10-Q 1 cmw2256.htm QUARTERLY REPORT

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, 2006

\|_\|	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 |_|

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

Large accelerated filer |_| Accelerated filer |X| Non-accelerated filer |_|

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

As of August 2, 2006, 22,031,927 shares of common stock, $.01 par value per share were outstanding.

HANGER ORTHOPEDIC GROUP, INC.

INDEX

		Page No.

Part I. FINANCIAL INFORMATION
Item 1.	Condensed Consolidated Financial Statements
Unaudited Condensed Consolidated Balance Sheets - June 30, 2006 and
December 31, 2005		1
Unaudited Condensed Consolidated Statements of Operations for the
Three and Six Months ended June 30, 2006 and 2005		3
Unaudited Condensed Consolidated Statements of Cash Flows for the
Six Months ended June 30, 2006 and 2005		4
Notes to Condensed Consolidated Financial Statements (Unaudited)		5
Item 2.	Management’s Discussion and Analysis of Financial
Condition and Results of Operations		28
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	45
Item 4.	Controls and Procedures	46
Part II. OTHER INFORMATION
Item 1.	Legal Proceedings	47
Item 1A.	Risk Factors	47
Item 4.	Submission of Matters to a Vote of Security Holders	48
Item 6.	Exhibits	49
SIGNATURES		52
Exhibit Index		53
Certifications of Chief Executive Officer and Chief Financial Officer

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

	June 30, 2006		December 31, 2005

ASSETS
CURRENT ASSETS
Cash and cash equivalents	$	12,691	$	7,921
Accounts receivable, less allowance for doubtful accounts
of $3,956 and $4,582 in 2006 and 2005, respectively		97,570		103,200
Inventories		78,418		76,725
Prepaid expenses, other assets and income taxes receivable		17,518		6,554
Deferred income taxes		8,656		7,087

Total current assets		214,853		201,487

PROPERTY, PLANT AND EQUIPMENT
Land		1,081		1,094
Buildings		5,631		5,833
Furniture and fixtures		12,054		11,874
Machinery and equipment		25,053		23,867
Leasehold improvements		31,479		29,431
Computer and software		45,999		44,364

Total property, plant and equipment, gross		121,297		116,463
Less accumulated depreciation and amortization		79,719		72,966

Total property, plant and equipment, net		41,578		43,497

INTANGIBLE ASSETS
Excess cost over net assets acquired		445,999		445,979
Patents and other intangible assets, $9,999 in each of 2006 and 2005, less
accumulated amortization of $6,651 and $6,234 in 2006 and 2005, respectively		3,348		3,765

Total intangible assets, net		449,347		449,744

OTHER ASSETS
Debt issuance costs, net		11,657		8,142
Other assets		1,481		1,597

Total other assets		13,138		9,739

TOTAL ASSETS	$	718,916	$	704,467

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

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

	June 30, 2006			December 31, 2005

LIABILITIES, REDEEMABLE PREFERRED STOCK
AND SHAREHOLDERS’ EQUITY
CURRENT LIABILITIES
Current portion of long-term debt	$	14,524		$	4,466
Accounts payable		18,408			20,520
Accrued expenses		10,739			10,955
Accrued interest payable		2,309			8,320
Accrued compensation related costs		18,501			21,675

Total current liabilities		64,481			65,936

LONG-TERM LIABILITIES
Long-term debt, less current portion		408,203			373,965
Deferred income taxes		32,162			30,851
Other liabilities		7,717			6,531

Total liabilities		512,563			477,283

COMMITMENTS AND CONTINGENCIES (Refer to Note I)
PREFERRED STOCK
7% Redeemable Preferred stock, liquidation preference of $1,000 per
share, 10,000,000 shares authorized, 37,881 shares issued and		--			61,942
outstanding in 2005
Series A Convertible Preferred stock, liquidation preference of $1,000
per share, 50,000 shares authorized, issued and outstanding in 2006		49,426			--

SHAREHOLDERS’ EQUITY
Common stock, $.01 par value; 60,000,000 shares authorized,
22,301,869 shares and 22,227,607 shares issued and outstanding in
2006 and 2005, respectively		223			222
Additional paid-in capital		154,772			156,346
Unearned compensation		--			(2,615	)
Retained earnings		2,588			11,945

		157,583			165,898
Treasury stock at cost (141,154 shares)		(656	)		(656	)

Total shareholders’ equity		156,927			165,242

TOTAL LIABILITIES, REDEEMABLE PREFERRED STOCK AND
SHAREHOLDERS’ EQUITY	$	718,916		$	704,467

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

HANGER ORTHOPEDIC GROUP, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
For the Three and Six Months Ended June 30,
(Dollars in thousands, except share and per share amounts)
(Unaudited)

	Three Months Ended June 30,					Six Months Ended June 30,
	2006			2005		2006			2005
Net sales	$	152,855		$	149,654	$	293,300		$	282,654
Cost of goods sold (exclusive of depreciation and amortization)		75,346			71,738		145,561			139,184
Selling, general and administrative		57,751			58,499		113,378			109,435
Depreciation and amortization		3,759			3,438		7,447			6,947

Income from operations		15,999			15,979		26,914			27,088
Interest expense		9,914			9,400		19,414			18,244
Extinguishment of debt		16,415			--		16,415			--

(Loss) income before taxes		(10,330	)		6,579		(8,915	)		8,844
(Benefit) provision for income taxes		(4,606	)		2,763		(4,020	)		3,693

Net (loss) income		(5,724	)		3,816		(4,895	)		5,151
Preferred stock dividend and accretion-7% Redeemable
Preferred Stock		1,186			1,455		2,751			2,874
Preferred stock dividend-Series A Convertible Preferred Stock		167			--		167			--
Accretion of beneficial conversion feature		2,224			--		2,224			--

Net (loss) income applicable to common stock	$	(9,301	)	$	2,361	$	(10,037	)	$	2,277

Basic Per Common Share Data
Net (loss) income applicable to common stock	$	(0.42	)	$	0.11	$	(0.46	)	$	0.11

Shares used to compute basic per common share amounts		21,946,319			21,661,157		21,891,694			21,644,918

Diluted Per Common Share Data
Net (loss) income applicable to common stock	$	(0.42	)	$	0.11	$	(0.46	)	$	0.10

Shares used to compute diluted per common share amounts		21,946,319			22,113,004		21,891,694			22,151,390

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

HANGER ORTHOPEDIC GROUP, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
For the Six Months Ended June 30,
Dollars in thousands)
(Unaudited)

	2006			2005
Cash flows from operating activities:
Net (loss) income	$	(4,895	)	$	5,151
Adjustments to reconcile net income to net cash provided by operating activities:
Extinguishment of debt		16,415			--
Premiums paid on early extinguishment of debt		(11,393	)		--
Gain on disposal of assets		10			--
Provision for bad debt		9,208			10,916
Provision for deferred income taxes		(234	)		1,623
Depreciation and amortization		7,447			6,947
Amortization of debt issuance costs		1,122			1,288
Compensation expense on stock options and restricted stock		765			542
Amortization of terminated interest rate swaps		(205	)		(253	)
Changes in assets and liabilities, net of effects of acquired companies:
Accounts receivable		(3,578	)		(6,310	)
Inventories		(1,604	)		(3,835	)
Prepaid expenses, other assets, and income taxes receivable		(10,982	)		(2,738	)
Other assets		68			46
Accounts payable		(1,002	)		(270	)
Accrued expenses, accrued interest payable, and income taxes payable		(6,228	)		(1,162	)
Accrued compensation related costs		(3,174	)		(9,071	)
Other liabilities		1,186			977

Net cash provided by (used in) operating activities		(7,074	)		3,851

Cash flows from investing activities:
Purchase of property, plant and equipment (net of acquisitions)		(5,177	)		(3,957	)
Acquisitions and earnouts (net of cash acquired)		(506	)		(2,215	)
Proceeds from sale of property, plant and equipment		57			--

Net cash used in investing activities		(5,626	)		(6,172	)

Cash flows from financing activities:
Borrowings under revolving credit agreement		21,000			29,000
Repayments under revolving credit agreement		(26,000	)		(31,000	)
Repayment of term loan		(146,625	)		--
Repayment of senior notes		(190,921	)		--
Repayment of senior subordinated debt		(15,485	)		--
Repurchase of 7% Redeemable Preferred Stock		(64,693	)		--
Proceeds from new term loan facility		230,000			--
Proceeds from senior note issuance		175,000			--
Proceeds from issuance of Series A Convertible Preferred Stock		50,000			--
Scheduled repayment of long-term debt		(1,129	)		(1,961	)
Increase in financing costs		(13,263	)		(3	)
Proceeds from issuance of Common Stock		253			189
Change in book overdraft		(667	)		6,684

Net cash provided by financing activities		17,470			2,909

Increase in cash and cash equivalents		4,770			588
Cash and cash equivalents, at beginning of period		7,921			8,351

Cash and cash equivalents, at end of period	$	12,691		$	8,939

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

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

NOTE A – BASIS OF PRESENTATION

The unaudited interim condensed consolidated financial statements as of and for the three and six months ended June 30, 2006 and 2005 have been prepared by the Company pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”) for interim financial reporting. These condensed consolidated statements are unaudited and, in the opinion of management, include all adjustments (consisting of normal recurring adjustments and accruals) necessary for a fair statement for the periods presented. The year-end condensed consolidated data was derived from audited financial statements but does not include all disclosures required by accounting principles generally accepted in the United States of America (“GAAP”).

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

NOTE B – SIGNIFICANT ACCOUNTING PRINCIPLES

Principles of Consolidation

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

Use of Estimates

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

Stock-Based Compensation

General

The Company issues options and restricted shares of common stock under two active share-based compensation plans, one for employees and the other for the Board of Directors. At June 30, 2006, 4.7 million shares of common stock are authorized for issuance under the Company’s share-based compensation plans. Shares of common stock issued under the share-based compensation plans are released from the Company’s authorized shares. Stock option and restricted share awards are granted at the fair market value of the Company’s common stock on the date immediately preceding the date of grant. Stock option awards vest over a period determined by the compensation plan, ranging from one to three years, and generally have a maximum term of ten

NOTE B – SIGNIFICANT ACCOUNTING PRINCIPLES (CONTINUED)

Stock-Based Compensation (continued)

General (continued)

years. Restricted shares of common stock vest over a period of time determined by the compensation plan, ranging from one to four years.

