 26, 2013 and requires quarterly principal and interest payments that commenced on September 30, 2006. From time to time, mandatory payments may be required as a result of capital stock issuances, additional debt incurrences, asset sales or other events as defined in the credit agreement. The obligations under the Term Loan are guaranteed by the Company’s subsidiaries and are secured by a first priority perfected interest in the Company’s subsidiaries’ shares, all of the Company’s assets and all the assets of the Company’s subsidiaries. The Term Loan is subject to covenants that mirror those of the Revolving Credit Facility. The Company secured, effective March 13, 2007, certain amendments to the Term Loan that included reducing the margin over LIBOR that the Company pays as interest under the existing Term Loan from 2.50% to 2.00%. The Term Loan bears interest, at the Company’s option, at LIBOR plus 2.00% or a Base Rate (as defined in the credit agreement) plus 1.00%. At June 30, 2010, the interest rate on the Term Loan was 2.35%.

10 ¼% Senior Notes

The 10 ¼% Senior Notes, entered into on May 26, 2006, mature June 1, 2014, are senior indebtedness and are guaranteed on a senior unsecured basis by all of the Company’s current and future domestic subsidiaries. Interest is payable semi-annually on June 1 and December 1, and commenced on December 1, 2006.

The notes were not redeemable at the Company’s option prior to June 1, 2010. On or after June 1, 2010, the Company may redeem all or part of the notes upon not less than 30 days and no more than 60 days’ notice, for the twelve-month period beginning on June 1 of the following years; at (i) 105.125% through May 31, 2011; (ii) 102.563% through May 31, 2012; and (iii) 100.0% beginning June 1, 2013 and thereafter through June 1, 2014.

Debt Covenants

The terms of the Senior Notes, the Revolving Credit Facility, and the Term Loan limit the Company’s ability to, among other things, incur additional indebtedness, create liens, pay dividends on or redeem capital stock, make certain investments, make restricted payments, make certain dispositions of assets, engage in transactions with affiliates, engage in certain business activities and engage in mergers, consolidations and certain sales of assets. At June 30, 2010, the Company was in compliance with all covenants under these debt agreements.

NOTE H — COMMITMENTS AND CONTINGENT LIABILITIES

Commitments

The Company’s wholly-owned subsidiary, Innovative Neurotronics, Inc. (“IN, Inc.”), is party to a non-binding purchase agreement under which it agreed to purchase assembled WalkAide System kits. As of June 30, 2010, IN, Inc. had outstanding purchase commitments of approximately $1.1 million that the Company expects to be fulfilled over the next three months.

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NOTE H — COMMITMENTS AND CONTINGENT LIABILITIES (CONTINUED)

Contingencies

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

The Company is also in a highly regulated industry and receives regulatory agency inquiries from time to time in the ordinary course of its business, including inquiries relating to the Company’s billing activities. To date, these inquiries have not resulted in material liabilities, but no assurance can be given that future regulatory agencies’ inquiries will be consistent with the results to date or that any discrepancies identified during a regulatory review will not have a material adverse effect on the Company’s consolidated financial statements.

Guarantees and Indemnifications

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

NOTE I — NET INCOME PER COMMON SHARE

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

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NOTE I — NET INCOME PER COMMON SHARE (CONTINUED)

Net income per share is computed as follows:

	Three Months Ended				Six Months Ended
	June 30,				June 30,
(In thousands, except share and per share data)	2010		2009		2010		2009
	(Unaudited)		(Unaudited)		(Unaudited)		(Unaudited)

Net income	$	9,762	$	10,036	$	13,764	$	14,551

Shares of common stock outstanding used to compute basic per common share amounts	32,032,265		31,250,047		31,957,007		31,105,742
Effect of dilutive restricted stock and options (1)	799,045		769,796		793,866		818,910
Shares used to compute dilutive per common share amounts	32,831,310		32,019,843		32,750,873		31,924,652

Basic income per share	$	0.30	$	0.32	$	0.43	$	0.47
Diluted income per share	$	0.30	$	0.31	$	0.42	$	0.46

(1) For the three and six months ended June 30, 2009, options to purchase 715,728 and 615,728, shares of common stock are not included in the computation of diluted income per share as these options are anti-dilutive because the exercise prices of the options were greater than the average market price of the Company’s common stock for the period. There were no anti-dilutive options for the three and six months ended June 30, 2010.

NOTE J — SUPPLEMENTAL EXECUTIVE RETIREMENT PLAN

The Company’s unfunded noncontributory defined benefit plan (the “Plan”) covers certain senior executives, is administered by the Company and calls for annual payments upon retirement based on years of service and final average salary. Benefit costs and liabilities balances are calculated based on certain assumptions including benefits earned, discount rates, interest costs, mortality rates and other factors. Actual results that differ from the assumptions are accumulated and amortized over future periods, affecting the recorded obligation and expense in future periods.

The following assumptions were used in the calculation of the net benefit cost and obligation at June 30, 2010:

Discount rate		5.50	%
Average rate of increase in compensation		3.25	%

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NOTE J — SUPPLEMENTAL EXECUTIVE RETIREMENT PLAN (CONTINUED)

The Company believes the assumptions used are appropriate, however, changes in assumptions or differences in actual experience may affect our benefit obligation and future expenses. The change in the Plan’s net benefit obligation is as follows:

	(In thousands)

Net benefit cost accrued at December 31, 2009	$	14,138
Service cost	831
Interest cost	401
Net benefit cost accrued at June 30, 2010 (unaudited)	$	15,370

NOTE K - STOCK-BASED COMPENSATION

The Company utilizes the authoritative guidance using the modified prospective method. Under the modified prospective method, compensation expense related to awards granted prior to and unvested as of the adoption of the authoritative guidance is calculated in accordance with the authoritative guidance and recognized in the consolidated statements of operations over the requisite remaining service period; compensation expense for all awards granted after the adoption of the authoritative guidance is calculated according to the provisions of such guidance.

