INTEGRA LIFESCIENCES HOLDINGS CORP - 10-Q Quarterly Report

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549

FORM 10-Q

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

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2003

COMMISSION FILE NUMBER 0-26224

INTEGRA LIFESCIENCES HOLDINGS CORPORATION
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

DELAWARE 51-0317849
(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.)

311 ENTERPRISE DRIVE
PLAINSBORO, NEW JERSEY 08536
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)

(609) 275-0500
(REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)

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.

/X/ - YES / / - NO

INDICATE BY CHECK MARK WHETHER THE REGISTRANT IS AN ACCELERATED FILER
/X/ YES / / NO

AS OF NOVEMBER 7, 2003 THE REGISTRANT HAD OUTSTANDING 27,149,060 SHARES OF
COMMON STOCK, $.01 PAR VALUE.

INTEGRA LIFESCIENCES HOLDINGS CORPORATION

INDEX

2

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

INTEGRA LIFESCIENCES HOLDINGS CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)

(In thousands, except per share amounts)

Three Months Ended Nine Months Ended
September 30, September 30,
2003 2002 2003 2002

3

INTEGRA LIFESCIENCES HOLDINGS CORPORATION
CONSOLIDATED BALANCE SHEETS
(UNAUDITED)
(In thousands, except per share amounts)
September 30, December 31,
2003 2002
--------------- --------------
ASSETS
Current Assets:
Cash and cash equivalents ............................... $ 83,951 $ 43,583
Short-term investments .................................. 31,523 55,278
Accounts receivable, net of allowances of
$837 and $1,387 ....................................... 26,961 19,412
Inventories ............................................. 38,395 28,502
Prepaid expenses and other current assets ............... 5,743 5,498
---------- ----------
Total current assets ................................ 186,573 152,273

Non-current investments .................................. 93,596 33,450
Property, plant, and equipment, net ...................... 17,873 16,556
Deferred income taxes, net ............................... 24,659 25,218
Identifiable intangible assets, net ...................... 51,070 23,091
Goodwill ................................................. 22,566 22,073
Other assets ............................................. 6,192 2,007
---------- ----------
Total assets .............................................. $ 402,529 $ 274,668
========== ==========

LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities:
Accounts payable, trade ................................. $ 6,604 $ 3,764
Income taxes payable .................................... 532 --
Customer advances and deposits .......................... 10,429 7,908
Deferred revenue ........................................ 3,317 816
Accrued expenses and other current liabilities .......... 11,561 9,433
---------- ----------
Total current liabilities ........................... 32,443 21,921

Long-term debt ........................................... 119,911 --
Deferred revenue ......................................... 406 3,263
Other liabilities ........................................ 2,714 1,887
---------- ----------
Total liabilities ......................................... 155,474 27,071

Stockholders' Equity:
Common stock; $0.01 par value; 60,000 authorized shares;
27,582 and 27,204 issued and outstanding at
September 30, 2003 and December 31, 2002,
respectively ......................................... 276 272
Additional paid-in capital .............................. 289,094 292,007
Treasury stock, at cost; 759 and 106 shares at September (17,955)
30, 2003 and December 31, 2002, respectively .......... (1,812)
Other ................................................... (6) (15)
Accumulated other comprehensive income (loss):
Unrealized gains (losses) on available-for-sale
securities ........................................ (153) 861
Foreign currency translation adjustment .............. 3,483 1,618
Minimum pension liability adjustment ................. (1,050) (1,011)
Accumulated deficit ..................................... (26,634) (44,323)
---------- ----------
Total stockholders' equity ............................ 247,055 247,597
---------- ----------
Total liabilities and stockholders' equity ................ $ 402,529 $ 274,668
========== ==========

The accompanying notes are an integral part of these consolidated financial statements

4

INTEGRA LIFESCIENCES HOLDINGS CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED) (In thousands)
Nine Months
Ended
September 30,
--------------------------
2003 2002
----------- -----------

5

INTEGRA LIFESCIENCES HOLDINGS CORPORATION
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

BASIS OF PRESENTATION

General

In the opinion of management, the September 30, 2003 unaudited consolidated
financial statements contain all adjustments (consisting only of normal
recurring adjustments) necessary for a fair presentation of the financial
position, results of operations, and cash flows of the Company. Certain
information and footnote disclosures normally included in financial statements
prepared in accordance with accounting principles generally accepted in the
United States have been condensed or omitted in accordance with the instructions
to Form 10-Q and Rule 10-01 of Regulation S-X. These unaudited consolidated
financial statements should be read in conjunction with the Company's
consolidated financial statements for the year ended December 31, 2002 included
in the Company's Current Report on Form 8-K dated June 27, 2003. As discussed in
that report, in 2003 the Company began to report financial results under a
single operating segment--the development, manufacturing, and distribution of
medical devices.

Operating results for the three and nine month periods ended September 30, 2003
are not necessarily indicative of the results to be expected for the entire
year.

The preparation of consolidated financial statements in conformity with
accounting principles generally accepted in the United States requires
management to make estimates and assumptions that affect the reported amount of
assets and liabilities, the disclosure of contingent liabilities, and the
reported amounts of revenues and expenses. Significant estimates affecting
amounts reported or disclosed in the consolidated financial statements include
allowances for doubtful accounts receivable and sales returns, net realizable
value of inventories, estimates of future cash flows associated with long-lived
asset valuations, depreciation and amortization periods for long-lived assets,
valuation allowances recorded against deferred tax assets, loss contingencies,
and estimates of costs to complete performance obligations associated with
research, licensing, and distribution arrangements for which revenue is
accounted for using percentage of completion accounting. These estimates are
based on historical experience and on various other assumptions that are
believed to be reasonable under the current circumstances. Actual results could
differ from these estimates.

The Company has reclassified certain prior year amounts to conform with the
current year's presentation.

New Accounting Policy

Derivatives

The Company reports all derivatives at their estimated fair value and records
changes in fair value in current earnings or defers these changes until a
related hedged item is recognized in earnings, depending on the nature and
effectiveness of the hedging relationship. The designation of a derivative as a
hedge is made on the date the derivative contract is executed. On an ongoing
basis, the Company assesses whether each derivative continues to be highly
effective in offsetting changes in the fair value or cash flows of hedged items.
If and when a derivative is no longer expected to be highly effective, the
Company discontinues hedge accounting. All hedge ineffectiveness is included in
current period earnings in other income (expense), net.

The Company documents all relationships between hedged items and derivatives.
The Company's overall risk management strategy describes the circumstances under
which the Company may undertake hedge transactions and enter into derivatives.

6

The objective of the Company's current risk management strategy is to hedge the
risk of changes in fair value attributable to interest rate risk with respect to
a portion of its fixed rate debt.

The determination of fair value of derivatives is based on valuation models that
use observable market quotes or projected cash flows and the Company's view of
the creditworthiness of the derivative counterparty.

Recently Issued Accounting Standards

In May 2003, the Financial Accounting Standards Board ("FASB") issued SFAS No.
150, "Accounting for Certain Instruments with Characteristics of both
Liabilities and Equity", which establishes standards for how an issuer
classifies and measures certain financial instruments with characteristics of
both liabilities and equity. SFAS 150 is effective for financial instruments
entered into or modified after May 31, 2003, and otherwise is effective at the
beginning of the first interim period beginning after June 15, 2003. In November
2003, the FASB deferred the effective date of SFAS 150 for certain mandatorily
redeemable financial instruments and non-controlling interests. The Company's
adoption of the initial recognition and initial measurement provisions of SFAS
150 did not have a material impact on the Company's results of operations or
financial position.

In April 2003, the FASB issued SFAS No. 149, "Amendment of Statement 133 on
Derivative Instruments and Hedging Activities", which amends and clarifies
financial accounting and reporting for derivative instruments, including certain
derivative instruments embedded in other contracts, and for hedging activities
under SFAS 133. SFAS 149 is effective for contracts entered into or modified
after June 30, 2003, and for hedging relationships designated after June 30,
2003. The adoption of SFAS 149 did not have a material impact on the Company's
results of operations or financial position.

In November 2002, the Emerging Issues Task Force (EITF) issued EITF 00-21
"Accounting for Revenue Arrangements with Multiple Deliverables". EITF 00-21
addresses when and how an arrangement involving multiple deliverables should be
divided into separate units of accounting. EITF 00-21 is effective for revenue
arrangements entered into in fiscal periods beginning after June 15, 2003. The
Company will continue to evaluate the impact of EITF 00-21 on revenue
arrangements it may enter into in the future.

