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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

for the quarterly period ended March 31, 2004

or

for the transition period from                      to                      .

Commission File Number 000-49804

Kyphon Inc.

(Exact name of registrant as specified in its charter)

Delaware

(State or other jurisdiction of incorporation or organization)

77-0366069

(I.R.S. Employer Identification No.)

1221 Crossman Avenue, Sunnyvale, California, 94089

(Address of principal executive offices, including Zip Code)

(408) 548-6500

(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 requirements for the past 90 days. YES x NO ¨

Indicate by check mark whether the registrant is an accelerated filer (as defined by rule 12b-2 of the Exchange Act). YES x NO ¨

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KYPHON INC.

FORM 10-Q

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PART I: FINANCIAL INFORMATION

ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

KYPHON INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share amounts)

(unaudited)

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

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KYPHON INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except per share amounts)

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

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KYPHON INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

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

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KYPHON INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

NOTE 1—Organization, Basis of Presentation, and Significant Accounting Policies:

Organization

Kyphon Inc. (“Kyphon” or the “Company”) is a medical device company focused on the design, manufacture and marketing of instruments used in minimally invasive therapies for surgeons and their patients for the restoration of spinal anatomy. The Company is currently commercializing surgical tools that use its proprietary balloon technologies for the repair of spine fractures. The Company markets its products through sales representatives in the United States, and through a combination of sales representatives, distributors and agents in its international markets. The Company is headquartered in Sunnyvale, California.

Basis of Presentation

The accompanying unaudited condensed consolidated financial statements have been prepared by the Company in accordance with accounting principles generally accepted in the United States of America for interim financial information and pursuant to the instructions to Form 10-Q and Article 10 of Regulation S-X of the Securities and Exchange Commission. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting only of normal recurring adjustments) considered necessary for a fair presentation have been included. The results for the three month period ended March 31, 2004 are not necessarily indicative of the results that may be expected for the year ending December 31, 2004, or for any future period. These condensed consolidated financial statements and notes should be read in conjunction with the consolidated financial statements included in the Company’s Form 10-K for the fiscal year ended December 31, 2003.

Significant Accounting Policies

The Company’s significant accounting policies are disclosed in the Company’s Form 10-K for the year ended December 31, 2003 and have not changed materially as of March 31, 2004.

NOTE 2—Net Income Per Share:

Basic net income per share is computed by dividing net income by the weighted-average number of common shares outstanding for the period. Diluted net income per share is computed giving effect to all potential dilutive common stock, including options, warrants and common stock subject to repurchase. A reconciliation of the numerator and denominator used in the calculation of basic and diluted net income per share follows (in thousands, except per share amounts):

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For the three months ended March 31, 2004 and 2003, respectively, 137,000 and 1,489,000 options outstanding were excluded from the computation of diluted net income per share as they had an antidilutive effect.

NOTE 3—Comprehensive Income:

Comprehensive income generally represents all changes in stockholders’ equity except those resulting from investments or contributions by stockholders. The Company’s unrealized gains on available-for-sale securities and cumulative translation adjustment represent the components of other comprehensive income that are excluded from net income.

The changes in components of other comprehensive income for the periods presented are as follows (in thousands):

The components of other comprehensive income reflected in the consolidated statements of stockholders’ equity are as follows (in thousands):

NOTE 4—Accounting for Stock-Based Compensation:

The Company uses the intrinsic value method of Accounting Principles Board Opinion No. 25 (“APB No. 25”), “Accounting for Stock Issued to Employees,” in accounting for its employee stock options, and presents disclosure of pro forma information required under SFAS No. 123, (“SFAS No. 123”), “Accounting for Stock-Based Compensation” as amended by SFAS No. 148, (“SFAS No. 148”), “Accounting for Stock Based Compensation-Transition and Disclosure-an amendment of FASB Statement No. 123”.

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The following table, provides a reconciliation of net income and net income per share to pro forma net income (loss) and pro forma net income (loss) per share had compensation cost for the Company’s stock option grants to employees been determined based on the fair value of each option on the date of grant consistent with the methodology prescribed by SFAS No. 123 (in thousands, except per share amounts):

The Company accounts for equity instruments issued to non-employees in accordance with the provisions of SFAS No. 123 and Emerging Issues Task Force Issue (“EITF”) No. 96-18, “Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services,” which require that these equity instruments are recorded at their fair value on the measurement date. The measurement of stock-based compensation is subject to periodic adjustment as the underlying equity instruments vest.

As of March 31, 2004, the Company has recorded a cumulative $25,204,000 of deferred stock-based compensation related to stock options granted to non-employees and employees. Stock-based compensation expense is being recognized on a straight-line basis over the vesting periods of the related options, generally four years. The Company recognized stock-based compensation expense as follows (in thousands):

NOTE 5—Inventories:

Inventories consisted of the following (in thousands):

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NOTE 6—Goodwill and Intangible Assets:

Goodwill and intangible assets consisted of the following (in thousands):

Intangible assets consist of patents acquired from Sanatis GmbH (“Sanatis”) in February 2003. Intangible asset amortization expense for the three months ended March 31, 2004 and 2003 was approximately $9,000 and $3,000, respectively. Based on the intangible assets held at March 31, 2004, the Company expects to recognize amortization expense of approximately $28,400 in each of the years from 2004 to 2007, and approximately $4,000 in 2008. The amortization period for intangible assets is five years.

NOTE 7—Acquisition:

In February 2003, the Company purchased all of the outstanding stock of Sanatis, a privately-held developer and manufacturer of orthopedic biomaterials based in Rosbach, Germany. The acquisition was made to add Sanatis’ experience developing and manufacturing orthopedic biomaterials and to complement the Company’s existing patent portfolio with Sanatis intellectual property surrounding calcium-based biomaterials and delivery technologies. The total purchase consideration for Sanatis consisted of $4,492,000 in cash, and other acquisition costs of $201,000. In December 2003, the Company paid an additional $157,000 to settle a contract Sanatis had with a third party prior to its acquisition. In accordance with SFAS 141, “Business Combinations,” this amount was included in the allocation of the purchase price to goodwill.

The acquisition of Sanatis was accounted for using the purchase method of accounting and, accordingly, the results of operations of Sanatis have been included in the Company’s consolidated financial statements subsequent to February 25, 2003. The purchase price was allocated to the net tangible and identifiable intangible assets acquired and the liabilities assumed based on their estimated fair values at the date of acquisition as determined by management. The excess of the purchase price over the fair value of the net identifiable assets was allocated to goodwill. The purchase price was allocated as follows (in thousands):

The fair value of the identifiable assets, including the portion of the purchase price attributed to the patents and purchased in-process research and development was determined by management. The income approach was used to value Sanatis’ patents and purchased in-process research and development, which included an analysis of the completion costs, cash flows, other required assets and risk associated with achieving such cash flows. The present value of these cash flows was calculated with an effective tax rate of 40% and a discount rate of 25% for the patent

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and purchased in-process research and development. No amount of goodwill is expected to be deductible for tax purposes.

