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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

for the quarterly period ended June 30, 2004

or

for the transition period from                      to                      .

Commission File Number 000-49804

Kyphon Inc.

(Exact name of registrant as specified in its charter)

Delaware

(State or other jurisdiction of incorporation or organization)

77-0366069

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

1221 Crossman Avenue, Sunnyvale, California, 94089

(Address of principal executive offices, including Zip Code)

(408) 548-6500

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such requirements for the past 90 days. YES x NO ¨

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

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KYPHON INC.

FORM 10-Q

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PART I: FINANCIAL INFORMATION

ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

KYPHON INC.

CONDENSED CONSOLIDATED INCOME STATEMENTS

(in thousands, except per share amounts)

(unaudited)

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

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KYPHON INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands)

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

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KYPHON INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

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

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KYPHON INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

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

Organization

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

Basis of Presentation

The accompanying unaudited condensed consolidated financial statements have been prepared by the Company in accordance with accounting principles generally accepted in the United States of America for interim financial information and pursuant to the instructions to Form 10-Q and Article 10 of Regulation S-X of the Securities and Exchange Commission. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting only of normal recurring adjustments) considered necessary for a fair presentation have been included. The results for the six month period ended June 30, 2004 are not necessarily indicative of the results that may be expected for the year ending December 31, 2004, or for any future period. These condensed consolidated financial statements and notes should be read in conjunction with the consolidated financial statements included in the Company’s Form 10-K for the fiscal year ended December 31, 2003.

Significant Accounting Policies

The Company’s significant accounting policies are disclosed in the Company’s Form 10-K for the year ended December 31, 2003 and have not changed materially as of June 30, 2004.

NOTE 2—Accounting for Stock-Based Compensation:

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

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

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

As of June 30, 2004, the Company has recorded cumulative of $25,232,000 deferred stock-based compensation related to stock options granted to non-employees and employees. Stock-based compensation expense is being recognized on a straight-line basis over the vesting periods of the related options, generally four years. The Company recognized stock-based compensation expense as follows (in thousands):

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NOTE 3—Net Income Per Share:

Basic net income per share is computed by dividing net income by the weighted-average number of common shares outstanding for the period. Diluted net income per share is computed by giving effect to all potential dilutive common stock, including options, warrants and common stock subject to repurchase. The following table sets forth the computation of basic and diluted net income per share (in thousands, except per share amounts):

NOTE 4—Comprehensive Income:

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

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

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

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NOTE 5—Inventories:

Inventories consisted of the following (in thousands):

NOTE 6—Goodwill and Intangible Assets:

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

Intangible assets consist of patents acquired from Sanatis GmbH (“Sanatis”) in February 2003. Intangible asset amortization expense for the three months ended June 30, 2004 and 2003 was approximately $8,000 and $7,000, respectively. Amortization expense for the six months ended June 30, 2004 and 2003 was approximately $16,000 and $10,000, respectively. Based on the intangible assets held at June 30, 2004, the Company expects to recognize amortization expense of approximately $16,000 for the remaining six months of fiscal 2004, $31,800 in each of the years from 2005 to 2007, and approximately $5,000 in 2008. The amortization period for intangible assets is five years.

NOTE 7—Commitments and Contingencies:

In April 2004, the Company filed two patent infringement suits against Disc-O-Tech Medical Technologies Ltd., an Israel-based company doing business in the United States as Disc Orthopaedic Technologies Inc. (“Disc-O-Tech”). The Company filed suit in the United States District Court in Delaware and in the International Trade Commission (ITC) in Washington, D.C. The Company’s complaints alleged, among other things, that by importing and promoting its SKy Bone Expander System for use in kyphoplasty procedures, Disc-O-Tech is infringing at least four of the Company’s U.S. patents, all of which generally concern the use of various medical devices to repair spinal compression fractures. In early July, Kyphon amended its Delaware complaint to add two additional patents to the Delaware suit. In the ITC proceeding, without admitting liability, Disc-O-Tech has already agreed to entry of a Consent Order barring all further importation of its infringing products into the United States and to cease all further sales activities and uses of those products. The ITC Administrative Law Judge has recommended that the Consent Order be adopted by the full Commission, which would terminate the ITC proceeding in Kyphon’s favor. An enforcement proceeding against Disc-O-Tech in the ITC may later be initiated if it is determined that Disc-O-Tech is not complying fully with the Commission’s Order. In Delaware, which is still in its early stages, the Company has asked the United States District Court to award damages and a permanent injunction to prevent Disc-O-Tech’s further willful infringement of its six patents-in-suit. The Company intends to use all of the information discovered during the ITC proceeding about Disc-O-Tech’s business activities to prosecute its case against Disc-O-Tech in Delaware and will do so vigorously. No provision for any liability that may result upon the resolution of this matter has been made in the accompanying financial statements.