In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based
Compensation - Transition and Disclosure". SFAS No. 148 provides alternative
methods of transition for a voluntary change to the fair value based method of
accounting for stock-based employee compensation and amends certain disclosure
requirements of SFAS No. 123 "Accounting for Stock Based Compensation". SFAS No.
148 does not require companies to expense stock options in current earnings. The
interim disclosure requirements became effective for the Company beginning with
its March 31, 2003 consolidated financial statements.

The Company recognizes employee stock-based compensation using the intrinsic
value method prescribed by APB Opinion No. 25 "Accounting for Stock Issued to
Employees" and FASB Interpretation No. 44 "Accounting for Certain Transactions
Involving Stock Compensation -an interpretation of APB Opinion No. 25".

7

Had the compensation cost for the Company's stock-based compensation plans been
determined based on the fair value at the date of grant consistent with the
provisions of SFAS No. 123, the Company's net income and basic and diluted net
income per share would have been as follows:

Three Months Ended Nine Months Ended
September 30, September 30,
2003 2002 2003 2002
-------- -------- -------- --------
(in thousands, except per share amounts)

As options vest over a varying number of years and awards are generally made
each year, the pro forma impacts shown above may not be representative of future
pro forma expense amounts. The pro forma additional compensation expense was
calculated based on the fair value of each option grant using a Black-Scholes
model.

2. ACQUISITIONS

In August 2003, the Company acquired substantially all of the assets of Tissue
Technologies, Inc., the manufacturer and distributor of the UltraSoft(TM) line
of implants for soft tissue augmentation of the facial area. The Company paid
$0.5 million in cash at closing and is obligated to pay the seller up to an
additional $1.6 million in cash, including contingent consideration based upon a
multiple of the Company's sales of the UltraSoft product in the third year
following the acquisition. The Company markets the UltraSoft products directly
to cosmetic and reconstructive surgeons through its plastic and reconstructive
surgery sales force and through a network of distributors. The acquired assets
consist primarily of technology, which is being amortized on a straight-line
basis over 10 years, and goodwill. Any future contingent consideration paid to
the seller will be recorded as additional goodwill.

In March 2003, the Company acquired all of the outstanding capital stock of J.
Jamner Surgical Instruments, Inc. (doing business as JARIT(R) Surgical
Instruments) ("JARIT") for $42.7 million in cash, including expenses associated
with the acquisition and net of $2.1 million of cash acquired, and subject to a
working capital adjustment and other adjustments with respect to certain income
tax elections. The Company has accrued an additional $1.0 million for the
current estimate of the amount payable to the seller under the terms of this
purchase price adjustment.

For more than 30 years, JARIT has marketed a wide variety of high quality,
reusable surgical instruments to virtually all surgical disciplines. JARIT sells
its products to more than 5,200 hospitals and surgery centers worldwide. In the
United States, JARIT sells through a nineteen person sales management force that
works with over 100 distributor sales representatives.

The acquisition of JARIT has broadened Integra's existing customer base and
surgical instrument product offering and has provided an opportunity to achieve
operating costs savings, including the procurement of Integra's Ruggles(TM) and
Padgett(TM) instruments products directly from the instrument manufacturers.

8

In connection with this acquisition, the Company recorded approximately $29.5
million of intangible assets, consisting primarily of trade name and customer
relationships, which are being amortized on a straight-line basis over lives
ranging from 5 to 40 years. The following table summarizes the preliminary fair
value of the assets acquired and liabilities assumed in the JARIT acquisition:

Current assets ....................... $ 17,338
Property, plant and equipment ........ 1,285
Intangible assets .................... 29,478
Other non-current assets ............. 104
---------
Total assets acquired ................ 48,205

Current liabilities .................. 2,391
Net assets acquired .................. $ 45,814

In December 2002, the Company acquired the neurosurgical shunt and epilepsy
monitoring business of the Radionics division of Tyco Healthcare Group for $3.5
million in cash, including expenses associated with the acquisition.

In October 2002, the Company acquired all of the outstanding capital stock of
Padgett Instruments, Inc., an established marketer of instruments used in
reconstructive and plastic surgery, for $9.6 million in cash, including expenses
associated with the acquisition. In March 2003, Padgett's distribution
operations were consolidated into the Company's distribution center located in
Cranbury, New Jersey.

In August 2002, the Company acquired all of the capital stock of the
neurosciences division of NMT Medical, Inc. for $5.7 million in cash, including
expenses associated with the acquisition. Through this acquisition, the Company
added a range of leading differential pressure valves and external ventricular
drainage products to its neurosurgical product line.

In July 2002, the Company acquired the assets of Signature Technologies, Inc., a
specialty manufacturer of titanium and stainless steel implants for the
neurosurgical and spinal markets, and certain other intellectual property
assets. The purchase price consisted of $2.9 million in cash (including expenses
associated with the acquisition) paid at closing, $0.5 million of deferred
consideration paid in March 2003, and royalties on future sales of products to
be developed.

The results of operations of these acquired businesses have been included in the
consolidated financial statements since their respective dates of acquisition.

The following unaudited pro forma financial information assumes that these
acquisitions had occurred as of the beginning of each period (in thousands,
except per share data):

Nine Months Ended Three Months Ended
September 30, September 30,
2003 2002 2002
-------- ------- --------

The impact of the Tissue Technologies acquisition was not material to these pro
forma results.

The pro forma financial results for the nine months ended September 30, 2003 and
2002, and for the three months ended September 30, 2002, respectively, include
approximately $0.1 million, $4.1 million and $1.4 million of gains associated
with foreign currency forward purchase contracts owned by JARIT. The Company
liquidated all of JARIT's foreign currency forward purchase contracts
concurrently with the closing of the acquisition.

9

In August 2002, the Company acquired certain assets, including the
NeuroSensor(TM) monitoring system and rights to certain intellectual property,
from Novus Monitoring Limited of the United Kingdom for $3.7 million in cash
(including expenses associated with the acquisition), an additional $1.5 million
to be paid upon Novus' achievement of a product development milestone, and up to
an additional $2.5 million payable based upon revenues from Novus' products. The
NeuroSensor(TM) system measures both intracranial pressure and cerebral blood
flow using a single combined probe and an electronic monitor for data display.
As part of the consideration paid, Novus has also agreed to conduct certain
clinical studies on the NeuroSensor(TM) system, continue development of a next
generation, advanced neuromonitoring product, and design and transfer to Integra
a validated manufacturing process for these products. The assets acquired from
Novus were accounted for as an asset purchase because the acquired assets did
not constitute a business under SFAS No. 141 "Business Combinations".

3. AMENDMENT TO SUPPLY, DISTRIBUTION AND COLLABORATION AGREEMENT WITH ETHICON,
INC.

In September 2003, Integra and ETHICON, Inc., a division of Johnson & Johnson,
("ETHICON") entered into an amendment to their Supply, Distribution and
Collaboration Agreement, which governs the marketing and distribution rights to
INTEGRA(R) Dermal Regeneration Template. ETHICON will continue to market and
sell INTEGRA Dermal Regeneration Template through December 31, 2003 under the
terms of the original agreement. On January 1, 2004, Integra will assume
exclusive responsibility for the sales, marketing and distribution of the
INTEGRA product. Under the terms of the amendment, ETHICON agreed to pay Integra
$2.0 million on December 31, 2003 in connection with the termination of the
agreement.

The Company and ETHICON resolved their disagreement regarding Integra's
attainment of certain clinical and regulatory events outlined in the original
agreement, and ETHICON agreed in September 2003 to pay $2.5 million to the
Company in connection with the attainment of those events. This amount has been
recorded as other revenue.

4. INVENTORIES

Inventories consisted of the following:

5. GOODWILL AND OTHER INTANGIBLE ASSETS

Changes in the carrying amount of goodwill for the nine months ended September
30, 2003, were as follows:

10

The components of the Company's identifiable intangible assets were as follows:

Excluding the effects of the acquisition of Spinal Specialties, Inc. in November
2003 (see Note 12), annual amortization expense is expected to approximate $2.9
million in 2003, $3.1 million in 2004, $2.9 million in 2005 and 2006, and $2.6
million in 2007. Identifiable intangible assets are initially recorded at fair
market value at the time of acquisition generally using an income or cost
approach.

6. DEBT

In March 2003, the Company completed a private placement of contingent
convertible subordinated notes totaling $100.0 million, due 2008. The Company
granted the initial purchasers an option to purchase up to an additional $20.0
million principal amount of notes, of which $5.0 million was exercised in March
and the remaining $15.0 million was exercised in April.

