KYPHON INC - 10-Q Quarterly Report

	Three Months Ended June 30,						Six Months Ended June 30,
	2002			2001			2002			2001
	(in thousands, except per share amounts)
Net sales	$	18,238		$	9,298		$	32,832		$	15,573
Cost of goods sold		2,393			2,116			4,663			3,759

Gross profit		15,845			7,182			28,169			11,814

Operating expenses:
Research and development		2,368			2,467			4,329			4,235
Sales and marketing		10,486			6,032			19,634			11,021
General and administrative		2,811			3,277			5,379			5,288

Total operating expenses		15,665			11,776			29,342			20,544

Income (loss) from operations		180			(4,594	)		(1,173	)		(8,730	)
Interest income (expense) and other, net		(3,141	)		8			(3,456	)		98

Net loss	$	(2,961	)	$	(4,586	)	$	(4,629	)	$	(8,632	)

Net loss per common share, basic and diluted	$	(0.15	)	$	(2.36	)	$	(0.42	)	$	(4.77	)

Weighted-average shares used in computing net loss per common share, basic and diluted		19,304			1,944			11,129			1,809

	June 30, 2002			December 31, 2001
	(Unaudited)			(Note 1)
	(in thousands)
Assets
Current assets:
Cash and cash equivalents	$	84,127		$	3,352
Accounts receivable, net		10,390			5,579
Inventories		4,287			2,393
Prepaid expenses and other current assets		1,125			940

Total current assets		99,929			12,264
Property and equipment, net		3,504			3,144
Related party notes receivable, net of discount		1,592			1,539
Other assets		1,323			1,340

Total assets	$	106,348		$	18,287

Liabilities, Convertible Preferred Stock and Stockholders’ Equity (Deficit)
Current liabilities:
Current portion of notes payable	$	13		$	116
Accounts payable		2,737			2,000
Accrued liabilities		4,838			3,771
Convertible promissory notes		—			12,000

Total current liabilities		7,588			17,887
Notes payable, net of current portion		11			43

		7,599			17,930

Convertible preferred stock		—			38,024

Stockholders’ equity (deficit):
Common stock		37			2
Additional paid-in capital		166,067			23,122
Deferred stock-based compensation, net		(18,145	)		(16,082	)
Accumulated other comprehensive income (loss)		112			(16	)
Accumulated deficit		(49,322	)		(44,693	)

Total stockholders’ equity (deficit)		98,749			(37,667	)

Total liabilities, convertible preferred stock and stockholders’ equity (deficit)	$	106,348		$	18,287

	Six Months Ended June 30,
	2002			2001
	(in thousands)
Cash flows from operating activities:
Net loss	$	(4,629	)	$	(8,632	)
Adjustments to reconcile net loss to net cash used for operating activities:
Provision for excess and obsolete inventories		179			—
Depreciation and amortization		545			399
Non-cash interest expense		3,081			—
Loss on disposal of property and equipment		20			7
Amortization of deferred stock-based compensation		3,305			2,910
Changes in operating assets and liabilities:
Accounts receivable		(4,811	)		(3,699	)
Inventories		(2,073	)		(566	)
Prepaid expenses and other current assets		(488	)		(195	)
Other assets		17			(8	)
Accounts payable		737			1,132
Accrued liabilities		1,103			1,109

Net cash used for operating activities		(3,014	)		(7,543	)

Cash flows from investing activities:
Acquisition of property and equipment		(979	)		(607	)

Net cash used for investing activities		(979	)		(607	)

Cash flows from financing activities:
Proceeds from issuance of common stock, net		94,925			—
Repurchase of common stock		(23	)		(25	)
Proceeds from exercise of warrants		77			—
Proceeds from exercise of stock options		791			61
Proceeds from convertible promissory notes		2,000			—
Proceeds from related party note receivable		379			—
Repayment of convertible promissory notes		(13,300	)		—
Repayment of notes payable		(136	)		(46	)

Net cash provided by (used for) financing activities		84,713			(10	)

Effect of foreign exchange rates on cash		55			—
Net increase (decrease) in cash and cash equivalents		80,775			(8,160	)
Cash and cash equivalents at beginning of period		3,352			8,898

Cash and cash equivalents at end of period	$	84,127		$	738

Kyphon Inc. (“Kyphon” or the “Company”) was incorporated in the state of Delaware on January 10, 1994 and commenced operations in September 1996. The Company develops medical devices for orthopedic applications using its proprietary balloon technology. The Company’s initial marketing focus is on surgeons who repair spine fractures caused by osteoporosis, a disease characterized by bone deterioration. These fractures are the most common type of spine fracture. The Company’s first commercial products, comprising the KyphX instruments, provide surgeons with tools to help repair a fracture during minimally-invasive spine surgeries. Alternative treatments include highly-invasive surgical procedures as well as therapies designed simply to manage pain rather than to repair the spine fracture.