The Company has issued options and restricted shares of common stock under two share-based compensation plans, one for employees and the other for the Board of Directors. On May 13, 2010, the stockholders of the Company approved the 2010 Omnibus Incentive Plan (the “2010 Plan”) and terminated the Amended and Restated 2002 Stock Incentive and Bonus Plan (the “2002 Plan”) and 2003 Non-Employee Directors’ Stock Incentive Plan (the “2003 Plan”). No new awards will be granted under the 2002 Plan or the 2003 Plan; however, awards granted under either the 2002 Plan or the 2003 Plan that were outstanding will remain outstanding and continue to be subject to all of the terms and conditions of the 2002 Plan or the 2003 Plan.

The 2010 Plan provides that 2.5 million shares of Common Stock are reserved for issuance, subject to adjustment as set forth in the 2010 Plan; provided, however, that only 1.5 million shares may be issued pursuant to the exercise of incentive stock options. Of these 2.5 million shares, 2.0 million are shares that are newly authorized for issuance under the 2010 Plan and 0.5 million are unissued shares not subject to awards that have been carried over from the shares previously authorized for issuance under the terms of the 2002 Plan and the 2003 Plan. Unless earlier terminated by the Board of Directors, the 2010 Plan will remain in effect until the earlier of (i) the date that is ten years from the date the plan is approved by the Company’s stockholders, which is the effective date for the plan, namely May 13, 2020, or (ii) the date all shares reserved for issuance have been issued.

At June 30, 2010, of the 6.2 million shares of common stock authorized for issuance under the Company’s existing and prior share-based compensation plans, and 3.7 million have been issued.

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NOTE K - STOCK-BASED COMPENSATION (CONTINUED)

Total unrecognized share-based compensation cost related to unvested restricted stock awards was approximately $13.2 million at June 30, 2010, and is expected to be expensed as compensation expense over approximately three years. The Company had no unrecognized expense related to its stock option grants for the periods ended June 30, 2010 and 2009. For the six months ended June 30, 2010 and 2009, the Company has included approximately $4.3 million and $3.4 million, respectively, for share-based compensation cost in the accompanying condensed consolidated statements of income. Compensation expense primarily relates to restricted share grants, as the amount of expense related to options is immaterial in all periods presented. The Company calculates the fair value of stock options using the Black-Scholes model. The total value of the stock option awards is expensed ratably over the requisite service period of the employees receiving the awards.

NOTE L — SEGMENT AND RELATED INFORMATION

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

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

Patient-Care Services — This segment consists of the Company’s owned and operated patient-care centers and fabrication centers of O&P components. The patient-care centers provide services to design and fit O&P devices to patients. These centers also instruct patients in the use, care and maintenance of the devices. Fabrication centers are involved in the fabrication of O&P components for both the O&P industry and the Company’s own patient-care centers.

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

Other — This consists of Hanger Corporate, Innovative Neurotronics, Inc. (IN, Inc.) and Linkia. IN, Inc. specializes in bringing emerging MyoOrthotics Technologies® to the O&P market.

MyoOrthotics Technologies represents the merging of orthotic technologies with electrical stimulation. Linkia is a national managed-care agent for O&P services and a patient referral clearing house.

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

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NOTE L — SEGMENT AND RELATED INFORMATION (CONTINUED)

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

(In thousands)	Patient-Care Centers			Distribution		Other			Consolidating Adjustments			Total
	(Unaudited)			(Unaudited)		(Unaudited)			(Unaudited)			(Unaudited)
Three Months Ended June 30, 2010
Net sales
Customers	$	181,160		$	24,230	$	418		$	—		$	205,808
Intersegments	—			43,282		1,136			(44,418		)	—
Depreciation and amortization	2,845			261		1,354			—			4,460
Income (loss) from operations	35,622			7,727		(20,162		)	(39		)	23,148
Interest (income) expense	7,094			855		(443		)	—			7,506
Income (loss) before taxes	28,527			6,872		(19,718		)	(39		)	15,642

Three Months Ended June 30, 2009
Net sales
Customers	$	171,189		$	21,953	$	381		$	—		$	193,523
Intersegments	—			38,448		327			(38,775		)	—
Depreciation and amortization	2,389			129		1,290			—			3,808
Income (loss) from operations	33,218			6,264		(15,338		)	12			24,156
Interest (income) expense	(1,596		)	1,770		7,421			—			7,595
Income (loss) before taxes	34,814			4,494		(22,592		)	12			16,728

Six Months Ended June 30, 2010
Net sales
Customers	$	337,206		$	46,047	$	871		$	—		$	384,124
Intersegments	—			81,436		2,119			(83,555		)	—
Depreciation and amortization	5,619			502		2,650			—			8,771
Income (loss) from operations	60,057			13,861		(36,475		)	(83		)	37,360
Interest (income) expense	14,183			1,706		(841		)	—			15,048
Income (loss) before taxes	45,874			12,155		(35,634		)	(83		)	22,312

Capital expenditures	9,938			755		3,047			—			13,740

Six Months Ended June 30, 2009
Net sales
Customers	$	318,955		$	42,870	$	845		$	—		$	362,670
Intersegments	—			73,410		1,075			(74,485		)	—
Depreciation and amortization	5,176			438		2,650			—			8,264
Income (loss) from operations	56,812			12,501		(30,144		)	117			39,286
Interest (income) expense	(3,221		)	3,539		14,884			—			15,202
Income (loss) before taxes	60,033			8,962		(44,861		)	117			24,251

Capital expenditures	5,249			302		546			—			6,097

Total Assets
June 30, 2010	882,453			131,154		(131,012		)	—			882,595
December 31, 2009	821,988			119,989		(66,941		)	—			875,036

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NOTE M — CORPORATE OFFICE RELOCATION

The Company is relocating its corporate headquarters from Bethesda, Maryland to Austin, Texas and anticipates that the move will be substantially completed by the end of the third quarter of 2010. The Company anticipates it will incur employee termination and relocation costs of approximately $10.0 million to $12.0 million and lease exit cost of approximately $3.0 million to $5.0 million. Employee termination costs are expensed over the service period and will be paid out over the next twelve months. Other relocation costs are expensed as incurred. For the three and six months ended June 30, 2010, the Company incurred $2.5 million and $4.0 million of employee termination costs, respectively, and $1.7 million and $2.2 million, respectively in other relocation associated costs.