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NOTE 8—Recent Accounting Pronouncements:

In March 2004, the EITF reached a consensus on EITF No. 03-06, Participating Securities and Two-Class Method under FASB Statement No. 128, Earnings per Share. EITF No. 03-06 addresses a number of questions regarding the computation of earnings per share (EPS) by companies that have issued securities other than common stock that contractually entitle the holder to participate in dividends and earnings of the company when, and if, it declares dividends on its common stock. EITF No. 03-06 also provides further guidance in applying the two-class method of calculating EPS. EITF No. 03-06 clarifies what constitutes a participating security and how to apply the two-class method of computing EPS once it is determined that a security is participating, including how to allocate undistributed earnings to such a security. The consensus reached on EITF No. 03-06 is effective for fiscal periods beginning after March 31, 2004 and requires restatement of prior period earnings per share amounts to ensure comparability year over year. The adoption of EITF No. 03-06 did not have any impact on the Company’s results of operations or financial condition.

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

Introduction

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

Executive Summary

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

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

We moved our U.S. headquarters at the end of the first quarter of 2004 from our old location also in Sunnyvale, California to our present location. The move of our manufacturing facility was completed during the second quarter of 2004.

Effective August 11, 2004, Mr. Arthur T. Taylor will assume the role as our Vice President, & Chief Financial Officer. Mr. Taylor most recently was Chief Financial Officer for Terayon Communication Systems, Inc. of Santa Clara,

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California. As previously announced, Mr. Jeffrey L. Kaiser, who has been our Vice President, Finance & Administration & Chief Financial Officer since March 2000, will transition into the role of Executive Vice President effective August 11, 2004, primarily as a result of health issues related to chronic hip and back ailments, and will transition into a part-time role soon thereafter.

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

During the first six months of 2004, our business experienced significant growth. Net sales in the first six months of 2004 increased to $95.2 million, compared to $56.2 million in the first six months of 2003, representing growth of 69%. We trained approximately 750 physicians to use our products during the first six months of 2004 in the United States and Europe. In the U.S., we added approximately 175 new hospitals to our customer base during that same period. We continued a program whereby additional spine education specialists were hired with a primary role of educating referring physicians about surgical options to treating patients with vertebral compression fractures.

In April 2004, we received 510(k) clearance from the FDA to market KyphX HV-R Bone Cement for the fixation of osteoporosis-related pathological fractures of the vertebral body during kyphoplasty. In July 2004, we received FDA clearance to expand the Indications for Use for our bone cement to also include fixation of pathological fractures due to cancer or benign lesions during kyphoplasty, as well as specific clearance of our KyphX Inflatable Bone Tamps for fracture reduction or void creation during kyphoplasty. These clearances allow us to promote numerous short- and long-term benefits associated with kyphoplasty procedures.

