RESULTS OF OPERATIONS

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our historical consolidated financial statements and related notes thereto in "Item 8. Financial Statements and Supplementary Data." The discussion below contains forward-looking statements that are based upon our current expectations and are subject to uncertainty and changes in circumstances. Actual results may differ materially from these expectations due to inaccurate assumptions and known or unknown risks and uncertainties, including those identified in "Cautionary Note Regarding Forward-Looking Statements" and "Item lA. Risk Factors" contained in this Annual Report on Form 10-K.

Overview of the Company

We develop, manufacture, market and sell orthopaedic implant devices, related surgical instrumentation, supplies and biologic materials to hospitals and physicians in the United States and internationally. Our revenues are derived from sales of knee, hip, and extremity joint replacement systems and spinal fusion products. Revenues from the worldwide distribution of biologic materials contributes to our total reported sales and has been a key component of growth over the last few years. Our continuing research and development projects will enable us to continue the introduction of new, advanced biologic materials and other products and services. Revenue from sales of other products, including surgical instrumentation, Cemex® bone cement, the InterSpace™ pre-formed, antibiotic cement hip, knee and shoulder spacers have contributed to revenue growth and are expected to continue to be an important part of our anticipated future revenue growth.

Our operating expenses consist of sales and marketing expenses, general and administrative expenses, research and development expenses, and depreciation expenses. The largest component of operating expenses, sales and marketing expenses, primarily consists of payments made to independent sales representatives for their services to hospitals and surgeons on our behalf. These expenses tend to be variable in nature and related to sales growth. Research and development expenses primarily consist of expenditures on projects concerning knee, extremities, spine and hip implant product lines and biologic materials and services.

In marketing our products, we use a combination of traditional targeted media marketing together with our primary marketing focus, direct customer contact and service to orthopaedic surgeons. Because surgeons are the primary decision maker when it comes to the choice of products and services that best meet the needs of their patients, our marketing strategy is focused on meeting the needs of the orthopaedic surgeon community. In cooperation with our organization of independent sales agencies in the United States and network of independent distributors and subsidiaries internationally, we conduct this marketing effort through continuing education forums, training programs and product development advisory panels.

Overview of 2008

Total sales increased 30% to $161.7 million during 2008 from $124.2 million in 2007. Gross profit margin decreased to 64% in 2008 from 65% in 2007. International sales of $49.3 million, which represented 30% of total sales, increased 78%, as compared to $27.7 million, or 22% of total sales in 2007. Increases in operating expenses in 2008 were driven by additional sales and marketing efforts to promote our products, which increased 32% from 2007, and increased legal expenses related to a Department of Justice inquiry, which totaled $2.6 million for 2008. Overall, operating expenses increased 29% from 2007 resulting in income from operations increasing 24% from 2007. Income before provision for income taxes increased 28% to $17.7 million from $13.8 million in 2007. Net income increased 31% from the prior year, equaling 7% of sales, comparable to the 7% of sales achieved in 2007.

On the balance sheet, at the end of 2008, working capital increased 47% to $78.8 million from $53.7 million in 2007. This change in working capital was a result of the increased inventory levels and the assets acquired in our two acquisitions this year. Current liabilities increased 26% to $21.8 million. Long-term liabilities increased to $24.1 million due to borrowings under our line of credit to fund our operations and acquisitions.

The following table includes the net revenue and percentage of net sales for each of our product lines for the years ended December 31, 2008, 2007 and 2006:

                             Sales by Product Line

                             (dollars in thousands)



                                                     Year Ended
                       December 31, 2008         December 31, 2007         December 31, 2006
 Knee                 $    72,629     44.9 %    $    63,402     51.1 %    $    53,573     52.3 %
 Hip                       22,777     14.1           22,589     18.2           17,867     17.5
 Biologics & Spine         26,453     16.4           16,202     13.0           13,344     13.0
 Extremities               16,844     10.4            9,539      7.7            4,904      4.8
 Other Products            23,027     14.2           12,477     10.0           12,742     12.4

 Total                $   161,730    100.0 %    $   124,209    100.0 %    $   102,430    100.0 %

The following table includes: (i) items from the Statements of Income for the year ended December 31, 2008 as compared to 2007, and the dollar and percentage change from year to year and the percentage relationship to net sales, and
(ii) items from the Statements of Income for the year ended December 31, 2007 as compared to 2006, and the dollar and percentage change from year to year and the percentage relationship to net sales (dollars in thousands):