The notes bear interest at 2.5 percent per annum, payable semiannually. The
Company will pay additional interest ("Contingent Interest") if, at thirty days
prior to maturity, Integra's common stock price is greater than $37.56 per
share. The Contingent Interest will be payable for each of the last three years
the notes remain outstanding in an amount equal to the greater of i) 0.50% of
the face amount of the notes and ii) the amount of regular cash dividends paid
during each such year on the number of shares of common stock into which each
note is convertible. The Company recorded a $365,000 liability related to the
estimated fair value of the Contingent Interest obligation at the time the notes
were issued. The fair value of the Contingent Interest obligation is marked to
its fair value at each balance sheet date, with changes in the fair value
recorded to interest expense. At September 30, 2003, the estimated fair value of
the Contingent Interest obligation was $458,000.

Debt issuance costs totaled $4.3 million and are being amortized using the
straight-line method over the five-year term of the notes.

Holders may convert their notes into shares of Integra common stock at an
initial conversion price of $34.15 per share, upon the occurrence of certain
conditions, including when the market price of Integra's common stock on the
previous trading day is more than 110% of the conversion price.

The notes are general, unsecured obligations of the Company and will be
subordinate to any future senior indebtedness of the Company. The Company cannot
redeem the notes prior to their maturity. Holders of the notes may require the
Company to repurchase the notes upon a change in control.

In September 2003, the Company registered the notes and the shares of common
stock issuable upon conversion of the notes with the Securities and Exchange
Commission.

Concurrent with the issuance of the notes, the Company used approximately $35.3
million of the proceeds to purchase 1.5 million shares of its common stock.

11

7. INTEREST RATE SWAP AGREEMENT

In August 2003, the Company entered into an interest rate swap agreement with a
$50 million notional amount to hedge the risk of changes in fair value
attributable to interest rate risk with respect to a portion of its fixed rate
contingent convertible subordinated notes. The Company receives a 2 1/2% fixed
rate from the counterparty, payable on a semi-annual basis, and pays to the
counterparty a floating rate based on 3 month LIBOR minus 35 basis points,
payable on a quarterly basis. The floating rate resets each quarter. The
interest rate swap agreement terminates on March 15, 2008, subject to early
termination upon the occurrence of certain events, including redemption or
conversion of the contingent convertible notes.

The interest rate swap agreement qualifies as a fair value hedge under SFAS No.
133, as amended, "Accounting for Derivative Instruments and Hedging Activities".
Accordingly, the interest rate swap is recorded at fair value and changes in
fair value are recorded in other income (expense), net. The net amount to be
paid or received under the interest rate swap agreement is recorded as a
component of interest expense. Interest expense for the three months ended
September 30, 2003 reflects a $118,000 reduction in interest expense associated
with the interest rate swap. Our effective interest rate on the hedged portion
of the notes was 0.77%.

The net fair value of the interest rate swap at inception was $767,000. At
September 30, 2003, the net fair value of the interest rate swap decreased
$343,000 to $424,000 and this amount is included in other liabilities. In
connection with this fair value hedge transaction, the Company recorded a
$239,000 net increase in the carrying value of its contingent convertible notes.
The $104,000 net difference between changes in the fair value of the interest
rate swap and the contingent convertible notes represents the ineffective
portion of the hedging relationship, and this amount is recorded in other
income.

8. COMPREHENSIVE INCOME

Comprehensive income was as follows:

12

9. NET INCOME PER SHARE

Basic and diluted net income per share were as follows:

Three Months Ended Nine Months Ended
September 30, September 30,
------------------- ----------------
2003 2002 2003 2002
------ ------ ------ ------
(In thousands, except per share amounts)

Options and warrants outstanding at September 30, 2003 and 2002, respectively,
to purchase approximately 464,000 and 712,000 shares of common stock were
excluded from the computation of diluted net income per share for the three and
nine month periods ended September 30, 2003 and 2002 because their exercise
price exceeded the average market price of the Company's common stock during the
period. Notes payable outstanding at September 30, 2003 that are convertible
into 3,514,166 shares of common stock were excluded from the computation of
diluted net income per share for the three and nine month periods ended
September 30, 2003 because the conditions required to convert the notes were not
met. Prior to its conversion on April 16, 2002 into 600,000 shares of common
stock, Series C Preferred Stock was excluded from the computation of diluted net
income per share for the nine month period ended September 30, 2002 because its
inclusion would have been antidilutive.

10. PRODUCT REVENUE AND GEOGRAPHIC INFORMATION

The Company develops, manufactures, and markets medical devices for use
primarily in neuro-trauma and neurosurgery, plastic and reconstructive surgery,
and general surgery. The Company's product lines include traditional medical
devices, such as monitoring and drainage systems, surgical instruments, and
fixation systems, as well as innovative tissue repair products that incorporate
our proprietary absorbable implant technology.

13

Product revenues are segregated into the following categories:

Certain of the Company's products, including the DuraGen(R) Dural Graft
products, NeuraGen(TM) Nerve Guide, INTEGRA(R) Dermal Regeneration Template, and
BioMend(R) Absorbable Collagen Membrane, contain material derived from bovine
tissue. Products that contain materials derived from animal sources, including
food as well as pharmaceuticals and medical devices, are increasingly subject to
scrutiny from the press and regulatory authorities. These products comprised
approximately 27% and 33% of product revenues in the nine month periods ended
September 30, 2003 and 2002, respectively. Accordingly, widespread public
controversy concerning collagen products, new regulation, or a ban of the
Company's products containing material derived from bovine tissue, could have a
material adverse effect on the Company's current business or its ability to
expand its business.

Product revenues by major geographic area are summarized below:

United Asia Other
States Europe Pacific Foreign Total
-------- -------- -------- -------- --------
(in thousands)

11. COMMITMENTS AND CONTINGENCIES

As consideration for certain technology, manufacturing, distribution and selling
rights and licenses, the Company has agreed to pay royalties on the sales of
certain of its products. Payments under these agreements were not significant
for any of the periods presented.

Various lawsuits, claims, and proceedings are pending or have been settled by
the Company. The most significant of those are described below.

In July 1996, the Company filed a patent infringement lawsuit in the United
States District Court for the Southern District of California (the "Court")
against Merck KGaA, a German corporation, Scripps Research Institute, a
California nonprofit corporation, and David A. Cheresh, Ph.D., a research
scientist with Scripps, seeking damages and injunctive relief. The complaint
charged, among other things, that the defendant Merck KGaA willfully and
deliberately induced, and continues to willfully and deliberately induce,
defendants Scripps Research Institute and Dr. Cheresh to infringe certain of the
Company's patents. These patents are part of a group of patents granted to The
Burnham Institute and licensed by the Company that are based on the interaction
between a family of cell surface proteins called integrins and the
arginine-glycine-aspartic acid ("RGD") peptide sequence found in many
extracellular matrix proteins. The defendants filed a countersuit asking for an
award of defendants' reasonable attorney fees.

In March 2000, a jury returned a unanimous verdict for the Company, finding that
Merck KGaA had willfully infringed and induced the infringement of the Company's
patents, and awarded $15,000,000 in damages. The Court dismissed Scripps and Dr.
Cheresh from the case.

14

In October 2000, the Court entered judgment in the Company's favor and against
Merck KGaA in the case. In entering the judgment, the Court also granted the
Company pre-judgment interest of approximately $1,350,000, bringing the total
amount to approximately $16,350,000, plus post-judgment interest. Merck KGaA
filed various post-trial motions requesting a judgment as a matter of law
notwithstanding the verdict or a new trial, in each case regarding infringement,
invalidity and damages. In September 2001, the Court entered orders in favor of
the Company and against Merck KGaA on the final post-judgment motions in the
case, and denied Merck KGaA's motions for judgment as a matter of law and for a
new trial.

Merck KGaA and Integra each appealed various decisions of the Court to the
United States Court of Appeals for the Federal Circuit. In June 2003 the
appellate court affirmed the Court's finding of infringement but found that the
basis of the jury's calculation of damages was not clear from the trial record.
The appellate court remanded the case to the Court for further factual
development and a new calculation of damages consistent with the appellate
court's decision. The new damages trial has not been scheduled. Integra has not
recorded any gain in connection with this matter.

The Company is also subject to various claims, lawsuits and proceedings in the
ordinary course of business, including claims by current or former employees and
distributors and with respect to its products. In the opinion of management,
such claims are either adequately covered by insurance or otherwise indemnified,
or are not expected, individually or in the aggregate, to result in a material
adverse effect on the Company's financial condition. However, it is possible
that the Company's results of operations, financial position and cash flows in a
particular period could be materially affected by these contingencies.

In September 2001, three subsidiaries of the recently acquired neurosciences
division of NMT Medical, Inc. received a tax reassessment notice from the French
tax authorities seeking more than $1.5 million in back taxes, interest and
penalties. NMT Medical, Inc., the former owner of these entities, has agreed to
specifically indemnify Integra against any liability in connection with these
tax claims. In addition, NMT Medical, Inc. has agreed to provide the French tax
authorities with payment of the tax, if required.