In April 2004, we filed two patent infringement suits against Disc-O-Tech Medical Technologies Ltd., an Israel-based company doing business in the United States as Disc Orthopaedic Technologies Inc. (“Disc-O-Tech”). We filed suit in the United States District Court in Delaware and in the International Trade Commission (ITC) in Washington, D.C. Our complaints alleged, among other things, that by importing and promoting its SKy Bone Expander System for use in kyphoplasty procedures, Disc-O-Tech is infringing at least four of our U.S. patents, all of which generally concern the use of various medical devices to repair spinal compression fractures. In early July, we amended the Delaware complaint to add two additional patents to the Delaware suit. In the ITC proceeding, without admitting liability, Disc-O-Tech has already agreed to entry of a Consent Order barring all further importation of its infringing products into the United States and to cease all further sales activities and uses of those products. The ITC Administrative Law Judge has recommended that the Consent Order be adopted by the full Commission, which would terminate the ITC proceeding in Kyphon’s favor. An enforcement proceeding against Disc-O-Tech in the ITC may later be initiated if it is determined that Disc-O-Tech is not complying fully with the Commission’s Order. In Delaware, which is still in its early stages, we have asked the United States District Court to award damages and a permanent injunction to prevent Disc-O-Tech’s further willful infringement of our six patents-in-suit. We intend to use all of the information discovered during the ITC proceeding about Disc-O-Tech’s business activities to prosecute our case against Disc-O-Tech in Delaware and will do so vigorously. Costs related to this litigation will be dilutive to our earnings.

In addition to Disc-O-Tech, several other companies either have already introduced one or more products into the U.S. and/or foreign markets to compete with our KyphX instruments for treating vertebral fractures or may be on the verge of doing so. To the extent any such products are deemed to infringe our patents, we will consider both how best to protect our market space as well as whether to take action against any potentially infringing competitor activities. As a result, we may decide that litigation or other legal activity to seek to protect and enforce our rights, in addition to our ongoing actions against Disc-O-Tech, would be appropriate. Regardless of if we do so, however, we likely will have to compete with these competitive products for some period of time and may lose market share or have our growth impeded as a result.

We have had several recent encouraging developments related to reimbursement for our products. First, in May 2004, the Centers for Medicare and Medicaid Services (CMS) ICD-9 Coordination and Maintenance Committee issued and published a recommendation for a specific ICD-9-CM code for the kyphoplasty procedure. On August 2, 2004, this rule was approved and the kyphoplasty procedure was assigned ICD-9-CM code 81.66 to go into effect on October 1, 2004. This code was assigned to the following five Diagnosis Related Groups (DRG) codes: 233, 234, 442, 443, and 486. DRG codes establish the payment levels that hospitals can claim reimbursement from Medicare and Medicaid and are in turn, key factors in determining reimbursement levels and ultimately the quantity of products used in such procedures as kyphoplasty. At this time it is not yet clear how each of these codes will be applied, especially 442,

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443, and 486 which are new. We anticipate increased clarification as more information becomes available from CMS in the next few months.

There was also progress in surgeon reimbursement during the year. On a national level, the Healthcare Common Procedure Coding System (HCPCS) National Editorial Panel established two new HCPCS “S” codes for kyphoplasty effective January 1, 2004. These S codes are intended for use by private payors, such as the Blue Cross Blue Shield Association and the Health Insurance Association of America, although no payment level is associated with these codes. In addition, policy and/or bulletin coverage is now established in 40 states, with the remaining states providing coverage on a case-by-case basis. The private payor community has also shown significant interest in establishing reimbursement policies for kyphoplasty. Specifically, Blue Cross Blue Shield has now adopted policy coverage for kyphoplasty in 24 states, and a number of private payors nationwide have also adopted policy coverage. However, there are some private payors that may continue to perceive the procedure which uses our products as experimental and thus not subject to reimbursement. Another challenge we face is to achieve consistent and/or increased payment levels among the different insurers. We continue to focus on addressing these issues.

No national current procedural terminology (CPT) code exists for surgeon reimbursement for performing kyphoplasty, and may not exist for some time. Were a CPT code to be issued for surgeon reimbursement for performing kyphoplasty, we do not know at this time how any such code would affect our business.

In Europe, kyphoplasty was assigned a code in the newly implemented German DRG system. In other European countries, we continue to focus efforts on obtaining reimbursement coverage for the procedure, however, no assurances can be provided that such efforts will result in a favorable outcome for the company.