Comparative Statement of Income Data



                                            Year Ended                    2008 - 2007              2007 - 2006
                                           December 31,                   Incr (decr)              Incr (decr)                 % of Sales
                                   2008        2007      2006             $          %             $         %          2008     2007     2006
Net sales                         161,730    124,209    102,430         37,521      30.2        21,779      21.3        100.0    100.0    100.0
Cost of goods sold                 58,620     43,758     36,571         14,862      34.0         7,187      19.7         36.2     35.2     35.7
Gross profit                      103,110     80,451     65,859         22,659      28.2        14,592      22.2         63.8     64.8     64.3
Operating expenses:
Sales and marketing                51,263     38,699     30,012         12,564      32.5         8,687      28.9         31.7     31.2     29.3
General and administrative         16,471     10,984      9,955          5,487      50.0         1,029      10.3         10.2      8.8      9.7
Research and development            9,255      8,126      6,241          1,129      13.9         1,885      30.2          5.7      6.5      6.1
Impairment loss                         -      1,519          -        (1,519 )        -         1,519         -            -      1.2        -
Depreciation and amortization       7,569      6,156      5,718          1,413      23.0           438       7.7          4.7      5.0      5.6
Total operating expenses           84,558     65,484     51,926         19,074      29.1        13,558      26.1         52.3     52.7     50.7
Income from operations             18,552     14,967     13,933          3,585      24.0         1,034       7.4         11.5     12.1     13.6
Other expenses, net                 (840 )   (1,174 )   (2,055 )           334    (28.4 )        (881 )   (42.9 )       (0.5 )   (0.9 )    (2.0)
Income before taxes                17,712     13,793     11,878          3,919      28.4         1,915      16.1         11.0     11.2     11.6
Provision for income taxes          6,521      4,859      3,954          1,662      34.2           905      22.9          4.0      3.9      3.9
Income before equity in loss of
other investments                  11,191      8,934      7,924          2,257      25.3         1,010      12.7          7.0      7.3      7.7
Equity in loss of other
investments                          (98 )     (451 )     (172 )           353    (78.3 )          279     162.2        (0.1 )   (0.4 )    (0.2)
Net income                         11,093      8,483      7,752          2,610      30.8           731       9.4          6.9      6.9      7.5

Net Sales

Net sales increased 30% to $161.7 million in 2008 from $124.2 million in 2007, as a result of increased unit sales. Our extremities revenues increased 77% to $16.8 million as compared to $9.5 million for 2007 due to continuing market penetration of our primary shoulder replacement system and the continued

rollout of our Equinoxe® reverse shoulder implants. We experienced growth of 63% in our biologic and spine services revenue to $26.5 million as compared to $16.2 million for 2007 due to our acquisition of the spine company, which contributed 44% of the growth in the segment and the increase in our biologics distribution. During 2008, sales of knee implant products increased 15% to $72.6 million as compared to $63.4 million for 2007, while sales of other products increased 85% to $23.0 million as compared to $12.5 million for 2007 as a result of cement sales increases and other products from our acquired French distributor. Our reported hip implant products increased 1% to $22.8 million as compared to $22.6 million for 2007, which is reflective of the comparison to Link hip products distributed during 2007, that were not distributed in 2008 due to the termination of the Link distribution agreement as of December 31, 2007. Excluding the comparative impact of Link hip products that were distributed in 2007, our hip implant product revenues increased 23% in 2008. Internationally, net sales increased 78% to $49.3 million, representing 30% of total sales, from $27.7 million, or 22% of total sales, during 2007, as we benefited from nine months of sales from our acquired French distributor and continued increases in market share in other areas of Europe. Domestically, sales increased 17% during 2008 to $112.4 million from $96.5 million in 2007, due to growth in all of our core product lines and the acquisition of the spine company. During 2008, we experienced sales growth throughout the year with our Optetrak® knee system, Novation® hip products, Equinoxe shoulder implants, and our biologic services, however, during the second half of 2008 our sales growth in our knee and hip products slowed slightly.