The accompanying unaudited condensed consolidated financial statements have been prepared by the Company in accordance with accounting principles generally accepted in the United States 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 of normal recurring adjustments) considered necessary for a fair presentation have been included. Operating results for the three and six month periods ended June 30, 2002 are not necessarily indicative of the results that may be expected for the year ending December 31, 2002, or for any future period. These financial statements and notes should be read in conjunction with the financial statements and notes thereto for the year ended December 31, 2001 included in the Company’s Registration Statement on Form S-1, as amended (No. 333-83678).

On May 17, 2002, the Company completed an initial public offering in which it sold 6,000,000 shares of common stock at $15.00 per share for net cash proceeds of approximately $82.4 million, net of underwriting discounts, commissions and other offering costs. Upon the closing of the offering, all the Company’s outstanding shares of convertible preferred stock converted into 26,151,288 shares of common stock. On May 29, 2002, the underwriters exercised the over-allotment option to purchase an additional 900,000 shares, resulting in net cash proceeds of approximately $12.6 million.

Basic net loss per share is computed by dividing net loss by the weighted-average number of common shares outstanding for the period. Diluted net loss per share is computed giving effect to all potential dilutive common stock, including options, warrants, convertible promissory notes and convertible preferred stock. Options, common stock subject to a right of repurchase, warrants, convertible promissory notes and convertible preferred stock were not included in the computation of diluted net loss per share for the Company because the effect would be antidilutive.

	Three Months Ended June 30,						Six Months Ended June 30,
	2002			2001			2002			2001
Numerator:
Net loss	$	(2,961	)	$	(4,586	)	$	(4,629	)	$	(8,632	)

Denominator:
Weighted-average common stock outstanding		19,469			2,087			11,291			2,273
Less: weighted-average shares subject to repurchase		(165	)		(143	)		(162	)		(464	)

Weighted-average shares used in computing basic and diluted net loss per common share		19,304			1,944			11,129			1,809

As of June 30, 2002, the Company has recorded a cumulative $28.0 million of deferred stock-based compensation related to stock options granted to non-employees and employees. Stock 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 compensation expense as follows (in thousands):

Between July 2001 and February 2002, the Company raised $13.3 million through the sale of convertible promissory notes with several affiliates pursuant to a loan agreement. The outstanding principal and accrued interest were repaid upon the closing of the Company’s initial public offering. In addition, in November 2001, the Company raised $700,000 through the sale of a convertible promissory note to one affiliate pursuant to the same loan agreement. The principal and accrued interest due on this note automatically converted into 49,090 shares of the Company’s common stock at the initial public offering price of $15.00 per share. As required by the terms of the loan agreement, upon the closing date of the Company’s initial public offering, the Company issued warrants exercisable for an aggregate of 99,334 shares of the Company’s common stock at an exercise price of $0.01 per share to the holders of the convertible promissory notes.

The Company allocated the gross proceeds received from the convertible promissory notes and accrued interest to the convertible promissory notes and the warrants, based on their relative fair values. This allocation resulted in $13.3 million of the proceeds being assigned to the convertible promissory note and $1.5 million being assigned to the warrants. The warrants were valued at the May 22, 2002 issuance date using the Black-Scholes pricing model. The Company recognized the allocated fair value of the warrants of $1.5 million as an immediate charge to interest expense. Based on the difference between the effective conversion price of the proceeds allocated to the convertible promissory notes and the fair market value of the common stock at the issuance date, the Company determined that the allocated value of the convertible promissory notes contained a beneficial conversion feature. The beneficial conversion feature, amounting to $1.6 million, represented additional interest yield on the convertible promissory notes and was also recognized as an immediate charge to interest expense.

In April of 2002, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 145 (“SFAS 145”), “Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections,” which is effective for fiscal years beginning after May 15, 2002. Under SFAS 145, gains and losses from the extinguishment of debt should be classified as extraordinary items only if they meet the criteria of Accounting Principles Board Opinion No. 30. SFAS 145 also addresses financial accounting and reporting for capital leases that are modified in such a way as to give rise to a new agreement classified as an operating lease. The Company believes that the adoption of SFAS 145 will not have a material impact on the consolidated financial position or results of the operations of the Company.