12. SUBSEQUENT EVENT

On November 1, 2003, the Company acquired all of the outstanding capital stock
of Spinal Specialties, Inc. from I-Flow Corporation for approximately $6.0
million in cash, subject to a working capital adjustment. Spinal Specialties
assembles and sells custom kits and products for chronic pain management,
including the OsteoJect(TM) Bone Cement Delivery System and the ACCU-DISC(TM)
Pressure Monitoring System. Spinal Specialties markets its products to
anesthesiologists and interventional radiologists through an in-house
telemarketing team and a network of distributors.

The determination of the fair value of the assets acquired and liabilities
assumed as a result of this acquisition is in progress.

15

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS

The following discussion and analysis of our financial condition and results of
operations should be read in conjunction with our consolidated financial
statements and the related notes thereto appearing elsewhere in this report and
our consolidated financial statements for the year ended December 31, 2002
included in our Current Report on Form 8-K dated June 27, 2003. As discussed in
that report, in 2003 the Company began to report financial results under a
single operating segment--the development, manufacturing, and distribution of
medical devices.

This discussion and analysis contains forward-looking statements that involve
risks, uncertainties and assumptions. Our actual results may differ materially
from those anticipated in these forward-looking statements as a result of many
factors, including but not limited to those set forth below under the heading
"Factors That May Affect Our Future Performance."

Regulation G, "Conditions for Use of Non-GAAP Financial Measures," and other
provisions of the Securities Exchange Act of 1934, as amended, define and
prescribe the conditions for the use of certain non-GAAP financial information.
In Management's Discussion and Analysis of Financial Condition and Results of
Operations, we provide information regarding growth in product revenues
excluding recently acquired product lines, which is a non-GAAP financial
measure. A reconciliation of this non-GAAP financial measure to the most
comparable GAAP measure is provided in Exhibit 99.1 to this quarterly report.

This non-GAAP financial measure should not be relied upon to the exclusion of
GAAP financial measures. Management believes that this non-GAAP financial
measure is important supplemental information to investors which reflects an
additional way of viewing aspects of our operations that, when viewed with our
GAAP results and the accompanying reconciliations, provides a more complete
understanding of factors and trends affecting our ongoing business and
operations. Management strongly encourages investors to review our financial
statements and publicly-filed reports in their entirety and to not rely on any
single financial measure. Because non-GAAP financial measures are not
standardized, it may not be possible to compare these financial measures with
other companies' non-GAAP financial measures having the same or similar names.

General

Integra develops, manufactures, and markets medical devices for use primarily in
neuro-trauma and neurosurgery, plastic and reconstructive surgery, and general
surgery. Our product lines include traditional medical devices, such as
monitoring and drainage systems, surgical instruments and fixation systems, as
well as innovative tissue repair products that incorporate our proprietary
absorbable implant technology.

16

To provide better insight into how our growth is distributed across our
products, we report revenue by the following product lines:

- - Neuromonitoring products, which include our intracranial monitoring
systems, systems for cerebrospinal fluid drainage and cranial access,
epilepsy monitoring electrodes and our Integra NeuroSupplies(TM)
business;
- - Operating Room products, which include the DuraGen(R) Dural Graft
products, NeuraGen(TM) Nerve Guide, and our neurosurgical shunts,
carotid shunts and absorbable collagen hemostatic agents;
- - Instruments, which include JARIT(R) Surgical Instruments, Padgett(TM)
Instruments, Ruggles(TM) neurosurgical and spinal instruments, and our
ultrasonic aspirators; and
- - Private Label products, which include INTEGRA(R) Dermal Regeneration
Template, VitaCuff(R) catheter access infection control device,
BioPatch(R) Antimicrobial Wound Dressing, and our absorbable collagen
membranes and wound dressings and cranial fixation devices and custom
cranial plates.

We sell our products directly through various sales forces and through a variety
of distribution channels. Our direct sales organizations include the following:

- - Our Integra NeuroSciences(TM) sales force provides neurosurgeons and
critical care units with implants, devices, instruments, and systems
used in neurosurgery, neuromonitoring, neurotrauma, and related
critical care. Integra NeuroSciences' direct marketing effort in the
United States and Europe currently involves more than 100
professionals, including direct salespeople (called neurospecialists in
the United States), sales managers, and clinical educators who educate
and train both our salespeople and customers in the use of our
products. In all other markets, Integra NeuroSciences products are sold
through a network of distributors.
- - Our JARIT(R) Surgical Instruments sales force markets a wide variety of
high quality surgical instruments for use in both traditional and
minimally invasive surgery in virtually all surgical applications,
including general, plastic, neuro, ear, nose and throat (ENT),
cardiovascular, ob-gyn, and ophthalmic surgical procedures. JARIT sells
its products in the United States through a nineteen-person sales
management force that works with over 100 distributor sales
representatives as well as certain original equipment manufacturer
accounts. Outside the United States, JARIT sells its products through a
network of distributors.
- - Our Plastic and Reconstructive sales force markets a wide variety of
high quality, reusable surgical instruments and implants for soft
tissue augmentation of the facial area to plastic and reconstructive
surgeons, burn surgeons, ENT surgeons, hospitals, surgery centers, and
other physicians. We market these products primarily through an
eight-person sales force in the United States and through a network of
distributors elsewhere. Effective January 1, 2004, we will assume
exclusive responsibility for the sales, marketing and distribution of
the INTEGRA Dermal Regeneration Template product. Accordingly, it is
our goal to increase the size of our Plastic and Reconstructive sales
organization to sixteen people by the beginning of 2004.

We market our private label products through distribution partners or OEM
customers. Our private label products address large, diverse markets, and we
believe that we can develop and promote many of these products more
cost-effectively through leveraging distribution partners than through
developing them ourselves or selling them through our own direct sales
infrastructure. We have partnered with market leaders, such as Johnson &
Johnson, Medtronic, Wyeth, and Zimmer for the development and marketing efforts
related to many of these products.

On November 1, 2003, we acquired all of the outstanding capital stock of Spinal
Specialties, Inc. from I-Flow Corporation for approximately $6.0 million in
cash, subject to a working capital adjustment. Spinal Specialties assembles and
sells custom kits and products for chronic pain management, including the
OsteoJect(TM) Bone Cement Delivery System and the ACCU-DISC(TM) Pressure
Monitoring System. Spinal Specialties markets its products to anesthesiologists
and interventional radiologists through an in-house telemarketing team and a

17

network of distributors. We will report sales of Spinal Specialties products as
instrument revenues.

Certain of our products, including the DuraGen(R) Dural Graft products,
NeuraGen(TM) Nerve Guide, INTEGRA(R) Dermal Regeneration Template, and
BioMend(R) Absorbable Collagen Membrane, contain material derived from bovine
tissue. Products that contain materials derived from animal sources, including
food as well as pharmaceuticals and medical devices, are increasingly subject to
scrutiny from the press and regulatory authorities. These products comprised
approximately 27% and 33% of product revenues in the nine month periods ended
September 30, 2003 and 2002, respectively. Accordingly, widespread public
controversy concerning collagen products, new regulation, or a ban of our
products containing material derived from bovine tissue, could have a material
adverse effect on our current business or our ability to expand our business.

Acquisitions

Our strategy for growing our business includes the acquisition of complementary
product lines and companies. Our acquisitions of the assets of Tissue
Technologies, Inc. in August 2003, J. Jamner Surgical Instruments, Inc.
("JARIT") in March 2003, the epilepsy monitoring and neurosurgical shunt
business of the Radionics division of Tyco Healthcare Group in December 2002,
Padgett Instruments, Inc. in October 2002, certain assets of Novus Monitoring
Limited in August 2002, the neurosciences division of NMT Medical, Inc. in
August 2002, and Signature Technologies, Inc. in July 2002, may make our
financial results for the three and nine month periods ended September 30, 2003
not directly comparable to those of the corresponding prior year periods.
Reported product revenues for the three and nine month periods ended September
30, 2003 and 2002 included the following amounts in revenues from acquired
product lines:

Three Months Ended Nine Months Ended
September 30, September 30,
2003 2002 2003 2002
------ ------ ------ ------
(in thousands)

18

Results of Operations

Third quarter ended September 30, 2003 compared to third quarter ended September
30, 2002

For the quarter ended September 30, 2003, total revenues increased by $16.9
million, or 56%, over the quarter ended September 30, 2002 to $47.1 million.
This increase was primarily attributable to an increase in product revenues of
$14.2 million, or 49%, over the prior year period. Other revenue increased by
$2.6 million primarily due to a $2.5 million event payment from ETHICON for the
achievement of various regulatory objectives.

