UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

(Mark One)

For the quarterly period ended March 31, 2004

or

For the transition period from___________________________to ____________________

Commission File Number: 0-21214

ORTHOLOGIC CORP.

(602) 286-5520

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 o No

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 126-2 of the Exchange Act): xYes o No

APPLICABLE ONLY TO CORPORATE ISSUERS:

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

34,527,152 shares of common stock outstanding as of April 30, 2004

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ORTHOLOGIC CORP.
INDEX

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PART I – Financial Information

ORTHOLOGIC CORP.

See Notes to Unaudited Condensed Consolidated Financial Statements

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ORTHOLOGIC CORP.

See Notes to Unaudited Condensed Consolidated Financial Statements

4

ORTHOLOGIC CORP.

See Notes to Unaudited Condensed Consolidated Financial Statements.

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ORTHOLOGIC CORP.

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

     Description of the Business.

     OrthoLogic is a drug-development company focused on the healing of musculoskeletal tissue, through biopharmaceutical approaches. Our research is focused exclusively on the potential commercialization of our Chrysalin® Product Platform. Chrysalin, or TP508, is a 23-amino acid synthetic peptide representing a receptor-binding domain of the human thrombin molecule, a naturally occurring molecule in the body responsible for both blood clotting and initiating many of the cellular events responsible for tissue repair in bone and cartilage. We are currently enrolling patients in a Phase 3 Chrysalin product human clinical trial for fracture indications, have just completed the enrollment of patients in a Phase 1/2 spine fusion clinical trial, have one potential product in late-stage pre-clinical development, and are planning the development for two additional areas of research.

     On November 26, 2003, we sold our Bone Device Business to dj Orthopedic, LLC for a purchase price of approximately $93.0 million in cash and the assumption of substantially all of the Bone Device Business trade payables and other current liabilities. Through this divestiture, we sold all of our revenue producing operations and became a pure drug development company. The Bone Device Business assets included the rights to produce and market the OL1000, OL1000 SC, SpinaLogic and OrthoFrame/Mayo.

     As of March 31, 2004, we had cash and cash equivalents of $67.1 million, short-term investments of $48.4 million and long-term investments of $4.6 million. We will be relying on these resources to fund the development, testing and commercialization of our Chrysalin product platform.

     On April 29, 2004, we announced that we had signed a definitive agreement to acquire substantially all of the assets and intellectual property of privately held Chrysalis BioTechnology, Inc. (“CBI”), based in Galveston, Texas, for $2.5 million in cash and up to $32.0 million in common stock. The agreement covers exclusive rights to proprietary technology and intellectual property in developing synthetic peptide-based therapeutics for a variety of indications. The transaction is subject to approval of the CBI stockholders, effectiveness of the registration statement to be filed by us with the Securities and Exchange Commission and other customary closing conditions. Closing of the acquisition is anticipated during the third quarter of 2004.

     In these notes, references to “we”, “our” and the “Company” refer to OrthoLogic Corp. and its subsidiaries. References to our Bone Device Business refer to our bone growth stimulation and fracture fixation device business, including our former OL1000 and SpinaLogic products.

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Financial Statement Presentation

     In the opinion of management, the unaudited interim financial statements include all adjustments necessary for the fair presentation of our financial position, results of operations, and cash flows. The results of operations for the interim periods are not necessarily indicative of the results to be expected for the complete fiscal year. The balance sheet as of December 31, 2003 is derived from our audited financial statements included in the 2003 Annual Report on Form 10-K. These financial statements should be read in conjunction with the financial statements and notes thereto included in the 2003 Annual Report on Form 10-K.

     Use of estimates. The preparation of the financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. These estimates and assumptions form the basis for the carrying values of assets and liabilities. On an on-going basis we evaluate these estimates, including those related to allowance for doubtful accounts, guarantees, income taxes, contingencies and litigation. Management bases its estimates on historical experience and various other assumptions and believes its estimates are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities not readily apparent from other sources. Under different assumptions and conditions, actual results may differ from these estimates.

     The significant estimates include the allowance for doubtful accounts (approximately $435,000 and $556,000 at March 31, 2004 and December 31, 2003, respectively), the fair value of certain representations and warranties issued in conjunction with the sale of the Bone Device Business, excess space reserve and the valuation allowance for deferred tax assets.

     Principles of consolidation. The consolidated financial statements include the accounts of OrthoLogic and its wholly-owned subsidiaries. All intercompany accounts and transactions have been eliminated. We prepare our consolidated financial statements in accordance with accounting principles generally accepted in the United States of America. Accordingly, the consolidated financial statements do not include all information and notes required for complete financial statements. The following briefly describes the significant accounting policies used in the preparation of the our financial statements.

     A. Cash and cash equivalents. Cash and cash equivalents consist of cash on hand and cash deposited with financial institutions, including money market accounts, and commercial paper purchased with an original maturity of three months or less.

     B. Furniture and equipment. Furniture and equipment are stated at cost or, in the case of leased assets under capital leases, at the present value of future lease payments at inception of the lease. Depreciation is calculated on a straight-line basis over the estimated useful lives of the various assets, which range from three to seven years. Leasehold improvements and leased assets under capital leases are amortized over the life of the asset or the period of the respective lease using the straight-line method, whichever is the shortest.

     We adopted Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS No. 144”) effective January 1, 2002. SFAS No. 144 addresses financial accounting and reporting for the impairment or disposal of

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long-lived assets, and supersedes Statement of Financial Accounting Standards No. 121, Accounting of the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of. SFAS No. 144 requires that we evaluate long-lived assets based on the net future cash flow expected to be generated from the asset on an undiscounted basis whenever significant events or changes in circumstances occur that indicate that the carrying amount of an asset may not be recoverable.

     C. Escrow receivable. A portion of the purchase price related to the sale of the Bone Device Business was required to be placed in escrow (Note 2). Under Financial Accounting Standards Board (“FASB”) Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of the Indebtedness of Others,” indemnifications, representations and warranties issued in conjunction with the sale of a business are required to be valued and recorded in the financial statements. We made certain representations and warranties in conjunction with the sale of the Bone Device Business and determined the discounted fair value to be approximately $1.9 million, which is reflected as a reduction of the escrow receivable. The discount is being accreted to interest expense through November 26, 2005, which is when the portion of the purchase price allocated to the representations and warranties is required to be released from escrow.

     D. Investment in Chrysalis. We own a minority ownership interest in Chrysalis BioTechnology, Inc., which is recorded at cost (see Note 4).