Net sales increased 21% in 2007 from 2006, as a result of increased unit sales. Our extremities revenues increased 95% due to continuing market penetration of our primary shoulder replacement and the introduction of our Equinoxe reverse shoulder implants during the second quarter of 2007. We experienced growth of 21% in our biologic services revenue primarily due to growth from our Optecure and Accelerate PRP services, and a 26% increase in our hip implant products resulting from our continued momentum in our Novation hip system. During 2007, sales of knee implant products increased 18%, while sales of other products decreased 2%. Internationally, net sales increased 24% to $27.7 million, representing 22% of total sales, from $22.3 million, or 22% of total sales, during 2006, as we continued to benefit from increases in market share in Europe. Domestically, sales increased 20% during 2007 to $96.5 million from $80.1 million in 2006, due to growth in all of our core product lines. During 2007, we experienced sales growth consistently throughout the year with our Optetrak knee system, Novation hip products and our Optecure biologic service. Sales growth in our extremities products for the second half of the year was 125% primarily due to the introduction of our Equinoxe reverse shoulder implants.

Gross Profit

Gross profit margin decreased in 2008 to 64% from 65% in 2007, which was principally due to the shift to more international business, which generally entails lower margins. We expect gross margins to stabilize or expand modestly during 2009, as we expect a more constant international and domestic mix of sales, and we continue to focus on improving manufacturing efficiencies. Gross profit margin increased in 2007 to 65% from 64% in 2006, which was a result of our ongoing initiative to improve our manufacturing efficiencies and increase the volume of our implant components produced internally.

Operating Expenses

Sales and marketing expenses increased 32% in 2008 from 2007, primarily due to our continued support for newly launched products, distribution subsidiary expenses and increased variable selling expenses. As a percentage of sales, sales and marketing expenses were 32% for 2008, as compared to 31% for 2007. In 2007, sales and marketing expenses increased 29% from 2006, primarily as a result of increases in the variable selling costs associated with the increase in sales and the costs associated with the promotion of new product lines including our Novation AHS ceramic-on-ceramic hip system, Equinoxe reverse shoulder system. We expect that sales and marketing expenses in 2009 will be similar to those for 2008 on a percentage of sales basis, as we will continue our marketing programs in support of new product launches and customer service.

General and administrative expenses increased 50% in 2008 from 2007. This increase was partially due to increased operating expenses related to the integration of the two acquisitions completed in 2008, and also due to the legal and related expenses we incurred during 2008 in connection with the Department of Justice inquiry. See Liquidity and Capital Resources-Operating Activities later in this MD&A for further discussion of the Department of Justice inquiry. The 10% increase in general and administrative expenses in 2007 from 2006 was principally a result of growth in operations, additional audit fees related to the year ended 2006, and stock compensation expense during 2007.

Research and development expenses increased 14% in 2008 from the prior year as we continued to invest in the clinical trial for the Optetrak RBKTM knee system, expansion of hip product lines and line extensions in our biologics portfolio. Our primary development efforts in 2008 continued to focus on broadening our scope of our hip and extremity product lines, enhancement to our Optetrak knee system and advanced biologic based materials. Research and development expenses increased 30% in 2007 from the prior year as we continued to invest in the clinical trial for the Optetrak RBKTM knee system, development of advanced bearing materials and line extensions in our biologics portfolio. As a percentage of sales, research and development expenses decreased, to 6% for 2008 from 7% for 2007. The primary reason for the reduction as percentage of sales was the acquisition of French distributor revenues without any corresponding research and development expenses. As we continue to invest in ongoing development projects in all of our product segments, we expect research and development expenditures to continue to increase in 2009 and continue to be in the range of 6% to 7% of total sales.

Our operating expenses during 2007 included an impairment loss of $1.5 million we recognized in association with the impairment of the full carrying value of a license to a patent we hold with Dimicron Corporation. The license is part of a purchase and distribution agreement that we entered into with Dimicron to market and distribute polycrystalline diamond compact hip bearings.

Depreciation and amortization expenses increased 23% in 2008, to $7.6 million, as we invested $16.1 million in capital equipment, including $1.9 million in facility expansion, $4.6 million to purchase manufacturing equipment, and $9.4 million in surgical instrumentation. Depreciation and amortization expenses increased 8% in 2007 when compared to 2006, as we invested $11.7 million in capital equipment, including $2.0 million in facility purchases and expansion, $3.1 million to purchase manufacturing equipment, and $5.4 million in surgical instrumentation. Capital expenditures in 2009 are anticipated to range from $15 million to $18 million to continue to support surgical instrumentation for product launches, increased manufacturing capacity and an expansion of our facilities.