Revenues from product lines acquired since the third quarter of 2002 accounted
for $10.3 million of the $14.2 million increase in product revenues over the
prior year period. Excluding revenues from acquired product lines, third quarter
product revenues grew by $3.9 million, or 15%, over the prior year quarter.
Changes in foreign currency exchange rates accounted for $362,000 of this $3.9
million increase and a $533,000 increase in total product revenues. Domestic
product revenues increased $10.8 million in the third quarter of 2003 to $34.4
million, or 79% of product revenues, as compared to 81% of product revenues in
the third quarter ended September 30, 2002.

Revenues from our neuromonitoring product lines increased $2.0 million, or 20%,
over the prior year period primarily as a result of increased sales of our
intracranial monitoring products and drainage systems. Our operating room
product line revenues increased over the prior year period by $3.4 million, or
33%, largely as a result of growth in sales of our DuraGen(R) Dural Graft Matrix
and NeuraGen(TM) Nerve Guide products and sales of neurosurgical shunt products
acquired from NMT Medical and Radionics in 2002. Revenues from our instrument
product lines increased by $9.6 million, or 274%, principally as a result of
revenues from the Padgett and JARIT surgical instrument lines we acquired in
2002 and 2003, respectively. Increased sales of our ultrasonic aspirator
products contributed the remainder of the growth in instrument product revenues.
Our private label product revenue decreased by $702,000, or 12%, primarily due
to a decline in revenues from the Absorbable Collagen Sponge we supply for use
in Medtronic's INFUSE bone graft product. Sales of the Absorbable Collagen
Sponge are expected to be lower through mid-2004 while Medtronic's existing
inventory is consumed. Although sales of certain private label products vary
highly from quarter to quarter depending on the timing and size of orders placed
by our marketing partners, we do not believe that the variability is as
significant on an annual basis.

We expect that our future revenue growth will be driven by our expanded product
lines, domestic and international sales and marketing organizations, and
distribution channels, the introduction of internally developed and acquired
products, and the direct sale by us of the INTEGRA(R) Dermal Regeneration
Template product starting in 2004. We also seek to acquire businesses that
complement our existing products and operations.

Our product revenues are subject to quarterly fluctuations, based on business
conditions and on the availability of funds for capital purchases by hospitals.
Our product revenues in the fourth quarter of each calendar year typically
benefit from hospitals' utilization of funding available at the end of their
fiscal years, our tying of compensation of our sales people to meeting annual
quotas, and annual minimum purchase requirements in supply and distribution
contracts with our private label customers.

Our gross margin on product revenues was 57% in both the third quarters of 2003
and 2002. A change in our product mix attributable to recent acquisitions,
$401,000 of fair value purchase accounting adjustments from the sale of acquired
JARIT inventory during the quarter, and temporary inefficiencies resulting from
recently completed product manufacturing transitions negatively affected our
current period gross margin. We expect these manufacturing transition activities
will begin to have a positive effect on our gross margins in 2004. We recorded
$225,000 fair value purchase accounting adjustments in the third quarter of
2002.

19

In September 2003, we and ETHICON amended our Supply, Distribution and
Collaboration Agreement for the INTEGRA Dermal Regeneration Template to provide
for the return to us on January 1, 2004 of the exclusive right to sell, market
and distribute the INTEGRA product. In the fourth quarter of 2003, we expect to
record a significant increase in other revenue and other income in connection
with this amendment. ETHICON is required to pay $2.0 million to us on December
31, 2003 in connection with the termination of the agreement. Additionally, on
December 31, 2003 ETHICON will forfeit all unused advances paid to us for the
purchase of inventory, which totaled $9.5 million at September 30, 2003. This
amount is recorded in customer advances and deposits. We are also accelerating
the amortization of the remaining balance of the upfront license fee paid to us
in 1999 over the remaining three months of the amended term. We have been
amortizing this amount over the ten-year term of the original agreement.

Total other operating expenses, which excludes cost of product revenue but
includes amortization, increased 8% to $17.3 million in the third quarter of
2003, compared to $16.0 million in the third quarter of 2002.

Research and development expenses decreased 44% to $2.6 million in the third
quarter of 2003, largely as a result of the $2.3 million in-process research and
development charges taken in the third quarter of 2002 in connection with
acquisitions. We recently announced our plans to consolidate all of the
activities performed in our Corporate Research Center into our San Diego
manufacturing facility by the end of 2003. We anticipate that any potential cost
savings from this initiative will be reallocated to other areas of our research
and development organization and will not reduce our overall research and
development spending.

We are obligated to pay $1.5 million to the sellers of the Novus Monitoring
Limited assets upon their achievement of a product development milestone. If
such payment is made, we estimate that approximately $1.0 million will be
recorded as an in-process research and development charge. Currently, we expect
that the product development milestone will be achieved in either the fourth
quarter of 2003 or in 2004.

Sales and marketing expenses increased 50% over the prior year period to $10.1
million as a result of increased sales commissions and the growth in our
marketing, sales support and sales management functions. Sales and marketing
expenses were 23% of product revenues in both the third quarter of 2003 and
2002. Sales and marketing expenses are expected to continue to increase as we
increase our marketing and sales infrastructure, particularly in the plastic and
reconstructive sales organization.

General and administrative expenses decreased 10% to $3.8 million in the
quarter. In the third quarter of 2002, we incurred certain costs related to
abandoned acquisitions and the integration of the three acquisitions we closed
during the quarter and various expenses associated with terminated distribution
agreements. During the third quarter of 2003, we continued the facility
consolidation initiatives begun earlier this year and transferred our Integra
NeuroSupplies distribution operation based in Connecticut to our Integra
Signature Technologies facility in Massachusetts. We expect that the benefits of
these efforts will be slightly offset by an increase in legal fees over the next
twelve months related to the next phase of our litigation with Merck KGaA (see
Note 11 to the unaudited consolidated financial statements) and higher insurance
costs.

Amortization expense increased $348,000 to $773,000 in the third quarter of 2003
as a result of amortization of intangible assets from recent acquisitions.
Excluding the effects of the acquisition of Spinal Specialties, Inc. in November
2003 (see Note 12 to the unaudited consolidated financial statements),
amortization expense is expected to remain consistent at approximately $800,000
per quarter in the near term.

In the fourth quarter of 2003, we expect that the significant increase in other
revenue and other income resulting from the amendment of the agreement with
ETHICON will be partially offset by a significant increase in operating
expenses. This expectation is based on our plans to accelerate spending related

20

to the increase in our plastic and reconstructive surgery sales force by the end
of 2003 prior to taking over distribution of the INTEGRA product and to
accelerate spending in other unrelated programs.

NON-OPERATING INCOME AND EXPENSES

We recorded net interest expense of $188,000 in the third quarter of 2003, as
compared to net interest income of $822,000 in the prior year period, primarily
as a result of $1.0 million of interest expense recorded on the contingent
convertible subordinated notes we issued earlier this year. Of this amount,
approximately $215,000 represents non-cash amortization of debt issuance costs.
Debt issuance costs totaled $4.3 million and are being amortized using the
straight-line method over the five-year term of the notes.

We will pay additional interest ("Contingent Interest") on our contingent
convertible subordinated notes if, at thirty days prior to maturity, Integra's
common stock price is greater than $37.56 per share. The fair value of this
Contingent Interest obligation is marked to its fair value at each balance sheet
date, with changes in the fair value recorded to interest expense. At September
30, 2003, the estimated fair value of the Contingent Interest obligation was
$458,000.

In August 2003, we entered into an interest rate swap agreement with a $50.0
million notional amount to hedge the risk of changes in fair value attributable
to interest rate risk with respect to a portion of our fixed rate contingent
convertible subordinated notes. We receive a 2 1/2% fixed rate from the
counterparty, payable on a semi-annual basis, and pay to the counterparty a
floating rate based on 3 month LIBOR minus 35 basis points, payable on a
quarterly basis. The interest rate swap agreement terminates on March 15, 2008,
subject to early termination upon the occurrence of certain events, including
redemption or conversion of the contingent convertible notes.

The interest rate swap agreement qualifies as a fair value hedge under SFAS No.
133, as amended "Accounting for Derivative Instruments and Hedging Activities".
The net amount to be paid or received under the interest rate swap agreement is
recorded as a component of interest expense. Interest expense for the three
months ended September 30, 2003 reflects a $118,000 reduction in interest
expense associated with the interest rate swap.

The net fair value of the interest rate swap at inception was $767,000. At
September 30, 2003, the net fair value of the interest rate swap decreased
$343,000 to $424,000, and this amount is included in other liabilities. In
connection with this fair value hedge transaction, we recorded a $239,000 net
increase in the carrying value of our contingent convertible notes. The net
$104,000 difference between changes in the fair value of the interest rate swap
and the contingent convertible notes represents the ineffective portion of the
hedging relationship, and this amount is recorded in other income.