     E. Excess Space Reserve. We lease a facility in Tempe, Arizona and sublease portions to other tenants. We have established a reserve for the period the available sublease space is anticipated to be vacant. In the opinion of management, the reserve balance of $209,000 at March 31, 2004 is adequate to allow for time necessary to acquire an additional tenant for the building.

     F. Income taxes. Under SFAS No. 109, “Accounting for Income Taxes,” income taxes are recorded based on current year amounts payable or refundable, as well as the consequences of events that give rise to deferred tax assets and liabilities. We base our estimate of current and deferred taxes on the tax laws and rates that are currently in effect in the appropriate jurisdiction. Pursuant to SFAS No. 109, we have determined that the majority of the deferred tax asset at March 31, 2004 requires a valuation allowance. We believe the remaining deferred tax asset of $770,000 will be realized as it relates to alternative minimum tax credits that do not expire.

     G. Research and development. Research and development represents both costs incurred internally for research and development activities, as well as costs incurred to fund the research activities with which we have contracted and certain milestone payments regarding the continued clinical testing of Chrysalin. All research and development costs are expensed when incurred.

     H. Stock-based compensation. At March 31, 2004, we had two stock-based employee compensation plans. We account for those plans under the recognition and measurement principles of APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. In the quarter ended March 31, 2004, we recorded a reduction of approximately $56,000 in compensation expense related to the vesting of performance based options.

     In December 2002, the FASB issued Statement of Financial Accounting Standards No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure” (“SFAS No.

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148”) which is effective for fiscal years ended after December 15, 2002. SFAS No. 148 amends SFAS No. 123 to provide alternative methods of transition to SFAS No. 123’s fair value method of accounting for stock-based employee compensation if a company elects to account for its equity awards under this method. SFAS No. 148 also amends the disclosure provisions of SFAS No. 123 and APB Opinion No. 28, Interim Financial Reporting, to require disclosure of the effects of an entity’s accounting policy with respect to stock-based employee compensation on reported net income and earnings per share in both annual and interim financial statements. We have provided the required additional annual disclosures below which illustrates the effect on net income and earnings per share if we had applied the fair value recognition provisions of FASB Statement No. 123, Accounting for Stock-Based Compensation, to stock-based employee compensation (in thousands except per share data).

     I. Income (loss) per common share. Income (loss) per common share is computed on the weighted average number of common or common and equivalent shares outstanding during each year. Basic earnings per share is computed as net income (loss) divided by the weighted average number of common shares outstanding during the period. Diluted earnings per share reflects the potential dilution that could occur from common shares issuable through stock options, warrants, and other convertible securities when the effect would be dilutive.

     J. Discontinued operations. Under SFAS No. 144, “Accounting for the Impairment and Disposal of Long-Lived Assets,” discontinued operations are reported if a component of the entity is held for sale or sold during the period. The Bone Device Business qualified as a component of the entity under the standard as of the November 26, 2003 sale date. Therefore, the related results of the Bone Device Business operations for 2003, prior to the sale, have been presented as discontinued operations in the financial statements.

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     K. New Accounting Pronouncements. In January 2003, the FASB issued Interpretation No. 46 (“FIN 46”), “Consolidation of Variable Interest Entities,” (revised in December 2003) which clarifies the application of Accounting Research Bulletin No. 51, “Consolidated Financial Statements,” relating to consolidation of certain entities. We do not participate in any variable interest entities. The adoption of FIN 46 did not have a material impact on our financial statements.

     L. Certain reclassifications. Certain reclassifications have been made to the prior year financial statements to conform to the 2004 presentation.

2. ASSET SALE OF THE BONE DEVICE BUSINESS

     On November 26, 2003, we completed the sale of the Bone Device Business assets and related liabilities (including the rights to produce and market the OL1000, OL1000 SC, SpinaLogic and OrthoFrame/Mayo) to dj Orthopedics, LLC. Pursuant to the asset purchase agreement, we sold substantially all of the assets of the Bone Device Business (other than our Medicare accounts receivable, which were $1.2 million in the aggregate), including substantially all of the related machinery, equipment, inventory, work in process, licenses, customer lists, intellectual property, certain agreements and contracts. dj Orthopedics paid $93.0 million in cash at closing and assumed substantially all of the Bone Device Business trade payables and other current liabilities less payables in an amount approximately equal to the amount of retained Medicare receivables. Upon the closing of the sale we assigned and dj Orthopedics agreed to assume and perform the obligations outstanding on November 26, 2003, related to the operation of the Bone Device Business (including various liabilities related to the Company’s employees).

     Of the $93.0 million we received in the sale, $7.5 million was placed in an escrow account. The funds were divided into two accounts: $7.0 million from which dj Orthopedics’ is eligible for indemnity and breach of contract claims, if any, may be paid and $0.5 million from which a portion of the agreed upon incentive stay bonuses will be paid by dj Orthopedics to former OrthoLogic executives on the first anniversary of the closing. The funds in the $7.0 million escrow account, in excess of the amount of any pending claims, will be released to us on the second anniversary of the closing. The amount included in escrow receivable is net of the $1.9 million liability related to the fair value of the representations and warranties.

     The transaction was considered an accelerating event for our stock-based compensation plans. Terminated employees’ unvested options vested immediately upon the sale. Our directors and employees who were retained had 75% of their unvested options vest upon the sale, with the remainder vesting over a 12 month period or on their regular vesting period, whichever is earlier.

     The sale of the Bone Device Business is accounted for as discontinued operations. The income from the divested business, and related tax effects are summarized as discontinued operations on the consolidated statement of operations. Included in the discontinued operations for the 2003 period is the net income from the Bone Device Business of $1.7 million resulting from the three months of operations through March 31, 2003.

     The presentation of discontinued operations for the Bone Device Business reflects the elimination of the historical revenues as well as historical expenses related to the operations of

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business. The revenue, cost of revenue, gross profit and pretax income attributable to the Bone Device Business for the March 31, 2003 quarter ended were as follows (in thousands):

     The historical expenses of the Bone Device Business were derived using a variety of factors including percentage of revenues, headcount, and specific identification. Subsequent to the sale, we no longer have any revenue producing products.

     The sale of our Bone Device Business was a transaction taxable to us for United States federal income tax purposes. We recognized taxable income for fiscal year ended 2003 equal to the amount realized on the sale in excess of our tax basis in the assets sold. A portion of the taxable gain was offset by available net operating loss carry forwards.

