Overview

The following is a discussion of our results of operations and financial condition for the periods described below. This discussion should be read in conjunction with the Consolidated Financial Statements included in this report. Our discussion of our results of operations and financial condition includes various forward-looking statements about our markets, the demand for our products and services and our future results. These statements are based on our current expectations, which are inherently subject to risks and uncertainties. Refer to risk factors disclosed in Part II, Item 1A of this filing as well as the risk factors disclosed in the Company's Annual Report on Form 10-K for the year ended December 31, 2008 for further discussion of risks and uncertainties. Our actual results and the timing of certain events may differ materially from those indicated in the forward looking statements.

Business Overview

General

We are the largest owner and operator of orthotic and prosthetic ("O&P") patient-care centers ("patient -care centers"), accounting for approximately 23% of the estimated $2.8 billion O&P patient-care market in the United States. At September 30, 2009, we operated 669 O&P patient-care centers in 45 states and the District of Columbia and employed in excess of 1,000 revenue-generating O&P practitioners ("practitioners"). In addition, through our wholly-owned subsidiary, Southern Prosthetic Supply, Inc. ("SPS"), we are the largest distributor of branded and private label O&P devices and components in the United States, all of which are manufactured by third parties. We also introduce new technologies, through our wholly-owned subsidiary, Innovative Neurotronics, Inc. ("IN, Inc.") for patients who have had a loss of mobility due to strokes, multiple sclerosis or other similar conditions. Another subsidiary, Linkia LLC ("Linkia"), develops programs to manage all aspects of O&P patient care for large private payors.

For the three and nine months ended September 30, 2009, our net sales were $192.3 million and $555.0 million, respectively, and we recorded net income of $9.6 million and $24.2 million, respectively. For the three and nine months ended September 30, 2008, our net sales were $178.7 and $517.6 million, respectively, and we recorded net income of $7.3 million and $18.9 million, respectively.

We conduct our operations primarily in two reportable segments - patient-care centers and distribution. For the three months ended September 30, 2009, net sales attributable to our patient-care services segment and distribution segment were $169.0 million and $23.0 million, respectively. For the nine months ended September 30, 2009, net sales attributable to our patient-care services segment and distribution segment were $487.9 million and $65.9 million, respectively. See Note L to our consolidated financial statements contained herein for further information related to our segments.

Patient Care Services

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

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

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 region.

Distribution Services

We distribute O&P components to the O&P market as a whole and to our own patient-care centers through our wholly-owned subsidiary, SPS, which is the nation's largest O&P distributor. SPS maintains an inventory of approximately 23,000 O&P related items, all of which are manufactured by other companies. SPS maintains distribution facilities in California, Florida, Georgia, Pennsylvania, and Texas, which allows us to deliver products via ground shipment anywhere in the United States within two business days.

Our distribution business enables us to:

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

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

†

†          quickly access prefabricated and finished O&P products;

†

†          perform inventory quality control;

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

† coordinate new product development efforts with key vendor "partners".

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

Product Development

IN, Inc. specializes in product development principally in the field of functional electrical stimulation. IN, Inc. identifies emerging MyoOrthotics Technologiesฎ developed at research centers and universities throughout the world that use neuromuscular stimulation to improve the functionality of an impaired limb. MyoOrthotics Technologiesฎ represents the merging of orthotic technologies with electrical stimulation. Working with the inventors under licensing and consulting agreements, IN, Inc. commercializes the design, obtains regulatory approvals, develops clinical protocols for the technology, and then introduces the devices to the marketplace through a variety of distribution channels. IN, Inc's. first product, the WalkAide System ("WalkAide"), has received FDA approval, achieved ISO 13485:2004 and ISO 9001:2000 certification, as well as the European CE Mark, which are widely accepted quality management standards for medical devices and related services. Additionally, in September 2007, the WalkAide earned the esteemed da Vinci Award for Adaptive Technologies from the National Multiple Sclerosis Society which honors outstanding engineering achievements in adaptive and assistive technology that provide solutions to accessibility issues for people with disabilities. In November 2008, the Centers for Medicare and Medicaid Services overturned a non-coverage decision and assigned a specific E-code to the WalkAide, which is reimbursable for beneficiaries with foot drop due to incomplete spinal cord injuries. The code was effective January 1, 2009. The Company continues to work on clinical trials to qualify the device for reimbursement for stroke patients. The WalkAide is sold in the United States through our patient care centers and SPS. IN, Inc. is also marketing the WalkAide internationally through licensed distributors.

Provider Network Management

Linkia is the first provider network management service company dedicated solely to serving the O&P market. Linkia is dedicated to managing the O&P services of national and regional insurance companies. Linkia partners with healthcare insurance companies by securing a national or regional contract either as a preferred provider or to manage their O&P network of providers. Linkia's network now totals approximately 1,000 O&P provider locations. As of September 30, 2009, Linkia had 16 contracts with national and regional providers.

Industry Overview

We estimate that the United States O&P patient care market is approximately $2.8 billion, of which we account for approximately 23%. The O&P patient care services market is highly fragmented and is characterized by local, independent O&P businesses, with the majority generally having a single facility with annual revenues of less than $1.0 million. We do not believe that any of our patient care competitors account for a market share of more than 2% of the country's total estimated O&P patient care services revenue.