Income from Operations

Income from operations increased 24% to $18.6 million in 2008 from $15.0 million in 2007, as a result of our 28% increase in gross profit and our focus to keep our growth in costs at an optimal level. Income from operations increased 7% in 2007 from 2006. Looking forward, we anticipate growth in sales and gross profit margin, coupled with lower growth in operating expenses, to result in income from operations in the range of 13% to 14% of sales exclusive of DOJ inquiry related expenses.

Other Income and Expenses

Other expenses, net of other income, decreased 28% to $840,000 for 2008 from $1.2 million for 2007 primarily due to a first quarter 2008 before tax gain of $485,000 that we recognized on a forward currency option we entered into in anticipation of our acquisition of our French distributor. Additionally, we experienced a reduction of interest to $1.1 million in 2008 from $1.3 million in 2007 as a result of more favorable interest rates during the year. In 2007, Other expenses, net of other income, decreased 43%, due to our reduction of debt, which resulted in interest expense decreasing to $1.3 million in 2007 from $2.2 million in 2006. Looking forward, we expect other expenses, net of other income, to increase as interest expense is incurred on increased anticipated borrowing under our line of credit to fund technology and expansion activity.

Equity Method Investee Gains and Losses

Losses from equity method investments in Altiva for 2008 totaled $98,000, prior to our acquisition of Altiva, effective January 2, 2008, at which time we began to consolidate their results from operations. Losses from equity method investments in Altiva totaled $451,000 in 2007 as compared to $172,000 in 2006 for losses of Altiva. See "Management's Discussion and Analysis of Financial Condition and Results of Operation-Investing Activities-Acquisition of Altiva" for further information on the acquisition.

Taxes and Net Income

Income before provision for income taxes increased 28% in 2008 from 2007. The effective income tax rate, as a percentage of income before taxes, for 2008 was 36.8%, as compared to 35.2% in 2007, as a result of the increase in our taxable revenue in higher tax jurisdictions resulting in a higher marginal tax rate. Income before provision for income taxes increased 16% in 2007 from 2006. The effective income tax rate, as a percentage of income before taxes, for 2007 was 35.2%, as compared to 33.3% in 2006, as a result of the increase in our taxable revenue resulting in a higher marginal tax rate. In 2009, we expect the effective tax rate to be approximately 37% as our revenue and marginal tax rate are expected to continue to be similar to that experienced in 2008.

As a result of the foregoing, we realized an increase in net income of 31% in 2008, representing 7% of sales, and diluted earnings per share of $0.87 as compared to 7% of sales and diluted earnings per share of $0.72 in 2007. The 2007 net income increased 9% from 2006, which was 7% of net sales and diluted earnings per share of $0.67.

Non-GAAP Financial Measures

In addition to providing results that are determined in accordance with accounting principles generally accepted in the United States, referred to as GAAP, we have provided certain financial measures that are not in accordance with GAAP. Our non-GAAP financial measures of adjusted net income and adjusted diluted earnings per share exclude the charges we incurred in relation to the DOJ inquiry, less the tax effect of the charges. Because the DOJ inquiry is a unique event, not directly related to our normal operations, we believe these non-GAAP financial measures may help investors better understand and compare our quarterly operating results and trends by eliminating this unusual component included in GAAP financial measures.

Excluding the impact of the pre-tax expenses of $2.6 million for the DOJ inquiry recognized during 2008, net income for the year ended December 31, 2008, increased 34% to $12.7 million, as compared to an adjusted 2007 net income of $9.5 million, adjusted for elimination of the asset impairment charge taken during 2007. Adjusted diluted earnings per share for 2008 increased to $0.99 as compared to adjusted diluted earnings per share of $.80 for 2007.

Excluding the impact of the pre-tax charge of $1.5 million for the intangible asset impairment recognized in the second quarter of 2007, net income for the year ended December 31, 2007, increased 22% to $9.5 million, as compared to net income of $7.8 million for the same period of 2006. Adjusted diluted earnings per share for 2007 increased to $0.80 as compared to diluted earnings per share of $0.67 for 2006.