3. CPM DIVESTITURE AND RELATED GAINS

     In July 2001, we announced the sale of our continuous passive motion (“CPM”) business to OrthoRehab, Inc. We received $12.0 million in cash, with OrthoRehab, Inc. assuming approximately $2.0 million in liabilities in connection with the sale of certain CPM related assets that we had recorded in our financial statements at a carrying value of approximately $20.7 million. We recorded a $6.9 million charge to write down the CPM assets to their fair value less direct costs of selling the assets. Under the CPM Asset Purchase Agreement, we were eligible to receive up to an additional $2.5 million of cash if certain objectives were achieved by OrthoRehab, Inc.

     We settled litigation over the $2.5 million payment and other matters in April 2003. OrthoRehab, Inc. agreed to pay $1.2 million to settle the contingent payment due to us, and all outstanding claims between the two companies. No cash payments were received during the first quarter of 2003. Payments of $111,000 were collected during the first quarter of 2004, and recognized on the “CPM divestiture and related gains” line item on the Consolidated Statement of Operations. The remaining balance plus interest is scheduled to be paid over the next 24 months. Due to the uncertainty of the future payments, income on the settlement will be recorded as cash is received.

4. LICENSING AGREEMENT FOR CHRYSALIN

     In January 1998, we acquired a minority equity investment (less than 10%) in a biotech firm, Chrysalis BioTechnology, Inc. (“CBI”), for $750,000. As part of the transaction, we were awarded a worldwide exclusive option to license the orthopedic applications of Chrysalin, a patented 23-amino acid synthetic peptide that had shown promise in accelerating the healing

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process. Our agreement with CBI contains provisions for us to continue and expand our option to license Chrysalin contingent upon regulatory approvals, successful pre-clinical trials, and certain trials and milestone payments to CBI.

     At this stage of research, we are not yet able to apply for FDA approval to market Chrysalin. The process of obtaining necessary government approvals is time consuming and expensive. There can be no assurance that the necessary approvals for new products or applications will be obtained by us or, if they are obtained, that they will be obtained on a timely basis. Significant additional costs for us will be necessary to complete development of these products.

     CBI does not own the patents to Chrysalin, but owns an exclusive worldwide license to Chrysalin from the University of Texas. Except for the $750,000 minority equity investment in Chrysalis, all payments made to Chrysalis have been expensed as research and development. The license agreement with Chrysalis calls for us to pay certain other additional milestone payments and royalty fees, based upon the product’s development and our achievement of commercial introduction.

     On April 29, 2004, we announced that we had signed a definitive agreement to acquire substantially all of the assets and intellectual property of privately held CBI, based in Galveston, Texas, for $2.5 million in cash and up to $32.0 million in common stock. The agreement covers exclusive rights to proprietary technology and intellectual property in developing synthetic peptide-based therapeutics for a variety of indications. The transaction is subject to approval of the CBI stockholders, effectiveness of the registration statement to be filed by us with the Securities and Exchange Commission and other customary closing conditions. Closing of the acquisition is anticipated during the third quarter of 2004.

5. LITIGATION

     OrthoRehab, Inc. and OrthoMotion, Inc. v. OrthoLogic Corporation and OrthoLogic Canada, Ltd., Superior Court of the State of Delaware, County of New Castle, Case No. C.A. No. 01C-11-224 WCC. In November 2001, OrthoRehab, Inc., filed a complaint in connection with its acquisition of certain assets used in the Company’s CPM business in July 2001 alleging, among other things, that some of the assets purchased were overvalued and that the Company had breached its contract. We settled the case in April 2003 by a payment of $1.2 million to us from OrthoRehab, Inc.

     In addition to the matters disclosed above, the Company is involved in various other legal proceedings that arise in the ordinary course of business. In management’s opinion, the ultimate resolution of these other legal proceedings are not likely to have a material adverse effect on the financial position, results of operations or cash flows of the Company.

     The health care industry is subject to numerous laws and regulations of federal, state, and local governments. Compliance with these laws and regulations, specifically those relating to the Medicare and Medicaid programs, can be subject to government review and interpretations, as well as regulatory actions unknown and unasserted at this time. Recently, federal government activity has increased with respect to investigations and allegations concerning possible violations by health care providers of regulations, which could result in the imposition of significant fines and penalties, as well as significant repayments of previously billed and

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collected revenues from patient services. Management believes that the Company is in substantial compliance with current laws and regulations.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

     When used in this report, the terms “OrthoLogic,” “we,” “our,” or “us” refer to OrthoLogic Corp. or OrthoLogic Corp. and its subsidiaries, as appropriate in the context, and the term “Bone Device Business” refers to our former business line of bone growth stimulation and fracture fixation devices, including the OL1000 product line, SpinaLogic® and our fracture fixation devices, OrthoFrame® and OrthoFrame/Mayo.

     The following is management’s discussion of significant factors that affected OrthoLogic’s interim financial condition and results of operations. This should be read in conjunction with our Management’s Discussion and Analysis of Financial Condition and Results of Operations included in our Annual Report on Form 10-K for the year ended December 31, 2003 and the “Special Note Regarding Forward Looking Statements” below, following Item 4.

     Overview

     On November 26, 2003, we sold our Bone Device Business to djOrthopedics, LLC for a purchase price of approximately $93.0 million in cash and the assumption of substantially all of the Bone Device Business trade payables and other current liabilities. Through this divestiture, we sold all of our revenue producing operations and became a pure drug development company. Our principal business remains focused on the healing of musculoskeletal tissue, although through biopharmaceutical approaches rather than through the use of medical devices.

     As of March 31, 2004, we had cash and cash equivalents of $67.1 million, short-term investments of $48.4 million and long-term investments of $4.6 million. We will be relying on these resources to fund the development, testing and commercialization of our Chrysalin product platform.

     On April 29, 2004, we announced that we had signed a definitive agreement to acquire substantially all of the assets and intellectual property of privately held Chrysalis BioTechnology, Inc. (“CBI”), based in Galveston, Texas, for $2.5 million in cash and up to $32.0 million in common stock. The agreement covers exclusive rights to proprietary technology and intellectual property in developing synthetic peptide-based therapeutics for a variety of indications. The transaction is subject to approval of the CBI stockholders, effectiveness of the registration statement to be filed by us with the Securities and Exchange Commission and other customary closing conditions. Closing of the acquisition is anticipated during the third quarter of 2004.