The in-process projects related primarily to the development of resorbable calcium phosphate (“CaP”) cements that are used for application as bone replacement materials. At the time of the purchase, the purchased in-process technology was not considered to have reached technological feasibility and it had no alternative future use. Accordingly, it was recorded as a component of operating expense. The revenues, expenses, cash flows and other assumptions underlying the estimated fair value of the purchased in-process research and development involve significant risks and uncertainties. The risks and uncertainties associated with completing the purchased in-process projects include retaining key personnel and being able to successfully and profitably produce, market and sell related products. Consistent with the expected timeline for approval of products in development at the time of the acquisition, in December 2003, the Company obtained a CE Mark for its KyphOs resorbable calcium phosphate bone filler material. The CE Mark cleared the product for sale in Europe.

NOTE 8—Commitments:

Operating leases

In March 2004, the Company moved into a larger corporate headquarters also in Sunnyvale, California. The facility lease agreement is for a ten-year period with a lease obligation period beginning March 1, 2004. Under the terms of the lease agreement, the Company has the option to lease an adjacent existing facility as well as an option to have additional square footage built and leased to the Company in the same surrounding campus. The remaining costs for the leasehold improvements of the old facility have been accelerated and were fully amortized by March 31, 2004.

In addition, the Company entered into a nine-year lease agreement ending in December 2011 for its European headquarters in Brussels, Belgium.

The Company’s aggregate future minimum facility lease payments are as follows (in thousands):

Portions of the Company’s payments for facility leases are denominated in foreign currencies and were translated in the tables above based upon their respective U.S. dollar exchange rates at March 31, 2004. These future payments are subject to foreign currency exchange rate risk.

Indemnification Agreements

The Company enters into standard indemnification arrangements in our ordinary course of business. Pursuant to these arrangements, the Company indemnifies, holds harmless, and agrees to reimburse the indemnified parties for losses suffered or incurred by the indemnified party, generally the Company’s business partners or customers, in connection with any trade secret, copyright, patent or other intellectual property infringement claim by any third party with respect to the Company’s products. The term of these indemnification agreements is generally perpetual anytime after the execution of the agreement. The maximum potential amount of future payments the Company could be required to make under these agreements is not determinable. The Company has never incurred costs to defend lawsuits or settle claims related to these indemnification agreements. As a result, the Company believes the estimated fair value of these agreements is minimal.

The Company has entered into indemnification agreements with its directors and officers that may require the Company: to indemnify its directors and officers against liabilities that may arise by reason of their status or service as directors or officers, other than liabilities arising from willful misconduct of a culpable nature; to advance their

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expenses incurred as a result of any proceeding against them as to which they could be indemnified; and to make a good faith determination whether or not it is practicable for the Company to obtain directors’ and officers’ insurance. The Company currently has directors’ and officers’ insurance.

Litigation

In April 2004, the Company filed two patent infringement suits against Disc-O-Tech Medical Technologies Ltd., an Israel-based company doing business in the United States as Disc Orthopaedic Technologies Inc. (“Disc-O-Tech”). The Company filed in the United States District Court in Delaware and in the International Trade Commission in Washington, D.C. The Company’s complaints allege, among other things, that by importing and promoting its SKy Bone Expander System for use in kyphoplasty procedures, Disc-O-Tech is infringing at least four of the Company’s U.S. patents, all of which generally concern the use of various medical devices to repair spinal compression fractures. The Company has asked the United States District Court to award damages and a permanent injunction to prevent Disc-O-Tech’s further infringement and has asked the International Trade Commission to exclude Disc-O-Tech’s infringing products from the U.S. market. On May 3, 2004, the International Trade Commission instituted the requested proceeding against Disc-O-Tech. Both cases are in their very early stages, Disc-O-Tech has so far not responded to either complaint, and formal discovery has not yet commenced in either proceeding.

NOTE 9—Income taxes:

Provision for income taxes was $3,200,000 for the three months ended March 31, 2004, which includes $2,900,000 for federal taxes, $100,000 for foreign taxes, and $200,000 for state income taxes. For liability purposes, the Company recorded a $200,000 tax liability for the three months ended March 31, 2004. The Company’s income taxes currently payable for federal and state purposes have been reduced primarily by the tax benefits from employee stock option transactions. These benefits totaled $2,794,000 for the three months ended March 31, 2004, and were recorded as additional paid-in capital in shareholders’ equity.

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

Introduction

Management’s discussion and analysis of financial condition and results of operations, or MD&A, is provided as a supplement to the accompanying consolidated financial statements and footnotes contained in Item 1 of this report and to provide an understanding of our results of operations, financial condition, and changes in financial condition. This discussion contains forward-looking statements. These statements are based on our current expectations, assumptions, estimates and projections about our business and our industry, and involve known and unknown risks, uncertainties and other factors that may cause our or our industry’s results, levels of activity, performance or achievement to be materially different from any future results, levels of activity, performance or achievements expressed or implied in or contemplated by the forward-looking statements. Our actual results and the timing of selected events could differ materially from those anticipated in these forward-looking statements as a result of selected factors, including those set forth in this section. MD&A is organized as follows:

Executive Summary

Company Description. We are a global medical device company specializing in the design, manufacture and marketing of medical devices to restore spinal anatomy using minimally invasive technology. Our devices are used primarily by surgeons who repair compression fractures of the spine caused by osteoporosis and cancer. Our first commercial products, comprising our KyphX instruments, utilize our proprietary balloon technology. Surgeons use these instruments to help repair fractures during minimally invasive spine surgeries, known as kyphoplasty procedures. Most alternative spine fracture treatments are either highly invasive or are pain management therapies.

Our corporate headquarters and U.S. operations are located in Sunnyvale, California, where we conduct our manufacturing, warehousing, research, regulatory and administrative activities. Outside the U.S., we operate sales, clinical and administrative facilities in Brussels, Belgium, research and biomaterial manufacturing facilities in Rosbach, Germany and we have direct selling operations in most of the major countries in Europe. Our global distribution network consists of a direct sales force in excess of 200 individuals who market our products to physicians, surgeons and hospitals.

We moved our U.S. headquarters at the end of the first quarter of 2004 to our new location also in Sunnyvale, California. The move of our manufacturing facility is expected to be completed during the second quarter of 2004.

We are presently in the process of searching for a candidate to succeed Jeffrey L. Kaiser as our Vice President, Finance & Administration and Chief Financial Officer. We previously announced that Mr. Kaiser will be transitioning into a part-time role at the Company as a result of health issues related to chronic hip and back ailments.