In June of 2002, the FASB issued Statement of Financial Accounting Standards No. 146 (“SFAS 146”), “Accounting for Costs Associated with Exit or Disposal Activities,” which is effective for exit or disposal activities initiated after December 31, 2002. SFAS 146 nullifies Emerging Issues Task Force Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring).” Under SFAS 146, a liability is required to be recognized for a cost associated with an exit or disposal activity when the liability is incurred. SFAS 146 applies to costs associated with an exit activity that does not involve an entity newly acquired in a business combination or with a retirement or disposal activity covered by FASB Statements No. 143, “Accounting for Asset Retirement Obligations,” and No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets”. The Company believes that the adoption of SFAS 146 will not have a material impact on the consolidated financial position or results of the operations of the Company.

This discussion and analysis should be read in conjunction with the consolidated financial statements and notes thereto for the year ended December 31, 2001 included in the Company’s Registration Statement on Form S-1, as amended (No. 333-83678). Operating results for the three and six month periods ended June 30, 2002 are not necessarily indicative of results that may occur in future periods.

The following discussion and analysis 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. Words such as “believe,” “anticipate,” “expect,” “intend,” “plan,” “will,” “may,” “should,” “estimate,” “predict,” “potential,” “continue” or the negative of such terms or other similar expressions identify 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 under “Risk Factors Affecting Operations and Future Results”.

We develop medical devices for orthopedic applications using our proprietary balloon technology. Currently, our KyphX instruments consist of our KyphX Inflatable Bone Tamp, KyphX Inflation Syringe, KyphX Bone Access Systems and KyphX Bone Filler Device. We have obtained clearance from the U.S. Food and Drug Administration, or FDA, for our KyphX Inflatable Bone Tamp to help repair fractures in specific sites in the spine, hand, leg, arm and heel. We believe that we are not required to obtain FDA clearance for our other KyphX products when promoted and sold as manual orthopedic surgical instruments. In May 2000, we commenced full commercial introduction of our KyphX instruments. From inception to June 30, 2002, we recognized $75.2 million in revenue from sales of our products.

Since inception, we have been unprofitable. We incurred net losses of approximately $5.2 million in 1999, $17.7 million in 2000, $17.8 million in 2001 and $4.6 million for the six months ended June 30, 2002. As of June 30, 2002, we had an accumulated deficit of approximately $49.3 million. Activities related to commercializing our KyphX instruments, enhancing physician reimbursement and initiating clinical studies, together with our general and administrative expenses, will cause our expenses to increase. As we proceed with commercialization, we will require additional sales and marketing resources, data from proposed clinical studies and greater physician reimbursement acceptance by payors.

Our future growth depends on increased penetration of our current market and on identifying new markets in which we can leverage our proprietary balloon technology. To the extent any current or additional markets do not materialize or grow in accordance with our expectations, our sales could be lower than expected. We intend to seek regulatory approval this year to initiate a clinical study designed to support FDA approval for the use of bone cement as a bone filler material in conjunction with our cleared KyphX instruments in a specific minimally-invasive spine procedure and to determine the benefits, if any, resulting from that procedure.

Cost of Goods Sold. Cost of goods sold consists of material, labor and overhead costs. Cost of goods sold were approximately $2.4 million for the three months ended June 30, 2002 as compared to approximately $2.1 million for the comparable period in 2001. The increase in the cost of goods sold resulted primarily from higher material, labor and overhead costs associated with increased sales volume of our products. As a percentage of revenue, cost of goods sold decreased to 13% in the three months ended June 30, 2002 from 23% in the three months ended June 30, 2001 as a result of fixed overhead costs being spread over higher production volume and lower unit costs, primarily related to our metal surgical instruments.

Research and Development. Research and development expenses consist of costs of product research, product development, regulatory and clinical functions and personnel. Those expenses decreased slightly to approximately $2.4 million for the three months ended June 30, 2002 from approximately $2.5 million for the comparable period in 2001. The slight decrease was attributable primarily to decreased clinical trial costs of $458,000 partially offset by increased personnel costs of $151,000 and increased amortization of deferred stock-based compensation of $205,000. We expect to continue to make substantial investments in research and development and anticipate that research and development expenses will increase in the future.