Research and Development of the Chrysalin Product Platform

     Chrysalin, or TP508, is a 23-amino acid synthetic peptide representing a receptor-binding domain of the human thrombin molecule, a naturally occurring molecule in the body responsible for both blood clotting and initiating many of the cellular events responsible for tissue repair in bone and cartilage. The Chrysalin molecule serves as the basis for a family of potential

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therapeutic products we refer to collectively as the “Chrysalin product platform.” To date, we have identified five potential orthopedic uses of Chrysalin:

•		fracture repair;
•		spine fusion;
•		cartilage defect repair;
•		ligament repair; and
•		tendon repair.

     We are currently enrolling patients in a Phase 3 Chrysalin product human clinical trial for fracture indications, have just completed enrollment in a Phase 1/2 human clinical trial for spine fusion indications, have one potential product in late-stage pre-clinical development in cartilage defect repair, and are planning the development for two additional areas of research in ligament and tendon repair.

     Fracture Repair

     Our fracture repair studies currently underway focus on isolating and identifying exact functions of Chrysalin in acceleration of fracture repair, and what genes are stimulated by the injection of the Chrysalin peptide. We are also conducting exploratory studies in bone defect repairs and distraction osteogenesis, the medical procedure of slowly moving apart two bone segments in a way that allows new bone tissue to grow to fill the gap. Our analysis of the effect of Chrysalin at the genetic level is performed using gene array and quantitative PCR technology, with this work performed both in house at OrthoLogic and in collaboration with academic institutions. Segmental defect, distraction osteogenesis and non-union experiments are performed by collaborators at academic institutions. Preclinical segmental defect studies are meant to mimic reconstructive surgical procedures. These studies provide information on advanced formulations of Chrysalin and potential new clinical indications to investigate. Distraction osteogenesis is a technique that is used to replace lost segments of bone due to severe injury, or to correct congenital deformity. Preclinical studies on non-union fractures address the effects of Chrysalin to heal fractures that do not heal in the normal expected time. Positive results in these studies may provide additional clinical indications for Chrysalin.

     Spine Fusion

     Our clinical studies on spine fusion address questions of safety and efficacy when the Chrysalin peptide is used in conjunction with allograft bone in spine fusion surgeries. All of these studies are performed by collaborators at academic institutions, with the experimental study design provided by OrthoLogic scientists. We completed enrollment in the spine trial during the first quarter of 2004.

     Cartilage Defect and Repair; Tendon and Ligament Repair

     All our pre-clinical cartilage repair studies are performed at academic institutions. The goal of these studies is to understand the way Chrysalin works to stimulate cartilage defect repair as well as to address formulation questions. Pre-clinical ligament and tendon repair studies are slated to begin this year and will be conducted in collaboration with academic institutions.

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Critical Accounting Policies and Estimates

     Allowance for Doubtful Accounts: The Company retained certain receivables related to the Bone Device Business after the divestiture. The allowance for doubtful accounts (approximately $435,000 and $556,000 at March 31, 2004 and December 31, 2003, respectively) is based primarily on trends in historical collection rates, consideration of current events, payor mix and other considerations. In the opinion of management, adequate allowances have been provided for doubtful accounts. If the financial condition of the third-party payors were to deteriorate, resulting in an inability to make payments, or the other considerations underlying the estimates was to change, additional allowances might be necessary.

     Income Taxes: SFAS No. 109 requires that a valuation allowance be established when it is more likely than not that all or a portion of a deferred tax asset will not be realized. Changes in valuation allowances from period to period are included in the tax provision in the period of change. In determining whether a valuation allowance is required, we take into account all evidence with regard to the utilization of a deferred tax asset included in past earnings history, expected future earnings, the character and jurisdiction of such earnings, unsettled circumstances that, if unfavorably resolved, would adversely affect utilization of a deferred tax asset, carryback and carryforward periods, and tax strategies that could potentially enhance the likelihood of realization of a deferred tax asset. The valuation allowance reduces deferred tax assets to an amount that management believes will more likely than not to be realized. We believe that the net deferred tax asset of $770,000 at March 31, 2004 will be realized as it relates to alternative minimum tax credits that do not expire. However, the amount of the deferred tax assets actually realized could differ if we have little or no future earnings.

     Discontinued Operations: Under SFAS No. 144, “Accounting for the Impairment and Disposal of Long-Lived Assets,” discontinued operations are reported if a component of the entity is held for sale or sold during the period. The Bone Device Business qualifies as a component of the entity under the standard. Therefore, the related results of the Bone Device Business operations prior to the sale have been presented as discontinued operations in the 2003 financial statements.

     Liability for Representations and Warranties Made in Conjunction with the Sale of the Bone Device Business: Under FASB Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of the Indebtedness of Others,” indemnifications, representations and warranties issued in conjunction with the sale of a business are required to be valued and recorded in the financial statements. We made certain representations and warranties in conjunction with the sale of the Bone Device Business and determined the discounted fair value to be approximately $1.9 million, which is reflected as a reduction to the escrow receivable. The discount is being accreted to interest expense through November 26, 2005, which is when the portion of the purchase price allocated to the representations and warranties is required to be released from escrow.

     Investment in CBI: We own a minority ownership interest in CBI, recorded on the balance sheet at cost. We recently announced a definitive agreement to acquire substantially all of the assets and intellectual property of CBI.

     Excess Space Reserve: We lease a facility in Tempe, Arizona. This approximately 100,000 square foot facility is designed and constructed for industrial purposes and is located in

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an industrial district. In November 2003, we subleased approximately 35,000 square feet of the facility to dj Orthopedics, LLC, the company which purchased our Bone Device Business. We previously subleased approximately 13,500 square feet of the building through June 2005 to another company. We believe the facility is well-maintained and adequate for use in the forseeable future. We believe the remainder of the facility that we are using is suitable for our purposes and is effectively utilized. While we believe the facility is well maintained and adequate for use in the forseeable future, there can be no guarantee that a different lessee will assume the remaining lease obligation. We established a reserve for the period the available sublease space was anticipated to be vacant. In the opinion of management, the reserve balance of $209,000 at March 31, 2004 is adequate to allow for time necessary to acquire an additional tenant for the building.

Results of Operations Comparing Three-Month Period Ended March 31, 2004 to the Corresponding Period in 2003.

     Revenues, Cost of Revenues and Gross profits: We are a research and development company. We had no revenues, costs of revenues, or gross profit from continuing operations in 2004 or 2003. The Bone Device Business revenue is included as discontinued operations and is presented reflecting only the net income after tax under the line item “Income from operations of Bone Device Business, net of taxes.”