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Products and Significant Business Trends. Our net sales include sales of our KyphX instruments including our KyphX Inflatable Bone Tamps, KyphX Inflation Syringe, KyphX Bone Access Systems, KyphX Bone Filler Device and KyphX Bone Biopsy Device, as well as our recently cleared KyphX HV-R Bone Cement.

During the first quarter of 2004, our business experienced significant growth. Net sales in the first quarter of 2004 increased to $44.4 million, compared to $25.1 million in the first quarter of 2003, representing growth of 77%. We trained approximately 380 physicians during the first quarter of 2004 in the Unites States and Europe. In the U.S., we added approximately 100 new hospitals to our customer base. We continued a program whereby additional spine education specialists were hired with a primary role of educating referring physicians about surgical options to treating patients with vertebral compression fractures.

In April 2004, we received 510(k) clearance from the FDA to market KyphX HV-R Bone Cement for the fixation of osteoporosis-related pathological fractures of the vertebral body during kyphoplasty and for promotion of various short- and long-term outcomes associated with kyphoplasty procedures.

In April 2004, we filed two patent infringement suits against Disc-O-Tech Medical Technologies Ltd., an Israel-based company doing business in the United States as Disc Orthopaedic Technologies Inc. (“Disc-O-Tech”). We filed in the United States District Court in Delaware and in the International Trade Commission in Washington, D.C. Our complaints allege, among other things, that by importing and promoting its SKy Bone Expander System for use in kyphoplasty procedures, Disc-O-Tech is infringing at least four of our U.S. patents, all of which generally concern the use of various medical devices to repair spinal compression fractures. We have asked the United States District Court to award damages and a permanent injunction to prevent Disc-O-Tech’s further infringement and have asked the International Trade Commission to exclude Disc-O-Tech’s infringing products from the U.S. market. On May 3, 2004, the International Trade Commission instituted the requested proceeding against Disc-O-Tech. Both cases are in their very early stages, Disc-O-Tech has so far not responded to either complaint, and formal discovery has not yet commenced in either proceeding. Costs related to this litigation will be dilutive to our earnings.

In addition to Disc-O-Tech, several other companies either have already introduced one or more products into the U.S. and/or foreign markets to compete with our KyphX instruments for treating vertebral fractures or may be on the verge of doing so. We will endeavor to remain informed about these competitive activities, and will continue to consider both how best to protect our market space as well as whether to take action against these competitive activities. As a result, we may decide that further litigation or other legal activity to seek to protect and enforce our rights, in addition to our ongoing actions against Disc-O-Tech, would be appropriate.

We have had several recent encouraging developments related to reimbursement for our products. First, the Centers for Medicare and Medicaid Services (CMS) ICD-9 Coordination and Maintenance Committee issued and published a recommendation for a specific ICD-9 code for the kyphoplasty procedure. This ICD-9 code became effective in October 2003 and officially recognizes kyphoplasty as a procedure by CMS. There was also progress in surgeon reimbursement during the year, and policy and/or bulletin coverage is now established in 40 states, with the remaining states providing coverage on a case-by-case basis. The private pay community has also shown significant interest in establishing reimbursement policies for kyphoplasty. Specifically, Blue Cross Blue Shield has now adopted policy coverage for kyphoplasty in 17 states, and a number of private payors nationwide have also adopted policy coverage. On a national level, the Healthcare Common Procedure Coding System (HCPCS) National Editorial Panel established two new HCPCS “S” codes for kyphoplasty effective January 1, 2004. These S codes are intended for use by private payors, such as the Blue Cross Blue Shield Association and the Health Insurance Association of America, although no payment level is associated with these codes. In addition, in Europe, kyphoplasty was assigned a code in the newly implemented German DRG system.

There are many private payors that continue to perceive the procedure which uses our products as experimental. Another challenge we face is to achieve consistent and/or increased payment levels among the different insurers.

We frequently evaluate potential opportunities for growth in our business by evaluating external products or technologies. While our ultimate focus will remain on our core business and the large opportunities the osteoporosis, cancer and trauma vertebral fracture markets present, we may choose to pursue one or more business development opportunities. These efforts may require us to seek additional funding and may be dilutive to our earnings.

Significant Industry Factors. Our industry is impacted by numerous competitive, regulatory and other significant factors. The growth of our business relies on our ability to continue to develop new products and innovative

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technologies, obtain regulatory clearance and compliance for our products, protect the proprietary technology of our products and our manufacturing processes, manufacture our products cost-effectively, and successfully market and distribute our products in a profitable manner. We, and the entire industry, are subject to extensive government regulation, primarily by the FDA. Failure to comply with regulatory requirements could have a material adverse effect on our business. Additionally, our industry is highly competitive and our success is dependent on our ability to compete successfully against our competitors. We devote significant resources to assessing and analyzing competitive, regulatory and economic risks and opportunities. A detailed discussion of these and other factors is provided in the “Factors Affecting Future Operating Results” section of our MD&A.

Results of Operations

Three Months Ended March 31, 2004 and March 31, 2003

The following table sets forth, for the periods indicated, our results of operations expressed as dollar amounts (in thousands) and as percentages of net sales:

Net Sales. Net sales increased $19.3 million, or 77%, for the three months ended March 31, 2004 as compared to the same period in 2003. The increase in net sales resulted from an increase in the number of trained physicians as well as an increase in the number of procedures performed by these trained physicians. The increase in international sales also reflected the currency impact of $530,000 in the three months ended March 31, 2004 as the Euro exchange rate continued to strengthen against the U.S. dollar. No customer accounted for more than 10% of total net sales for the three months ended March 31, 2004 and 2003. As of March 31, 2004, we had trained approximately 3,100 surgeons in the U.S. and approximately 1,100 surgeons in Europe. We believe the total number of potential physicians who can be trained for the use of our products is approximately 5,000 to 5,500 in the U.S. The number of trainable physicians in Europe is less well defined at this time, but we believe them to be more than 3,000.

Cost of Goods Sold. Cost of goods sold consists of material, labor, subcontract, and overhead costs. Cost of goods sold increased $1.6 million, or 47%, for the three months ended March 31, 2004 as compared to the same period in 2003. However, cost of goods sold as a percentage of net sales continue to decrease primarily as a result of fixed overhead costs being spread over increased production volume. The absolute increase in cost of goods sold resulted primarily from increased material, labor, subcontract, overhead costs and inventory provisions in relation to the increased sales volume of our products. Production volumes also increased in the first quarter of 2004 as inventory levels were raised somewhat in anticipation of moving our manufacturing operations as part of our overall facility

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move. This specific production volume increase, and resulting favorable impact on our gross profit margins, should be temporary as our move is completed during the second quarter. Our cost of goods sold and corresponding gross profit percentages can be expected to fluctuate in future periods depending upon changes in our product sales mix and prices, distribution channels and geographies, manufacturing yields, period expenses and levels of production volume.