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

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

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

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

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

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

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

† Leading market position, with an approximate 23% share of total industry revenues and operations in 45 states and the District of Columbia, in an otherwise fragmented industry;

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

† establish our brand name and generate economies of scale;

† implement best practices throughout the Company;

† utilize shared fabrication facilities;

† contract with national and regional managed care entities;

† identify, test and deploy emerging technology; and

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

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

† negotiate greater purchasing discounts from manufacturers and freight providers;

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

† quickly access prefabricated and finished O&P products;

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

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

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

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

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

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

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

† History of successful integration of small and medium-sized O&P business acquisitions, including 78 O&P businesses since 1997, representing over 186 patient-care centers;

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

† Experienced and committed management team; and

† Successful government relations efforts including:

† Supported our patients' efforts to pass "The Prosthetic Parity Act" in 11 states;

†          Increased Medicaid reimbursement levels in several states; and



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

Business Strategy

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

† Improve our performance by:

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

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

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

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

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

† Increase our market share and net sales by:

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

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

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

† increasing the number of practitioners through our residency program;

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

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

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

† Provide our practitioners with:

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

† career development and increased compensation opportunities;

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

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

† selective application of new technology to improve patient care.

Results

Net sales for the three months ended September 30, 2009 increased by $13.6 million, or 7.6%, to $192.3 million from $178.7 million in the prior year's third quarter. The sales increase was principally the result of a $6.7 million, or 4.3% increase in same-center sales in our patient care business, a $2.1 million, or 10.0% increase in external sales of our distribution segment, and a $4.8 million increase primarily related to sales from acquired entities. As a result of the sales increase, income from operations increased $3.6 million to $23.8 million in the three months ended September 30, 2009 from $20.2 million in the same period in 2008.

Net income for the three months ended September 30, 2009 increased $2.3 million to $9.6 million compared to $7.3 million in the same period of the prior year. The current period benefited from the combination of increased sales, effective expense management, and lower interest costs.

Net sales for the nine months ended September 30, 2009 increased by $37.4 million, or 7.2%, to $555.0 million from $517.6 million in the same period of the prior year. The sales increase was principally the result of a $19.2 million, or 4.3%, increase in same-center sales in our patient care business, a $5.0 million, or 8.1%, increase in external sales of our distribution segment, and a $13.2 million increase primarily related to sales from acquired entities. As a result of the sales increase, income from operations increased $7.2 million to $63.0 million in the nine months ended September 30, 2009 from $55.8 million in the same period in 2008.

Net income for the nine months ended September 30, 2009 increased $5.3 million to $24.2 million, compared to $18.9 million in the same period of the prior year. The current period benefited from the combination of increased sales, effective expense management, and lower interest costs.

Net cash provided by operations improved by $11.3 million for the nine months ended September 30, 2009 to $46.2 million compared to $34.9 million in the same period of the prior year. The improvement in cash provided by operations for the period was primarily the result of improved operating results and a $0.8 million decrease in working capital. Days sales outstanding improved to 47 days as of September 30, 2009 from 50 days as of September 30, 2008.

As of September 30, 2009, $76.1 million, or 18.6%, of the Company's total debt of $409.7 million was subject to variable interest rates. The Company had access to funds of $131.2 million, comprised of $78.4 million of cash and $52.8 million available under its Revolving Credit Facility at September 30, 2009. On October 23, 2009, Barclays Bank PLC replaced $10.0 million of $17.8 million defaulted Lehman commitment under the Revolving Credit Facility, which increases the current amount available under the credit facility to $62.8 million. The Company believes that it has sufficient liquidity to conduct its normal operations and fund its acquisition plan in 2009.

For the full year 2009, the Company expects revenues to be between $750 million and $760 million, which would result in growth of 6.7% to 8.1% compared to fiscal 2008. The Company also expects diluted EPS in the range of $1.05 to $1.07 for twelve months ended December 31, 2009.

Critical Accounting Policies and Estimates

Our analysis and discussion of our financial condition and results of operations is based upon our Consolidated Financial Statements that have been prepared in accordance with accounting principles generally accepted in the United States of America ("GAAP"). The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. GAAP provides the framework from which to make these estimates, assumptions and disclosures. 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 accounting policies are stated in Note B to the Consolidated Financial Statements included elsewhere in this report. We believe the following accounting policies are critical to understanding our results of operations and the more significant judgments and estimates used in the preparation of our Consolidated Financial Statements.

† Revenue Recognition: Revenues from 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 from 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 revenues 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 revenues 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 composition of our accounts receivable balance by payor:

September 30, 2009 (unaudited)
(In thousands)                    0-60 days     61-120 days     Over 120 days      Total
Commercial and other             $    47,136   $       8,838   $         6,392   $  62,366
Private pay                            4,299           1,597             1,358       7,254
Medicaid                               9,415           2,022             1,262      12,699
Medicare                              18,775           2,049             1,251      22,075
VA                                     1,348             143                69       1,560
                                 $    80,973   $      14,649   $        10,332   $ 105,954

December 31, 2008
(In thousands)                    0-60 days     61-120 days     Over 120 days      Total
Commercial and other             $    48,209   $       9,072   $         6,357   $  63,638
Private pay                            3,090           2,065             1,031       6,186
Medicaid                               8,582           2,725             1,339      12,646
. . .