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. 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 25% of the estimated $2.5 billion O&P patient-care market, in the United States. At September 30, 2008, we operated 677 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 create new products, 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 month periods ended September 30, 2008, our net sales were $178.7 million 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, 2008, net sales attributable to our patient-care services segment and distribution segment were $157.2 million and $20.9 million, respectively. For the nine months ended September 30, 2008, net sales attributable to our patient-care services segment and distribution segment were $454.5 million and $61.0 million, respectively. See Note M to our consolidated financial statements contained herein for further information related to our segments.

Patient Care Services

As of September 30, 2008, we provided O&P patient care services through 677 patient-care centers and over 1,000 practitioners in 45 states and the District of Columbia. Substantially all of our practitioners are certified, or candidates for formal certification, by the O&P industry certifying boards.

One or more practitioners closely manage each of our patient-care centers. Our patient-care centers also employ highly trained technical personnel who assist in the provision of services to patients and who fabricate various O&P devices, as well as office administrators who schedule patient visits, obtain approvals from payors and bill and collect for services rendered.

An attending physician determines a patient's treatment, writes a prescription and refers the patient to one of our patient-care centers. Our practitioners then consult with both the referring physician and the patient with a view toward assisting in the formulation of the prescription for, and design of, an orthotic or prosthetic device to meet the patient's need.

The fitting process often involves several stages in order to successfully achieve desired functional and cosmetic results. The practitioner creates a cast and takes detailed measurements, frequently using our digital imaging system (Insignia), of the patient to ensure an anatomically correct fit. Prosthetic devices are custom fabricated by technicians and fit by skilled practitioners. The majority of the orthotic devices provided by us are custom designed, fabricated and fit; the remainder are prefabricated but custom fit.

Custom devices are fabricated by our skilled technicians using the plaster castings, measurements and designs made by our practitioners as well as utilization of our proprietary Insignia system. The Insignia system replaces plaster casting of a patient's residual limb with the generation of a computer scanned image. Insignia provides a very accurate image, faster turnaround for the patient, and a more professional overall experience. Technicians use advanced materials and technologies to fabricate a custom device under quality assurance guidelines. Custom designed devices that cannot be fabricated at the patient-care centers are fabricated at one of several central fabrication facilities. After final adjustments to the device by the practitioner, the patient is instructed in the use, care and maintenance of the device. Training programs and scheduled follow-up and maintenance visits are used to provide post-fitting treatment, including adjustments or replacements as the patient's physical condition and lifestyle change.

To provide timely service to our patients, we employ technical personnel and maintain laboratories at many of our patient-care centers. We have earned a strong reputation within the O&P industry for the development and use of innovative technology in our products, which has increased patient comfort and capability, and can significantly enhance the rehabilitation process. The quality of our products and the success of our technological advances have generated broad media coverage, building our brand equity among payors, patients and referring physicians.

A substantial portion of our O&P services involves the treatment of a patient in a non-hospital setting, such as our patient-care centers, a physician's office, an out-patient clinic or other facility. In addition, O&P services are increasingly rendered to patients in hospitals, long-term care facilities, rehabilitation centers and other alternate-site healthcare facilities. In a hospital setting, the

practitioner works with a physician to provide either orthotic devices or temporary prosthetic devices that are later replaced by permanent prosthetic devices.

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. In July 2007, SPS acquired certain assets of SureFit, LLC, a leading manufacturer and distributor of therapeutic footwear for diabetic patients in the podiatric market. SPS maintains in inventory approximately 21,000 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;

† access prefabricated and finished O&P products quickly;

† 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 2004, we formed a new subsidiary, IN, Inc. Specializing 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. advances the design and manufacturing and 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 ("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. In addition, in September 2007 the WalkAide earned the esteemed da Vinci Award for Adaptive Technologies from the National Multiple Sclerosis Society. In the

spirit of the 15th century artist and visionary Leonardo da Vinci, the da Vinci Awards honor outstanding engineering achievements in adaptive and assistive technology that provide solutions to accessibility issues for people with disabilities. The WalkAide is sold in the United States through the Company's 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 was created by us during 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 their O&P networks, of which our patient care centers represent the majority of the participating providers. In 2004, Linkia entered into its first contract, and in September 2005, Linkia signed an agreement with CIGNA HealthCare which presently covers approximately nine million beneficiaries. We will continue to invest in and develop Linkia's networks and capabilities, as well as market Linkia's services to other national payors.