The following is a summary of the office relocation costs to be paid in future periods:

	(In thousands)
Balance as of December 31, 2009 (unaudited)	$	—
Salaries, wages, and benefits accrued	3,617
Salaries, wages, and benefits paid	—
Balance as of June 30, 2010 (unaudited)	$	3,617

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

Overview

The following is a discussion of our results of operations and financial condition for the periods described below. This discussion should be read in conjunction with the Consolidated Financial Statements included in this report. Our discussion of our results of operations and financial condition includes various forward-looking statements about our markets, the demand for our products and services and our future results. These statements are based on our current expectations, which are inherently subject to risks and uncertainties. Refer to risk factors disclosed in Part II, Item 1A of this filing as well as the risk factors disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2009 for further discussion of risks and uncertainties. Our actual results and the timing of certain events may differ materially from those indicated in the forward looking statements.

Business Overview

General

Hanger Orthopedic Group, Inc. (the “Company”) is the largest owner and operator of orthotic and prosthetic (“O&P”) patient-care centers, (“patient-care centers”), accounting for approximately 27% of the estimated $2.6 billion O&P patient-care market in the United States. At June 30, 2010, the Company operated 681 O&P patient-care centers in 45 states and the District of Columbia with over 3700 employees including 1,128 revenue-generating O&P practitioners (“practitioners”). In addition, through our wholly-owned subsidiary, Southern Prosthetic Supply, Inc. (“SPS”), we are the largest distributor of branded and private label O&P devices and components in the United States, all of which are manufactured by third parties. We also introduce new technologies, through our wholly-owned subsidiary, Innovative Neurotronics, Inc. (“IN, Inc.”) for patients who have had a loss of mobility due to strokes, multiple sclerosis or other similar conditions. Another subsidiary, Linkia LLC (“Linkia”), develops programs to manage all aspects of O&P patient care for large private payors.

For the three and six months ended June 30, 2010, our net sales were $205.8 million and $384.1, respectively, and the Company recorded net income of $9.8 million and $13.8 million, respectively. For the three and six months ended June 30, 2009, our net sales were $193.5 million and $362.7 million, respectively, and the Company recorded net income of $10.0 million and $14.6 million, respectively.

The Company conducts our operations primarily in two reportable segments — patient-care services and distribution. For the three months ended June 30, 2010, net sales attributable to our patient-care services segment and distribution segment were $181.1 million and $24.2 million, respectively. See Note L to our consolidated financial statements contained herein for further information related to our segments.

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Industry Overview

The Company estimates that the United States O&P patient care market is approximately $2.6 billion, of which the Company accounts for approximately 27%. The O&P patient care services market is highly fragmented and is characterized by local, independent O&P businesses, with the majority generally having a single facility with annual revenues of less than $1.0 million. We do not believe that any of our patient care competitors account for a market share of more than 2% of the country’s total estimated O&P patient care services revenue.

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

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

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

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

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

Advancing Technology. The range and effectiveness of treatment options for patients requiring O&P services have increased in connection with the technological sophistication of O&P devices. Advances in design technology and lighter, stronger and more cosmetically acceptable

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materials have enabled patients to replace older O&P devices with new O&P products that provide greater comfort, protection and patient acceptability. As a result, treatment can be more effective or of shorter duration, giving the patient greater mobility and a more active lifestyle. Advancing technology has also increased the prevalence and visibility of O&P devices in many sports, including skiing, running and tennis.

Business Strategy

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

· Improve our performance by:

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

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

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

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

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

· Increase our market share and net sales by:

· continued marketing of Linkia to regional and national providers and contracting with national and regional managed care providers who we believe select us as a preferred O&P provider because of our reputation, national reach, density of our patient-care centers in certain markets and our ability to monitor quality and outcomes as well as reducing administrative expenses;

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

· expanding the breadth of products being offered out of our patient-care centers; and

· developing new distribution channels to sell our existing products;

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· Develop businesses that provide services and products to the broader rehabilitation and post-surgical healthcare areas;

· Continue to create, license or patent and market devices based on new cutting edge technology;

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

· Provide our practitioners with:

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

· career development and increased compensation opportunities;

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

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

· selective application of new technology to improve patient care.

Business Description

Patient Care Services

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

Patients are referred to our local patient-care centers directly by physicians as a result of our reputation with them or through our agreements with managed care providers. Practitioners, technicians and office administrators staff our patient-care centers. Our practitioners generally design and fit patients with, and the technicians fabricate, O&P devices as prescribed by the referring physician. Following the initial design, fabrication and fitting of our O&P devices, our technicians conduct regular, periodic maintenance of O&P devices as needed.

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Our practitioners are also responsible for managing and operating our patient-care centers and are compensated, in part, based on their success in managing costs and collecting accounts receivable. The Company provides centralized administrative, marketing and materials management services to take advantage of economies of scale and to increase the time practitioners have to provide patient care. In areas where we have multiple patient-care centers, we also utilize shared fabrication facilities where technicians fabricate devices for practitioners in that region.

Distribution Services

The Company distributes O&P components to the O&P market as a whole and to our own patient-care centers through our wholly-owned subsidiary, SPS, which is the nation’s largest O&P distributor. SPS maintains an inventory of over 27,000 O&P related items, all of which are manufactured by other companies. SPS maintains distribution facilities in California, Florida, Georgia, Pennsylvania, and Texas, which allows us to deliver products via ground shipment anywhere in the United States within two business days.

Our distribution business enables us to:

· lower our material costs by negotiating purchasing discounts from manufacturers;

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

· quickly access prefabricated and finished O&P products;

· perform inventory quality control;

· encourage our patient-care centers to use clinically appropriate products that enhance our profit margins; and

· coordinate new product development efforts with key vendor “partners”.