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

The Company adopted SFAS 123R using the modified prospective method allowed for in SFAS 123R. Under the modified prospective method, compensation expense related to awards granted prior to and unvested as of the adoption of SFAS 123R is calculated in accordance with SFAS 123, Accounting for Stock-Based Compensation (“SFAS 123”) and recognized in the statements of operations over the requisite remaining service period; compensation expense for all awards granted after the adoption of SFAS 123R is calculated according to the provision of SFAS 123R. Results for prior periods have not been restated. For the three month period ended June 30, 2006, the Company recognized $0.4 million in compensation expense, of which less than $0.1 million related to options. The Company recognized $0.7 million in compensation expense during the six month period ended June 30, 2006, of which $0.1 million related to options. The Company calculates the fair value of stock options using the Black-Scholes model. The total value of the stock option awards is expensed ratably over the requisite service period of the employees receiving the awards. At June 30, 2006, the Company continues to evaluate the available methods for computing the windfall tax pool as required under SFAS 123R.

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

NOTE B – SIGNIFICANT ACCOUNTING PRINCIPLES (CONTINUED)

Stock-Based Compensation (continued)

General (continued)

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

	Three Months Ended June 30, 2005			Six Months Ended June 30, 2005
(In thousands, except per share amounts)
Net income applicable to common stock, as reported	$	2,361		$	2,277
Add: stock-based employee compensation expense related to
restricted shares of common stock, net of related tax effects,
included in net income as reported		165			317
Deduct: total stock-based employee compensation
expense determined under the fair value method for all
awards, net of related tax effects		(2,269	)		(2,829	)

Pro forma net income (loss) applicable to common stock	$	257		$	(235	)

Income (loss) per share:
Basic - as reported	$	0.11		$	0.11
Basic - pro forma		0.01			(0.01	)
Diluted - as reported		0.11			0.10
Diluted - pro forma		0.01			(0.01	)

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

NOTE B – SIGNIFICANT ACCOUNTING PRINCIPLES (CONTINUED)

Stock-Based Compensation (continued)

Options

A summary of the stock option activity for the six month period ended June 30, 2006 is as follows:

	Employee Plans					Director Plans					Non-Qualified Awards
(In thousands, except per share and weighted average price amounts)	Shares			Weighted Average Price		Shares			Weighted Average Price		Shares		Weighted Average Price
Outstanding at December 31, 2005		2,576,050		$	10.24		198,411		$	9.83		406,000	$	5.95
Granted		--			--		--			--		--		--
Terminated		(22,882	)		8.19		--			--		--		--
Exercised		(74,262	)		2.72		(10,000	)		5.88		--		--

Outstanding at June 30, 2006		2,478,906		$	10.49		188,411		$	10.04		406,000	$	5.95

Aggregate intrinsic value at June 30, 2006	$	26,004				$	1,892				$	2,415
Weighted average remaining contractual term (years)		3.4					5.7					3.8

The intrinsic value of options exercised during the three and six month periods ended June 30, 2006 was $0.1 million and $0.3 million, respectively. Options exercisable under the Company’s share-based compensation plans at June 30, 2006 were 3.0 million shares with a weighted average exercise price of $13.32, an average remaining contractual term of 3.5 years, and an aggregate intrinsic value of $30.0 million. Cash received by the Company related to the exercise of options during the three and six month periods ended June 30, 2006 amounted to $0.1 million and $0.2 million, respectively. As of June 30, 2006, total unrecognized compensation cost related to stock option awards was approximately $0.1 million and the related weighted-average period over which it is expected to be recognized is approximately 1.1 years.

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

	Three Months Ended June 30, 2005			Six Months Ended June 30, 2005
Expected term (years)		1.0			3.5
Volatility factor		83	%		83	%
Risk free interest rate		3.9	%		3.9	%
Dividend yield		0.0	%		0.0	%
Fair value	$	1.71		$	4.26

NOTE B – SIGNIFICANT ACCOUNTING PRINCIPLES (CONTINUED)

Stock-Based Compensation (continued)

Options (continued)

The expected term of options is an average of the contractual terms and historical data. The expected stock price volatility is based on historical data of the Company’s common stock performance. The risk-free interest rate is based on an average of the U.S. 5-year Treasury bill rate. The Company did not grant any options during the three and six month periods ended June 30, 2006.

Restricted Shares of Common Stock

A summary of the activity of restricted shares of common for the six month period ended June 30, 2006 is as follows:

	Employee Plans					Director Plans
	Shares			Weighted Average Grant Date Fair Value		Shares			Weighted Average Grant Date Fair Value
Nonvested at December 31, 2005		388,000		$	8.28		28,571		$	5.18
Granted		742,250			7.96		87,762			7.54
Vested		(71,125	)		6.72		(22,682	)		5.09
Forfeited		(5,000	)		--		--			--

Nonvested at June 30, 2006		1,054,125		$	8.16		93,651		$	7.41

During the three month period ended June 30, 2006, 26,182 restricted shares of common stock with an intrinsic value of $0.1 million became fully vested. During the six month period ended June 30, 2006, 93,807 restricted shares of common stock with an intrinsic value of $0.6 million became fully vested. As of June 30, 2006, total unrecognized compensation cost related to restricted shares of common stock was approximately $9.8 million and the related weighted-average period over which it is expected to be recognized is approximately 3.2 years.

Segment Information

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

NOTE B – SIGNIFICANT ACCOUNTING PRINCIPLES (CONTINUED)

New Accounting Standards

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

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

In June 2006, the FASB issued FIN 48, Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109, Accounting for Income Taxes (“FIN 48”), which clarifies the accounting for uncertainty in income taxes. FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. The interpretation requires the Company to recognize, in its financial statements, the impact of a tax position if that position is more likely than not of being sustained on audit, based on the technical merits of the position. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods and disclosure. The provisions of FIN 48 are effective beginning January 1, 2007 with the cumulative effect of the change in accounting principle recorded as an adjustment to opening retained earnings. The Company is currently evaluating the impact of adopting FIN 48 on its 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)	2006			2005
Cash paid during the period for:
Interest	$	24,618		$	17,210
Income taxes		4,254			2,184
Non-cash financing and investing activities:
Preferred stock dividends declared and accretion	$	2,918		$	2,874
Accretion of beneficial conversion feature		2,224			--
Issuance of notes in connection with acquisitions		--			485
(Cancellation) issuance of restricted shares of common stock		(32	)		1,828

NOTE D — GOODWILL AND OTHER INTANGIBLE ASSETS

The activity related to goodwill for the six month period ended June 30, 2006 is as follows:

(In thousands)	Patient-Care Centers		Distribution		Total
Balance at December 31, 2005	$	417,596	$	28,383	$	445,979
Additions due to acquisitions		--		--		--
Additions due to earn-outs		20		--		20

Balance at June 30, 2006	$	417,616	$	28,383	$	445,999

NOTE E – ACQUISITIONS

The Company did not make any acquisitions during the three and six month periods ended June 30, 2006. During the three and six month periods ended June 30, 2005, the Company acquired three and four orthotics and prosthetics companies, respectively, that operated a total of two and five patient-care centers, respectively. The Company paid $0.4 million and $2.1 million for acquisitions realized during the three and six month periods ended June 30, 2005, respectively.

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

In connection with acquisitions, the Company occasionally agrees to make earnout payments if future earnings targets are reached. Earnouts are defined in the purchase agreement and are accrued based on earnout targets for the following quarter being attained. These estimates are adjusted in the actual quarter the payment is made. The Company made earnout payments of $0.5 million and $0.8 million during the six month periods ended June 30, 2006 and 2005, respectively. The Company accounts for these amounts as additional purchase price, resulting in an increase in excess cost over net assets acquired. The Company estimates that it may pay up to $1.2 million related to earnout provisions in future periods.

NOTE F – INVENTORY

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

	June 30, 2006		December 31, 2005
(In thousands)
Raw materials	$	36,412	$	31,796
Work-in-process		25,983		26,409
Finished goods		16,023		18,520

	$	78,418	$	76,725

NOTE G – LONG TERM DEBT

Long-term debt consists of the following:

	June 30, 2006			December 31, 2005
(In thousands)
Revolving Credit Facility	$	--		$	5,000
Term Loan		230,000			146,625
10 3/8% Senior Notes due 2009 (1)		9,140			201,605
11 1/4% Senior Subordinated Notes due 2009		77			15,562
10 1/4% Senior Notes due 2014		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 6.0% to 10.8%, maturing
through December 2011		8,510			9,639

		422,727			378,431
Less current portion		(14,524	)		(4,466	)

	$	408,203		$	373,965

(1) At June 30, 2006 and December 31, 2005, the outstanding amount includes $0.1 million and $1.6 million, respectively, of interest rate swap termination income to be recognized, as a reduction of interest expense, using the effective interest method, over the remaining life of the Senior Notes.

Refinancing

On May 26, 2006, the Company refinanced its debt and preferred stock with the issuance of the following instruments: (i) $175.0 million of 10 ¼% Senior Notes due 2014; (ii) a $230.0 million term loan facility; and (iii) $50.0 million of Series A Convertible Preferred Stock. The Company also established a new $75.0 million revolving credit facility, which was unused at June 30, 2006. The proceeds from these instruments were used to retire (i) $190.9 million of the 10 3/8% Senior Notes; (ii) $15.5 million of the 11 ¼% Senior Subordinated Notes; (iii) $146.3 million of the Term Loan; (iv) $11.0 million outstanding under the Revolving Credit facility; (v) $64.7 million of 7% Redeemable Preferred Stock; and (vi) pay $24.7 million of transaction costs. At

NOTE G – LONG TERM DEBT (CONTINUED)

Refinancing (continued)

June 30, 2006, $9.1 million of 10 3/8% Senior Notes and $0.1 million of 11 ¼% Senior Subordinated Notes remained outstanding. Such outstanding notes were redeemed in July 2006. In conjunction with the refinancing, the Company incurred a $16.4 million loss on the extinguishment of debt. The extinguishment loss is comprised of $11.4 million of premiums paid to debt holders, $0.3 million of fees paid to the 7% Redeemable Preferred Stock holders and $6.0 million write-off of debt issuance costs offset by a $1.3 million gain related to the interest rate swap.