Our net other income/expense increased by $320,000 from $11,000 of expense to
$309,000 of income and included $109,000 in gains realized on the sale of
marketable securities and the $104,000 gain from the ineffective portion of our
interest rate swap hedge.

Income tax expense was approximately 38% and 35% of income before income taxes
for the third quarters of 2003 and 2002, respectively. Income tax expense for
the third quarters of 2003 and 2002 included a deferred income tax provision of
$3.2 million and $0.6 million, respectively. The increase in the effective
income tax rate in 2003 results primarily from a change in the geographic mix of
projected taxable income for 2003, including the effects of the additional
revenue associated with the amendment to our distribution agreement with
ETHICON.

We reported net income for the third quarter of 2003 of $6.8 million, or $0.23
per diluted share, as compared to net income of $1.6 million, or $0.05 diluted
per share, for the prior year quarter.

21

In periods when the holders of such securities are permitted to exercise their
conversion rights, the "if-converted" method will be used to determine the
dilutive effect on earnings per share of our 2 1/2% contingent convertible
notes, which are convertible into approximately 3.5 million shares of common
stock.

Nine-month period ended September 30, 2003 compared to the nine-month period
ended September 30, 2002

For the nine months ended September 30, 2003, total revenues increased by $44.0
million, or 53%, over the nine months ended September 30, 2002 to $126.6
million. Product revenues increased by $41.3 million, or 53%, over the prior
year period and accounted for nearly all of the growth in total revenues.

Revenues of products acquired since the third quarter of 2002 accounted for
$28.7 million of the $41.3 million increase in product revenues over the prior
year period. Excluding revenues from acquired product lines, product revenues
grew by $12.6 million, or 17%, over the prior year period. Changes in foreign
currency exchange rates accounted for $1.2 million of this increase. Domestic
product revenues increased $31.7 million during 2003 to $94.8 million, or 79% of
product revenues, as compared to 80% of product revenues during 2002.

Revenues from our neuromonitoring product lines increased $6.1 million, or 23%,
over the prior year period primarily as a result of increased sales of our
intracranial monitoring products and our drainage systems. Our operating room
product line revenues increased over the prior year period by $12.5 million, or
47%, largely as a result of growth in sales of our DuraGen(R) Dural Graft Matrix
and NeuraGen(TM) Nerve Guide products and sales of neurosurgical shunt products
acquired from NMT Medical and Radionics in 2002. Revenues from our instrument
product lines increased by $20.7 million, or 188%, principally as a result of
revenues from the Padgett and JARIT surgical instrument lines we acquired in
2002 and 2003, respectively. Increased sales of our Selector(R) Integra
Ultrasonic Aspirator product line also contributed to the growth in our
instrument revenues. Our private label product revenue grew by $2.0 million, or
14%, due in large part to revenues from Integra Signature Technologies, which we
acquired in 2002. A decline in revenues from the Absorbable Collagen Sponge we
supply for use in Medtronic's INFUSE bone graft product was offset by increased
sales of our other private label products.

Our gross margin on product revenues in 2003 was 59% as compared to 60% for the
prior year period. A change in our product mix attributable to recent
acquisitions, $1.3 million of fair value purchase accounting adjustments from
the sale of acquired inventory during the year, and temporary inefficiencies
resulting from the recently completed product manufacturing transitions
negatively affected the 2003 gross margin. We recorded $225,000 of fair value
purchase accounting adjustments in the prior year period.

Other revenue increased by $2.7 million from the prior year to $6.7 million as a
result of increased product development revenue and event payments from ETHICON.

Total other operating expenses, which exclude cost of product revenues but
include amortization, increased 30% to $50.3 million during 2003, compared to
$38.6 million in the prior year period.

Sales and marketing expenses increased 46% over the prior year period to $26.7
million, as a result of increased sales commissions, the build out of our
marketing and sales support and management functions and recent acquisitions. As
a percentage of product revenues, sales and marketing expenses declined slightly
from 23% in 2002 to 22% in the nine months ending September 30, 2003.

Research and development expenses decreased 11% to $8.0 million in 2003, largely
as a result of the $2.3 million of in-process research and development charges
taken in the third quarter of 2002 in connection with acquisitions. Offsetting
this was an increase in year-to-date research and development spending from
operations acquired in the third quarter of 2002.

22

General and administrative expenses increased 33% to $13.4 million in 2003, due
primarily to costs incurred in operating and integrating businesses acquired in
2002 and 2003, increased headcount, and higher insurance costs.

Amortization expense increased $1.0 million during 2003 to $2.1 million, as a
result of amortization of intangible assets from recent acquisitions.

NON-OPERATING INCOME AND EXPENSES

We recorded net interest income of $390,000 in the nine months ended September
30, 2003, as compared to net interest income of $2.8 million in the prior year
period. This $2.4 million decrease was the result of $2.1 million of interest
expense recorded on the contingent convertible notes we issued in 2003 and a
continued decline in interest rates earned on our invested cash. Interest
expense associated with the contingent convertible notes includes $430,000 of
non-cash amortization of debt issuance costs.

Interest expense for the nine months ended September 30, 2003 reflects a
$118,000 benefit associated with our interest rate swap.

Our net other income/expense increased by $1.1 million in 2003. This amount
included $609,000 in gains realized on the sale of marketable securities and a
$104,000 benefit from the ineffective portion of our interest rate swap hedge.

Income tax expense was approximately 37% and 35% of income before income taxes
for the nine-month periods ending September 30, 2003 and 2002, respectively.
Income tax expense for the nine months ending September 30, 2003 and 2002
included a deferred income tax provision of $8.2 million and $4.2 million,
respectively.

We reported net income for the nine-month period ending September 30, 2003 of
$17.7 million, or $0.58 per diluted share, as compared to net income of $9.9
million, or $0.32 per diluted share, for the prior year period.

International Product Revenues and Operations

We generate significant revenues outside the United States in euros,
British pounds and in U.S. dollar-denominated transactions conducted with
customers who generate revenue in currencies other than the U.S. dollar.
For those foreign customers who purchase our products in U.S. dollars,
currency fluctuations between the U.S. dollar and the currencies in which
those customers do business may have an impact on the demand for our products
in foreign countries where the U.S. dollar has increased or decreased in value
compared to the local currency.

Because we have operations based in Europe and we generate certain revenues and
incur certain operating expenses in British pounds and the euro, we will
experience currency exchange risk with respect to foreign currency denominated
revenues or expenses. Our exposure to currency exchange risk has increased
because the recently acquired JARIT business purchases substantially all of its
instruments from vendors in Europe in euro-denominated transactions, but
generates the majority of its sales in U.S. dollars. Additionally, we are
substantially increasing the use of these vendors for purchases of our other
instrument product lines. Historically, we have purchased the majority of these
instruments through vendors in U.S. dollar-denominated transactions.

Currently, we do not use derivative financial instruments to manage foreign
currency risk. As the volume of our business transacted in foreign currencies
increases, we will continue to assess the potential effects that changes in
foreign currency exchange rates could have on our business. If we believe that
this potential impact presents a significant risk to our business, we may enter
into derivative financial instruments, including forward contracts to purchase
or sell foreign currencies, to mitigate this risk.

23

In general, we cannot predict the consolidated effects of exchange rate
fluctuations upon our future operating results because of the number of
currencies involved, the variability of currency exposure and the potential
volatility of currency exchange rates.

Our sales to foreign markets may be affected by local economic conditions.
Relationships with customers and terms of sale frequently vary by country, and
foreign sales often result in longer-term receivables than are typical in the
United States.

Product revenues by major geographic area are summarized below:

United Asia Other
States Europe Pacific Foreign Total
-------- -------- -------- -------- --------
(in thousands)

In the nine months ending September 30, 2003, product revenues from customers
outside the United States totaled $25.0 million, or 21% of consolidated product
revenues, of which approximately 64% were to European customers. Of this amount,
$13.9 million was generated in foreign currencies primarily by our subsidiaries
in the United Kingdom, Germany and France.

In the nine months ending September 30, 2002, product revenues from customers
outside the United States totaled $15.5 million, or 20% of consolidated product
revenue, of which approximately 63% were to European customers. Of this amount,
$8.5 million was generated in foreign currencies by our subsidiaries in the
United Kingdom, Germany and France.

Liquidity and Capital Resources

Cash provided by operations has recently been and is expected to continue to be
our primary means of funding existing operations and capital expenditures. Prior
to 2001, we primarily relied on funds generated from private and public
offerings of equity securities, research and collaboration funding, and
borrowings under a revolving credit facility to fund existing operations and
capital expenditures. Since 2001, we have generated positive operating cash
flows on an annual basis, including $15.7 million in 2001 and $32.0 million in
2002, and we have generated $31.2 million of operating cash flows in the nine
months ending September 30, 2003.