This is accomplished at competitive prices as a result of our direct purchases from manufacturers. Marketing of our distribution services is conducted on a national basis through a dedicated sales force, print and e-commerce catalogues and exhibits at industry and medical meetings and conventions. The Company directs specialized catalogues to segments of the healthcare industry, such as orthopedic surgeons, physical and occupational therapists, and podiatrists.

Product Development

IN, Inc. specializes in product development principally in the field of functional electrical stimulation. IN, Inc. identifies emerging MyoOrthotics Technologies® developed at research centers and universities throughout the world that use neuromuscular stimulation to improve the functionality of an impaired limb. MyoOrthotics Technologies® represents the merging of orthotic technologies with electrical stimulation. Working with the inventors under licensing and consulting agreements, IN, Inc. commercializes the design, obtains regulatory approvals, develops clinical protocols for the technology, and then introduces the devices to the marketplace

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through a variety of distribution channels. IN, Inc’s. first product, the WalkAide System (“WalkAide”), has received FDA approval, achieved ISO 13485:2004 and ISO 9001:2000 certification, as well as the European CE Mark, which are widely accepted quality management standards for medical devices and related services. Additionally, in September 2007, the WalkAide earned the esteemed da Vinci Award for Adaptive Technologies from the National Multiple Sclerosis Society which honors outstanding engineering achievements in adaptive and assistive technology that provide solutions to accessibility issues for people with disabilities. In November 2008, the Centers for Medicare and Medicaid Services overturned a non-coverage decision and assigned a specific E-code to the WalkAide, which is reimbursable for beneficiaries with foot drop due to incomplete spinal cord injuries. The code was effective January 1, 2009. The Company continues to work on clinical trials to qualify the device for reimbursement for stroke patients. The WalkAide is sold in the United States through our patient care centers and SPS. IN, Inc. is also marketing the WalkAide internationally through licensed distributors.

Provider Network Management

Linkia is the first provider network management service company dedicated solely to serving the O&P market. Linkia is dedicated to managing the O&P services of national and regional insurance companies. Linkia partners with healthcare insurance companies by securing a national or regional contract either as a preferred provider or to manage their O&P network of providers. Linkia’s network now totals approximately 1,000 O&P provider locations. As of June 30, 2010, Linkia had 43 contracts with national and regional providers.

Competitive Strengths

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

· Leading market position, with an approximate 27% share of total industry revenues and operations in 45 states and the District of Columbia, in an otherwise fragmented industry;

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

· establish our brand name and generate economies of scale;

· implement best practices throughout the Company;

· utilize shared fabrication facilities;

· contract with national and regional managed care entities;

· identify, test and deploy emerging technology; and

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

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

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· negotiate greater purchasing discounts from manufacturers and freight providers;

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

· quickly access prefabricated and finished O&P products;

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

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

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

· Development of leading-edge technology to be brought to market through our patient practices and licensed distributors worldwide;

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

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

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

· History of successful integration of small and medium-sized O&P business acquisitions, including 84 O&P businesses since 1997, representing over 207 patient-care centers;

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

· Experienced and committed management team; and

· Successful government relations efforts including:

· Supported our patients’ efforts to pass “The Prosthetic Parity Act” in 17 states;

· Increased Medicaid reimbursement levels in several states; and

· Created the Hanger Orthopedic Political Action Committee (The Hanger PAC).

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Critical Accounting Policies and Estimates

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

· Revenue Recognition: Revenues in our patient care centers are derived from the sale of orthotic and prosthetic (“O&P”) devices and the maintenance and repair of existing devices. The sale of O&P devices includes the design, fabrication, assembly, fitting and delivery of a wide range of braces, limbs and other devices. Revenues from the sale of these devices are recorded when (i) acceptance by and delivery to the patient has occurred; (ii) persuasive evidence of an arrangement exists and there are no further obligations to the patients; (iii) the sales price is fixed or determinable; and (iv) collectibility is reasonably assured. Revenues from maintenance and repairs are recognized when the service is provided. Revenues from the sale of O&P devices to customers by our distribution segment are recorded upon the shipment of products, in accordance with the terms of the invoice, net of merchandise returns received and the amount established for anticipated returns. Discounted sales are recorded at net realizable value.

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The following represents the composition of our accounts receivable balance by payor:

June 30, 2010 (unaudited)
(In thousands)	0-60 days		61-120 days		Over 120 days		Total
Commercial and other	$	48,810	$	10,039	$	7,767	$	66,616
Private pay	4,863		2,210		2,069		9,142
Medicaid	10,715		2,273		1,966		14,954
Medicare	22,314		2,402		1,690		26,406
VA	1,373		304		70		1,747
	$	88,075	$	17,228	$	13,562	$	118,865

December 31, 2009
(In thousands)	0-60 days		61-120 days		Over 120 days		Total
Commercial and other	$	52,768	$	9,862	$	5,587	$	68,217
Private pay	3,543		2,061		1,564		7,168
Medicaid	9,929		2,177		1,382		13,488
Medicare	22,624		1,796		1,316		25,736
VA	1,087		240		71		1,398
	$	89,951	$	16,136	$	9,920	$	116,007

Certain accounts receivable may be uncollectible, even if properly pre-authorized and billed. Regardless of the balance, accounts receivable amounts are periodically evaluated to assess collectibility. In addition to the actual bad debt expense recognized during

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collection activities, the Company estimates the amount of potential bad debt expense that may occur in the future. This estimate is based upon historical experience as well as a review of the receivable balances.

· Inventories: Inventories, which consist principally of raw materials, work in process and finished goods, are stated at the lower of cost or market using the first-in, first-out method. For its patient-care centers segment, the Company calculates cost of goods sold-materials in accordance with the gross profit method for all reporting periods. The Company bases the estimates used in applying the gross profit method on the actual results of the most recently completed fiscal year and other factors, such as a change in the sales mix or changes in the trend of purchases. Cost of goods sold-materials during the interim periods are reconciled and adjusted when the annual physical inventory is taken. The Company treats these adjustments as changes in accounting estimates.