Revolving Credit Facility

The $75.0 million Revolving Credit Facility matures on May 26, 2011. The Revolving Credit Facility bears interest, at the Company’s option, of LIBOR plus 2.75% or a Base Rate (as defined in the credit agreement) plus 1.75%. The obligations under the Revolving Credit 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. Beginning September 30, 2006, the Company is subject to certain covenants including but not limited to (i) minimum consolidated interest coverage ratio; (ii) maximum total leverage ratio; and (iii) maximum annual capital expenditures. As of June 30, 2006, the Company has not made draws on the Revolving Credit Facility.

Term Loan

The $230.0 million Term Loan matures on May 26, 2013 and requires quarterly payments commencing 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 Term Loan bears interest, at the Company’s option, of LIBOR plus 2.50% or a Base Rate (as defined in the credit agreement) plus 1.50%. 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.

10 ¼% Senior Notes

The 10 ¼% Senior Notes mature June 1, 2014, are senior indebtness 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, commencing December 1, 2006.

On or prior to June 1, 2009, the Company may redeem up to 35% of the aggregate principal amount of the notes at a redemption price of 110.250% of the principal amount thereof, plus accrued and unpaid interest and additional interest, if any, with the net cash proceeds of an equity offering; provided that (i) at least 65% of the aggregate principal amount of the notes remains outstanding immediately after the redemption (excluding notes held by the Company and its

NOTE G – LONG TERM DEBT (CONTINUED)

10 ¼% Senior Notes (continued)

subsidiaries); and (ii) the redemption occurs within 90 days of the date of the closing of the equity offering.

Except as discussed above, 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 May 26 of the following years; at (i) 105.125% during 2010; (ii) 102.563% during 2011; and (iii) 100.0% during 2012 and thereafter.

NOTE H –RESTRUCTURING

The activity related to the restructuring reserve during the six month period ended June 30, 2006 is as follows:

	Total Restructuring Reserve
(In thousands)
2001 Restructuring Reserve
Balance at December 31, 2005	$	220
Spending		(64	)

Balance at June 30, 2006		156
2004 Restructuring Reserve
Balance at December 31, 2005		161
Spending		(50	)

Balance at June 30, 2006		111

2001 and 2004 Restructuring Reserves	$	267

2001 Restructuring Reserve

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

As of December 31, 2002, all properties had been vacated, all of the employees had been terminated and all corresponding payments under the severance initiative had been made. At June 30, 2006, the remaining reserve of $0.2 million is adequate to provide for the lease costs which are expected to be paid through October 2012.

NOTE H –RESTRUCTURING (CONTINUED)

2004 Restructuring Reserve

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

As of December 31, 2005, all of the nine patient-care centers had been closed/merged and approximately $0.3 million in lease costs were paid, and the employment of 11 employees had been terminated and $0.1 million of severance payments had been paid. At June 30, 2006, the remaining reserve of $0.1 million is adequate to provide for the lease costs which are expected to be paid through April 2008.

NOTE I – COMMITMENTS AND CONTINGENT LIABILITIES

Contingencies

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

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

On June 18, 2004, the Company announced that on June 17, 2004, the Audit Committee of the Company’s Board of Directors had engaged the law firm of McDermott, Will & Emery LLP to serve as independent counsel to the Audit Committee and to conduct an independent investigation of the allegations. The scope of that independent investigation was expanded to cover certain of the Company’s other patient-care centers and included consideration of some of the allegations made in the Amended Complaint recently filed in the class actions discussed below. On June 17, 2004, the U.S. Attorney’s Office for the Eastern District of New York subpoenaed records of the Company regarding various billing activities and locations. In addition, the Company also announced on June 18, 2004 that the Securities and Exchange Commission had commenced an informal inquiry into the matter. The Company is cooperating with the regulatory authorities. The Audit Committee’s investigation will not be complete until all regulatory authorities have indicated that their inquiries are complete.

Management believes that any billing discrepancies are likely to be primarily at the West Hempstead patient-care center. Furthermore, management does not believe the resolution of the matters raised by the allegations will have a material adverse effect on the Company’s financial statements. The West Hempstead facility generated $0.3 million and $0.7 million in net sales during the six month period ended June 30, 2006 and the year ended 2005, respectively, or less than 0.5% of the Company’s net sales, for each period.

NOTE I – COMMITMENTS AND CONTINGENT LIABILITIES (CONTINUED)

Contingencies (continued)

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

Between June 22, 2004 and July 1, 2004, five putative securities class action complaints were filed against the Company, four in the Eastern District of New York, Twist Partners v. Hanger Orthopedic Group, Inc., et al., No. 1:04-cv-02585 (filed 06/22/2004, E.D.N.Y); Shapiro v. Hanger Orthopedic Group, Inc., et al., No. 1:04-cv-02681 (filed 06/28/2004, E.D.N.Y.); Imperato v. Hanger Orthopedic Group, Inc., No. 1:04-cv-02736 (filed 06/30/2004, E.D.N.Y.); Walters v. Hanger Orthopedic Group, Inc., et al., No. 1:04-cv-02826 (filed 07/01/2004, E.D.N.Y.); and one in the Eastern District of Virginia, Browne v. Hanger Orthopedic Group, Inc., et al., No. 1:04-cv-715 (filed 06/23/2004, E.D. Va.). The complaints asserted that the Company’s reported revenues were inflated through certain billing improprieties at one of the Company’s facilities. The plaintiffs in Browne subsequently dismissed their complaint without prejudice, and the four remaining cases were consolidated into a single action in the Eastern District of New York encaptioned In re Hanger Orthopedic Group, Inc. Securities Litigation, No. 1:04-cv-2585 (the “Consolidated Securities Class Action”). On June 12, 2006, a Second Consolidated Amended Class Action Complaint was filed against the Company in the District of Maryland, In re Hanger Orthopedic Group, Inc. Securities Litigation, No. 8:06-cv-00579-AW (the “Second Amended Complaint”). The Second Amended Complaint asserts that the Company’s reported revenues were inflated through certain billing improprieties at some of the Company’s facilities. In addition, the Second Amended Complaint asserts that the Company violated the federal securities laws in connection with a restatement announced by the Company on August 16, 2004, restating certain of the Company’s financial statements during 2001 through the first quarter of 2004. The Second Amended Complaint purports to allege violations of Section 10(b) of the Securities Exchange Act of 1934 (the “Exchange Act”) and Rule 10b-5 promulgated thereunder, as well as violations of Section 20(a) of the Exchange Act by certain of the Company’s executives as “controlling persons” of the Company. The Company has not yet filed its response to the Second Amended Complaint. On February 28, 2006, the court granted the Company’s motion to transfer the Consolidated Securities Class Action to the District of Maryland.

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

On March 17, 2005, a derivative action was filed against the Company and its directors in the Circuit Court for Montgomery County, Maryland. The lawsuit which was encaptioned James Elgas v. Ivan Sabel, et al, Civil No. 259940-V, largely repeated the billing allegations made in the consolidated amended complaint filed by the plaintiffs in In re Hanger Orthopedic Group, Inc. Securities Litigation, discussed above. On that basis, the Elgas complaint alleged that Hanger’s directors breached their fiduciary duties to the Company. The plaintiff sought monetary damages

NOTE I – COMMITMENTS AND CONTINGENT LIABILITIES (CONTINUED)

Contingencies (continued)

and unspecified equitable relief, on behalf of the Company, against the Company’s directors. The Company and the individual defendants filed motions to dismiss the suit for failure to state a claim and for failure to comply with the demand requirement under Delaware law. At a hearing on August 12, 2005, the Circuit Court granted the defendants’ motion to dismiss for failure to comply with the demand requirement, granting the plaintiff leave to amend within 90 days. The plaintiff filed an amended complaint, and the defendants again moved to dismiss the suit for failure to state a claim and for failure to comply with the demand requirement. Subsequently, the plaintiff sold his shares of the Company’s common stock and this action has been dismissed with prejudice.

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

Guarantees and Indemnifications

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

NOTE J –REDEEMABLE PREFERRED STOCK

In May 2006, in connection with its debt refinancing, the Company redeemed 37,881 shares of its 7% Redeemable Preferred Stock for $64.7 million and issued 50,000 shares of Series A Convertible Preferred Stock (“Series A Preferred”) with a stated value of $1,000 per share. The Company incurred $0.3 million of fees in connection with the redemption of the 7% Redeemable Preferred Stock and $2.3 million of costs to issue the Series A Preferred shares. The Series A Preferred provides for cumulative dividends at a rate of 3.33% per annum, payable quarterly in arrears. The Company may elect to defer the payment of dividends. The Series A Preferred may be converted into common shares at $7.56 per share at the option of the holders after a required holding period of 61 days or at the option of the Company upon satisfaction of certain conditions. In addition, the initial holders of the Series A Preferred are entitled to have representation on the board of directors of the Company and are entitled to vote on all matters on which the holders of the Company’s common stock are entitled to vote.

The Company has separately accounted for the beneficial conversion feature granted to the holders of the Series A Preferred. The value of the beneficial conversion feature is $3.8 million and is comprised of $1.8 million related to the cost paid by the Company on behalf of the holders and $2.0 million related to the difference between the stated conversion price of the preferred shares and the fair market value of the common stock at the commitment date. The beneficial conversion feature has been included in the value of the Series A Preferred; and is being amortized as a reduction of income available to common shareholders over the 61 day holding period.

NOTE K – NET (LOSS) 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, restricted shares, and redeemable preferred stock and are calculated using the treasury stock method.

NOTE K – NET (LOSS) INCOME PER COMMON SHARE (CONTINUED)

Net (loss) income per share is computed as follows:

	Three Months Ended June 30,					Six Months Ended June 30,
(In thousands, except share and per share data)	2006			2005		2006			2005
Net (loss) income	$	(5,724	)	$	3,816	$	(4,895	)	$	5,151
Less preferred stock dividends declared and accretion-7% Redeemable Preferred Stock (1)		1,186			1,455		2,751			2,874
Less preferred stock dividends declared-Series A Convertible Preferred Stock (1)		167			--		167			--
Accretion of beneficial conversion feature		2,224			--		2,224			--

Net (loss) income applicable to common stock	$	(9,301	)	$	2,361	$	(10,037	)	$	2,277

Shares of common stock outstanding used to compute basic per common share amounts		21,946,319			21,661,157		21,891,694			21,644,918
Effect of dilutive options		--			451,847		--			506,472

Shares used to compute dilutive per common share amounts (2)		21,946,319			22,113,004		21,891,694			22,151,390

Basic (loss) income per share applicable to common stock	$	(0.42	)	$	0.11	$	(0.46	)	$	0.11
Diluted (loss) income per share applicable to common stock		(0.42	)		0.11		(0.46	)		0.10

(1) For the three and six month periods ended June 30, 2006 and 2005, excludes the effect of the conversion of the 7% Redeemable Preferred Stock as it is considered anti-dilutive. For the three and six month periods ended June 30, 2006, excludes the effect of the Series A Convertible Preferred Stock as it is considered anti-dilutive.