Our principal uses of funds during the nine month period ended September 30,
2003 were $42.7 million for acquisition consideration, $35.4 million for the
purchase of treasury stock, $35.1 million for purchases of investments, net of
maturities and sales, and $2.4 million for purchases of property and equipment.
Principal sources of funds were approximately $116.0 million from the issuance
of convertible notes, $31.2 million in operating cash flows and $8.6 million
from the issuance of common stock through the exercise of stock options.

In March and April 2003, we received approximately $116.0 million of net
proceeds from the sale of $120.0 million of our contingent convertible
subordinated notes due 2008. We will pay interest on the notes at an annual rate
of 2 1/2% each September 15th and March 15th. We will also pay contingent
interest on the notes if, at thirty days prior to maturity, Integra's common
stock price is greater than $37.56. The contingent interest will be payable for
each of the last three years the notes remain outstanding in an amount equal to
the greater of i) 0.50% of the face amount of the notes and ii) the amount of
regular cash dividends paid during each such year on the number of shares of
common stock into which each note is convertible. Holders of the notes may
convert the notes into shares of our common under certain circumstances,

24

including when the market price of our common stock on the previous trading day
is more than $37.56 per share, based on an initial conversion price of $34.15
per share.

The notes are general, unsecured obligations of Integra and will be subordinate
to any future senior indebtedness. We cannot redeem the notes prior to their
maturity, and the notes' holders may compel us to repurchase the notes upon a
change of control.

In August 2003, we entered into an interest rate swap agreement with a $50
million notional amount to hedge the risk of changes in fair value attributable
to interest rate risk with respect to a portion of the notes. We receive a 2
1/2% fixed rate from the counterparty, payable on a semi-annual basis, and pay
to the counterparty a floating rate based on 3 month LIBOR minus 35 basis
points, payable on a quarterly basis. The interest rate swap agreement
terminates on March 15, 2008, subject to early termination upon the occurrence
of certain events, including redemption or conversion of the contingent
convertible notes.

At September 30, 2003, we had cash, cash equivalents and current and non-current
investments totaling approximately $209.1 million. Our investments consist
almost entirely of highly liquid, interest bearing debt securities. We believe
that our cash and marketable securities are sufficient to finance our operations
and capital expenditures in the short term. However, given the significant level
of liquid assets and our objective to grow by acquisitions and alliances, our
financial position and future financial results could change significantly if we
were to use a significant portion of our liquid assets.

We are obligated to pay $3.0 million of interest per year on our contingent
convertible notes and to repay their principal amount of $120.0 million on March
15, 2008 if the notes are not converted into common stock before that date.

We are contractually obligated to pay the following amounts under the terms of
operating lease agreements for our facilities:

2003 $1.9 million
2004 1.6 million
2005 1.0 million
2006 0.8 million
2007 0.8 million
Thereafter 2.0 million

We are obligated to pay Novus an additional $1.5 million upon Novus' achievement
of a development milestone and up to an additional $2.5 million based upon
revenues from products that either we purchased from Novus or that Novus
develops for us. We are also obligated to pay the seller of the Tissue
Technologies business up to an additional $1.6 million in cash, including
contingent consideration based upon a multiple of our sales of the acquired
UltraSoft(TM) products in the third year following the acquisition. We currently
estimate that we will pay the seller of the JARIT business an additional $1.0
million in cash consideration based on working capital and other adjustments
with respect to certain income tax elections. Additionally, we are obligated to
pay royalties based on sales of certain of our products and fees to various
group purchasing organizations based on a percentage of sales of certain of our
products. We have no other significant future contractual obligations.

In February 2003, our Board of Directors authorized us to repurchase up to an
additional 1.0 million shares of our common stock for an aggregate purchase
price not to exceed $15 million. We may repurchase shares under this program
through February 2004 either in the open market or in privately negotiated
transactions. Repurchases under this program are separate and in addition to the
1.5 million shares of common stock repurchased concurrent with the issuance of
the contingent convertible notes in March 2003. Through September 30, 2003, we
have purchased a de minimus amount of shares of our common stock under this
program.

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During 2002, we repurchased approximately 100,000 shares of our common stock
under a previously authorized share repurchase program.

In November 2003, we paid $6.0 million in cash to acquire the stock of Spinal
Specialties, Inc., a subsidiary of I-Flow Corporation.

Use of Estimates and Critical Accounting Policies

The following discussion is an update to our critical accounting policy
disclosure as reported under the heading "Use of Estimates and Critical
Accounting Policies" in our 2002 Annual Report on Form 10-K.

Derivatives

We report all derivatives at their estimated fair value and record changes in
fair value in current earnings or defer these changes until a related hedged
item is recognized in earnings, depending on the nature and effectiveness of the
hedging relationship. The designation of a derivative as a hedge is made on the
date the derivative contract is executed. On an ongoing basis, we assess whether
each derivative continues to be highly effective in offsetting changes in the
fair value or cash flows of hedged items. If and when a derivative is no longer
expected to be highly effective, we discontinue hedge accounting. All hedge
ineffectiveness is included in current period earnings in other income
(expense), net.

We document all relationships between hedged items and derivatives. Our overall
risk management strategy describes the circumstances under which we may
undertake hedge transactions and enter into derivatives. The objective of our
current risk management strategy is to hedge the risk of changes in fair value
attributable to interest rate risk with respect to a portion of our fixed rate
debt.

The determination of fair value of derivatives is based on valuation models that
use observable market quotes or projected cash flows and our view of the
creditworthiness of the derivative counterparty.

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FACTORS THAT MAY AFFECT OUR FUTURE PERFORMANCE

Our Operating Results May Fluctuate.

Our operating results, including components of operating results, such as gross
margin on product sales, may fluctuate from time to time, which could affect our
stock price. Our operating results have fluctuated in the past and can be
expected to fluctuate from time to time in the future. Some of the factors that
may cause these fluctuations include:

o the impact of acquisitions;

o the timing of significant customer orders;

o market acceptance of our existing products, as well as products in
development;

o the timing of regulatory approvals;

o the timing of payments received and the recognition of those payments
as revenue under collaborative arrangements and other alliances;

o expenses incurred and business lost in connection with product field
corrections or recalls;

o our ability to manufacture our products efficiently; and

o the timing of our research and development expenditures.

The Industry And Market Segments in Which We Operate Are Highly Competitive, And
We May Be Unable to Compete Effectively with Other Companies.

In general, the medical technology industry is characterized by intense
competition. We compete with established medical technology and pharmaceutical
companies. Competition also comes from early stage companies that have
alternative technological solutions for our primary clinical targets, as well as
universities, research institutions and other non-profit entities. Many of our
competitors have access to greater financial, technical, research and
development, marketing, manufacturing, sales, distribution services and other
resources than we do. Further, our competitors may be more effective at
implementing their technologies to develop commercial products.

Our competitive position will depend on our ability to achieve market acceptance
for our products, develop new products, implement production and marketing
plans, secure regulatory approval for products under development, and obtain
patent protection. We may need to develop new applications for our products to
remain competitive. Technological advances by one or more of our current or
future competitors could render our present or future products obsolete or
uneconomical. Our future success will depend upon our ability to compete
effectively against current technology as well as to respond effectively to
technological advances. Competitive pressures could adversely affect our
profitability. For example, the introduction of a competitively priced onlay
dural graft matrix could reduce the sales, or growth in sales, of our DuraGen(R)
Dural Graft products. We expect that one or more other companies will introduce
such a product within the next two years.

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Our largest competitors in the neurosurgery markets are the Medtronic
Neurotechnologies division of Medtronic, Inc., the Codman division of Johnson &
Johnson, the Aesculap division of B. Braun, and the Valleylab division of Tyco
International Ltd. In addition, various of our product lines compete with
smaller specialized companies or larger companies that do not otherwise focus on
neurosurgery. Our plastic and reconstructive surgery business is small compared
to its principal competitors, which include major medical device and wound care
companies such as ETHICON Inc., Smith and Nephew, Inamed, Mentor, and Zimmer.
Our private label products face diverse and broad competition, depending on the
market addressed by the product. Finally, in certain cases our products compete
primarily against medical practices that treat a condition without using a
device, rather than any particular product, such as autograft tissue as an
alternative for INTEGRA(R) Dermal Regeneration Template.

Our Current Strategy Involves Growth Through Acquisitions, Which Requires Us To
Incur Substantial Costs And Potential Liabilities For Which We May Never
Realize The Anticipated Benefits.

In addition to internal growth, our current strategy involves growth through
acquisitions. Since 1999, we have acquired 14 businesses or product lines at a
total cost of approximately $114 million.