· Fair Value: Effective January 1, 2008, the Company adopted the authoritative guidance for fair value measurements and disclosures, which establishes a framework for measuring fair value and requires enhanced disclosures about fair value measurements. The authoritative guidance requires disclosure about how fair value is determined for assets and liabilities and establishes a hierarchy by which these assets and liabilities must be grouped, based on significant levels of inputs as follows:

Level 1		quoted prices in active markets for identical assets or liabilities;
Level 2		quoted prices in active markets for similar assets and liabilities and inputs that are observable for the asset or liability;
Level 3		unobservable inputs, such as discounted cash flow models and valuations.

The determination of where assets and liabilities fall within this hierarchy is based upon the lowest level of input that is significant to the fair value measurement.

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Effective January 1, 2009, the Company adopted the authoritative guidance for fair value measurements and disclosures for all non-financial assets and liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis. As of June 30, 2010, there has been no impact to the Company’s consolidated financial statements related to the application of fair value measurements and disclosures guidance for non-financial assets and liabilities.

Our investments consisted of two auction rate securities (“ARS”) totaling $7.5 million of par value, $5.0 million is collateralized by Indiana Secondary Market Municipal Bond — 1998 (“Indiana ARS”) and $2.5 million collateralized by Primus Financial Products Subordinated Deferrable Interest Notes (“Primus ARS”). ARS are securities that are structured with short-term interest rate reset dates which generally occur every 28 days and are linked to LIBOR. At the reset date, investors can attempt to sell via auction or continue to hold the securities at par. The Company’s ARS are reported at fair value.

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determined the fair value of the Rights was $0.3 million and the fair value of the ARS was $4.7 million. The change in the fair value of the Rights and the ARS for the six months ended June 30, 2010 are reflected as components of earnings.

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As of December 31, 2009, liabilities from the interest rate swap were $5.3 million, with $4.4 million reported in accrued expenses, while the remainder reported in other liabilities. Of the $5.3 million in liabilities reported as of December 31, 2009, $4.8 million related to the effective portion of the interest rate swaps and was reported as a component of accumulated other comprehensive loss on our consolidated balance sheets.

· Goodwill and Other Intangible Assets: Goodwill represents the excess of purchase price over the value assigned to net identifiable assets of purchased businesses. The Company assesses goodwill for impairment annually on October 1st, or when events or circumstances indicate that the carrying value of the reporting units may not be recoverable. Any impairment would be recognized by a charge to operating results and a reduction in the carrying value of the intangible asset. Our annual impairment test for goodwill primarily utilizes the income approach and considers the market approach and the cost approach in determining the value of our reporting units. Non-compete agreements are recorded based on agreements entered into by us and are amortized, using the straight-line method, over their terms ranging from five to seven years. Other definite-lived intangible assets are recorded at cost and are amortized, using the straight-line method, over their estimated useful lives of up to 17 years. Whenever the facts and circumstances indicate that the carrying amounts of these intangibles may not be recoverable, management reviews and assesses the future cash flows expected to be generated from the related intangible for possible impairment. Any impairment would be recognized as a charge to operating results and a reduction in the carrying value of the intangible asset. As of June 30, 2010, there were no indicators of impairment.

· Income Taxes: The Company recognizes deferred income tax liabilities and assets for the expected future tax consequences of events that have been included in the consolidated financial statements or tax returns. We account for income taxes under the liability method, whereby deferred income tax liabilities and assets are determined based on the difference between the financial statement and the tax basis of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. Valuation allowances are established, when necessary, to reduce tax assets when we expect the amount of tax benefit to be realized to be less than the carrying value of the deferred tax asset.

· New Accounting Guidance: In January 2010, the FASB issued additional authoritative guidance for fair value measurements and disclosures. This includes the disclosure of significant transfers in and out of Level 1 and 2 measurements and describing the reasons for the transfers, reporting of information separately for purchases, sales, issuances, and settlements within Level 3 measurements, level of disaggregation, and input and valuation techniques. The additional authoritative guidance, except for the reporting of information within Level 3 measurements was effective January 1, 2010. The adoption of the additional guidance on January 1, 2010 did not have a material impact on the Company’s consolidated financial statements. The additional authoritative guidance for the reporting of activity for purchases, sales, issuances, and settlements within Level 3 measurements is effective January 1, 2011 The Company believes the impact of the additional authoritative guidance for fair value measurements and disclosures for Level 3

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measurements will not have a material impact on the Company’s consolidated financial statements.

Results of Operations

The following table sets forth for the periods indicated certain items from our Consolidated Statements of Operations as a percentage of our net sales:

	Three Months Ended				Six Months Ended
	June 30,				June 30,
	2010		2009		2010		2009
	(Unaudited)		(Unaudited)		(Unaudited)		(Unaudited)

Net sales	100.0	%	100.0	%	100.0	%	100.0	%
Cost of goods sold - materials	30.5		30.4		30.3		30.3
Personnel costs	34.3		34.0		36.3		35.8
Other operating expenses	19.8		21.2		19.8		20.8
Relocation expenses	2.0		—		1.6		—
Depreciation and amortization	2.2		1.9		2.3		2.3
Income from operations	11.2		12.5		9.7		10.8
Interest expense	3.6		3.8		3.9		4.1
Income before taxes	7.6		8.7		5.8		6.7
Provision for income taxes	2.9		3.5		2.2		2.7
Net income	4.7	%	5.2	%	3.6	%	4.0	%

Three Months Ended June 30, 2010 Compared to the Three Months Ended June 30, 2009

Net Sales. Net sales for the three months ended June 30, 2010 increased by $12.3 million, or 6.4%, to $205.8 million from $193.5 million for the three months ended June 30, 2009. The sales increase was principally the result of a $6.8 million, or 4.0% increase in same-center sales in our patient care business, a $2.3 million, or 10.4% increase in external sales of our distribution segment, and a $3.2 million increase principally related to sales from acquired entities.