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

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

Results of Operations

Three Months Ended June 30, 2004 and June 30, 2003

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

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Net Sales. Net sales increased $19.7 million, or 63%, for the three months ended June 30, 2004 as compared to the same period in 2003. The increase in net sales resulted from an increase in the number of trained physicians as well as an increase in the number of procedures performed by these trained physicians. The increase in international sales also reflected the favorable currency impact of $324,000 in the three months ended June 30, 2004 as the Euro exchange rate strengthened against the U.S. dollar. No customer accounted for more than 10% of total net sales for the three months ended June 30, 2004 and 2003. As of June 30, 2004, we had trained approximately 3,300 surgeons in the U.S. and approximately 1,400 surgeons in Europe. We believe the total number of potential physicians who can be trained for the use of our products is approximately 5,000 to 5,500 in the U.S. The number of trainable physicians in Europe is less well defined at this time, but we believe it to be more than 3,000.

Cost of Goods Sold. Cost of goods sold consists of material, labor, subcontract, and overhead costs. Cost of goods sold increased $2.1 million, or 52%, for the three months ended June 30, 2004 as compared to the same period in 2003. However, cost of goods sold as a percentage of net sales continue to decrease primarily as a result of fixed overhead costs being spread over increased production volume. The absolute increase in cost of goods sold resulted primarily from increased material, labor, subcontract, and overhead costs in relation to the increased sales volume of our products. Our cost of goods sold and corresponding gross profit percentages can be expected to fluctuate in future periods depending upon changes in our product sales mix and prices, distribution channels and geographies, manufacturing yields, period expenses and levels of production volume.

Research and Development. Research and development expenses consist of costs of product research, product development, regulatory and clinical functions and personnel. Research and development expenses increased $786,000, or 19%, for the three months ended June 30, 2004 as compared to the same period in 2003. The increase was primarily attributable to increased personnel costs of $664,000, and increased clinical expense of $258,000, offset partially by decreased deferred stock-based compensation of $366,000. We expect to continue to make substantial investments in research and development and anticipate that research and development expenses for the rest of 2004 will increase in absolute dollars. As a percentage of net sales, we anticipate our research and development expenses to be in the range of 10% to 11% for 2004.

Sales and Marketing. Sales and marketing expenses consist of costs for personnel, physician training programs and marketing activities. Sales and marketing expenses increased $8.7 million, or 53%, for the three months ended June 30, 2004 as compared to the same period in 2003. The increase resulted primarily to increased costs of hiring, training and compensating additional direct selling representatives of $6.2 million and increased sales travel expenses of $1.1 million. As we continue to commercialize our KyphX instruments during 2004, we expect to significantly increase our

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sales and marketing efforts and expenditures in absolute dollars while maintaining our sales and marketing expenses as a percentage of net sales to between 49% to 50% for the year.

General and Administrative. General and administrative expenses consist of personnel costs, professional service fees, expenses related to intellectual property rights and general corporate expenses. General and administrative expenses increased $3.0 million, or 77%, for the three months ended June 30, 2004 as compared to the same period in 2003. The increase resulted primarily from increased legal litigation fees, and increased legal and accounting consulting fees of $1.2 million, and increased personnel costs of $1.1 million. We expect general and administrative expenses to increase in the future as we add personnel, continue to expand our patent portfolio, incur litigation fees, and incur public reporting, governmental compliance and investor-related expenses as a public company. In addition, we anticipate legal expenses of $4.0 to $4.5 million related to our litigation with Disc-O-Tech during 2004. We expect that our general and administrative expenses will increase in absolute dollars as we expand our infrastructure and incur litigation costs. As a percentage of net sales, we expect that our general and administrative expenses will range between 13% and 14% during 2004.

Other and Interest Income, Net. Other and interest income, net, increased $14,000 for the three months ended June 30, 2004 as compared to the same period in 2003. The increase resulted primarily from decreased losses on disposal of property and equipment.