Sales and Marketing. Sales and marketing expenses consist of costs for personnel, physician training programs and marketing activities. These expenses increased to approximately $10.5 million for the three months ended June 30, 2002 from approximately $6.0 million for the comparable period in 2001 as we continued to build our sales and marketing organization in conjunction with increased product sales. The increase in sales and marketing expenses related primarily to a $2.3 million increase in the cost of hiring, training and compensating additional direct selling representatives, as well as increased travel expenditures of $595,000, increased expenditures related to advertising, trade shows and market research activities of $440,000 and increased amortization of deferred stock-based compensation of $334,000. As we continue to commercialize our KyphX instruments, we expect to significantly increase our sales and marketing efforts and expenditures.

General and Administrative. General and administrative expenses consist of personnel costs, professional service fees, expenses related to intellectual property rights and general corporate expenses. These expenses decreased to approximately $2.8 million for the three months ended June 30, 2002 from approximately $3.3 million for the three months ended June 30, 2001. The decrease resulted primarily from the decreased amortization of deferred stock-based compensation of $1.2 million partially offset by increased miscellaneous taxes, licenses and insurance expenditures of $330,000 and increased patent and public company expenses of $231,000. We expect general and administrative expenses to increase in the future as we add personnel, continue to expand our patent portfolio and incur reporting and investor-related expenses as a public company.

Other and Interest Income (Expense), Net. Other and interest income (expense), net, decreased to approximately ($3.1) million for the three months ended June 30, 2002 from $8,000 for the three months ended June 30, 2001. Interest expense for the three months ended June 30, 2002 includes non-cash interest expense of approximately $3.1 million related to the beneficial conversion feature and the fair value of warrants issued in connection with the convertible promissory notes. In addition, interest expense increased from these outstanding convertible promissory notes offset by increased interest income from higher cash and cash equivalent and short-term investment balances resulting from our initial public offering proceeds.

Net Sales. Net sales generated from sales of our products increased to approximately $32.8 million for the six months ended June 30, 2002 from approximately $15.6 million in the comparable prior year period. 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 trained physicians. In the six months ended June 30, 2002 and 2001, 94% and 99%, respectively, of net sales were recognized in the United States. No customer accounted for more than 10% of total net sales for the six months ended June 30, 2002 and 2001.

Cost of Goods Sold. Cost of goods sold increased to approximately $4.7 million for the six months ended June 30, 2002 from approximately $3.8 million for the six months ended June 30, 2001. The increase in cost of goods sold resulted from higher material, labor and overhead costs associated with increased sales volume of our products. As a percentage of revenue, cost of goods sold decreased to 14% for the six months ended June 30, 2002 from 24% in the comparable prior year period primarily as a result of fixed overhead costs being spread over higher production volume and lower unit costs, primarily related to our metal surgical instruments.

Research and Development. Research and development expenses increased to approximately $4.3 million for the six months ended June 30, 2002 from approximately $4.2 million for the comparable prior year period. The increase primarily resulted from amortization of deferred stock-based compensation of $375,000 and increased personnel costs of $327,000 partially offset by decreased clinical trial consulting costs of $657,000.

Sales and Marketing. Sales and marketing expenses increased to approximately $19.6 million for the six months ended June 30, 2002 from approximately $11.0 million for the comparable prior year period as we continued to build our sales and marketing organization in conjunction with increased product sales. The increase resulted primarily from increased personnel costs of $4.5 million, increased sales travel expenses of $1.3 million, increased advertising, trade shows and market research expenses of $577,000 and increased amortization of deferred stock-based compensation of $737,000.

General and Administrative. General and administrative expenses increased to approximately $5.4 million for the six months ended June 30, 2002 from approximately $5.3 million for the comparable prior year period. The increase resulted primarily from increased miscellaneous taxes, licenses and insurance expenditures of $407,000 and increased patent and public company expenses and accounting fees of $306,000 offset partially by decreased amortization of deferred stock-based compensation of $788,000.

Other and Interest Income (Expense), Net. Other and interest income (expense), net, decreased to approximately ($3.5) million for the six months ended June 30, 2002 from approximately $98,000 for the comparable prior year period. Interest expense for the six months ended June 30, 2002 includes non-cash interest expense of $3.1 million related to the beneficial conversion feature and the fair value of warrants issued in connection with the convertible promissory notes. In addition, increased interest expense resulted from outstanding convertible promissory notes offset partially by increased interest income from higher cash and cash equivalent and short-term investment balances resulted from our initial public offering proceeds.