Cost of Goods Sold - Materials. Cost of goods sold - materials for the three months ended June 30, 2010 was $62.8 million, an increase of $4.0 million, or 6.8%, over $58.8 million for the three months ended June 30, 2009. The increase was the result of the growth in sales. Cost of goods sold - materials as a percentage of net sales increased to 30.5% in 2010 from 30.4% in 2009 due to a slight change in payor mix.

Personnel Costs. Personnel costs for the three months ended June 30, 2010 increased by $4.9 million to $70.6 million from $65.7 million for the three months ended June 30, 2009. The increase of $4.9 million from the prior year is due primarily to $1.3 million from acquired entities, $2.4 million related to merit increases and other compensation, and employee benefit costs of $1.2 million.

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Other Operating Expenses. Other operating expenses for the three months ended June 30, 2010 decreased by $0.3 million to $40.7 million from $41.0 million for the three months ended June 30, 2009. The decrease is due primarily to continued expense management, including lower bad debt expense and variable compensation accruals. Other operating expenses as a percentage of net revenues decreased 40 basis points to 19.8% from 21.2% in the first quarter 2010 and 2009, respectively, due to continued focus on expense management.

Depreciation and Amortization. Depreciation and amortization for the three months ended June 30, 2010 was $4.5 million compared to $3.8 million for the three months ended June 30, 2009. The increase from the prior year was commensurate with the increase in fixed asset purchases over the last 12 months.

Income from Operations. Income from operations decreased $1.1 million to $23.1 million for the three months ended June 30, 2010 compared to $24.2 million in the three months ended June 30, 2009. The decrease in the current period over the same period prior in the year is due mainly to expenses related to our corporate office relocation, offset by increases in sales.

Interest Expense. Interest expense for the three months ended June 30, 2010 was consistent with expenses in the same quarter in the previous year due to variable interest rates remaining approximately the same.

Provision for Income Taxes. The provision for income taxes for the three months ended June 30, 2010 was $5.9 million or 37.6% of pre tax income, compared to $6.7 million or 40.0% of pre tax income for the three months ended June 30, 2009. The decrease in the income tax provision was primarily the result of lower income from operations. The effective tax rate in the six month period ended June 30, 2010 benefited from the release of $0.3 million in tax reserves. The rate consists principally of the federal statutory tax rate of 35.0% and state income taxes.

Net Income. Net income decreased $0.2 million, or 2.5%, to $9.8 million for three months ended June 30, 2010 from $10.0 million for the three months ended June 30, 2009. The current period decreased over the same period in the prior year due mainly to corporate office relocation expenses, partially offset by increases in sales.

Six Months Ended June 30, 2010 Compared to the Six Months Ended June 30, 2009

Net Sales. Net sales for the six months ended June 30, 2010 increased by $21.4 million, or 5.9%, to $384.1 million from $362.7 million for the same period in the prior year. The sales increase was principally the result of a $12.4 million, or 3.9%, increase in same-center sales in our patient care business, a $3.2 million increase in external sales of our distribution segment, and a $5.9 million increase associated with acquisitions.

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Cost of Goods Sold - Materials. Cost of goods sold - materials for the six months ended June 30, 2010 was $116.4 million, an increase of $6.5 million, or 5.9%, over $109.9 million for the same period in the prior year. The increase was the result of growth in sales. Cost of goods sold - materials as a percentage of net sales was 30.3% in both 2010 and 2009.

Personnel Costs. Personnel costs for the six months ended June 30, 2010 increased by $9.5 million to $139.3 million from $129.8 million for the six months ended June 30, 2009. The increase was principally due to $2.7 million of additional personnel cost from acquired entities, $5.2 million related to merit increases and other compensation, and employee benefit costs of $1.6 million.

Other Operating Expenses. Other operating expenses for the six months ended June 30, 2010 were $76.0 million which is consistent with the prior year.

Relocation Expenses. The Company is relocating its corporate headquarters from Bethesda, Maryland to Austin, Texas and anticipates the move will be substantially complete by the end of the third quarter of 2010. The Company anticipates incurring a total of approximately $10 to $12 million of employee termination and relocation costs. During the six months ended June 30, 2010 the Company incurred a total of $6.2 million, made up of $4.0 million of employee termination costs and $2.2 million in other relocation costs.

Depreciation and Amortization. Depreciation and amortization for the six months ended June 30, 2010 was $8.8 million versus $8.3 million for the six months ended June 30, 2009. The increase is commensurate with the increase in fixed asset purchases over the last 12 months.

Income from Operations. Principally due to the increase in operating expenses, income from operations decreased $1.9 million to $37.4 million for the six months ended June 30, 2010 compared to $39.3 million in the six months ended June 30, 2009.

Interest Expense. Interest expense for the six months ended June 30, 2010 was consistent with expenses in the same period in the previous year due to variable interest rates remaining approximately the same.

Provision for Income Taxes: The provision for income taxes for the six months ended June 30, 2010 was $8.5 million, or 38.3% of pre tax income, compared to $9.7 million or 40% of pre tax income for the six months ended June 30, 2009. The decrease in the income tax provision was primarily the result of lower income from operations. The effective tax rate in the six month period ended June 30, 2010 benefited from the release of $0.3 million of tax reserves. The rate consists principally of the federal statutory tax rate of 35.0% and state income taxes.

Net Income. As a result of the above, the Company recorded net income of $13.8 million for the six months ended June 30, 2010 compared to $14.6 million for the same period in the prior year.

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Financial Condition, Liquidity, and Capital Resources

Cash Flows

Our working capital at June 30, 2010 was $230.7 million compared to $216.7 million at December 31, 2009. Cash flow provided by operations was $7.5 million for the six months ended June 30, and was $13.3 million less than $20.8 million in the prior year. The reduced cash flow is due to the build in working capital and the relocation expense in the current year. Days sales outstanding (“DSO”), which is the number of days between the billing for our O&P services and the date of our receipt of payment thereof is 49 days, which is consistent with the prior year.