Provision for Income Taxes. Provision for income taxes was $3.2 million for the three months ended June 30, 2004 as compared to no provision for income taxes in the same period in 2003. We recorded a $200,000 tax liability, net, for the three months ended June 30, 2004. We believe that in 2004 our effective tax rate will be approximately 40%, even though the actual amount of taxes paid may be reduced by net operating loss and research and development tax credit carryforwards as well as deductions due to stock option activities. Our income taxes currently payable for federal and state purposes have been reduced primarily by the tax benefits from employee stock option transactions. We incurred no tax liability for the three months ended June 30, 2003 as a result of using net operating losses carried forward from 2002. We also recorded no provision for income taxes for this period as a result of utilizing deferred tax assets that were reserved by a full valuation allowance.

Six Months Ended June 30, 2004 and June 30, 2003

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

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Net Sales. Net sales increased $39.0 million, or 69%, for the six months ended June 30, 2004 as compared to the same period in 2003. The increase in international sales also reflected the favorable currency impact of $854,000 in the six months ended June 30, 2004 as the Euro exchange rate strengthened against the U.S. dollar. 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. No customer accounted for more than 10% of total net sales for the six months ended June 30, 2004 and 2003.

Cost of Goods Sold. Cost of goods sold increased $3.6 million, or 50%, for the six months ended June 30, 2004 as compared to the same period in 2003. The increase in the cost of goods sold resulted primarily from increased material, labor, and overhead costs associated with increased sales volume of our products. However, cost of goods sold as a percentage of net sales continue to decrease primarily as a result of fixed overhead costs being spread over increased production volume.

Research and Development. Research and development expenses increased $2.3 million, or 33%, for the six months ended June 30, 2004 as compared to the same period in 2003. The increase primarily resulted from increased personnel costs of $1.5 million, increased clinical expense of $357,000 and increased travel expense of $323,000, offset partially by decreased deferred stock-based compensation expense of $512,000.

Sales and Marketing. Sales and marketing expenses increased $16.3 million, or 52%, for the six months ended June 30, 2004 as compared to the same period in 2003. The increase resulted primarily from increased costs of hiring, training and compensating additional direct selling representatives of $11.7 million, increased travel expenses of $2.0 million and increased advertising, promotion and trade show expenses of $965,000.

General and Administrative. General and administrative expenses increased $4.8 million, or 65%, for the six months ended June 30, 2004 as compared to the same period in 2003. The increase resulted primarily from increased personnel costs of $1.8 million, increased litigation fees, and increased legal and accounting consulting fees of $1.6 million.

Purchased In-Process Research and Development. In February 2003, we acquired Sanatis, a privately-held developer and manufacturer of orthopedic biomaterials based in Rosbach, Germany. An independent appraisal was performed to determine the fair value of identified intangible assets and the allocation of the purchase price. The total cost of the acquisition was $4.7 million including assumed liabilities and acquisition costs, $636,000 of which was

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immediately expensed to purchased in-process research and development for the six months ended June 30, 2003. It was immediately expensed to operations as the technology acquired was not considered to have reached technological feasibility and it has no alternative future use.

Other and Interest Income, Net. Other and interest income, net, decreased $34,000 for the six months ended June 30, 2004 as compared to the same period in 2003. The decrease resulted primarily from lower interest income due to lower interest rates.

Provision for Income Taxes. Provision for income taxes was $6.4 million for the six months ended June 30, 2004 as compared to no provision for income taxes in the same period in 2003. We recorded a $400,000 tax liability, net, for the six months ended June 30, 2004. Our income taxes currently payable for federal and state purposes have been reduced primarily by the tax benefits from employee stock option transactions. We incurred no tax liability for the six months ended June 30, 2003 as a result of using net operating losses carried forward from 2002. We also recorded no provision for income taxes for this period as a result of utilizing deferred tax assets that were reserved by a full valuation allowance.