In May 2002, we received net proceeds of approximately $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. From July 2001 through February 2002, pursuant to a loan agreement, we issued to affiliates $14.0 million in promissory notes, all of which have either been repaid or converted into common stock. To a lesser extent, we also financed our operations through equipment financing loans, which totaled $24,000 in principal outstanding at June 30, 2002. As of June 30, 2002, we had $84.1 million of cash and cash equivalents and working capital of $92.3 million.

Cash Used for Operations. Net cash used for operations was approximately $3.0 million and approximately $7.5 million for the six months ended June 30, 2002 and 2001, respectively. For both periods, cash used for operations was attributable primarily to net losses after adjustment for non-cash charges related to depreciation and amortization of deferred stock-based compensation, and increases in accounts receivable and inventories. These increases in use of cash for operations were offset in part by increases in accounts payable and accrued liabilities. In addition, for the six months ended June 30, 2002, $3.1 million of non-cash interest expense was included in adjustments to net loss.

Cash Provided by (Used for) Financing Activities. Net cash provided by financing activities was approximately $84.7 million for the six months ended June 30, 2002, resulting primarily from the proceeds of approximately $94.9 million from issuing common stock in our initial public offering partially offset by repayment of convertible promissory notes of $13.3 million. Net cash used for financing activities was $10,000 for the six months ended June 30, 2001, primarily due to the repayment of notes payable and repurchase of common stock partially offset by proceeds from the exercise of stock options.

Equipment Financing. In 1997 and 1998, we entered into two equipment financing lines totaling $650,000. Both of these lines were repaid entirely as of June 30, 2002. We issued warrants to the lenders in connection with these lines at a weighted-average exercise price of $0.62 per share. The warrants were exercised for 17,601 shares of common stock subsequent to our initial public offering.

Convertible Promissory Notes. Between July 2001 and February 2002, we raised $13.3 million through the sale of convertible promissory notes to several of our affiliates pursuant to a loan agreement. We repaid the outstanding principal and accrued interest upon the closing of our initial public offering. In addition, in November 2001, we raised $700,000 through the sale of a convertible promissory note to one affiliate pursuant to the same loan agreement. The principal and accrued interest due on this note automatically converted into 49,090 shares of our common stock at the initial public offering price of $15.00 per share. As required by the terms of the loan agreement, upon the closing date of the Company’s initial public offering, we issued warrants exercisable for an aggregate of 99,334 shares of our common stock at an exercise price of $0.01 per share to the holders of the convertible promissory notes.

We allocated the gross proceeds received from the convertible promissory notes and accrued interest to the convertible promissory notes and the warrants, based on their relative fair values. This allocation resulted in $13.3 million of the proceeds being assigned to the convertible promissory note and $1.5 million being assigned to the warrants. We valued the warrants at the May 22, 2002 issuance date using the Black-Scholes pricing model. We recognized the allocated fair value of the warrants of $1.5 million as an immediate charge to interest expense. Based on the difference between the effective conversion price of the proceeds allocated to the convertible promissory notes and the fair market value of the common stock at the issuance date, we determined that the allocated value of the convertible promissory notes contained a beneficial conversion feature. The beneficial conversion feature, amounting to $1.6 million, represented additional interest yield on the convertible promissory notes and was also recognized as an immediate charge to interest expense.

We believe our current cash and cash equivalents 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 and cash generated from operations are insufficient to satisfy our liquidity requirements, 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.

In April of 2002, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 145 (“SFAS 145”), “Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections,” which is effective for fiscal years beginning after May 15, 2002. Under SFAS 145, gains and losses from the extinguishment of debt should be classified as extraordinary items only if they meet the criteria of Accounting Principles Board Opinion No. 30. SFAS 145 also addresses financial accounting and reporting for capital leases that are modified in such a way as to give rise to a new agreement classified as an operating lease. We believe the adoption of SFAS 145 will not have a material impact on our consolidated financial position or results of operations.

In June of 2002, the FASB issued Statement of Financial Accounting Standards No. 146 (“SFAS 146”), “Accounting for Costs Associated with Exit or Disposal Activities,” which is effective for exit or disposal activities initiated after December 31, 2002. SFAS 146 nullifies Emerging Issues Task Force Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring).” Under SFAS 146, a liability is required to be recognized for a cost associated with an exit or disposal activity when the liability is incurred. SFAS 146 applies to costs associated with an exit activity that does not involve an entity newly acquired in a business combination or with a retirement or disposal activity covered by FASB Statements No. 143, “Accounting for Asset Retirement Obligations,” and No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets”. We believe the adoption of SFAS 146 will not have a material impact on our consolidated financial position or results of operations.