Research and Development. Research and development expenses consist of costs of product research, product development, regulatory and clinical functions and personnel. Research and development expenses increased $1.5 million, or 50%, for the three months ended March 31, 2004 as compared to the same period in 2003. The increase was primarily attributable to increased personnel costs of $840,000, increased basic and applied research funding of $204,000, increased research and development consulting fees of $102,000, and increased travel of $134,000, offset partially by decreased deferred compensation of $146,000. We expect to continue to make substantial investments in research and development and anticipate that research and development expenses in 2004 will increase in absolute dollars. As a percentage of net sales, we anticipate our research and development expenses to be in the range of 11% to 12% for 2004.

Sales and Marketing. Sales and marketing expenses consist of costs for personnel, physician training programs and marketing activities. Sales and marketing expenses increased $7.6 million, or 52%, for the three months ended March 31, 2004 as compared to the same period in 2003. The increase related primarily to a $5.5 million increase in the costs of hiring, training and compensating additional direct selling representatives and increased sales travel expenses of $943,000. As we continue to commercialize our KyphX instruments during 2004, we expect to significantly increase our sales and marketing efforts and expenditures in absolute dollars while reducing our sales and marketing expenses as a percentage of net sales to between 49% to 51% for the year.

General and Administrative. General and administrative expenses consist of personnel costs, professional service fees, expenses related to intellectual property rights and general corporate expenses. General and administrative expenses increased $1.8 million, or 52%, for the three months ended March 31, 2004 as compared to the same period in 2003. The increase resulted primarily from increased personnel costs of $718,000, increased legal and accounting consulting fee of $292,000, increased office expenses of $201,000, and increased legal litigation fee of $168,000. We expect general and administrative expenses to increase in the future as we add personnel, continue to expand our patent portfolio, incur litigation fees, and incur public reporting, governmental compliance and investor-related expenses as a public company. In addition, we anticipate substantial expenses related to our recently initiated litigation with Disc-O-Tech. However, due to the early stage of these lawsuits, an estimate of such costs during 2004 is undeterminable at this time. Therefore, we anticipate that our general and administrative expenses will increase in absolute dollars as we expand our infrastructure and incur litigation costs. As a percentage of net sales, we expect that our general and administrative expenses will range between 12% and 15% during 2004.

Purchased In-Process Research and Development. In February 2003, we purchased Sanatis GmbH (“Sanatis”), for approximately $4.7 million in cash and acquisition costs of $201,000. Sanatis is a privately-held developer and manufacturer of orthopedic biomaterials based in Rosbach, Germany. The acquisition was made to add Sanatis’ experience developing and manufacturing orthopedic biomaterials and to complement our existing patent portfolio with Sanatis’ intellectual property surrounding calcium-based biomaterials and delivery technologies. The impact to our financial operating results during 2003 was an increase in research and development expenses of approximately $624,000. We have recorded the transaction using the purchase method of accounting. As a result of this transaction, we recorded an expense associated with the purchase of in-process research and development expenses of $636,000, and capitalized net tangible assets of $176,000, intangible assets of $142,000 and goodwill of $4,072,000. We are amortizing the intangible assets on a straight line basis over a five-year period. No amortization of goodwill has been recorded. Instead, we perform an assessment for impairment by applying a fair-value based test annually, or more frequently, if changes in circumstances or the occurrence of events suggests the remaining value is not recoverable.

Other and Interest Income (Expense), Net. Other and interest income (expense), net, decreased $48,000 for the three months ended March 31, 2004 as compared to the same period in 2003. The decrease resulted primarily from lower interest income from lower interest rates.

Provision for Income Taxes. Provision for income taxes was $3.2 million for the three months ended March 31, 2004, which includes $2.9 million for federal taxes, $100,000 for foreign taxes, and $200,000 for state income taxes. We recorded a $200,000 tax liability for the three months ended March 31, 2004. Our income taxes currently payable for federal and state purposes have been reduced primarily by the tax benefits from employee stock option transactions. We account for income taxes under the provisions of SFAS No. 109, “Accounting for Income Taxes.”

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Under this method, deferred tax assets and liabilities are determined based on the difference between the financial statement and tax bases of assets and liabilities using the enacted tax rates in effect for the year in which the differences are expected to affect taxable income. We believe that in 2004 our tax rate will be approximately 40%, even though the actual amount of taxes paid may be reduced by net operating loss and research and development tax credit carryforwards as well as deductions due to stock option activities.

Liquidity and Capital Resources

In May 2002, we received net proceeds of $94.9 million from our initial public offering of common stock. From inception through June 2001, we raised $38.0 million through private sales of redeemable convertible preferred stock. As of March 31, 2004, we had $64.8 million of cash and cash equivalents, $27.8 million of investments (short and long-term), and working capital of $100.5 million.

Cash Provided by (Used in) Operations. Our operating cash flow in the first three months of 2004 was primarily the result of our operational profitability. Specifically, net cash provided by operations was approximately $8.4 million for the three months ended March 31, 2004 attributable primarily to net income of $4.8 million and adjustments for non-cash charges related to deferred taxes including tax benefit from stock options of $3.1 million, amortization of deferred stock-based compensation of $1.2 million, increases in accrued liabilities of $1.5 million and decreases in other current assets of $1.7 million, offset partially by the increases in accounts receivable of $3.3 million as we increased our sales. Our net cash flow from operations in the first three months of 2003 was slightly negative reflecting positive operational cash inflows more than offset by growing working capital needs. Specifically, net cash used in operations was approximately $485,000 for the three months ended March 31, 2003 attributable primarily to increases in accounts receivable of $2.6 million due to increased sales partially offset by net income after adjustment for non-cash charges related to amortization of deferred stock-based compensation of $1.3 million and write-off of purchased in-process research and development expenses of $636,000.

Cash Used in Investing Activities. Net cash used in investing activities was $3.2 million for the three months ended March 31, 2004 and primarily reflected purchases of property and equipment due to the outfitting of our new Sunnyvale facility. Net cash used in investing activities was $5.4 million for the three months ended March 31, 2003 and primarily reflected the payment of $4.7 million in connection with the Sanatis acquisition.

Cash Provided by Financing Activities. Net cash provided by financing activities was $2.4 million during the three months ended March 31, 2004 and was attributable to proceeds from the issuance of common stock under the employee stock purchase plan of $1.4 million and exercise of stock options of $928,000. Net cash provided by financing activities was $1.1 million during the three months ended March 31, 2003 and was attributable to proceeds from the issuance of common stock under the employee stock purchase plan of $722,000 and exercise of stock options of $362,000.