Net cash used in investing activities was $19.0 million for the six months ended June 30, 2010 versus $8.1 million for the same period in the prior year. Cash used in investing activities in the current period included $13.7 million related to the purchase of computer related assets, machinery and equipment, and leasehold improvements and $6.8 million related to acquisitions of patient-care centers. These amounts were offset by the sale of our Primus Auction Rate Security in May 2010, with proceeds totaling $1.5 million.

Net cash used in financing activities was $0.9 million for the six months ended June 30, 2010 compared to cash provided by financing activities of $5.3 million for the six months ended June 30, 2009. The decrease in cash provided by financing activities was due to the proceeds from the UBS loan obtained in conjunction with the Rights agreement that was included in the prior year and additional scheduled repayment of long-term debt in the current year.

Debt

Long-term debt consisted of the following:

	June 30,			December 31,
(In thousands)	2010			2009
	(Unaudited)			(Unaudited)

Line of Credit	$	3,657		$	3,628
Term Loan	220,800			221,956
10 1/4% Senior Notes due 2014	175,000			175,000
Subordinated seller notes, non-collateralized, net of unamortized discount with principal and interest payable in either monthly, quarterly or annual installments at effective interest rates ranging from 3.50% to 7.00%, maturing through September 2013	9,717			9,888
	409,174			410,472
Less current portion	(9,025		)	(8,835		)
	$	400,149		$	401,637

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Revolving Credit Facility

Line of Credit

Term Loan

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10 ¼% Senior Notes

The notes are not redeemable at the Company’s option prior to June 1, 2010. On or after June 1, 2010, the Company may redeem all or part of the notes upon not less than 30 days and no more than 60 days’ notice, for the twelve-month period beginning on June 1 of the following years; at (i) 105.125% through May 31, 2011; (ii) 102.563% through May 31, 2012; and (iii) 100.0% beginning June 1, 2013 and thereafter through June 1, 2014.

Debt Covenants

General

We are actively evaluating refinancing our current debt, including our revolving credit facility which matures on May 26, 1011. However, we believe that based on current levels of operations and anticipated growth, cash generated from operations, together with other available sources of liquidity, will be sufficient for the foreseeable future to fund anticipated working capital, capital expenditures and to make required debt service payments. We will continue to evaluate potential acquisitions and expect to fund such acquisitions from our available sources of liquidity, as discussed above. We are limited to $50.0 million in acquisitions annually, plus any unused portion of such amount from the previous fiscal year, by the terms of the Revolving Credit Facility agreement.

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Obligations and Commercial Commitments

The following table sets forth our contractual obligations and commercial commitments as of June 30, 2010 (unaudited):

Payments Due by Period

(In thousands)	2010		2011		2012		2013		2014		Thereafter		Total

Long-term debt	$	6,675	$	6,101	$	5,495	$	215,796	$	175,107	$	—	$	409,174
Interest payments on long-term debt	14,108		25,352		23,204		20,492		8,972		713		$	92,841
Operating leases	19,845		35,324		29,647		22,529		16,557		36,946		$	160,848
Capital leases and other long-term obligations (1)	2,998		6,349		5,581		3,193		2,753		8,477		$	29,351
Total contractual cash obligations	$	43,626	$	73,126	$	63,927	$	262,010	$	203,389	$	46,136	$	692,214

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

In addition to the table above, the Company has certain other tax liabilities as of June 30, 2010 comprised of $1.0 million of unrecognized tax benefits, of which $0.4 million is expected to be settled in the fiscal year 2010, with the remainder thereafter.

Off-Balance Sheet Arrangements

The Company’s wholly-owned subsidiary, Innovative Neurotronics, Inc. (“IN, Inc.”), is party to a non-binding purchase agreement under which it purchases assembled WalkAide System kits. As of June 30, 2010, IN, Inc. had outstanding purchase commitments of approximately $1.1 million that we expect to be fulfilled over the next three months.

Market Risk

The Company is exposed to the market risk that is associated with changes in interest rates. At June 30, 2010, all our outstanding debt, with the exception of $74.5 million of the Term Loan and the Line of Credit, is subject to fixed interest rates (see Item 3 below).

Forward Looking Statements

This report contains forward-looking statements setting forth our beliefs or expectations relating to future revenues, contracts and operations, as well as the results of an internal investigation and certain legal proceedings. Actual results may differ materially from projected or expected results due to changes in the demand for our O&P products and services, uncertainties relating to the results of operations or recently acquired O&P patient-care centers, our ability to enter into and derive benefits from managed-care contracts, our ability to successfully attract and retain qualified O&P practitioners, federal laws governing the health-care industry, uncertainties inherent in incomplete investigations and legal proceedings, governmental policies affecting O&P operations and other risks and uncertainties generally affecting the health-care industry. Readers are cautioned not to put undue reliance on forward-looking statements. Refer to risk factors disclosed in Part II, Item 1A of this filing as well as the risk factors disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2009 for discussion of risks and uncertainties. The Company disclaims any intent or obligation to publicly update

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these forward-looking statements, whether as a result of new information, future events or otherwise.

ITEM 3.

Quantitative and Qualitative Disclosures about Market Risk

We have existing obligations relating to our 10 ¼% Senior Notes, Term Loan, Subordinated Seller Notes, and Line of Credit. As of June 30, 2010, we have cash flow exposure to the changing interest rates on $74.5 million of the Term Loan and the entire Line of Credit. The other obligations have fixed interest or dividend rates.

In addition, in the normal course of business, we are exposed to fluctuations in interest rates. From time-to-time, we execute LIBOR contracts to fix interest rate exposure for specific periods of time. At June 30, 2010, we had one contract outstanding which fixed LIBOR at 2.35% and expired on July 28, 2010.

In May 2008, the Company entered into two interest rate swap agreements under which $150.0 million of the Company’s variable rate Term Loans were converted to a fixed rate of 5.4%. The agreements expire in April 2011.

Presented below is an analysis of our financial instruments as of June 30, 2010 that are sensitive to changes in interest rates. The table demonstrates the changes in estimated annual cash flow related to the outstanding balance under the Term Loan and the Interest Rate Swap, calculated for an instantaneous parallel shift in interest rates, plus or minus 50 basis points (“BPS”), 100 BPS, and 150 BPS.