(2) For the three months ended June 30, 2006 and 2005, options to purchase 1,684,065 and 2,396,801 shares of common stock, respectively, are not included in the computation of diluted income per share as these options are anti-dilutive because the exercise prices of these options were greater than the average market price of the Company’s stock during the period. Options to purchase 1,684,065 and 2,330,801 shares of common stock are not included in the computation of diluted income per share for the six month periods ended June 30, 2006 and 2005, respectively, as these options are anti-dilutive.

NOTE L –SUPPLEMENTAL EXECUTIVE RETIREMENT PLAN

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

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

	(In thousands)
Benefit obligation at December 31, 2005	$	3,624
Service cost		1,010
Interest cost		103
Amortization of (gain) loss		--

Benefit obligation at June 30, 2006	$	4,737

NOTE L – SUPPLEMENTAL EXECUTIVE RETIREMENT PLAN (CONTINUED)

At June 30, 2006, the Company has accrued approximately $4.7 million in benefit obligations related to the Plan.

NOTE M – SEGMENT AND RELATED INFORMATION

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

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

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

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

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

NOTE M – 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.

	Patient-Care Centers			Distribution		Other			Total
(In thousands)
Three Months Ended June 30, 2006
Net sales
Customers	$	138,416		$	14,439	$	--		$	152,855
Intersegments		--			27,878		(27,878	)		--
Depreciation and amortization		3,138			76		545			3,759
Income (loss) from operations		21,090			4,916		(10,007	)		15,999
Interest (income) expense		(1,586	)		1,727		9,773			9,914
Income (loss) before taxes		22,676			3,188		(36,194	)		(10,330	)
Three Months Ended June 30, 2005
Net sales
Customers	$	138,635		$	11,019	$	--		$	149,654
Intersegments		--			19,816		(19,816	)		--
Depreciation and amortization		2,922			72		444			3,438
Income (loss) from operations		20,739			3,509		(8,269	)		15,979
Interest (income) expense		(1,546	)		1,733		9,213			9,400
Income (loss) before taxes		22,285			1,776		(17,482	)		6,579
(In thousands)
Six Months Ended June 30, 2006
Net sales
Customers	$	265,555		$	27,745	$	--		$	293,300
Intersegments		--			51,981		(51,981	)		--
Depreciation and amortization		6,241			152		1,054			7,447
Income (loss) from operations		36,878			9,582		(19,546	)		26,914
Interest (income) expense		(3,160	)		3,454		19,120			19,414
Income (loss) before taxes		40,039			6,128		(55,082	)		(8,915	)
Total assets		628,817			86,550		3,549			718,916
Capital expenditures		4,198			45		934			5,177
Six Months Ended June 30, 2005
Net sales
Customers	$	261,472		$	21,182	$	--		$	282,654
Intersegments		--			36,436		(36,436	)		--
Depreciation and amortization		5,902			147		898			6,947
Income (loss) from operations		35,830			6,775		(15,517	)		27,088
Interest (income) expense		(3,104	)		3,465		17,883			18,244
Income (loss) before taxes		38,934			3,311		(33,401	)		8,844
Total assets		614,704			75,815		14,983			705,502
Capital expenditures		3,504			41		412			3,957

NOTE N – CONSOLIDATING FINANCIAL INFORMATION

The Company’s Revolving Credit Facility, Senior Notes, Senior Subordinated Notes, and Term Loan are guaranteed fully, jointly and severally, and unconditionally by all of the Company’s current and future domestic subsidiaries. The following are summarized Condensed Consolidating Balance Sheets as of June 30, 2006 and December 31, 2005, Condensed Statements of Operations for the three and six month periods ended June 30, 2006 and 2005 and Condensed Cash Flows for the six month periods ended June 30, 2006 and 2005 of the Company, segregating the parent company (Hanger Orthopedic Group, Inc.) and its guarantor subsidiaries, as each of the Company’s subsidiaries is 100% owned. The parent company accounts for its investment in subsidiaries under the equity method of accounting.

NOTE N – CONSOLIDATING FINANCIAL INFORMATION (CONTINUED)

BALANCE SHEET - June 30, 2006	Hanger Orthopedic Group (Parent Company)			Guarantor Subsidiaries			Consolidating Adjustments			Consolidated Totals
(In thousands)
ASSETS
Cash and cash equivalents	$	7,892		$	4,799		$	--		$	12,691
Accounts receivable		--			97,570			--			97,570
Inventories		--			78,418			--			78,418
Prepaid expenses, other assets and income taxes receivable		11,775			5,743			--			17,518
Intercompany receivable		383,077			--			(383,077	)		--
Deferred income taxes		8,656			--			--			8,656

Total current assets		411,400			186,530			(383,077	)		214,853
Property, plant and equipment, net		5,364			36,214			--			41,578
Intangible assets, net		--			449,347			--			449,347
Investment in subsidiaries		248,931			--			(248,931	)		--
Other assets		11,913			1,225			--			13,138

Total assets	$	677,608		$	673,316		$	(632,008	)	$	718,916

LIABILITIES, REDEEMABLE PREFERRED STOCK
AND SHAREHOLDERS’ EQUITY
Current portion of long-term debt	$	11,517		$	3,007		$	--		$	14,524
Accounts payable		1,244			17,164			--			18,408
Accrued expenses		7,537			3,202			--			10,739
Accrued interest payable		2,200			109			--			2,309
Accrued compensation related costs		1,176			17,325			--			18,501
Income taxes payable		3,494			(3,494	)		--			--

Total current liabilities		27,168			37,313			--			64,481
Long-term debt, less current portion		402,700			5,503			--			408,203
Deferred income taxes		37,024			(4,862	)		--			32,162
Intercompany payable		--			383,077			(383,077	)		--
Other liabilities		4,363			3,354			--			7,717

Total liabilities		471,255			424,385			(383,077	)		512,563

Redeemable preferred stock		49,426			--			--			49,426

Common stock		223			35			(35	)		223
Additional paid-in capital		154,772			7,460			(7,460	)		154,772
Retained earnings		2,588			241,976			(241,976	)		2,588
Treasury stock		(656	)		(540	)		540			(656	)

Total shareholders’ equity		156,927			248,931			(248,931	)		156,927

Total liabilities, redeemable preferred stock
and shareholders’ equity	$	677,608		$	673,316		$	(632,008	)	$	718,916

NOTE N – CONSOLIDATING FINANCIAL INFORMATION (CONTINUED)

BALANCE SHEET - December 31, 2005	Hanger Orthopedic Group (Parent Company)			Guarantor Subsidiaries			Consolidating Adjustments			Consolidated Totals
(In thousands)
ASSETS
Cash and cash equivalents	$	3,120		$	4,801		$	--		$	7,921
Accounts receivable		--			103,200			--			103,200
Inventories		--			76,725			--			76,725
Prepaid expenses, other assets and income taxes receivable		1,520			5,034			--			6,554
Intercompany receivable		425,211			--			(425,211	)		--
Deferred income taxes		7,087			--			--			7,087

Total current assets		436,938			189,760			(425,211	)		201,487
Property, plant and equipment, net		5,263			38,234			--			43,497
Intangible assets, net		--			449,744			--			449,744
Investment in subsidiaries		206,163			--			(206,163	)		--
Other assets		8,400			1,339			--			9,739

Total assets	$	656,764		$	679,077		$	(631,374	)	$	704,467

LIABILITIES, REDEEMABLE PREFERRED STOCK
AND SHAREHOLDERS’ EQUITY
Current portion of long-term debt	$	1,500		$	2,966		$	--		$	4,466
Accounts payable		2,534			17,986			--			20,520
Accrued expenses		7,096			3,859			--			10,955
Accrued interest payable		8,257			63			--			8,320
Accrued compensation related costs		1,485			20,190			--			21,675

Total current liabilities		20,872			45,064			--			65,936
Long-term debt, less current portion		367,292			6,673			--			373,965
Deferred income taxes		35,713			(4,862	)		--			30,851
Income taxes payable		2,418			(2,418	)		--			--
Intercompany payable		--			425,211			(425,211	)		--
Other liabilities		3,285			3,246			--			6,531

Total liabilities		429,580			472,914			(425,211	)		477,283

Redeemable preferred stock		61,942			--			--			61,942

Common stock		222			35			(35	)		222
Additional paid-in capital		156,346			7,460			(7,460	)		156,346
Unearned compensation		(2,615	)		--			--			(2,615	)
Retained earnings		11,945			199,208			(199,208	)		11,945
Treasury stock		(656	)		(540	)		540			(656	)

Total shareholders’ equity		165,242			206,163			(206,163	)		165,242

Total liabilities, redeemable preferred stock
and shareholders’ equity	$	656,764		$	679,077		$	(631,374	)	$	704,467

NOTE N – CONSOLIDATING FINANCIAL INFORMATION (CONTINUED)

STATEMENT OF OPERATIONS Three Months Ended June 30, 2006 (In thousands)	Hanger Orthopedic Group (Parent Company)			Guarantor Subsidiaries		Consolidating Adjustments			Consolidated Totals
Net sales	$	--		$	152,855	$	--		$	152,855
Cost of goods sold (exclusive of depreciation and amortization)		--			75,346		--			75,346
Selling, general and administrative		7,986			49,765		--			57,751
Depreciation and amortization		419			3,340		--			3,759

(Loss) income from operations		(8,405	)		24,404		--			15,999
Interest expense, net		9,773			141		--			9,914
Extinguishment of debt		16,415			--		--			16,415
Equity in earnings of subsidiaries		24,263			--		(24,263	)		--

(Loss) income before taxes		(10,330	)		24,263		(24,263	)		(10,330	)
Income taxes benefit		(4,606	)		--		--			(4,606	)