     General and Administrative (“G&A”) Expenses: G&A expenses related to our ongoing development operations decreased by approximately 56.9% from $1.3 million to $555,000 from the first quarter of 2003 to 2004. Our administrative functions previously serviced a large organization that had manufacturing, sales, healthcare reimbursement and research and development functions, compared to the pure research and development company that exists currently.

     Research and Development Expenses: Research and development expenses were $3.4 million in 2004 compared to $1.4 million in 2003. The rise in our research and development expenses is attributed to our significant expansion of our research and preclinical programs since the first quarter of 2003. In addition, we have more patients enrolled in the clinical trials than in 2003, when we had just begun our Phase 3 human clinical trial for fracture repair indications. During 2004, we incurred additional research costs for the development of specific programs that we believe will enhance our ability to successfully receive authorization for a new drug application filing for our fracture indication. Research and development expenses consisted primarily of Chrysalin related expenses, which include pre-clinical studies in cartilage defect repair, final patient enrollment and the early completion of the Phase 1/2 spinal fusion clinical trial and continuation of the Phase 3 human clinical trial for fracture repair. During 2004, we expect to double our research and development expenses over 2003 levels of $9.0 million.

     CPM Divestiture and Change in Estimated Collectability of CPM Receivables: In July 2001, we announced the sale of our continuous passive motion (“CPM”) business to OrthoRehab, Inc. We settled litigation over certain contingent purchase price payment matters in April 2003. OrthoRehab, Inc. agreed to pay $1.2 million to settle the dispute arising out of a contingent payment due to us, and all outstanding claims between the two companies. The payments of $111,000 appearing on the “CPM divestiture and related gains” line on the Statement of Operations were received during the first quarter of 2004. The remaining balance

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plus interest is scheduled to be paid over the next 24 months. Due to the uncertainty of the future payments, income on the settlement will be recorded as cash is received.

     Other Income: Other income in 2004 and 2003 consisted primarily of interest income. Other income increased from $132,000 in 2003 to $306,000 in 2004 primarily as a result of the additional interest earned on the cash and investments from the sale of the Bone Device Business.

     Discontinued operations of the Bone Device Business: The sale of the Bone Device Business in 2003 is accounted for as discontinued operations. The operating income from the divested business and related tax effects are summarized as discontinued operations on the consolidated statement of operations. Included in the discontinued operations for the first quarter of 2003 is the net income from the Bone Device Business of $1.7 million, which is net of taxes.

     Net Income (Loss): We had a net loss in the first quarter of 2004 of $3.2 million compared to net income of $142,000 in 2003. The net income in 2003 is composed primarily of the income of $1.7 million from the discontinued operations of the Bone Device Business and a ($1.6) million loss resulting from continuing operations.

Liquidity and Capital Resources

     We have historically financed our operations through operating cash flows and the public and private sales of equity securities. With the sale of our Bone Device Business, we sold all of our revenue producing operations. We received approximately $93.0 million in cash from the sale of our Bone Device Business. At March 31, 2004, we had cash and cash equivalents of $67.1 million, short-term investments of $48.4 million and long-term investments of $4.6 million.

     With the exception of the anticipated purchase of substantially all of the assets of CBI, we do not expect to make significant capital investments in 2004, but anticipate growing our research and development expenditures related to clinical trials for Chrysalin in fresh fracture repair and spinal fusion and for further studies in articular cartilage repair. We anticipate that our cash and short term investments will be sufficient to meet our presently projected research and development expenses and other working capital requirements for the next 12 months. However, we believe our research and development of our Chrysalin product platform will require substantial additional capital beyond 2004. Our forecasts of the period of time through which our financial resources will be adequate to support our research and development depends on many factors, most notably the progress of our research and development relative to our projections and to the pace of our competitors. If we decide to expand our clinical trials, in particular, or if we consider other opportunities in the market, our projected expense levels may change, which could require us to seek other sources of financial resources. There is no assurance that we will be successful in obtaining such other resources. If such a situation were to arise, we may be required to scale back or delay our research and development programs.

     The following table sets forth all known commitments as of March 31, 2004 and the year in which these commitments become due or are expected to be settled (in thousands):

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     Approximately 17% of the leased facility is subleased through June 2005 and another approximately 44% is subleased through November of 2004, payments from which will offset a portion of the lease commitments listed above.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

     We have no debt outstanding and no derivative instruments at March 31, 2004.

     Our Canadian operations were sold as part of the CPM asset sale, and consequently we have no exposure to foreign currency exchange rate risks as of March 31, 2004.

     Our investment portfolio is used to preserve our capital until it is required to fund our operations. All of these investment instruments are classified as held-to-maturity. We do not own derivative financial instruments in our investment portfolio. Our investment portfolio contains instruments that are subject to the risk of a decline in interest rates. We maintain a non-trading investment portfolio of investment grade, liquid debt securities that limit the amount of credit exposure to any one issue, issuer or type of instrument. Due to the short duration and conservative nature of these instruments, we do not believe that we have a material exposure to interest rate risk.

     We have deposited our cash with national banking institutions which we believe are stable. Even though our accounts in each of these banks have balances in excess of the $100,000 limit that is insured by the Federal Deposit Insurance Corporation, we believe these accounts are not subject to significant market risk due to bank failure.

Item 4. Controls and Procedures

     Our Chief Executive Officer and Chief Financial Officer have reviewed and evaluated the effectiveness of our disclosure controls and procedures as of the end of the period covered by this Form 10-Q, which included inquiries made to certain other employees. Based on their evaluation, the Chief Executive Officer and Chief Financial Officer have each concluded that, as of the end of such period, our disclosure controls and procedures are effective and sufficient to ensure that we record, process, summarize, and report information required to be disclosed in the reports we file under the Securities Exchange Act of 1934 within the time periods specified by the Securities and Exchange Commission’s rules and forms. There have been no significant changes in our internal controls over financial reporting during our most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

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SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

     We may from time to time make written or oral forward-looking statements, including statements contained in our filings with the Securities and Exchange Commission and its reports to stockholders. This report contains forward-looking statements made pursuant to the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995. In connection with these “safe harbor” provisions, we identify important factors that could cause actual results to differ materially from those contained in any forward-looking statements made by or on our behalf. Any such forward-looking statement is qualified by reference to the following cautionary statements.