Cash Flow Risk	Annual Interest Expense Given an Interest Rate Decrease of X Basis Points						No Change in		Annual Interest Expense Given an Interest Rate Increase of X Basis Points
(In thousands)	(150 BPS)		(100 BPS)		(50 BPS)		Interest Rates		50 BPS		100 BPS		150 BPS
Term Loan	$	1,877	$	2,981	$	4,085	$	5,189	$	6,293	$	7,397	$	8,501
Interest Rate Swap	6,840		6,090		5,339		4,590		3,840		3,090		2,340

	$	8,717	$	9,071	$	9,424	$	9,779	$	10,133	$	10,487	$	10,841

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ITEM 4.

Controls and Procedures

Disclosure Controls and Procedures

The Company’s disclosure controls and procedures are designed to provide reasonable assurance that information required to be disclosed by it in its periodic reports filed with the Securities and Exchange Commission is recorded, processed, summarized and reported, within the time periods specified in the Commission’s rules and forms. Based on an evaluation of the Company’s disclosure controls and procedures conducted by the Company’s Chief Executive Officer and Chief Financial Officer, such officers concluded that the Company’s disclosure controls and procedures were effective at the reasonable assurance level as of June 30, 2010 to ensure that information required to be disclosed in the reports filed under the Exchange Act was accumulated and communicated to management, including the Company’s Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosures.

Change in Internal Control Over Financial Reporting

In accordance with Rule 13a-15(d) under the Securities Exchange Act of 1934, management, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, determined that there was no change in the Company’s internal control over financial reporting that occurred during the quarter ended June 30, 2010, that has materially effected, or is reasonably likely to materially effect, the Company’s internal control over financial reporting.

Part II. Other Information

ITEM 1A. RISK FACTORS.

Part I, Item 1A (“Risk Factors”) of the Company’s Annual Report on Form 10-K for the year ended December 31, 2009 sets forth information relating to important risks and uncertainties that could materially adversely affect the Company’s business, financial condition or operating results. Those risk factors continue to be relevant to an understanding of the Company’s business, financial condition and operating results. Certain of those risk factors have been updated in this Form 10-Q to provide updated information, as set forth below. References to “we,” “our” and “us” in these risk factors refer to the Company.

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

We derived 40.7% and 41.0% of our net sales for the three months ended June 30, 2010 and 2009, respectively, from reimbursements for O&P services and products from programs administered by Medicare, Medicaid and the U.S. Department of Veterans Affairs. For the six months ended June 30, 2010 and 2009, we derived 40.6% and 41.2%, respectively, of our net sales from reimbursements for O&P services and products from programs administered by Medicare, Medicaid and the U.S. Department of Veterans Affairs. Each of these programs set maximum reimbursement levels for O&P services and products. If these agencies reduce reimbursement levels for O&P services and products in the future, our net sales could substantially decline. In addition, the percentage of our net sales derived from these sources may

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increase as the portion of the U.S. population over age 65 continues to grow, making us more vulnerable to maximum reimbursement level reductions by these organizations. Reduced government reimbursement levels could result in reduced private payor reimbursement levels because fee schedules of certain third-party payors are indexed to Medicare. Furthermore, the healthcare industry is experiencing a trend towards cost containment as government and other third-party payors seek to impose lower reimbursement rates and negotiate reduced contract rates with service providers. This trend could adversely affect our net sales. For example, a number of states are in the process of reviewing Medicaid reimbursement policies generally, including for prosthetic and orthotic devices, and Arizona has recently enacted legislation limiting Medicaid orthotic eligibility for those over 21 years of age. This legislation does not become effective until October 1, 2010, and we are evaluating its impact on our business in Arizona. Additionally, Medicare provides for reimbursement for O&P products and services based on prices set forth in fee schedules for ten regional service areas. Medicare prices are adjusted each year based on the Consumer Price Index- Urban (“CPIU”) unless Congress acts to change or eliminate the adjustment. The Medicare price increases for 2010, 2009, 2008 and 2007 were 0.0%, 5.0%, 2.7% and 4.3%, respectively. If the U.S. Congress were to legislate additional modifications to the Medicare fee schedules, our net sales from Medicare and other payors could be adversely and materially affected. We cannot predict whether any such modifications to the fee schedules will be enacted or what the final form of any modifications might be.

ITEM 6.	Exhibits

(a)	Exhibits. The following exhibits are filed herewith or incorporated by reference:

	Exhibit No.	Document

	10.1	Hanger Orthopedic Group, Inc. 2010 Omnibus Incentive Plan (incorporated by reference to Annex A to Hanger Orthopedic Group, Inc.’s Proxy Statement for its 2010 Annual Meeting of Stockholders filed on April 2, 2010).

	10.2*	Form of Restricted Stock Agreement for Non-Employee Directors (filed herewith).

	10.3*	Form of Restricted Stock Agreement for Executives (filed herewith).

	10.4*	Form of Restricted Stock Agreement for Employees (filed herewith).

	10.5*	Form of Non-Employee Director Non-Qualified Stock Option Agreement (filed herewith).

	10.6*	Form of Executive Non-Qualified Stock Option Agreement (filed herewith).

	10.7*	Form of Non-Qualified Stock Option Agreement (filed herewith).

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

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

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


		* Management contract or compensatory plan.

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SIGNATURES

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

	HANGER ORTHOPEDIC GROUP, INC.


Dated: August 9, 2010		/s/Thomas F. Kirk
		Thomas F. Kirk
		President and Chief Executive Officer
		(Principal Executive Officer)


Dated: August 9, 2010		/s/George E. McHenry
		George E. McHenry
		Executive Vice President and
		Chief Financial Officer
		(Principal Financial Officer)


Dated: August 9, 2010		/s/Thomas C. Hofmeister
		Thomas C. Hofmeister
		Vice President of Finance
		(Chief Accounting Officer)

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