In October 2000, we received a warning letter from the FDA challenging the promotional claims that we were making for our KyphX instruments. It was the FDA’s position that our regulatory clearance for the KyphX Inflatable Bone Tamp did not permit us to promote the product for use in any specific sites in the body, or for any specific surgical procedures. The FDA also stated that we could not promote any clinical benefits of surgical procedures using our instruments until we obtained additional regulatory approvals related to the benefits. After discussions and correspondence with the FDA, we agreed to abide by these restrictions and revised our promotional campaign accordingly. Subsequently, we obtained an additional clearance to promote the KyphX Inflatable Bone Tamp specifically for use as a conventional bone tamp in the reduction of fractures and/or creation of a void in cancellous bone in the spine, hand, tibia, radius and calcaneus. Until we conduct appropriate clinical studies supporting the use of bone cement as a bone filler material for use in the spine and documenting the clinical benefits of procedures using our instruments, if any, and receive prior FDA approval, we will not be allowed to promote our instruments for any treatment benefits or promote, or train physicians in performing, specific procedures with bone cement in the spine using our instruments. If we fail to obtain these additional necessary regulatory approvals, our ability to generate revenues will be harmed.

As the FDA’s position is that we may not train physicians about specific procedures in the spine, we limit our training and education of physicians to the specialized skills involved in the proper use of our instruments. Although physicians may use our instruments with bone filler material of their choice, including bone cement, the FDA has taken the position that we cannot promote the use of bone cement, or train surgeons to use bone cement, with our instruments unless bone cement is specifically approved for use in the spine with our instruments. We instruct our trainers, both physician faculty consultants and employees, not to discuss the use of any bone filler material, including bone cement, with our instruments. However, they may respond to questions about bone cement that are raised by physician participants during a training program. Although we believe our training methods are proper, if the FDA determines that our training constitutes promotion of an unapproved use, they can request that we modify our training or subject us to regulatory enforcement actions, including the issuance of a warning letter, injunction, seizure, civil fine and criminal penalty.

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 significantly longer and can be significantly more expensive than the 510(k) clearance process. Although we have obtained 510(k) clearance for the KyphX Inflatable Bone Tamp to help repair fractures in specific sites in the spine, hand, leg, arm and heel, our 510(k) clearance can be revoked if safety or effectiveness problems develop. We also may be required to obtain 510(k) clearance or premarket approval to market additional instruments or for new indications for our KyphX instruments. Before we can market any bone cement product for use with our instruments in spine surgery, we must first obtain regulatory approval. We cannot be certain that we would obtain 510(k) clearance or premarket approval in a timely manner or at all. Delays in obtaining clearances or approvals will adversely affect our revenue and future profitability.

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, but we believe that new 510(k) clearances are not required. 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 modification 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 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 unannounced inspections. We have never been through a Quality System inspection, and we cannot assure you that we would pass. 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 a recall of our instruments, which would cause our instrument sales and business to suffer.

We have a limited operating history upon which you can evaluate our business. We commenced commercial sales of our KyphX instruments in May 2000. We have incurred losses every year since we began operations. In particular, we incurred losses of $5.2 million in 1999, $17.7 million in 2000, $17.8 million in 2001 and $4.6 million for the six months ended June 30, 2002. As of June 30, 2002, we had an accumulated deficit of approximately $49.3 million. Even if we are able to increase revenue from our instrument sales, we may have operating losses based on our plans to expand our sales force, both domestically and internationally, and devote substantial resources to our continuing research and development efforts and clinical studies. It is possible that we will never generate sufficient revenues from instrument sales to achieve profitability.

In some cases, physicians performing a procedure using our instruments have not been reimbursed. Widespread adoption of our instruments by the medical community is unlikely to occur 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 procedures performed using our KyphX instruments. 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 for the use of our products in 50 states and in the District of Columbia. Until a specific code is granted, physician reimbursement from large insurance companies and Medicare may be unavailable or difficult to obtain in some states. In addition, the absence of FDA approval specifically allowing us to promote the use of bone cement in the spine may affect the availability of reimbursement for spine surgeries in which our instruments are used. Future regulatory action by a government agency 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, if at all. If physicians 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.

Even if the use of our instruments is reimbursed by private payors and Medicare, adverse changes in payors’ policies toward reimbursement for the procedure 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. 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.