Net (loss) income	$	(5,724	)	$	24,263	$	(24,263	)	$	(5,724	)

STATEMENT OF OPERATIONS Three Months Ended June 30, 2005 (In thousands)	Hanger Orthopedic Group (Parent Company)			Guarantor Subsidiaries		Consolidating Adjustments			Consolidated Totals
Net sales	$	--		$	149,654	$	--		$	149,654
Cost of goods sold (exclusive of depreciation and amortization)		--			71,738		--			71,738
Selling, general and administrative		6,525			51,974		--			58,499
Depreciation and amortization		386			3,052		--			3,438

(Loss) income from operations		(6,911	)		22,890		--			15,979
Interest expense, net		9,213			187		--			9,400
Equity in earnings of subsidiaries		22,703			--		(22,703	)		--

Income before taxes		6,579			22,703		(22,703	)		6,579
Provision for income taxes		2,763			--		--			2,763

Net income	$	3,816		$	22,703	$	(22,703	)	$	3,816

NOTE N – CONSOLIDATING FINANCIAL INFORMATION (CONTINUED)

STATEMENT OF OPERATIONS Six Months Ended June 30, 2006 (In thousands)	Hanger Orthopedic Group (Parent Company)			Guarantor Subsidiaries		Consolidating Adjustments			Consolidated Totals
Net sales	$	--		$	293,300	$	--		$	293,300
Cost of goods sold (exclusive of depreciation and amortization)		--			145,561		--			145,561
Selling, general and administrative		15,314			98,064		--			113,378
Depreciation and amortization		833			6,614		--			7,447

(Loss) income from operations		(16,147	)		43,061		--			26,914
Interest expense, net		19,120			294		--			19,414
Extinguishment of debt		16,415			--		--			16,415
Equity in earnings of subsidiaries		42,767			--		(42,767	)		--

(Loss) income before taxes		(8,915	)		42,767		(42,767	)		(8,915	)
Income taxes benefit		(4,020	)		--		--			(4,020	)

Net (loss) income	$	(4,895	)	$	42,767	$	(42,767	)	$	(4,895	)

STATEMENT OF OPERATIONS Six Months Ended June 30, 2005 (In thousands)	Hanger Orthopedic Group (Parent Company)			Guarantor Subsidiaries		Consolidating Adjustments			Consolidated Totals
Net sales	$	--		$	282,654	$	--		$	282,654
Cost of goods sold (exclusive of depreciation and amortization)		--			139,184		--			139,184
Selling, general and administrative		12,505			96,930		--			109,435
Depreciation and amortization		782			6,165		--			6,947

(Loss) income from operations		(13,287	)		40,375		--			27,088
Interest expense, net		17,883			361		--			18,244
Equity in earnings of subsidiaries		40,014			--		(40,014	)		--

Income before taxes		8,844			40,014		(40,014	)		8,844
Provision for income taxes		3,693			--		--			3,693

Net income	$	5,151		$	40,014	$	(40,014	)	$	5,151

NOTE N – CONSOLIDATING FINANCIAL INFORMATION (CONTINUED)

STATEMENTS OF CASH FLOWS Six Months Ended June 30, 2006 (In thousands)	Hanger Orthopedic Group (Parent Company)			Guarantor Subsidiaries			Consolidating Adjustments		Consolidated Totals
Cash flows from operating activities:
Net cash (used in) provided by operating activities	$	(12,893	)	$	5,819		$	--	$	(7,074	)

Cash flows from investing activities:
Purchase of property, plant and equipment		(934	)		(4,243	)		--		(5,177	)
Acquisitions and earnouts		--			(506	)		--		(506	)
Proceeds from sale of property, plant and equipment		--			57			--		57

Net cash used in investing activities		(934	)		(4,692	)		--		(5,626	)

Cash flows from financing activities:
Borrowings under revolving credit agreement		21,000			--			--		21,000
Repayments under revolving credit agreement		(26,000	)		--			--		(26,000	)
Repayment of term loan		(146,625	)		--			--		(146,625	)
Repayment of senior notes		(190,921	)		--			--		(190,921	)
Repayment of senior subordinated debt		(15,485	)		--			--		(15,485	)
Repurchase of 7% Redeemable Preferred Stock		(64,693	)		--			--		(64,693	)
Proceeds from new term loan facility		230,000			--			--		230,000
Proceeds from senior note issuance		175,000			--			--		175,000
Proceeds from issuance of Series A Convertible Preferred Stock		50,000			--			--		50,000
Scheduled repayment of long-term debt		--			(1,129	)		--		(1,129	)
Increase in financing costs		(13,263	)		--			--		(13,263	)
Proceeds from issuance of Common Stock		253			--			--		253
Change in book overdraft		(667	)		--			--		(667	)

Net cash provided by (used in) financing activities		18,599			(1,129	)		--		17,470

Net increase (decrease) in cash and cash equivalents		4,772			(2	)		--		4,770
Cash and cash equivalents, at beginning of period		3,120			4,801			--		7,921

Cash and cash equivalents, at end of period	$	7,892		$	4,799		$	--	$	12,691

STATEMENTS OF CASH FLOWS Six Months Ended June 30, 2005 (In thousands)	Hanger Orthopedic Group (Parent Company)			Guarantor Subsidiaries			Consolidating Adjustments		Consolidated Totals
Cash flows from operating activities:
Net cash (used in) provided by operating activities	$	(3,988	)	$	7,839		$	--	$	3,851

Cash flows from investing activities:
Purchase of property, plant and equipment		(412	)		(3,545	)		--		(3,957	)
Acquisitions and earnouts		--			(2,215	)		--		(2,215	)

Net cash used in investing activities		(412	)		(5,760	)		--		(6,172	)

Cash flows from financing activities:
Borrowings under revolving credit agreement		29,000			--			--		29,000
Repayments under revolving credit agreement		(31,000	)		--			--		(31,000	)
Scheduled repayment of long-term debt		(750	)		(1,211	)		--		(1,961	)
Increase in financing costs		(3	)		--			--		(3	)
Proceeds from issuance of Common Stock		189			--			--		189
Change in book overdraft		4,350			2,334			--		6,684

Net cash provided by financing activities		1,786			1,123			--		2,909

Net (decrease) increase in cash and cash equivalents		(2,614	)		3,202			--		588
Cash and cash equivalents, at beginning of period		3,466			4,885			--		8,351

Cash and cash equivalents, at end of period	$	852		$	8,087		$	--	$	8,939

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

Overview

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

Business Overview

General

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

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

Patient Care

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

At June 30, 2006, we operated 621 O&P patient-care centers (“patient-care centers”) in 45 states and the District of Columbia and employed in excess of 1,000 revenue-generating O&P practitioners (“practitioners”). Patients are referred to our local patient-care centers directly by physicians as a result of our reputation with them or through our agreements with managed care providers. Practitioners, technicians and office administrators staff our patient-care centers. Our practitioners generally design and fit patients with, and the technicians fabricate, O&P devices as prescribed by the referring physician. Following the initial design, fabrication and fitting of our O&P devices, our technicians conduct regular, periodic maintenance of O&P devices as needed. Our practitioners are also responsible for managing and operating our patient-care centers and are compensated, in part, based on their success in managing costs and collecting accounts receivable. We provide centralized administrative, marketing and materials management services to take advantage of economies of scale and to increase the time practitioners have to provide patient care. In areas where we have multiple patient-care centers, we also utilize shared fabrication facilities where technicians fabricate devices for practitioners in that area.

Distribution

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

Products

In 2004, the Company formed a new subsidiary, IN, Inc. Specializing in the field of functional electrical stimulation, IN, Inc. identifies emerging MyoOrthotics Technologies® developed at research centers and universities throughout the world that use neuromuscular stimulation to improve the functionality of an impaired limb. MyoOrthotics Technologies represents the merging of orthotic technologies with electrical stimulation. Working with the inventors, IN, Inc. advances the design and manufacturing, as well as the regulatory and clinical aspects of the technology, and then introduces the devices to the marketplace through a variety of distribution channels. IN, Inc.’s first product, the WalkAide System, was released for sale during the second quarter of 2006.

Provider Network Management

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

Industry Overview

We estimate the O&P patient care market in the United States represented approximately $2.5 billion in revenues in 2005, of which we accounted for approximately 21%. The O&P patient care services market is highly fragmented and is characterized by local, independent O&P businesses, with the majority generally having a single facility with annual revenues of less than $1.0 million. We do not believe that any of our patient care competitors account for a market share of more than 2% of the country’s total estimated O&P patient care services revenue.

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

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

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

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

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

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

Competitive Strengths

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

•

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

•

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

establish our brand name and generate economies of scale;

implement best practices throughout the country;

utilize shared fabrication facilities;

contract with national and regional managed care entities;

identify, test and deploy emerging technology; and

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

•

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

negotiate greater purchasing discounts from manufacturers and freight providers;

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

quickly access prefabricated and finished O&P products;

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

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

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

•

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

•

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

•

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

•

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

•

History of successful integration of small and medium-sized O&P business acquisitions, including 55 O&P businesses since 1997, representing over 150 patient-care centers;

•

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

•

Experienced and committed management team.

Business Strategy

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

•

improve our performance by:

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

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

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

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

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

•

increase our market share and net sales by:

continued marketing of Linkia services to regional and national providers;

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

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

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

•

develop businesses that provide services and products to the broader rehabilitation and post-surgical healthcare areas as demonstrated by our emerging venture called TotalCare, a program designed to provide comprehensive O&P services to our patients;

•

continue to create, license or patent and market devices based on new cutting edge technology. We anticipate bringing new technology to the market through our IN, Inc. product line. The first new product, the WalkAide System, became available for sale in May 2006;

•

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

•

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

•

provide our practitioners with:

career development and increased compensation opportunities;

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

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

selective application of new technology to improve patient care.

Critical Accounting Estimates

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

•

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

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

The following represents the summary aging of our patient-care segment’s accounts receivable balance by payor at June 30, 2006:

(In thousands)	0-60 days		61-120 days		Over 120 days		Total
Commercial and other	$	35,328	$	7,759	$	7,679	$	50,766
Private pay		3,988		1,714		3,102		8,804
Medicaid		8,404		2,348		2,940		13,692
Medicare		11,453		2,693		2,814		16,960
VA		1,289		199		146		1,634

	$	60,462	$	14,713	$	16,681	$	91,856

We completed the rollout of OPS, the Company’s centralized, computerized billing system, in the second quarter of 2005, prior to which we were unable to develop reports to determine the composition of our accounts receivable by payor.