Contractual Cash Obligations. At March 31, 2004 we had contractual cash obligations as follows (in thousands):

The amounts reflected in the table above for operating leases represent aggregate future minimum lease payments under noncancellable facility leases. Portions of these payments are denominated in foreign currencies and were translated in the tables above based on their respective U.S. dollar exchange rates at March 31, 2004. These future payments are subject to foreign currency exchange rate risk. In accordance with accounting principles generally accepted in the U.S., our operating leases are not recognized in our consolidated balance sheet; however, the aggregate minimum lease payments related to these agreements are disclosed in Note 8 to the consolidated financial statements contained in Item I of this report, as well as in the table above.

Our purchase obligations relate to the construction and remodeling of our new facility. Purchase orders or contracts for the purchase of raw materials and other goods and services are not included in the table above. We are not able to

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determine the aggregate amount of such purchase orders that represent contractual obligations, as purchase orders may represent authorizations to purchase rather than binding agreements. For the purposes of this table, contractual obligations for purchase of goods or services are defined as agreements that are enforceable and legally binding on Kyphon and that specify all significant terms, including: fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of the transaction. Our purchase orders are based on our current manufacturing needs and are fulfilled by our vendors within short time horizons. We do not have significant agreements for the purchase of raw materials or other goods specifying minimum quantities or set prices that exceed our expected requirements for three months. We also enter into contracts for outsourced services; however, the obligations under these contracts were not significant and the contracts generally contain clauses allowing for cancellation without significant penalty.

Off-Balance-Sheet Arrangements.As of March 31, 2004, we did not have any significant off-balance-sheet arrangements, as defined in Item 303(a)(4)(ii) of SEC Regulation S-K.

Stock Repurchase. The Board of Directors approved a stock repurchase program on November 7, 2002 pursuant to which up to 2,000,000 shares of our outstanding common stock may be repurchased. The duration of the repurchase program is open-ended. Under the program, we may purchase shares of common stock through open market transactions at prices deemed appropriate by management. The purchases will be funded from available working capital. As of March 31, 2004, we had repurchased 30,000 shares pursuant to this repurchase program.

Summary. We believe our current cash, cash equivalents, investments, and cash generated from operations will be sufficient to meet our anticipated cash needs for working capital and capital expenditures for at least the next 12 months. If existing cash, cash equivalents, and cash generated from operations are insufficient to satisfy our liquidity requirements, or for other reasons related to our business, we may seek to sell additional equity or debt securities or obtain an additional credit facility. The sale of additional equity or convertible debt securities could result in dilution to our stockholders. If additional funds are raised through the issuance of debt securities, these securities could have rights senior to those associated with our common stock, and could contain covenants that would restrict our operations. Any additional financing may not be available in amounts or on terms acceptable to us, or at all. If we are unable to obtain this additional financing, we may be required to reduce the scope of our planned product development and marketing efforts.

We expect to increase capital expenditures consistent with our anticipated growth in manufacturing, infrastructure and personnel as well as revisions and upgrades to our new facility. We also may increase our capital expenditures as we expand our product lines or invest to address new markets.

Critical Accounting Policies and Estimates

Our critical accounting policies and estimates are disclosed in our Annual Report on Form 10-K for the year ended December 31, 2003 that was filed with the Securities and Exchange Commission on March 10, 2004. Our critical accounting policies and estimates have not materially changed since December 31, 2003.

Factors Affecting Future Operating Results

Because we face significant competition from other medical device companies with greater resources than we have, we may be unable to maintain our competitive position and sales of our instruments may decline.

The market for medical devices is intensely competitive, subject to rapid change and significantly affected by new product introductions and other market activities of industry participants. While the direct competition we have faced to date has been limited, we are aware that several companies are developing and already introducing products to directly compete with ours in similar procedures, both in the United States and abroad. Some of these competitors’ products may be successful in our market as a result of greater efficacy, less expensive alternatives to our products, or some other advantage that makes their products more attractive than ours, which could significantly impact our anticipated revenues and future growth. Our industry also includes large pharmaceutical companies that are developing drug products that may reduce the incidence of osteoporosis and cancer and, therefore, the market for our instruments. Our ability to compete successfully depends in part on our ability to respond quickly to medical and technological changes and user preferences through the development and introduction of new products that are of high quality and that address patient and surgeon requirements. We compete with many larger companies that enjoy several competitive advantages, including:

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At any time, other companies may develop additional competitive products. If we are unable to compete effectively against existing or future competitors, sales of our instruments will decline.

If we are unable to prevent third parties from using our intellectual property, our ability to compete in the market will be harmed.

We believe that the proprietary technology embodied in our instruments and methods gives us a competitive advantage. Maintaining this competitive advantage is important to our future success. We rely on patent protection in the U.S. and abroad, as well as on a combination of copyright, trade secret and trademark laws, to protect our proprietary technology. However, these legal means afford only limited protection and may not adequately protect our rights or permit us to gain or keep any competitive advantage. For example, our patents may be challenged, invalidated or circumvented by third parties. Our two earliest patents, which we believe provide broad protection to our technology but which are so far untested, expire no later than February 2009. Our patent applications may not issue as patents at all or in a form that will be advantageous to us. We may not be able to prevent the unauthorized disclosure or use of our technical knowledge or other trade secrets by consultants, vendors, former employees and current employees, despite the existence of nondisclosure and confidentiality agreements and other contractual restrictions. Furthermore, the laws of foreign countries may not protect our intellectual property rights to the same extent as the laws of the United States and may permit others to copy our products without effective recourse. If our intellectual property rights are not adequately protected, we may be unable to keep other companies from competing directly with us, which could result in a decrease in our market share. To protect our rights, we may in the future initiate other claims or litigation against third parties for infringement of our proprietary rights, in order to protect our rights or further determine the scope and validity of our intellectual property protection. We may also begin one or more patent proceedings in various administrative agencies, such as the world’s various Patent Offices, to protect our patent rights and prevent them from being undermined by our competitors’ patent filings. If we decide to enforce our intellectual property rights to prevent or inhibit appropriation of our technology by competitors, that process will be expensive and time consuming to litigate or otherwise dispose of, will divert management’s attention from our core business, and may harm our business if we do not prevail.

We have initiated patent infringement litigation against Disc-O-Tech Medical Technologies Ltd. that will be costly to us and may hurt our competitive position if we do not prevail.