We believe that physicians will not widely adopt our instruments unless they determine, based on experience, clinical data and published peer reviewed journal articles, that the use of our KyphX instruments provides an effective alternative to conventional means of treating spine fractures. Patient studies or clinical experience may indicate that treatment with our instruments does not provide patients with sustained benefits. Further, because some of the data has been produced in studies that involve small patient groups, the data may not be reproduced in wider

patient populations. In addition, we believe that continued recommendations and support for the use of KyphX instruments by influential physicians are essential for widespread market acceptance. If our KyphX instruments do not continue to receive support from these physicians or from long-term data, surgeons may not use, and hospitals may not purchase, our instruments.

We manufacture medical devices that are used on patients in spine surgery procedures. Spine surgery involves significant risk of serious complications, including bleeding, nerve injury, paralysis and death. Consequently, companies that produce instruments for use in the spine are subject to a significant risk of product liability litigation. If our instruments are 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.

We are dependent upon outside suppliers to provide us with our KyphX Inflation Syringe, as well as other key components necessary for the manufacture of our products. Because we obtain components through purchase orders rather than long-term supply agreements and generally do not maintain large volumes of inventory, the disruption or termination of the supply of components could lead to:

Our sales force has increased from 31 employees in October 2000 to 112 employees in June 2002. The growth that we have experienced, and in the future may 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. 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.

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. Our industry also includes large pharmaceutical companies that are developing drug products that may reduce the incidence of osteoporosis 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 change and user preference 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:

We may seek additional funds from public and private stock offerings, borrowings under lease lines of credit or other sources. We cannot assure you that additional financing will be available on a timely basis on terms acceptable to us, or at all, or that any financing will not be dilutive to stockholders. If adequate funds are not available, we may have to delay development or commercialization of our instruments or license to third parties the rights to commercialize products or technologies that we would otherwise seek to commercialize for ourselves. We also may have to reduce the marketing, customer support or other resources devoted to our instruments.

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, 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 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. 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. Enforcement of our intellectual property rights to prevent or inhibit appropriation of our technology by competitors can be expensive and time-consuming to litigate or otherwise dispose of and can divert management’s attention from carrying on with our core business.

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. In addition, they may claim that their patents have priority over ours because their patents issued first. Because patent applications can take many years to issue, there may be applications now pending of which we are 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 of which we are unaware. 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, can be expensive and time-consuming to litigate or otherwise dispose of and can divert management’s attention from carrying on with 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 prohibit us from using essential technologies. 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, we may not be able to obtain a license on reasonable terms or at all.

Our officers, directors and principal stockholders together control approximately 64.8% of our outstanding common stock. 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 have the effect of delaying or preventing a change in control and might adversely affect the market price of our common stock. This concentration of ownership may not be in the best interest of our other stockholders.

Our basic corporate documents and Delaware law contain provisions that might enable our management to resist a takeover. 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.

Sales of a substantial number of shares of our common stock in the public market could significantly and negatively affect the market price for our common stock. As of June 30, 2002, we had 36,796,567 shares of common stock outstanding. The 6,900,000 shares of our common stock sold in our May 2002 initial public offering are freely tradable. The remaining 29,896,567 of these shares are subject to a lock-up agreement under which the holders of these shares have agreed not to sell or otherwise dispose of their shares of common stock until 180 days after the effective date of our May 2002 initial public offering. All of these shares will be available for sale after the expiration of the lock-up period on November 13, 2002, and approximately 23.8 million of these shares will be subject to volume restrictions because they are held by our affiliates. In addition, U.S. Bancorp Piper Jaffray Inc., the lead underwriter of our initial public offering, may waive these lock-up restrictions prior to the expiration of the lock-up period without prior notice.

We consummated the initial public offering of our common stock in May 2002. Accordingly, there has only been a public market for shares of our common stock since May 2002. An active public trading market may not develop or, if developed, may not be sustained. Further, we expect that the market price of our common stock may fluctuate substantially. The market price for the common stock may be affected by a number of factors, including:

Our exposure to interest rate risk at June 30, 2002 is related to our investment portfolio and our borrowings. Fixed rate investments and borrowings may have their fair market value adversely impacted from changes in interest rates. Floating rate investments may produce less income than expected if interest rates fall, and floating rate borrowings will lead to additional interest expense if interest rates increase. Due in part to these factors, our future investment income may fall short of expectations due to changes in U.S. interest rates.