Risks Related to Our Industry

We are in a highly regulated field with high investment costs and high risks.

     Our Chrysalin product platform is currently in the human testing phase for two potential products and earlier preclinical testing phases for another potential product. The U.S. Food and Drug Administration (“FDA”) and comparable agencies in many foreign countries impose substantial limitations on the introduction of new pharmaceuticals through costly and time-consuming laboratory and clinical testing and other procedures. The process of obtaining FDA and other required regulatory approvals is lengthy, expensive and uncertain. Chrysalin, as a new drug, is subject to the most stringent level of FDA review.

     Even after we have invested substantial funds in the development of our three Chrysalin products and even if the results of our current clinical trials are favorable, there can be no guarantee that the FDA will grant approval of Chrysalin for the indicated uses or that it will do so in a timely manner.

     If we successfully bring one or more products to market, there is no assurance that we will be able to successfully manufacture or market the products or that potential customers will buy them if, for example, a competitive product has greater efficacy or is deemed more cost effective. In addition, the market in which we will sell any such products is dominated by a number of large corporations that have vastly greater resources than we have, which may impact our ability to successfully market our products or maintain any technological advantage we might develop. We also would be subject to changes in regulations governing the manufacture and marketing of our products, which could increase our costs, reduce any competitive advantage we may have and/or adversely affect our marketing effectiveness.

The results of our late stage clinical trials may be insufficient to obtain FDA approval.

     Positive results from preclinical studies and early clinical trials do not ensure positive results in more advanced clinical trials. If we are unable to demonstrate that a product candidate will be safe and effective in advanced clinical trials involving larger numbers of patients, we will be unable to submit the new drug application (“NDA”) necessary to receive approval from the FDA to commercialize that product.

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     We are currently conducting a Phase 3 human clinical trial on Chrysalin for fracture repair indications. We expect to have enrollment for the trial completed by late summer/fall of 2004. If we fail to achieve the primary endpoints in this Phase 3 clinical trial or the results are ambiguous, we will have to determine whether to redesign our Chrysalin fracture repair product candidate and our protocols and continue with additional testing, or cease activities in this area. Redesigning the product could be extremely costly and time-consuming. A substantial delay in obtaining FDA approval or termination of the Chrysalin fracture repair product candidate could result in a delay in our ability to generate revenue.

Patients may discontinue their participation in our clinical studies, which may negatively impact the results of these studies and extend the timeline for completion of our development programs.

     As with all clinical trials, we are subject to the risk that patients enrolled in our clinical studies may discontinue their participation at any time during the study as a result of a number of factors, including, withdrawing their consent or experiencing adverse clinical events, which may or may not be judged related to our product candidates under evaluation. We are subject to the risk that if a large number of patients in any one of our studies discontinue their participation in the study, the results from that study may not be positive or may not support an NDA for regulatory approval of our product candidates.

     In addition, the time required to complete clinical trials is dependent upon, among other factors, the rate of patient enrollment. Patient enrollment is a function of many factors, including:

•		the size of the patient population;
•		the nature of the clinical protocol requirements;
•		the diversion of patients to other trials or marketed therapies;
•		our ability to recruit and manage clinical centers and associated trials;
•		the proximity of patients to clinical sites; and
•		the patient eligibility criteria for the study.

Even if we obtain marketing approval, our products will be subject to ongoing regulatory oversight, which may affect our ability to successfully commercialize any products we may develop.

     Even if we receive regulatory approval of a product candidate, the approval may be subject to limitations on the indicated uses for which the product is marketed or require costly post-marketing follow-up studies. After we obtain marketing approval for any product, the manufacturer and the manufacturing facilities for that product will be subject to continual review and periodic inspections by the FDA and other regulatory agencies. The subsequent discovery of previously unknown problems with the product, or with the manufacturer or facility, may result in restrictions on the product or manufacturer, including withdrawal of the product from the market.

     If we fail to comply with applicable regulatory requirements, we may be subject to fines, suspension or withdrawal of regulatory approvals, product recalls, seizure of products, operating restrictions and criminal prosecution.

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Our product candidates may not gain market acceptance among physicians, patients and the medical community.

     Even if we obtain regulatory approval for our products, market acceptance will depend on our ability to demonstrate to physicians and patients the benefits of our products in terms of safety, efficacy, convenience, ease of administration and cost effectiveness. In addition, we believe market acceptance depends on the effectiveness of our marketing strategy, the pricing of our products and the reimbursement policies of government and third-party payors. Physicians may not prescribe our products, and patients may determine, for any reason, that our product is not useful to them. If any of our product candidates fails to achieve market acceptance, our ability to generate revenue will be limited.

Our success also depends on our ability to operate and commercialize products without infringing on the patents or proprietary rights of others.

     Third parties may claim that we or our licensors or suppliers are infringing their patents or are misappropriating their proprietary information. In the event of a successful claim against us or our licensors or suppliers for infringement of the patents or proprietary rights of others, we may be required to, among other things:

•		pay substantial damages;
•		stop using our technologies;
•		stop certain research and development efforts;
•		develop non-infringing products or methods; and
•		obtain one or more licenses from third parties.

     A license required under any such patents or proprietary rights may not be available to us, or may not be available on acceptable terms. If we or our licensors or suppliers are sued for infringement, we could encounter substantial delays in, or be prohibited from, developing, manufacturing and commercializing our product candidates.

The pharmaceutical industry is subject to stringent regulation, and failure to obtain regulatory approval will prevent commercialization of our products.

     Our research, development, preclinical and clinical trial activities and the manufacture and marketing of any products that we may successfully develop are subject to an extensive regulatory approval process by the FDA and other regulatory agencies in the United States and abroad. The process of obtaining required regulatory approvals for drugs is lengthy, expensive and uncertain, and any such regulatory approvals may entail limitations on the indicated usage of a drug, which may reduce the drug’s market potential.

     In order to obtain FDA approval to commercialize any product candidate, an NDA must be submitted to the FDA demonstrating, among other things, that the product candidate is safe and effective for use in humans for each target indication. Our regulatory submissions may be delayed, or we may cancel plans to make submissions for product candidates for a number of reasons, including:

•		negative or ambiguous preclinical or clinical trial results;
•		changes in regulations or the adoption of new regulations;
•		unexpected technological developments; and
•		developments by our competitors that are more effective than our product candidates.