In April 2004, we filed two patent infringement suits against Disc-O-Tech Medical Technologies Ltd., an Israel-based company doing business in the United States as Disc Orthopaedic Technologies Inc. We filed in the United States District Court in Delaware and in the International Trade Commission in Washington, D.C. Our complaints allege, among other things, that by importing and promoting its SKy Bone Expander System for use in kyphoplasty procedures, Disc-O-Tech is infringing at least four of our U.S. patents, all of which generally concern the use of various medical devices to repair spinal compression fractures. We have asked the United States District Court to award damages and a permanent injunction to prevent Disc-O-Tech’s further infringement and have asked the International Trade Commission to exclude Disc-O-Tech’s infringing products from the U.S. market. On May 3, 2004, the International Trade Commission instituted the requested proceeding against Disc-O-Tech. Both cases are in their very early stages, Disc-O-Tech has so far not responded to either complaint, and formal discovery has not yet commenced in either proceeding. While we believe our allegations have merit and we are not aware of any patents on which Disc-O-Tech may countersue us for infringement, we cannot assure you that we will prevail in our suits against Disc-O-Tech. Regardless of whether we prevail, these suits will be costly to us and will divert management’s attention and resources away from our business. If we do not prevail, our proprietary rights may be damaged, which may harm our valuation and our ability to protect our business from competition. In addition, our stock price may decline as a result of the impact of the litigation, including the financial impact of the cost of the litigation, announcements of intermediate results and rulings on various motions, and/or the public’s perception of the litigations’ progression.

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Public announcements of litigation events may hurt our stock price.

During the course of our lawsuits with Disc-O-Tech, there may be public announcements of the results of hearings, motions, and other interim proceedings or developments. If securities analysts or investors perceive these results to be negative, it could have a substantial negative effect on the trading price of our stock.

Adverse changes in reimbursement procedures by domestic and international payors may impact our ability to market and sell our instruments.

Even if the use of our instruments is reimbursed by private payors and Medicare, adverse changes in payors’ policies toward reimbursement for procedures using our products would harm our ability to market and sell our instruments. We are unable to predict what changes will be made in the reimbursement methods used by payors. We cannot be certain that under prospective payment systems, such as those utilized by Medicare, and in many managed care systems used by private health care payors, the cost of our instruments will be justified and incorporated into the overall cost of the procedure.

Even if we fulfill international regulatory requirements to market our instruments, our success will be partly dependent upon the availability of reimbursement within prevailing health care payment systems in those jurisdictions in which we operate. Reimbursement and health care payment systems in international markets vary significantly by country and include both government-sponsored health care and private insurance. In addition, health care cost containment efforts similar to those we face in the United States are prevalent in many of the other countries in which we intend to sell our instruments, and these efforts are expected to continue. Although we intend to seek international reimbursement approvals, we may not obtain approvals in a timely manner, if at all, or any approvals may not be adequate to justify use of our products.

If reimbursement for the procedures using our instruments becomes difficult to obtain or is not available in sufficient amounts, our instruments may not be widely adopted.

In a small number of cases, physicians performing a procedure using our instruments have not been reimbursed, either adequately or at all. In addition, reimbursement for competing procedures, such as vertebroplasty, may be perceived to be more favorable for the doctor or hospital and thus may reduce the frequency with which procedures using our products are performed. Continued adoption of our instruments by the medical community may be adversely impacted if physicians do not receive sufficient reimbursement from payors for their services in performing the procedures using our instruments. Currently, there is no specific procedure code under which reimbursement to physicians is available for kyphoplasty procedures in the United States. Physicians must report procedures using our instruments under an unlisted current procedural terminology, or CPT, code, and hospitals receive reimbursement for an inpatient stay. Physicians have obtained reimbursement from Medicare for the use of our products in all 50 states and in the District of Columbia. However, physicians in some states believe that the level of reimbursement we have achieved thus far is too low. Until a specific national CPT code is granted, physician reimbursement from Medicare may be harder to obtain in some states. To date, no application for a national CPT code has been filed and none may be filed for one or more years and we cannot assure you that adoption of such a code ultimately will be more beneficial than harmful to our business. Future regulatory action by a government agency, including the adoption of a national CPT code, or negative clinical results may diminish reimbursement coverage for both the physician and hospital. Finally, reimbursement differs from state to state, and some states may not reimburse for a procedure in an adequate amount. Internationally, specific reimbursement codes for these instruments and procedures either have not been established or are in the early sates of development. If physicians or hospitals are unable to obtain adequate reimbursement for procedures in which our KyphX instruments are used, we may be unable to sell our instruments and our business could suffer.

Our failure to maintain necessary regulatory clearances or approvals, or to obtain additional regulatory clearances or approvals, could hurt our ability to commercially distribute and market our KyphX instruments.

Our KyphX instruments are considered medical devices and are subject to extensive regulation in the United States and in foreign countries where we intend to do business. Unless an exemption applies, each medical device that we wish to market in the United States must first receive either 510(k) clearance or premarket approval from the FDA. The FDA’s 510(k) clearance process usually takes from three to 12 months, but may take longer. The premarket approval process generally takes from one to three years from the time the application is filed with the FDA, but it can be longer and can be significantly more expensive than the 510(k) clearance process. So far we have obtained 510(k) clearance for the KyphX Inflatable Bone Tamps for fracture reduction in specific sites including the spine, hand, tibia, radius and calcaneus, clearance for our KyphX HV-R Bone Cement for the treatment of osteoporosis-related

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pathological fractures of the vertebral body during kyphoplasty procedures, and clearance to promote various short- and long-term clinical outcomes associated with kyphoplasty procedures. Nevertheless, our 510(k) clearances can be revoked if safety or effectiveness problems develop. We also will be required to obtain 510(k) clearance or premarket approval to market additional instruments or some of our other products, such as, for example, biomaterials or bone cement for use in cancer or trauma-related fractures, and will be required to obtain additional clearances/approvals for new indications for our KyphX instruments such as treatment of fractures caused by cancer and certain other resultant patient benefits we perceive exist from use of our products including improved pulmonary function and decreased depression, some of which are likely to require additional clinical data to support any applications we may file. If the clinical data gathered are not supportive, then applications will not be filed. If we choose to seek additional clearances or approvals by filing one or more applications, we cannot be certain that we would obtain any further 510(k) clearances or premarket approvals in a timely manner or at all, and delays in obtaining clearances or approvals may adversely affect our revenue growth and future profitability.

If regulatory authorities do not modify or retract their prior pronouncements concerning the use of bone cement in the spine, our ability to sell and promote our instruments may be harmed.

In October 2002, the FDA published a Public Health Web Notification entitled “Complications Related to the Use of Bone Cement in Vertebroplasty and Kyphoplasty Procedures.” In April 2003 the FDA published an update to the original notification entitled “Complications Related to the Use of Bone Cement in Treating Compression Fractures of the Spine”. The updated notification states that reported complications related to the use of polymethylmethacrylate bone cements to treat compression fractures of the spine, such as soft tissue damage and nerve root pain and compression, have resulted from leakage of bone cement, and that other complications including pulmonary embolism, respiratory and cardiac failure, abdominal intrusions/ileus and death have been reported. The notification is subject to potential future revision at the sole discretion of the FDA. The content of any further revised notification cannot be predicted. The notification indicates that the FDA is working with appropriate professional organizations and manufacturers of orthopedic devices to develop a basis for evaluating the safety and effectiveness of bone cements used to treat compression fractures of the spine. The notification requests that the healthcare community follow established procedures for reporting of deaths or serious injuries resulting from the use of medical devices, including bone cement.