We may be unable to continue to implement our growth strategy, and our strategy
may be ultimately unsuccessful. A significant portion of our growth in revenues
has resulted from, and is expected to continue to result from, the acquisition
of businesses complementary to our own. We engage in evaluations of potential
acquisitions and are in various stages of discussion regarding possible
acquisitions, certain of which, if consummated, could be significant to us. Any
potential acquisitions may result in material transaction expenses, increased
interest and amortization expense, increased depreciation expense and increased
operating expense, any of which could have a material adverse effect on our
operating results. As we grow by acquisitions, we must integrate and manage the
new businesses to realize economies of scale and control costs. In addition,
acquisitions involve other risks, including diversion of management resources
otherwise available for ongoing development of our business and risks associated
with entering new markets with which our marketing and sales force has limited
experience or where experienced distribution alliances are not available. Our
future profitability will depend in part upon our ability to develop further our
resources to adapt to these new products or business areas and to identify and
enter into satisfactory distribution networks. We may not be able to identify
suitable acquisition candidates in the future, obtain acceptable financing or
consummate any future acquisitions. If we cannot integrate acquired operations,
manage the cost of providing our products or price our products appropriately,
our profitability could suffer. In addition, as a result of our acquisitions of
other healthcare businesses, we may be subject to the risk of unanticipated
business uncertainties or legal liabilities relating to those acquired
businesses for which the sellers of the acquired businesses may not indemnify
us. Future acquisitions may also result in potentially dilutive issuances of
securities.

To Market Our Products under Development We Will First Need To Obtain Regulatory
Approval. Further, If We Fail To Comply With The Extensive Governmental
Regulations That Affect Our Business, We Could Be Subject To Penalties And Could
Be Precluded From Marketing Our Products.

Our research and development activities and the manufacturing, labeling,
distribution and marketing of our existing and future products are subject to
regulation by numerous governmental agencies in the United States and in other
countries. The Food and Drug Administration (FDA) and comparable agencies in
other countries impose mandatory procedures and standards for the conduct of
clinical trials and the production and marketing of products for diagnostic and
human therapeutic use.

Our products under development are subject to FDA approval or clearance prior to
marketing for commercial use. The process of obtaining necessary FDA approvals
or clearances can take years and is expensive and full of uncertainties. Our
inability to obtain required regulatory approval on a timely or acceptable basis

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could harm our business. Further, approval or clearance may place substantial
restrictions on the indications for which the product may be marketed or to whom
it may be marketed. Further studies, including clinical trials and FDA
approvals, may be required to gain approval for the use of a product for
clinical indications other than those for which the product was initially
approved or cleared or for significant changes to the product. In addition, for
products with an approved premarket approval application (PMA), the FDA requires
annual reports and may require post-approval surveillance programs to monitor
the products' safety and effectiveness. Results of post-approval programs may
limit or expand the further marketing of the product.

Another risk of application to the FDA relates to the regulatory classification
of new products or proposed new uses for existing products. In the filing of
each application, we make a legal judgment about the appropriate form and
content of the application. If the FDA disagrees with our judgment in any
particular case and, for example, requires us to file a PMA application rather
than allowing us to market for approved uses while we seek broader approvals or
requires extensive additional clinical data, the time and expense required to
obtain the required approval might be significantly increased or approval might
not be granted.

Approved products are subject to continuing FDA requirements relating to quality
control and quality assurance, maintenance of records, reporting of adverse
events and product recalls, documentation, and labeling and promotion of medical
devices.

The FDA and foreign regulatory authorities require that our products be
manufactured according to rigorous standards. These regulatory requirements may
significantly increase our production or purchasing costs and may even prevent
us from making or obtaining our products in amounts sufficient to meet market
demand. If a third-party manufacturer or we change our approved manufacturing
process, the FDA may require a new approval before that process may be used.
Failure to develop our manufacturing capability may mean that even if we develop
promising new products, we may not be able to produce them profitably, as a
result of delays and additional capital investment costs. Manufacturing
facilities, both international and domestic, are also subject to inspections by
or under the authority of the FDA. In addition, failure to comply with
applicable regulatory requirements could subject us to enforcement action,
including product seizures, recalls, withdrawal of clearances or approvals,
restrictions on or injunctions against marketing our product or products based
on our technology, and civil and criminal penalties. See
"Business--Regulation--Government Regulation" in our 2002 Annual Report on Form
10-K.

Certain Of Our Products Contain Materials Derived From Animal Sources And May
Become Subject To Additional Regulation.

Certain of our products, including the DuraGen(R) Dural Graft products, the
NeuraGen(TM) Nerve Guide, and the INTEGRA(R) Dermal Regeneration Template,
contain material derived from bovine tissue. Products that contain materials
derived from animal sources, including food as well as pharmaceuticals and
medical devices, are increasingly subject to scrutiny in the press and by
regulatory authorities. Regulatory authorities are concerned about the potential
for the transmission of disease from animals to humans via those materials. This
public scrutiny has been particularly acute in Canada, Japan and Western Europe
with respect to products derived from cattle, because of concern that materials
infected with the agent that causes bovine spongiform encephalopathy, otherwise
known as BSE or mad cow disease, may, if ingested or implanted, cause a variant
of the human Creutzfeldt-Jakob Disease, an ultimately fatal disease with no
known cure. A recent case of BSE discovered in Canada has increased awareness of
the issue in North America.

We take great care to provide that our products are safe and free of agents that
can cause disease. In particular, the collagen used in the manufacture of our
products is derived only from the Achilles tendon of cattle from the United
States, where no cases of BSE have been reported. Scientists and regulatory
authorities classify the Achilles tendon as having a negligible risk of

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containing the agent that causes BSE (an improperly folded protein known as a
prion) compared with other parts of the body. Additionally, we use processes in
the manufacturing of our products that are believed to inactivate prions.
Nevertheless, products that contain materials derived from animals, including
our products, may become subject to additional regulation, or even be banned in
certain countries, because of concern over the potential for prion transmission.
New regulation, or a ban of our products, could have a material effect on our
current business or our ability to expand our business.

Lack Of Market Acceptance For Our Products Or Market Preference For Technologies
That Compete With Our Products Could Reduce Our Revenues And Profitability.

We cannot be certain that our current products or any other products that we may
develop or market will achieve or maintain market acceptance. Certain of the
medical indications that can be treated by our devices can also be treated by
other medical devices or by medical practices that do not include a device. The
medical community widely accepts many alternative treatments, and certain of
these other treatments have a long history of use. For example, the use of
autograft tissue is a well-established means for repairing the dermis, and it
competes for acceptance in the market with the INTEGRA(R) Dermal Regeneration
Template.

We cannot be certain that our devices and procedures will be able to replace
those established treatments or that either physicians or the medical community
in general will accept and utilize our devices or any other medical products
that we may develop. For example, we cannot be certain that the medical
community will accept the NeuraGen(TM) Nerve Guide over conventional
microsurgical techniques for connecting severed peripheral nerves.

In addition, our future success depends, in part, on our ability to develop
additional products. Even if we determine that a product candidate has medical
benefits, the cost of commercializing that product candidate may be too high to
justify development. Competitors may develop products that are more effective,
cost less, or are ready for commercial introduction before our products. For
example, our sales of shunt products could decline if neurosurgeons increase
their use of programmable valves and we fail to introduce a competitive product
or our sales of certain catheters may be adversely affected by the recent
introduction by other companies of catheters that contain anti-microbial agents
intended to reduce the incidence of infection after implantation. If we are
unable to develop additional commercially viable products, our future prospects
could be adversely affected.

Market acceptance of our products depends on many factors, including our ability
to convince prospective collaborators and customers that our technology is an
attractive alternative to other technologies, to manufacture products in
sufficient quantities and at acceptable costs, and to supply and service
sufficient quantities of our products directly or through our distribution
alliances. In addition, limited funding available for product and technology
acquisitions by our customers, as well as internal obstacles to customer
approvals of purchases of our products, could harm acceptance of our products.
The industry is subject to rapid and continuous change arising from, among other
things, consolidation and technological improvements. One or more of these
factors may vary unpredictably, which could materially adversely affect our
competitive position. We may not be able to adjust our contemplated plan of
development to meet changing market demands.

Our Intellectual Property Rights May Not Provide Meaningful Commercial
Protection For Our Products, Which Could Enable Third Parties To Use Our
Technology Or Very Similar Technology And Could Reduce Our Ability To Compete In
The Market.

Our ability to compete effectively depends in part, on our ability to maintain
the proprietary nature of our technologies and manufacturing processes, which

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includes the ability to obtain, protect and enforce patents on our technology
and to protect our trade secrets. We own or have licensed patents that cover
significant aspects of many of our product lines. However, you should not rely
on our patents to provide us with any significant