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     Consequently, we cannot assure you that we will make our submissions to the FDA in the timeframe that we have planned, or at all, or that our submissions will be approved by the FDA. Even if regulatory clearance is obtained, post-market evaluation of our products, if required, could result in restrictions on a product’s marketing or withdrawal of a product from the market as well as possible civil and criminal sanctions.

     Clinical trials are subject to oversight by institutional review boards and the FDA to ensure compliance with the FDA’s good clinical practice regulations, as well as other requirements for good clinical practices. We depend, in part, on third-party laboratories and medical institutions to conduct preclinical studies and clinical trials for our products and other third-party organizations, usually universities, to perform data collection and analysis, all of which must maintain both good laboratory and good clinical practices. If any such standards are not complied with in our clinical trials, the FDA may suspend or terminate such trial, which would severely delay our development and possibly end the development of a product candidate.

     We also currently and in the future will depend upon third party manufacturers of our products, which are and will be required to comply with the applicable FDA Good Manufacturing Practice regulations. We cannot be certain that our present or future manufacturers and suppliers will comply with these regulations. The failure to comply with these regulations may result in restrictions in the sale of, or withdrawal of the products from the market. Compliance by third parties with these standards and practices are outside of our direct control.

     In addition, we are subject to regulation under state and federal laws, including requirements regarding occupational safety, laboratory practices, environmental protection and hazardous substance control, and may be subject to other local, state, federal and foreign regulation. We cannot predict the impact of such regulations on us, although they could impose significant restrictions on our business and require us to incur additional expenses to comply.

If our competitors develop and market products that are more effective than ours, or obtain marketing approval before we do, our commercial opportunities will be reduced or eliminated.

     Competition in the pharmaceutical and biotechnology industries is intense and is expected to increase. Several biotechnology and pharmaceutical companies, as well as academic laboratories, universities and other research institutions, are involved in research and/or product development for various treatments for or involving fracture repair, spine fusion surgery, cartilage defect repair and ligament and tendon repair. Many of our competitors have significantly greater research and development capabilities, experience in obtaining regulatory approvals and manufacturing, marketing, financial and managerial resources than we have.

     Our competitors may succeed in developing products that are more effective than the ones we have under development or that render our proposed products or technologies noncompetitive or obsolete. In addition, certain of such competitors may achieve product commercialization before we do. If any of our competitors develops a product that is more effective than one we are developing or plan to develop, or is able to obtain FDA approval for commercialization before we do, we may not be able to achieve significant market acceptance for certain products of ours, which would have a material adverse effect on our business.

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Healthcare reform and restrictions on reimbursements may limit our financial returns.

     Our ability to successfully commercialize our products may depend in part on the extent to which government health administration authorities, private health insurers and other third party payors will reimburse consumers for the cost of these products. Third party payors are increasingly challenging both the need for, and the price of, novel therapeutic drugs and uncertainty exists as to the reimbursement status of newly approved therapeutics. Adequate third party reimbursement may not be available for our drug products to enable us to maintain price levels sufficient to realize an appropriate return on our investments in research and product development, which could restrict our ability to commercialize a particular drug candidate.

     We caution that the foregoing list of important factors is not exclusive. We do not undertake to update any forward-looking statement that may be made from time to time by or on behalf of us.

Risks Related to Our Business

We are a biopharmaceutical company with no revenue generating operations and high investment costs.

     On November 26, 2003, we sold all of our revenue generating operations to become a pure drug development company. We are now focused on developing and testing the product candidates in our Chrysalin product platform and have allocated most of our resources to bringing these product candidates to the market. We may invest in other orthobiologic or complementary technology in the future, but we have no current specific plans to do so at this time. We currently have no pharmaceutical products being sold or ready for sale and do not expect to be able to introduce any pharmaceutical products for at least several years. As a result of our significant research and development, clinical development, regulatory compliance and general and administrative expenses and the lack of any products to generate revenue, we expect to incur losses for at least the next several years and expect that our losses will increase as we expand our research and development activities and incur significant expenses for clinical trials. Our cash reserves, including the cash received from the sale of our bone growth stimulation device business in November 2003, are the primary source of our working capital. We do not expect to receive any revenue from product sales unless and until we receive regulatory approval and begin commercialization of our product candidates. We cannot predict when that will occur or if it will occur.

Our product candidates are in various stages of development and may not be successfully developed or commercialized.

     We currently do not sell any products. We are subject to the risk that:

•		the FDA finds some or all of our product candidates ineffective or unsafe;
•		we do not receive necessary regulatory approvals;
•		we are unable to get some or all of our product candidates to market in a timely manner;
•		we are not able to produce our product candidates in commercial quantities at reasonable costs;
•		our products undergo post-market evaluations resulting in marketing restrictions or withdrawal of our products; or

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•

the patient and physician community does not accept our products.

     In addition, our product development programs may be curtailed, redirected or eliminated at any time for many reasons, including:

•		adverse or ambiguous results;
•		undesirable side effects which delay or extend the trials;
•		inability to locate, recruit, qualify and retain a sufficient number of patients for our trials;
•		regulatory delays or other regulatory actions;
•		difficulties in obtaining sufficient quantities of the particular product candidate or any other components needed for our preclinical testing or clinical trials;
•		change in the focus of our development efforts; and
•		re-evaluation of our clinical development strategy.

     We cannot predict whether we will successfully develop and commercialize any of our product candidates. If we fail to do so, we will not be able to generate revenue.

Our product candidates are all based on the same chemical peptide, Chrysalin. If one of our product candidates reveals safety or fundamental inefficacy issues in clinical trials, it could impact the development path for all our other current product candidates.

     The development of each of our product candidates in the Chrysalin product platform is based on our knowledge and understanding of how the human thrombin molecule contributes to the repair of soft tissue and bone. While there are important differences in each of the product candidates in terms of their purpose (fracture repair, spine fusion, cartilage repair, etc.), each product candidate is focused on accelerating the repair of soft tissue and bone and is based on the ability of Chrysalin to mimic specific attributes of the human thrombin molecule to stimulate the body’s natural healing processes.

     Since we are developing the product candidates in the Chrysalin product platform in parallel, we expect to learn from the results of each trial and apply some of our findings to the development of the other product candidates in the platform. If one of the product candidates has negative clinical trial results or is shown to be ineffective, it could impact the development path or future development of the other product candidates in the platform. If we find that one of the biopharmaceutical product candidates is unsafe, it could impact the development of our other product candidates in clinical trials.

If we fail to meet our obligations under our license agreements, or our license agreements are terminated for any other reason, we may lose our rights to use the Chrysalin technology.