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

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

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

•

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

•

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

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

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

•

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

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

•

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

•

Stock-Based Compensation. Stock-based compensation is accounted for using the grant-date fair value method. Compensation expense is recognized ratably over the service period. We estimate a 0% forfeiture rate for unvested options, as they relate to director awards and we do not foresee any director terminations prior to vesting. Based on the history of restricted stock forfeitures, we do not believe future forfeitures will have a material impact on future compensation expense or earnings per share.

•

Supplemental Executive Retirement Plan. Benefit costs and liabilities balances are calculated based on certain assumptions including benefits earned, discount rates, interest costs, mortality rates and other factors. Actual results that differ from the assumptions are accumulated and amortized over future periods, affecting the recorded obligation and expense in future periods. The following assumptions were used in the calculation of the net benefit cost and obligation at June 30, 2006:

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

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

New Accounting Guidance

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

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

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

We adopted SFAS 123R using the modified prospective method allowed for in SFAS 123R. Under the modified prospective method, compensation expense related to awards granted prior to and unvested as of the adoption of SFAS 123R is calculated in accordance with SFAS 123 and recognized in the statements of operations over the requisite remaining service period; compensation expense for all awards granted after the adoption of SFAS 123R is calculated according to the provision of SFAS 123R. Results for prior periods have not been restated. For the three and six month periods ended June 30, 2006, we recognized $0.4 million and $0.7 million in compensation expense, respectively. For the three and six month periods ended June 30, 2006 less than $0.1 million and $0.1 million of compensation expense related to options.

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

As of June 30, 2006, total unrecognized compensation cost related to stock option awards was approximately $0.1 million and the related weighted-average period over which it is expected to be recognized is approximately 1.1 years. Total unrecognized compensation cost related to restricted shares of common stock was approximately $9.8 million as of June 30, 2006 and the weighted-average period over which it is expected to be recognized is approximately 3.2 years.

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

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

In June 2006, the FASB issued FIN 48, Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109, Accounting for Income Taxes (“FIN 48”), which clarifies the accounting for uncertainty in income taxes. FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. The interpretation requires us to recognize, in our financial statements, the impact of a tax position if that position is more likely than not of being sustained on audit, based on the technical merits of the position. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods and disclosure. The provisions of FIN 48 are effective beginning January 1, 2007 with the cumulative effect of the change in accounting principle recorded as an adjustment to opening retained earnings. We are currently evaluating the impact adoption FIN 48 may have on our financial statements.

Results of Operations

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

	Three Months Ended June 30,						Six Months Ended June 30,
	2006			2005			2006			2005
Net sales		100.0	%		100.0	%		100.0	%		100.0
Cost of goods sold		49.3			47.9			49.6			49.2
Selling, general and administrative		37.8			39.1			38.8			38.7
Depreciation and amortization		2.5			2.3			2.5			2.5

Income from operations		10.4			10.7			9.1			9.6
Interest expense, net		6.5			6.3			6.6			6.5
Extinguishment of debt		10.7			--			5.6			--

(Loss) income before taxes		(6.8	)		4.4			(3.1	)		3.1
(Benefit) provision for income taxes		(3.1	)		1.9			(1.4	)		1.3

Net (loss) income		(3.7	)		2.5			(1.7	)		1.8

Three Months Ended June 30, 2006 Compared to the Three Months Ended June 30, 2005

Net Sales. Net sales for the three months ended June 30, 2006 were $152.9 million, an increase of $3.2 million, or 2.1%, versus net sales of $149.7 million for the three months ended June 30, 2005. The sales increase was the result of a $0.2 million, or 0.1%, same-center sales growth and a $3.4 million, or 31.0%, increase in external sales of our distribution segment, offset by a $0.3 million decline as a result of closed practices.

Cost of Goods Sold. Cost of goods sold for the three months ended June 30, 2006 was $75.3 million, an increase of $3.6 million, or 5.0%, over $71.7 million for the same period in the prior year. The increase was the result of the increased sales volume at our patient-care centers and distribution segments. Cost of goods sold as a percentage of net sales increased to 49.3% in 2006 from 47.9% in 2005 as a result of an increase in the cost of materials. The increase in cost of materials was due principally to the increase in external sales at our distribution segment.

Selling, General and Administrative. Selling, general and administrative expenses for the three months ended June 30, 2006 decreased by $0.7 million to $57.8 million, or 37.8% of net sales from $58.5 million, or 39.1% of net sales, for the three months ended June 30, 2005. The decrease was principally due to a $0.9 million decrease in bad debt expense and a $0.5 million reduction in labor costs, offset by a $0.7 million increase in the investments in our growth initiatives.

Depreciation and Amortization. Depreciation and amortization for the three months ended June 30, 2006 was $3.8 million versus $3.4 million for the three months ended June 30, 2005. This increase was primarily due to the depreciation of computer related assets and amortization of leasehold improvements.

Income from Operations. As a result of the above, income from operations for each of the three month periods ended June 30, 2006 and 2005 was $16.0 million. Income from operations, as a percentage of net sales, decreased to 10.4% for the three months ended June 30, 2006 versus 10.7% for the prior year’s comparable period as a result of the increase in net sales in the three month period ended June 30, 2006.

Interest Expense, Net. Interest expense in the three months ended June 30, 2006 increased to $9.9 million compared to $9.4 million in the three months ended June 30, 2005 due to higher variable interest rates coupled with interest expense being recognized on both the existing and refinanced debt instruments during part of the quarter.

Extinguishment of Debt. During May of 2006, we completed a refinancing of substantially all our outstanding debt and preferred stock, in conjunction with which we recognized a $16.4 million loss on extinguishment of debt.

Income Taxes. An income tax benefit of $4.6 million was recognized for the three months ended June 30, 2006 compared to an expense of $2.8 million for the same period of the prior year. The change in the income tax provision was primarily the result of the loss on the extinguishment of debt. The effective tax rate for the three months ended June 30, 2006 was 44.6% compared to 42.0% for the three months ended June 30, 2005. The lower net income in the 2006 period coupled with permanent book-to-tax differences resulted in the higher effective tax rate.

Net Income. As a result of the above, we recorded a net loss of $5.7 million for the three months ended June 30, 2006, compared to net income of $3.8 million for the same period in the prior year.

Six Months Ended June 30, 2006 Compared to the Six Months Ended June 30, 2005

Net Sales. Net sales for the six months ended June 30, 2006 were $293.3 million, an increase of $10.6 million, or 3.7%, versus net sales of $282.7 million for the six months ended June 30, 2005. The sales increase was the result of a $5.0 million, or 1.9%, same-center sales growth and a $6.6 million, or 31.0%, increase in external sales of our distribution segment, offset by a $0.7 million decline as a result of closed practices.

Cost of Goods Sold. Cost of goods sold for the six months ended June 30, 2006 was $145.6 million, an increase of $6.4 million, or 4.6%, over $139.2 million for the same period in the prior year. The increase was the result of the increased sales volume at our patient-care centers and distribution segments. Cost of goods sold as a percentage of net sales increased to 49.6% in 2006 from 49.2% in 2005 as a result of an increase in the cost of materials. The increase in cost of materials was due principally to the increase in external sales at our distribution segment.

Selling, General and Administrative. Selling, general and administrative expenses for the six months ended June 30, 2006 increased by $4.0 million to $113.4 million, or 38.8% of net sales from $109.4 million, or 38.7% of net sales, for the six months ended June 30, 2005. The increase was principally due to the following: (i) $3.4 million increase in labor costs related to merit increases and increased health insurance costs; (ii) $1.6 million invested in Linkia and IN, Inc. growth strategies; and (iii) $0.6 million in professional fees, offset by a $1.7 million decrease in bad debt expense.

Depreciation and Amortization. Depreciation and amortization for the six months ended June 30, 2006 was $7.4 million versus $6.9 million for the six months ended June 30, 2005. This increase was primarily due to the depreciation of computer related assets and amortization of leasehold improvements.

Income from Operations. As a result of the above, income from operations for the six months ended June 30, 2006 was $26.9 million compared to $27.1 million for the six months ended June 30, 2005. Income from operations, as a percentage of net sales, decreased to 9.1% for the six months ended June 30, 2006 versus 9.6% for the prior year’s comparable period primarily as a result of the increase in net sales in the six month period ended June 30, 2006.

Interest Expense, Net. Interest expense in the six months ended June 30, 2006 increased to $19.4 million compared to $18.2 million in the six months ended June 30, 2005 due to higher variable interest rates as well as the recognition of interest expense on both the old and refinanced debt instruments during part of the six month period.

Extinguishment of Debt. In May 2006, we completed a refinancing of substantially all of our outstanding debt and preferred stock; in conjunction with this transaction, a $16.4 million loss on extinguishment of debt was recorded.

Income Taxes. Income tax benefit of $4.0 million was recognized for the six months ended June 30, 2006 compared to an expense of $3.7 million for the same period of the prior year. The change in the income tax provision was primarily the result of the loss on extinguishment of debt. The effective tax rate for the six months ended June 30, 2006 was 45.1% compared to 41.8% for the six months ended June 30, 2005. The lower net income in the 2006 period coupled with permanent book-to-tax differences resulted in a higher effective tax rate.

Net Income. As a result of the above, we recorded a net loss of $4.9 million for the six months ended June 30, 2006, compared to net income of $5.2 million for the same period in the prior year.

Ratio of Earnings to Fixed Charges

Our ratio of earnings to fixed charges for the three month periods ended June 30, 2006 and 2005 was 2.28 to 1 and 2.34 to 1, respectively. For the six month periods ended June 30, 2006 and 2005 our ratio of earnings to fixed charges was 2.09 to 1 and 2.17 to 1, respectively. For the purpose of calculating the ratio of earnings to fixed charges, earnings consist of income from continuing operations before income taxes plus fixed charges. Fixed charges consist of interest expense (including amortization of debt issuance costs, but not losses relating to the early extinguishment of debt) and 33% of rental expense (considered to be representative of the interest factors).