The reconciliations of these non-GAAP financial measures are as follows (in thousands, except per share amounts):

                                                                       Year Ended
                                                                      December 31,
                                                            2008          2007          2006
Net Income                                               $   11,093     $   8,483     $   7,752
Adjustments for DOJ inquiry expenses and asset
impairment charges:
DOJ inquiry expenses, pre-tax                                 2,605             -             -
Impairment loss, pre-tax                                          -         1,519             -
Income tax benefit                                           (1,026 )        (542 )

Adjustments, net of tax                                       1,579           977             -

Adjusted net income - excluding DOJ related expenses
and asset impairment charges                             $   12,672     $   9,460     $   7,752


Diluted earnings per share                               $     0.87     $    0.72     $    0.68
Adjustment of DOJ and asset impairment related
expenses, net                                                  0.12          0.08             -

Adjusted diluted earnings per share                      $     0.99     $    0.80     $    0.67

The weighted-average diluted shares outstanding used in the calculation of these non-GAAP financial measures are the same as the weighted-average shares outstanding used in the calculation of the reported per share amounts.

Liquidity and Capital Resources

We have financed our operations through a combination of commercial debt financing, sales of equity securities and cash flows from operating activities. At December 31, 2008, we had working capital of $78.8 million, an increase of 47% from $53.7 million at the end of 2007. Working capital in 2008 increased primarily as a result of the additional inventory we held as of December 31, 2008, and as a result of the additional current assets acquired as part of the two acquisitions during 2008. We project that cash flows from operating activities and borrowing under our existing line of credit will be sufficient to meet our commitments and cash requirements in the following twelve months and for the foreseeable future. If not, we will seek additional funding options with any number of possible combinations of additional debt, additional equity or convertible debt. See Item 1A. Risk Factors for discussion on the capital markets.

Operating Activities

Operating activities provided net cash of $4.9 million for 2008, as compared to $25.9 million in 2007, primarily as a result of an increase in total inventory of $13.0 million, which was primarily due to the addition of our Japan and France distribution centers, as well as the new products we introduced during the year. Looking forward, we anticipate the inventory balance to increase during the first half of 2009 and stabilize or decrease slightly during the second half of 2009. The increase in inventory balances during 2008 was outpaced by the sales growth resulting in a residual effect on inventory turns, which increased to 1.11 during 2008 from 0.92 during 2007.

In 2008, our total accounts receivable balances increased 37% to $31.8 million from $23.1 million in 2007 and the total days sales outstanding (DSO) ratio, based on average accounts receivable balances, increased from 59 for 2007 to 61 for 2008. Our allowance for doubtful accounts and sales return allowance at December 31, 2008, increased to $1.0 million as compared to $663,000 at December 31, 2007, primarily as a result of our increased sales for 2008. We expect increases in accounts receivable during 2009 to be slightly higher than sales growth due to current economic pressures.

Litigation

We are subject to claims, lawsuits, disputes with third parties and actions involving various allegations

against us incident to the operation of our business, principally product liability cases. We are currently a party to several product liability suits related to the products distributed by Exactech on behalf of RTI Biologics, Inc. or RTI. Pursuant to our license and distribution agreement with RTI, we will tender all cases to RTI. While we believe that is the various claims are without merit, we are unable to predict the ultimate outcome of such litigation. Therefore, we maintain insurance, subject to self-insured retention limits, for these and all such claims, and establish accruals for product liability and other claims based upon our experience with similar past claims, advice of counsel and the best information available. At December 31, 2008 and 2007, we had no accrual for product liability claims. These types of matters are subject to various uncertainties, and it is possible that some of these matters may be resolved unfavorably to Exactech. However, while it is not possible to predict with certainty the outcome of these types of claims, it is the opinion of management that, upon ultimate resolution, any pending claims will not have a material adverse effect on our consolidated financial position, results of operations or cash flows.

In December 2007, we received a grand jury subpoena from the U.S. Attorney for the District of New Jersey requesting documents dating from January 1, 1998 to the present related to consulting and professional service agreements between Exactech and orthopaedic surgeons and other medical professionals. We believe the subpoena relates to an investigation the Department of Justice is conducting with respect to the use of such agreements and arrangements by orthopedic implant manufacturers and distributors. We continue to cooperate fully with the Department of Justice request and cannot estimate what, if any, future financial impact this inquiry and its ultimate resolution may have on our financial position, operating results or cash flows. Our legal and other expenses related . . .