     Our rights to the development, use and marketing of all of our therapeutic products within the Chrysalin product platform are governed by a series of licensing agreements from Chrysalis BioTechnology, Inc. Chrysalis BioTechnology, Inc., which is still managed by the University of Texas professor who discovered the peptide, has a license for the exclusive worldwide rights to Chrysalin from the University of Texas. As part of our acquisition of a minority interest in Chrysalis, Chrysalis granted a sublicense to us with worldwide rights to use Chrysalin for all orthopedic indications. We extended our worldwide license for Chrysalin to include the rights for orthopedic “soft tissue” indications including cartilage, tendon and ligament repair. Our failure to achieve milestones, or meet any of our financial or other

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obligations under these licensing agreements could result in the loss of our rights to Chrysalin. If we lose our rights to Chrysalin under any of these license agreements, we would be unable to continue our product development programs and our business and prospects would be materially harmed.

If we cannot protect the Chrysalin patent or our intellectual property generally, our ability to develop and commercialize our products will be severely limited.

     Our success will depend in part on Chrysalis’, the University of Texas’ and our ability to maintain and enforce patent protection for Chrysalin and each product resulting from Chrysalin. Without patent protection, other companies could offer substantially identical products for sale without incurring the sizable discovery, development and licensing costs that we have incurred. Our ability to recover these expenditures and realize profits upon the sale of products would then be diminished.

     Chrysalin is patented and there have been no successful challenges to the Chrysalin patent. However, if there were to be a challenge to the patent or any of the patents for product candidates, a court may determine that the patents are invalid or unenforceable. Even if the validity or enforceability of a patent is upheld by a court, a court may not prevent alleged infringement on the grounds that such activity is not covered by the patent claims. Any litigation, whether to enforce our rights to use our or our licensors’ patents or to defend against allegations that we infringe third party rights, will be costly, time consuming, and may distract management from other important tasks.

     As is commonplace in the biotechnology and pharmaceutical industry, we employ individuals who were previously employed at other biotechnology or pharmaceutical companies, including our competitors or potential competitors. To the extent our employees are involved in research areas which are similar to those areas in which they were involved at their former employers, we may be subject to claims that such employees and/or we have inadvertently or otherwise used or disclosed the alleged trade secrets or other proprietary information of the former employers. Litigation may be necessary to defend against such claims, which could result in substantial costs and be a distraction to management and which may have a material adverse effect on us, even if we are successful in defending such claims.

     We also rely in our business on trade secrets, know-how and other proprietary information. We seek to protect this information, in part, through the use of confidentiality agreements with employees, consultants, advisors and others. Nonetheless, we cannot assure you that those agreements will provide adequate protection for our trade secrets, know-how or other proprietary information and prevent their unauthorized use or disclosure. To the extent that consultants, key employees or other third parties apply technological information independently developed by them or by others to our proposed products, disputes may arise as to the proprietary rights to such information, which may not be resolved in our favor. The risk that other parties may breach confidentiality agreements or that our trade secrets become known or independently discovered by competitors, could adversely affect us by enabling our competitors, who may have greater experience and financial resources, to copy or use our trade secrets and other proprietary information in the advancement of their products, methods or technologies.

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Some of our product candidates are in early stages of development and may never be commercialized.

     Research, development and pre-clinical testing are long, expensive and uncertain processes. Other than indications for fracture repair and spine fusions, none of our other Chrysalin product candidates has reached clinical trial testing. Our development of Chrysalin for the repair of cartilage defects, ligaments and tendons is currently in pre-clinical testing or the research stage. Our future success depends, in part, on our ability to complete pre-clinical development of these and other product candidates and advance them to the clinical trials.

     If we are unsuccessful in advancing our early stage product candidates into clinical testing for any reason, our business prospects will be harmed.

The loss of our key management and scientific personnel may hinder our ability to execute our business plan.

     As a small company with 34 employees, our success depends on the continuing contributions of our management team and scientific personnel, and maintaining relationships with the network of medical and academic centers in the United States that conduct our clinical trials. We are highly dependent on the services of our key scientific employees, as well as the other principal members of our management staff. Our success depends in large part upon our ability to attract and retain highly qualified personnel. We face intense competition in our hiring efforts with other pharmaceutical and biotechnology companies, as well as universities and nonprofit research organizations, and we may have to pay higher salaries to attract and retain qualified personnel. The loss of one or more of such individuals, or our inability to attract additional qualified personnel, could substantially impair our ability to implement our business plan.

We face an inherent risk of liability in the event that the use or misuse of our products results in personal injury or death.

     The use of our product candidates in clinical trials, and the sale of any approved products, may expose us to product liability claims, which could result in financial losses. Our clinical liability insurance coverage may not be sufficient to cover claims that may be made against us. In addition, we may not be able to maintain insurance coverage at a reasonable cost or in sufficient amounts or scope to protect us against losses. Any claims against us, regardless of their merit, could severely harm our financial condition, strain our management and other resources and adversely impact or eliminate the prospects for commercialization of the product which is the subject of any such claim.

Our stock price is volatile and fluctuates due to a variety of factors.

     Our stock price has varied significantly in the past and may vary in the future due to a number of factors, including:

•		fluctuations in our operating results;
•		developments in litigation to which we or a competitor is subject;
•		announcements and timing of potential acquisitions, divestitures, and conversions of preferred stock,
•		announcements of technological innovations or new products by us or our competitors;
•		FDA and international regulatory actions;
•		actions with respect to reimbursement matters;

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•		developments with respect to our or our competitors’ patents or proprietary rights;
•		public concern as to the safety of products developed by us or others;
•		changes in health care policy in the United States and internationally;
•		changes in stock market analyst recommendations regarding us, other drug development companies or the pharmaceutical industry generally; and
•		general market conditions.

     In addition, the stock market has from time to time experienced significant price and volume fluctuations that are unrelated to the operating performance of particular companies. These broad market fluctuations may adversely affect the market price of our stock.

Part II – Other Information

Item 6. Exhibits and Reports

(a)		Exhibit Index
		See Exhibit List following this report
(b)		Reports on Form 8-K
		Form 8-K furnished January 27, 2004 announcing the appointment of Michael D. Casey to the OrthoLogic Corp. Board of Directors.

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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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OrthoLogic Corp.
Exhibit Index to Quarterly Report on Form 10-Q
For the Quarterly Period Ended March 31, 2004

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