Restructuring and Integration Costs

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

(In thousands)	Total Restructuring Reserve
2001 Restructuring Reserve
Balance at December 31, 2005	$	220
Spending		(64	)

Balance at June 30, 2006		156
2004 Restructuring Reserve
Balance at December 31, 2005		161
Spending		(50	)

Balance at June 30, 2006		111

2001 and 2004 Restructuring Reserves	$	267

2001 Restructuring Reserve

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

2004 Restructuring Reserve

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

Financial Condition, Liquidity, and Capital Resources

Our working capital at June 30, 2006 was $150.4 million compared to $135.6 million at December 31, 2005. Working capital increased principally as a result of the increase in prepaid expenses and cash on hand, offset by an increase in the current balance of long-term debt. Prepaid expenses increased principally due to an $8.0 million increase in income tax receivable which was generated as a result of the net loss for the period and cash on hand increased as a result of cash received from the May refinancing. The current balance of long-term debt increased as a result of the $9.1 million balance of the 10 3/8% Senior Notes, $0.1 million of 11 ¼% Senior Subordinated Notes and $0.1 million of interest rate swap, all of which were redeemed in July 2006. Days sales outstanding (“DSO”), which is the number of days between the billing for our O&P services and the date of our receipt of payment thereof, for the six months ended June 30, 2006, decreased to 60 days, compared to 66 days for the same period last year. The decrease in DSO is due to a continued effort at our patient-care centers to target collections as well as the implementation of electronic billing and standard workflow protocols. Our ratio of current assets to current liabilities was 3.3 to 1 at June 30, 2006 compared to 3.1 to 1 at December 31, 2005. At June 30, 2006 the Company did not have any outstanding Revolving Credit Facility balance.

Net cash used in operating activities for the six months ended June 30, 2006 was $7.1 million, compared to net cash provided by operating activities of $3.9 million for the six months ended June 30, 2005. The current year operating cash flows included payment of $11.4 million of premiums related to the refinancing of certain debt instruments. In addition, the current year operating cash flows reflected improved collections coupled with the recognition of income taxes receivable as a result of the net loss for the period, offset by an increase in interest payments due to the debt refinancing and the quarterly payment of the variable compensation plan.

Net cash used in investing activities was $5.6 million for the six months ended June 30, 2006, versus $6.2 million for the same period in the prior year. Cash used in investing activities was principally related to the purchase of computer related assets, machinery and equipment and leasehold improvements.

Net cash provided by financing activities was $17.5 million for the six months ended June 30, 2006, compared to $2.9 million for the six months ended June 30, 2005. The increase in cash provided by financing activities was primarily due to the debt refinancing, as discussed below.

On May 26, 2006, we refinanced our debt and preferred stock with the issuance of the following instruments: (i) $175.0 million of 10 ¼% Senior Notes due 2014; (ii) a $230.0 million term loan facility; and (iii) $50.0 million of Series A Convertible Preferred Stock. We also established a new $75.0 million revolving credit facility, which was unused at June 30, 2006. The proceeds from these instruments were used to retire (i) $190.9 million of the 10 3/8% Senior Notes; (ii) $15.5 million of the 11 ¼% Senior Subordinated Notes; (iii) $146.3 million of the Term Loan; (iv) $11.0 million outstanding under the Revolving Credit facility; (v) $64.7 million of 7% Redeemable Preferred Stock; and (vi) pay $24.7 million of transaction costs. At June 30, 2006, we had $9.1 million of 10 3/8% Senior Notes and $0.1 million of 11 ¼% Senior Subordinated Notes still outstanding. Such outstanding notes were redeemed in July 2006. In conjunction with the refinancing, we incurred a $16.4 million loss on the extinguishment of debt. The extinguishment loss is comprised of $11.4 million of premiums paid to debt holders, $0.3 million of fees paid to the 7% Redeemable Preferred Stock holders and $6.0 million write-off of debt issuance costs offset by a $1.3 million gain related to the interest rate swap.

The Revolving Credit Facility and the Term Loan require compliance with various covenants, including, but not limited to, a minimum consolidated interest coverage ratio, a maximum total leverage ratio and a maximum annual capital expenditure limit. Beginning September 30, 2006, we will assess, on a quarterly basis, our compliance with these covenants and monitor any matters critical to continue our compliance.

We believe that, based on current levels of operations and anticipated growth, cash generated from operations, together with other available sources of liquidity, including borrowings available under the Revolving Credit Facility, will be sufficient for at least the next twelve months to fund anticipated capital expenditures and make required payments of principal and interest on our debt, including payments due on our outstanding debt. In addition, we continually evaluate potential acquisitions and expect to fund such acquisitions from our available sources of liquidity, as discussed above. We are limited to $40.0 million in acquisitions, annually, by the terms of the Revolving Credit Facility.

The following table sets forth our contractual obligations and commercial commitments as of June 30, 2006:

	Payments Due by Period
	2006		2007		2008		2009		2010		Thereafter		Total
(In thousands)
Long-term debt	$	12,144	$	5,384	$	4,644	$	3,152	$	2,511	$	394,832	$	422,667
Interest payments on long-term debt		18,942		36,537		36,165		35,862		35,644		104,505		267,655
Operating leases		26,314		24,021		19,232		13,618		6,828		4,911		94,924
Capital leases		93		166		87		35		--		--		381
Other long-term obligations (1)		464		416		232		276		12,746		720		14,854

Total contractual cash obligations	$	57,957	$	66,524	$	60,360	$	52,943	$	57,729	$	504,968	$	800,481

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

Market Risk

We are exposed to the market risk that is associated with changes in interest rates. At June 30, 2006, all our outstanding debt, with the exception of the Revolving Credit Facility and the Term Loan, is subject to a fixed interest rate. (See Item 3 below.)

Forward Looking Statements

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

ITEM 3. Quantitative and Qualitative Disclosures about Market Risk

We have existing obligations relating to our 10 ¼% Senior Notes, Term Loan, Subordinated Seller Notes, and Series A Convertible Preferred Stock. As of June 30, 2006, we have cash flow exposure to the changing interest rate on the Term Loan and Revolving Credit Facility. The other obligations have fixed interest or dividend rates.

We have a $75.0 million revolving credit facility, with no outstanding balance at June 30, 2006, as discussed in Note G to our Condensed Consolidated Financial Statements. The rates at which interest accrues under the entire outstanding balance are variable.

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, 2006, we had one contract outstanding which fixed LIBOR at 8.0% and is set to expire on September 29, 2006.

Presented below is an analysis of our financial instruments as of June 30, 2006 that are sensitive to changes in interest rates. The table demonstrates the change in estimated annual cash flow related to the outstanding balance under the Term Loan (the Revolving Credit Facility did not have an outstanding balance at June 30, 2006), 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 Interest Rates		Annual Interest Expense Given an Interest Rate Increase of X Basis Points
(In thousands)	(150 BPS)		(100 BPS)		(50 BPS)				50 BPS		100 BPS		150 BPS
Term Loan	$	14,950	$	16,100	$	17,250	$	18,400	$	19,550	$	20,700	$	21,850

	$	14,950	$	16,100	$	17,250	$	18,400	$	19,550	$	20,700	$	21,850

ITEM 4. Controls and Procedures

Disclosure Controls and Procedures

The Company’s disclosure controls and procedures are designed to provide reasonable assurance that information required to be disclosed by it in its periodic reports filed with the Securities and Exchange Commission is recorded, processed, summarized and reported, within the time periods specified in the Commission’s rules and forms. Based on an evaluation of the Company’s disclosure controls and procedures conducted by the Company’s Chief Executive Officer and Chief Financial Officer, such officers concluded that the Company’s disclosure controls and procedures were effective as of June 30, 2006.

Change in Internal Control Over Financial Reporting

In accordance with Rule 13a-15(d) under the Securities Exchange Act of 1934, management, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer determined that there was no change in the Company’s internal control over financial reporting that occurred during the quarter ended June 30, 2006, that has materially effected, or is reasonably likely to materially effect, the Company’s internal control over financial reporting.

Part II. Other Information

ITEM 1. Legal Proceedings

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

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

ITEM 1A. Risk Factors

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

We incurred net losses for the three and six month periods ended June 30, 2006 and for the year ended December 31, 2004 and could incur net losses in the future.

We incurred a net loss of $23.4 million for the year ended December 31, 2004 primarily as a result of the recognition of $45.8 million in non-cash charges related to goodwill impairment. For the three and six month periods ended June 30, 2006 we generated net losses of $5.7 million and $4.9 million, respectively, as a result of our debt refinancing. During the year ended December 31, 2005, we generated net income of $17.8 million. We cannot assure that we will not incur net losses in the future.

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

We derived 41.4% and 42.6% of our net sales for the three months ended June 30, 2006 and 2005, respectively, from reimbursements for O&P services and products from programs administered by Medicare, Medicaid and the U.S. Veterans Administration. For the six month periods ended June 30, 2006 and 2005, we derived 41.5% and 42.6%, respectively, in reimbursements from the programs administered by Medicare, Medicaid and the U.S. Veterans Administration. Each of these programs sets maximum reimbursement levels for O&P services and products. If these agencies reduce reimbursement levels for O&P services and products in the future, our net sales could substantially decline. In addition, the percentage of our net sales derived from these sources may increase as the portion of the U.S. population over age 65 continues to grow, making us more vulnerable to maximum reimbursement level reductions by these organizations. Reduced government reimbursement levels could result in reduced private payor reimbursement levels because fee schedules of certain third-party payors are indexed to Medicare. Furthermore, the healthcare industry is experiencing a trend towards cost containment as government and other third-party payors seek to impose lower reimbursement rates and negotiate reduced contract rates with service providers. This trend could adversely affect our net sales. Medicare provides for reimbursement for O&P products and services based on prices set forth in fee schedules for ten regional service areas. Additionally, if the U.S. Congress were to legislate modifications to the Medicare fee schedules, our net sales from Medicare and other payors could be adversely and materially affected. We cannot predict whether any such modifications to the fee schedules will be enacted or what the final form of any modifications might be. In November 2003, Congress legislated a three-year freeze on Medicare reimbursement levels beginning January 1, 2004 on all O&P services. The effect of this legislation has been a downward pressure on our income from operations. We have, however, initiated certain purchasing and efficiency programs which we believe will minimize such effects.