In July 2003, the Medicines and Healthcare Products Regulatory Agency (MHRA) of the United Kingdom issued a Medical Device Alert entitled, “Injectable polymeric cements in percutaneous vertebroplasty, balloon kyphoplasty and pedicle screw augmentation procedures.” The UK MHRA has received reports of bone cement leaking during vertebroplasty and pedicle screw augmentation procedures leading to patient complications. The Alert noted that there have been no complications reported to MHRA from balloon kyphoplasty procedures, but stated that it was including balloon kyphoplasty procedures in the Alert due to similarities the MHRA perceived exist between balloon kyphoplasty procedures and the other procedures it identified in its Alert. We believe the MHRA’s Alert concerning balloon kyphoplasty pertains directly to our KyphX products, since our products are the only balloons used in Europe to perform kyphoplasty. The notification asks physicians to consider alternatives before performing procedures using bone cement in the spine, to use the manufacturer’s instructions in preparing bone cements for use in the spine, and to take specific precautions before and during those procedures.

If these notifications are not modified or retracted in light of the FDA’s recent clearance of our proprietary KyphX HV-R Bone Cement for specific use in the spine, these notifications themselves may raise concerns with our customers, potential customers and reimbursement organizations, which could negatively impact our ability to sell and promote our instruments. An increase in reports of deaths or serious injuries could lead the FDA or foreign regulatory agencies to issue safety alerts, health advisories, or mandated labeling changes restricting use of our instruments, including new warnings regarding their use or contraindicating their use with bone cement. In addition, use of our products in the spine causes a surgeon to use a bone void filler of choice, typically bone cement, in the spine to fill the voids created by our products. Although we now are able to promote our KyphX HV-R bone cement for use in certain kyphoplasty procedures, increased reporting of adverse events in connection with use of our or other bone void filler materials during kyphoplasty could expose us to increased risk of product liability litigation, and our current insurance coverage limits may not be adequate. Product liability insurance is expensive and may not be available to us in the future on acceptable terms, if at all.

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Modifications to our marketed devices may require new 510(k) clearances or premarket approvals or may require us to cease marketing or recall the modified devices until clearances are obtained.

Any modification to a 510(k)-cleared device that could significantly affect its safety or effectiveness, or that would constitute a major change in its intended use, requires a new 510(k) clearance or, possibly, premarket approval. The FDA requires every manufacturer to make this determination in the first instance, but the FDA can review any manufacturer’s decision. We have modified aspects of our KyphX instruments without seeking new 510(k) clearances. The FDA may not agree with any of our decisions not to seek new clearances or approvals. If the FDA requires us to seek 510(k) clearance or premarket approval for any of these modifications to a previously cleared instrument, we may be required to cease marketing or to recall the modified device until we obtain clearance or approval, and we may be subject to significant regulatory fines or penalties.

Our instruments could infringe on the intellectual property rights of others, which may lead to costly litigation, payment of substantial damages or royalties and/or our inability to use essential technologies.

The medical device industry has been characterized by extensive litigation and administrative proceedings regarding patents and other intellectual property rights. Whether an instrument infringes a patent involves complex legal and factual issues, the determination of which is often uncertain. Our competitors may assert that our instruments and methods infringe their patents. From time to time, we may receive correspondence from various third parties accusing us of infringing their patents or inviting us to license their patents. In addition, they may claim that their patents have priority over ours because they invented first or their patents were filed or issued first. Because patent applications can take many years to issue, there may be applications now pending of which we may be aware or unaware, which may later result in issued patents that our instruments or methods may infringe. There could also be existing patents that one or more of our instruments or methods may inadvertently be infringing. As the number of competitors in the market for minimally invasive spine disorder treatments grows, the possibility of a patent infringement claim against us increases.

Infringement and other intellectual property claims, with or without merit, against us can be expensive and time-consuming to litigate or otherwise dispose of and can divert management’s attention from our core business. In addition, if we lose an intellectual property litigation matter, a court could require us to pay substantial damages and/or royalties and/or issue a preliminary or permanent injunction that would prohibit us from making, using and selling essential technologies unless we could design around the patents, which we may be unable to do. Also, although we may seek to obtain a license under a third party’s intellectual property rights to bring an end to any claims or actions asserted or threatened against us or to address an injunction, we may not be able to obtain a license on reasonable terms or at all. If we cannot design around a patent, are enjoined from infringing it, and cannot obtain a satisfactory license, we may be forced to cease selling our products, which would do substantial harm to our business.

Because injuries that occur during spine surgery can be significant, we are subject to an increased risk of product liability lawsuits. If we are sued in a product liability action, we could be forced to pay substantial damages.

We manufacture medical devices that are used on patients in spine surgery procedures. Spine surgery involves significant risk of serious complications, including cardiac arrest, cerebrovascular accident, myocardial infarction, pulmonary embolism, and death. Use of bone filler material by surgeons to fill the void created using our KyphX Inflatable Bone Tamp may also lead to these complications, as a result of leakage of the bone filler material into the spinal canal or surrounding tissue or for other reasons. Consequently, companies that produce instruments for use in the spine are subject to a significant risk of product liability litigation. If any of our instruments is found to have caused or contributed to any injury, we could be held liable for substantial damages, and our current product liability coverage limits may not be adequate to protect us from any liabilities we might incur. In addition, we may require increased product liability coverage if sales of our instruments increase. Product liability insurance is expensive and may not be available to us in the future on acceptable terms, if at all.

Our non-U.S. sales present special risks.

Sales outside of the United States account for a significant percentage of our revenues and we intend to continue to expand our presence in international markets. Non-U.S. sales are subject to a number of special risks. For example:

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Any of these events could harm our operations.

Our reliance on suppliers could limit our ability to meet demand for our products in a timely manner or within our budget.

We are dependent upon outside suppliers to provide us with key components necessary for the manufacture of our products. In addition, we are presently sourcing our KyphX Inflation Syringe and our KyphX HV-R Bone Cement from single suppliers, without any present viable alternative suppliers qualified. Generally, since we obtain components through purchase orders rather than long-term supply agreements and do not maintain large volumes of inventory, a product recall, disruption or termination of the supply of components could adversely affect our continued ability to conduct business, including causing:

Any one of these results could harm our sales and profits and make it difficult to meet our business goals.