Industry Overview

We estimate that the O&P patient care market in the United States is approximately $2.5 billion, of which we account for approximately 25%. 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

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 25% 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 69 O&P businesses since 1997, representing over 178 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. We anticipate bringing new technology to the market through our IN, Inc. product line;

† 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;

† selective application of new technology to improve patient care; and

† lobbying of government officials at both the state and federal level on issues important to Hanger, our patients, and the O&P industry.

Results

Net sales for the three months ended September 30, 2008 increased by $16.4 million, or 10.1%, to $178.7 million from $162.3 million in the prior year's third quarter. The sales growth was primarily the result of a $10.5 million, or 7.3%, increase in same-center sales in our patient care business, a $2.9 million, or 15.9%, increase in sales of the Company's distribution segment, and a $2.8 million increase related to acquired entities. Income from operations increased by $1.7 million, or 9.0%, to $20.2 million for the three months ended September 30, 2008, from $18.5 million in the same period in 2007. Income from operations increased due principally to the increase in sales volume, and lower cost of goods, partially offset by higher selling, general and administrative costs. Net income for the three months ended September 30, 2008 increased $2.9 million to $7.3 million, compared to net income of $5.4 million in the same period of the prior year. The current period benefited from sales growth and lower interest costs.

Net sales for the nine months ended September 30, 2008 increased by $51.0 million, or 10.9%, to $517.6 million from $466.6 million for the same period in the prior year. The sales growth was principally the result of a $28.6 million, or 6.9%, increase in same-center sales in our patient care business, a $9.4 million, or 21.1%, increase in sales of the Company's distribution segment, and a $12.0 million increase related to acquired entities. Income from operations increased by $7.0 million for the nine months ended September 30, 2008, to $55.8 million, or 10.8% of net sales, from $48.8 million, or 10.5% of net sales, in the same period in 2007. Income from operations increased due principally to the increase in sales volume allowing us to leverage our relatively fixed labor costs. Net income for the nine months ended September 30, 2008 increased $6.6 million to $18.9 million, compared to net income of $12.3 million in the same period of the prior year. The current period benefited from the sales volume increase and lower interest costs.

Critical Accounting Policies and Estimates

Our analysis and discussion of our financial condition and results of operations are based upon our consolidated financial statements. The unaudited interim consolidated financial statements as of and for the three and nine months ended September 30, 2008 and 2007 have been prepared by the Hanger Orthopedic Group, Inc. (the "Company") pursuant to the rules and regulations of the Securities and Exchange Commission (the "SEC") for interim financial reporting. These consolidated statements are unaudited and, in the opinion of management, include all adjustments (consisting of normal recurring adjustments and accruals) necessary for a fair statement for the periods presented. The year-end consolidated data was derived from audited financial statements but does not include all disclosures required by accounting principles generally accepted in the United States of America ("GAAP").

These consolidated financial statements should be read in conjunction with the consolidated financial statements of the Company and notes thereto included in the Annual Report on Form 10-K for the year ended December 31, 2007, filed by the Company with the SEC. 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 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) collectability 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 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 composition of our patient-care segment's accounts receivable balance by payor:

September 30, 2008      0-60 days     61-120 days     Over 120 days      Total
(In thousands)
Commercial and other   $    40,675   $       8,208   $         5,962   $  54,845
Private pay                  3,586           1,462             1,170       6,218
Medicaid                     9,881           2,632             1,731      14,244
Medicare                    20,396           1,727             1,250      23,373
VA                           1,440             174                52       1,666
                       $    75,978   $      14,203   $        10,165   $ 100,346

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