We have operated mainly in the United States, and 94% and 99% of our sales were made in U.S. dollars in the six months ended June 30, 2002 and 2001, respectively. To date, we have not had any material exposure to foreign currency rate fluctuations. The majority of our European sales are 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 (deficit) as a component of accumulated other comprehensive income (loss).

In May 2002, we completed our initial public offering, including exercise of the underwriters’ over-allotment option, of 6,900,000 shares at an initial public offering price of $15.00 per share, for aggregate cash proceeds of approximately $103.4 million. Our managing underwriters for the offering were U.S. Bancorp Piper Jaffray Inc., Banc of America Securities LLC and Bear, Stearns & Co. Inc. In connection with the offering, we paid a total of approximately $7.2 million in underwriting discounts and commissions and $1.3 million in other offering costs and expenses. After deducting the underwriting discounts and commissions and the offering costs and expenses, our net proceeds from the offering, including the over-allotment option, were approximately $94.9 million. We are currently investing the remaining net proceeds from the offering for future use as additional working capital. Such remaining net proceeds have been invested in highly liquid instruments with an average maturity of less than 90 days.

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 auditor. 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 federal and state taxes; (2) the preparation of federal and state income tax returns; (3) quarterly reviews; and (4) 401(k) audits.

Number		Description

3.2	*	Amended and Restated Certificate of Incorporation of the Registrant.

3.4	*	Bylaws of the Registrant.

4.1	*	Specimen common stock certificate of the Registrant.

10.1	*	Form of Indemnification Agreement for directors and executive officers.

10.2	*	1996 Stock Option Plan, including form of option agreement.

10.3	*	2002 Stock Plan, including form of option agreement.

10.4	*	2002 Employee Stock Purchase Plan, including form of employee stock purchase plan subscription agreement.

10.5	*	2002 Director Option Plan, including form of option agreement.

10.8	*	Lease dated January 27, 2000 for office space located at 1350 Bordeaux Drive, Sunnyvale, CA 94089 and Second Amendment to Lease dated November 29, 2001.

10.8.1	*	Third Amendment to Lease dated March 29, 2002 for office space located at 1350 Bordeaux Drive, Sunnyvale, CA 94089.

10.9	*	Employment Agreement between the Registrant and Gary L. Grenter dated July 16, 2001.

10.10	*	Promissory Note Secured by Deed of Trust between the Registrant and Gary L. Grenter dated December 31, 2001.

10.11	*	Amended and Restated Stockholder Rights Agreement effective as of December 14, 1999, among the Registrant and certain stockholders of the Registrant.

99.1		Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

99.2		Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

Delaware		77-0366069
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

Class		Shares Outstanding at August 9, 2002
Common Stock, $0.001 par value		36,801,722

		Page
Part I: Financial Information
Item 1. Condensed Consolidated Financial Statements (unaudited):
Condensed Consolidated Statements of Operations for the Three and Six Months Ended June 30, 2002 and 2001		3
Condensed Consolidated Balance Sheets at June 30, 2002 and December 31, 2001		4
Condensed Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2002 and 2001		5
Notes to Condensed Consolidated Financial Statements		6
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		9
Item 3. Quantitative and Qualitative Disclosures About Market Risk		19
Part II: Other Information
Item 2. Changes in Securities and Use of Proceeds		20
Item 5. Other Information		20
Item 6. Exhibits and Reports on Form 8-K		20
Signature		21

	June 30,
	2002	2001
Options to purchase common stock	6,516	5,695
Common stock subject to repurchase	159	139
Convertible preferred stock	—	26,291
Warrants	99	43

	Three Months Ended June 30,				Six Months Ended June 30,
	2002		2001		2002		2001
Cost of goods sold	$	149	$	113	$	294	$	224
Research and development		513		309		905		532
Sales and marketing		547		213		1,123		385
General and administrative		415		1,642		982		1,770

	$	1,624	$	2,277	$	3,304	$	2,911

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	June 30, 2002		December 31, 2001
Raw materials	$	1,344	$	586
Work-in-process		734		431
Finished goods		2,209		1,376

	$	4,287	$	2,393

By:		/S/ GARY L. GRENTER
		Gary L. Grenter
		President, Chief Executive Officer and Director (Principal Executive Officer)

By:		/S/ JEFFREY L. KAISER
		Jeffrey L. Kaiser
		Vice President of Finance and Administration and Chief Financial Officer (Principal Accounting and Financial Officer)