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

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

As of June 30, 2006 and December 31, 2005, our accounts receivable over 120 days represented approximately 17.5% and 20.4% of total accounts receivable outstanding in each period, respectively. If we cannot collect our accounts receivable, our business, results of operations, financial condition and ability to satisfy our obligations under our indebtedness could be adversely affected. In addition, our principal means of control with respect to accounting for inventory and costs of goods sold is a physical inventory conducted on an annual basis. This accepted method of accounting controls and procedures may result in an understatement or overstatement, as the case may be, of inventory between our annual physical inventories. We did not record a book-to-physical inventory adjustment as a result of our October 1, 2005 inventory count. Because our income from operations percentage is based on our inventory levels, adjustments to inventory during interim periods following our physical inventory could adversely affect our results of operations and financial condition.

ITEM 4. Submission of Matters to a Vote of Security Holders

The Company’s Annual Meeting of Shareholders was held on May 12, 2006.

The first proposal was the election of directors. The following persons were nominated and elected to serve as members of the Board of Directors for one year or until their successors are elected and qualified by the votes indicated: Edmond E. Charrette, M.D. (17,429,530 shares for and 2,692,455 shares withheld), Thomas P. Cooper, M.D. (17,316,268 shares for and 2,805,717 shares withheld), Cynthia L. Feldman (17,227,980 shares for and 2,894,005 shares withheld), William R. Floyd (17,364,664 shares for and 2,757,321 shares withheld), Eric A. Green (17,031,397 shares for and 3,090,588 shares withheld), Isaac Kaufman (17,358,809 shares for and 2,763,176 shares withheld), Thomas F. Kirk (17,532,787 shares for and 2,589,198 shares withheld), Ivan R. Sabel (17,523,788 shares for and 2,598,197 shares withheld), and H.E. Thranhardt (17,653,633 shares for and 2,468,352 shares withheld).

The second proposal was a proposed amendment to the Company’s 2002 Stock Incentive Plan and authorization of an additional 2,700,000 shares of the Company’s Common Stock for issuance under that plan. The proposal was approved by the holders of more than the required majority of the shares of Common Stock voting at the meeting. The proposal was approved by a vote of 10,014,974 shares of Common Stock for (representing approximately 68.58% of the shares voting), 4,587,546 shares of Common Stock against, with 23,740 shares of Common Stock abstaining.

The third proposal was a proposed amendment to the Company’s 2003 Non-Employee Directors’ Stock Incentive Plan to provide for (i) an automatic annual grant of 8,500 restricted shares of common stock to eligible directors in lieu of the current equity component of a director’s compensation, and (ii) an automatic annual grant of 2,000 restricted shares of common stock to the lead non-management director. The proposal was approved by the holders of more than the required majority of the shares of Common Stock voting at the meeting. The proposal was approved by a vote of 10,843,365 shares of Common Stock for (representing approximately 74.25% of the shares voting), 3,759,323 shares of Common Stock against, with 23,572 shares of Common Stock abstaining.

ITEM 6. Exhibits

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

Exhibit No.

Document

3.1

Certificate of Designations of Series A Convertible Preferred Stock filed by the Registrant with the Delaware Secretary of State on May 26, 2006. (Incorporated herein by reference to Exhibit 3.1 to the Registrant’s Form 8-K dated May 23, 2006.)

10.1

Purchase Agreement, dated as of May 23, 2006, between the Registrant and the Initial Purchasers named in Schedule I thereto relating to the Registrant’s 10 ¼% Senior Notes due 2014. (Incorporated herein by reference to Exhibit 10.1 to the Registrant’s Form 8-K dated May 23, 2006.)

10.2

Indenture, dated as of May 26, 2006, among the Registrant, the Registrant’s subsidiaries signatory thereto and Wilmington Trust Company, as trustee, relating to the Registrant’s 10 ¼% Senior Notes due 2014. (Incorporated herein by reference to Exhibit 10.2 to the Registrant’s Form 8-K dated May 26, 2006.)

10.3

Registration Rights Agreement, dated as of May 26, 2006, among the Registrant, the Registrant’s subsidiaries signatory thereto and the initial purchasers named therein relating to the Registrant’s 10 ¼% Senior Notes due 2014. (Incorporated herein by reference to Exhibit 10.3 to the Registrant’s Form 8-K dated May 26, 2006.)

10.4

Amended and Restated Preferred Stock Purchase Agreement, dated as of May 25, 2006, by and among the Registrant, Ares Corporate Opportunities Fund, L.P. and the Initial Purchasers identified therein. (Filed herewith.)

10.5

Registration Rights Agreement, dated as of May 26, 2006, among the Registrant and Ares Corporate Opportunities Fund, L.P. (Filed herewith.)

10.6

Letter Agreements, dated May 26, 2006, between the Registrant and Ares Corporate Opportunities Fund, L.P. regarding board and management rights. (Filed herewith.)

10.7

Credit Agreement, dated as of May 26, 2006, among the Registrant, the Several Lenders identified therein, Lehman Brothers Inc. and Citigroup Global Markets Inc., as Joint Lead Arrangers and Joint Book-Runners, Citicorp North America, Inc., as Administrative Agent, Lehman Commercial Paper Inc., as Syndication Agent, and LaSalle Bank National Association and General Electric Capital Corporation, as Co-Documentation Agents. (Filed herewith.)

10.8

Guarantee and Collateral Agreement, dated as of May 26, 2006, made by the Registrant, as Borrower, and certain of its subsidiaries, in favor of Citicorp North America, Inc., as Administrative Agent. (Filed herewith.)

Computation of Ratio of Ratio of Earnings to Fixed Charges. (Filed herewith)

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

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

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 4, 2006	/s/ Ivan R. Sabel
	Ivan R. Sabel, CPO
	Chairman and Chief Executive Officer
	(Principal Executive Officer)
Dated: August 4, 2006	/s/ George E. McHenry
	George E. McHenry
	Executive Vice President and
	Chief Financial Officer
	(Principal Financial Officer)
Dated: August 4, 2006	/s/ Thomas C. Hofmeister
	Thomas C. Hofmeister
	Vice President of Finance
	(Chief Accounting Officer)

Exhibit Index

Exhibit No.

Document

10.4

10.5

Registration Rights Agreement, dated as of May 26, 2006, among the Registrant and Ares Corporate Opportunities Fund, L.P. (Filed herewith.)

10.6

Letter Agreements, dated May 26, 2006, between the Registrant and Ares Corporate Opportunities Fund, L.P. regarding board and management rights. (Filed herewith.)

10.7

10.8

Computation of Ratio of Ratio of Earnings to Fixed Charges. (Filed herewith)

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

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

FORM 10-Q

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

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

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

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

HANGER ORTHOPEDIC GROUP, INC. CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS For the Three and Six Months Ended June 30, (Dollars in thousands, except share and per share amounts) (Unaudited)

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

HANGER ORTHOPEDIC GROUP, INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS For the Six Months Ended June 30, Dollars in thousands) (Unaudited)

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

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

NOTE A – BASIS OF PRESENTATION

NOTE B – SIGNIFICANT ACCOUNTING PRINCIPLES

NOTE B – SIGNIFICANT ACCOUNTING PRINCIPLES (CONTINUED)

NOTE B – SIGNIFICANT ACCOUNTING PRINCIPLES (CONTINUED)

NOTE B – SIGNIFICANT ACCOUNTING PRINCIPLES (CONTINUED)

NOTE B – SIGNIFICANT ACCOUNTING PRINCIPLES (CONTINUED)

NOTE C — SUPPLEMENTAL CASH FLOW FINANCIAL INFORMATION

NOTE D — GOODWILL AND OTHER INTANGIBLE ASSETS

NOTE E – ACQUISITIONS

NOTE F – INVENTORY

NOTE G – LONG TERM DEBT

NOTE G – LONG TERM DEBT (CONTINUED)

NOTE H –RESTRUCTURING

NOTE H –RESTRUCTURING (CONTINUED)

NOTE I – COMMITMENTS AND CONTINGENT LIABILITIES

NOTE I – COMMITMENTS AND CONTINGENT LIABILITIES (CONTINUED)

NOTE I – COMMITMENTS AND CONTINGENT LIABILITIES (CONTINUED)

NOTE J –REDEEMABLE PREFERRED STOCK

NOTE K – NET (LOSS) INCOME PER COMMON SHARE

NOTE K – NET (LOSS) INCOME PER COMMON SHARE (CONTINUED)

NOTE L –SUPPLEMENTAL EXECUTIVE RETIREMENT PLAN

NOTE L – SUPPLEMENTAL EXECUTIVE RETIREMENT PLAN (CONTINUED)

NOTE M – SEGMENT AND RELATED INFORMATION

NOTE M – SEGMENT AND RELATED INFORMATION (CONTINUED)

NOTE N – CONSOLIDATING FINANCIAL INFORMATION

NOTE N – CONSOLIDATING FINANCIAL INFORMATION (CONTINUED)

NOTE N – CONSOLIDATING FINANCIAL INFORMATION (CONTINUED)

NOTE N – CONSOLIDATING FINANCIAL INFORMATION (CONTINUED)

NOTE N – CONSOLIDATING FINANCIAL INFORMATION (CONTINUED)

NOTE N – CONSOLIDATING FINANCIAL INFORMATION (CONTINUED)

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

Overview

Business Overview

Industry Overview

Competitive Strengths

Business Strategy

Critical Accounting Estimates

New Accounting Guidance

Results of Operations

Three Months Ended June 30, 2006 Compared to the Three Months Ended June 30, 2005

Six Months Ended June 30, 2006 Compared to the Six Months Ended June 30, 2005

Ratio of Earnings to Fixed Charges

Restructuring and Integration Costs

Financial Condition, Liquidity, and Capital Resources

Market Risk

Forward Looking Statements

ITEM 3. Quantitative and Qualitative Disclosures about Market Risk

ITEM 4. Controls and Procedures

Disclosure Controls and Procedures

Change in Internal Control Over Financial Reporting

Part II. Other Information

ITEM 1. Legal Proceedings

ITEM 1A. Risk Factors

We incurred net losses for the three and six month periods ended June 30, 2006 and for the year ended December 31, 2004 and could incur net losses in the future.

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

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

ITEM 4. Submission of Matters to a Vote of Security Holders

ITEM 6. Exhibits

SIGNATURES

Exhibit Index

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

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

HANGER ORTHOPEDIC GROUP, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
For the Three and Six Months Ended June 30,
(Dollars in thousands, except share and per share amounts)
(Unaudited)

HANGER ORTHOPEDIC GROUP, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
For the Six Months Ended June 30,
Dollars in thousands)
(Unaudited)

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