If we do not effectively manage our growth, our existing infrastructure may become strained, and as a result we may be unable to increase sales of our KyphX instruments or generate significant revenue growth.

Our world-wide direct sales organization has increased from 31 employees in October 2000 to over 200 employees in March 2004, which we believe represents very significant growth over a relatively short period of time. The growth that we have experienced, and in the future likely will experience, provides challenges to our organization, requiring us to rapidly expand our personnel and manufacturing operations. We may not be able to hire sufficient personnel to meet our growth goals or may have difficulty managing such rapid growth. As a result, our failure to recruit additional sales personnel may result in our inability to meet our projections. Future growth may strain our infrastructure, operations, product development and other managerial and operating resources. If our business resources become strained, we may not be able to deliver instruments in a timely manner.

Since we depend upon distributors in some markets, if we lose a distributor or a distributor fails to perform, our operations will be harmed.

With the present exception of the larger countries in Europe and in Canada, we sell our KyphX instruments in foreign markets through distributors. To the extent we rely on distributors, our success will depend upon the efforts of others, over which we may have little control. If we lose a distributor or a distributor fails to perform, our revenues will be harmed.

If we fail to comply with Quality System regulations, our manufacturing operations could be delayed, and our product sales and profitability could suffer.

Our manufacturing processes and those of our suppliers are required to comply with the FDA’s Quality System Regulations, which cover the procedures and documentation of the design, testing, production, control, quality assurance, labeling, packaging, storage and shipping of our instruments. The FDA enforces its Quality System Regulations through periodic announced or unannounced inspections. If we fail a Quality System inspection, our operations could be disrupted and our manufacturing delayed. Failure to take adequate corrective action in response to an adverse Quality System inspection could force a shut-down of our manufacturing operations and/or a recall of our instruments, which would cause our instrument sales and business to suffer.

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If we make acquisitions or divestitures, we could encounter difficulties that harm our business.

We may acquire companies, products or technologies that we believe to be complementary to our present or future direction of our business. If we do so, we may have difficulty integrating the acquired personnel, financials, operations, products or technologies. Acquisitions may dilute our earnings per share, disrupt our ongoing business, distract our management and employees and increase our expenses, which could harm our business.

That our principal stockholders have significant voting power and stock ownership may not be in the best interests of our other stockholders.

Our officers, directors and principal stockholders together control approximately 45% of our outstanding common stock as of April 20, 2004. If these stockholders act together, they will be able to control our management and affairs in all matters requiring stockholder approval, including the election of directors and approval of significant corporate transactions. This concentration of ownership may adversely affect the market price of our common stock. This concentration of ownership may not be in the best interests of our other stockholders. In addition, our other stockholders may not perceive that one or more actions taken by this concentrated group of stockholders is in the Company’s or the remaining stockholders’ best interests, which could harm our valuation and our stock price may decline.

Our certificate of incorporation and by-laws include a “poison pill” and other anti-takeover provisions that enable our management to resist an unwelcome takeover attempt by a third party.

Our basic corporate documents and Delaware law contain provisions that enable our management to attempt to resist a takeover unless it is deemed by management and our board of directors to be in the best interests of our shareholders. Those provisions might discourage, delay or prevent a change in the control of our company or a change in our management. The existence of these provisions could adversely affect the voting power of holders of common stock and limit the price that investors might be willing to pay in the future for shares of our common stock.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Our exposure to interest rate risk at March 31, 2004 is related primarily to our investment portfolio. Our investment portfolio includes fixed rate debt instruments of the U.S. government and its agencies and high quality corporate issuers. A change in prevailing interest rates may cause the fair value of our investments to fluctuate. For example, if we hold a security that was issued with a fixed interest rate at the then-prevailing rate and the prevailing rate rises, the fair value of the principal amount of our investment will probably decline. To minimize this risk, investments are generally held to maturity and the weighted average duration of our investments is 12 months or less. Due to the short-term nature of these investments, we believe we have no material exposure to interest rate risk arising from our investments.

We have operated mainly in the United States, and 91% and 90% of our sales were made in U.S. dollars for the three months ended March 31, 2004 and 2003, respectively. To date, we have not had any material exposure to foreign currency rate fluctuations. The majority of our European sales is derived from European Union countries and are denominated in the Euro. Monthly income and expense from our European operations are translated using average rates and balance sheets are translated using month end rates. Differences are recorded within stockholders’ equity as a component of accumulated other comprehensive income (loss).

ITEM 4. CONTROLS AND PROCEDURES

An evaluation of the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934) as of the end of the period covered by this report was carried out under the supervision and with the participation of our management, including our chief executive officer and chief financial officer. Based on that evaluation, our chief executive officer and chief financial officer have concluded that our disclosure controls and procedures are effective to ensure that material information relating to us, including our consolidated subsidiaries, is made known to them by others within such entities, particularly during the period in which this report was prepared, in order to allow timely decisions regarding required disclosure.

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There was no change in our internal control over financial reporting (as defined in Rule 13a-15(f) under the Securities Exchange Act of 1934) that occurred during our most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II: OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

In April 2004, the Company filed two patent infringement suits against Disc-O-Tech Medical Technologies Ltd., an Israel-based company doing business in the United States as Disc Orthopaedic Technologies Inc. The Company filed in the United States District Court in Delaware and in the International Trade Commission in Washington, D.C. The Company’s complaints allege, among other things, that by importing and promoting its SKy Bone Expander System for use in kyphoplasty procedures, Disc-O-Tech is infringing at least four of the Company’s U.S. patents, all of which generally concern the use of various medical devices to repair spinal compression fractures. The Company has asked the United States District Court to award damages and a permanent injunction to prevent Disc-O-Tech’s further infringement and has asked the International Trade Commission to exclude Disc-O-Tech’s infringing products from the U.S. market. On May 3, 2004, the International Trade Commission instituted the requested proceeding against Disc-O-Tech. Both cases are in their very early stages, Disc-O-Tech has so far not responded to either complaint, and formal discovery has not yet commenced in either proceeding.

The Company is presently party to no other material litigation.

ITEM 5. OTHER INFORMATION

In accordance with Section 10A(i)(2) of the Securities Exchange Act of 1934, as added by Section 202 of the Sarbanes-Oxley Act of 2002 (the “Act”), we are required to disclose the non-audit services approved by our Audit Committee to be performed by PricewaterhouseCoopers LLP, our external accountants. Non-audit services are defined in the Act as services other than those provided in connection with an audit or a review of the financial statements of a company. The Audit Committee has approved the engagement of PricewaterhouseCoopers LLP for the following non-audit services: (1) tax matter consultations concerning foreign, U.S. federal and state taxes; (2) the preparation of federal and state income tax returns; (3) the 401(k) audit; and (4) services related to the assessment of internal accounting and risk management controls.

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

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