Deferred Stock-Based Compensation

We recorded deferred stock-based compensation for financial reporting purposes as the difference between the exercise price of options granted to employees and the deemed fair value of our common stock at the time of grant. Deferred stock-based compensation is amortized to cost of goods sold, research and development expense, sales and marketing expense and general and administrative expense. Deferred stock-based compensation recorded through June 30, 2004 was $18.6 million, with accumulated amortization of $15.1 million. The remaining $3.5 million will be amortized over the vesting periods of the options, generally four years from the date of grant. All option amounts are being amortized using a straight-line method. We expect to record amortization expense for deferred stock-based compensation as follows:

Stock-based compensation expense related to stock options granted to non-employees is recognized as the stock options are earned. The stock-based compensation expense will fluctuate as the fair market value of our common stock fluctuates. In connection with the grant of stock options to non-employees, we recorded deferred stock-based compensation of $6.6 million through June 30, 2004, of which $6.1 million has been amortized to expense as of June 30, 2004.

Liquidity and Capital Resources

In May 2002, we received net proceeds of $94.9 million from our initial public offering of common stock. From inception through June 2001, we raised $38.0 million through private sales of redeemable convertible preferred stock. As of June 30, 2004, we had $72.6 million of cash and cash equivalents, $25.9 million of investments (short and long-term), and working capital of $116.3 million.

Cash Provided by Operations. Our operating cash flow in the first six months of 2004 was primarily the result of our operational profitability. Specifically, net cash provided by operations was $14.4 million for the six months ended June 30, 2004 attributable primarily to net income of $9.5 million, adjustments for non-cash charges related to deferred taxes including tax benefit from stock options of $5.5 million, amortization of deferred stock-based compensation of $2.4 million, and increases in accrued liabilities of $5.7 million, offset partially by the increases in accounts receivable of $7.7 million and inventories of $2.1 million. Our accrued liabilities, accounts receivables and inventories have increased as we increased our sales and operating expenses during 2004. Our net cash flow from operations in the first six months of 2003 was primarily the result of our operational profitability. Specifically, net cash provided by operations was $2.6 million for the six months ended June 30, 2003 attributable primarily to net income of $3.4 million, adjustments for non-cash charges related to amortization of deferred stock-based compensation of $2.9 million, and increases in accounts payable of $1.1 million as we increased our operating expenses, offset partially by the increases in accounts receivable of $4.4 million and inventories of $1.6 million as we increased our sales.

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Cash Used in Investing Activities. Net cash used in investing activities was $3.1 million for the six months ended June 30, 2004 and primarily reflected purchases of property and equipment of $4.4 million due to the outfitting of our new Sunnyvale facility. Net cash used in investing activities was $10.7 million for the six months ended June 30, 2003 and primarily reflected the payment of $4.7 million in connection with the Sanatis acquisition and $4.2 million in net purchases of investments.

Cash Provided by Financing Activities. Net cash provided by financing activities was $4.0 million during the six months ended June 30, 2004 and was attributable to proceeds from the exercise of stock options of $2.5 million and issuance of common stock under the employee stock purchase plan of $1.4 million. Net cash provided by financing activities was $1.6 million during the six months ended June 30, 2003 and was attributable to proceeds from the exercise of stock options of $866,000 and issuance of common stock under the employee stock purchase plan of $722,000.

Contractual Cash Obligations. At June 30, 2004 we had contractual cash obligations as follows (in thousands):

The amounts reflected in the table above for operating leases represent aggregate future minimum lease payments under non-cancellable facility leases. Portions of these payments are denominated in foreign currencies and were translated in the tables above based on their respective U.S. dollar exchange rates at June 30, 2004. These future payments are subject to foreign currency exchange rate risk.

Purchase orders or contracts for the purchase of raw materials and other goods and services are not included in the table above. We are not able to determine the aggregate amount of such purchase orders that represent contractual obligations, as purchase orders may represent authorizations to purchase rather than binding agreements. Although we also entered into contracts for outsourced services, the obligations under these contracts were not significant and the contracts generally contain clauses allowing for cancellation without significant penalty.

Off-Balance-Sheet Arrangements.As of June 30, 2004, we did not have any significant off-balance-sheet arrangements, as defined in Item 303(a)(4)(ii) of SEC Regulation S-K.

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

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

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

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Recent Accounting Pronouncements

In March 2004, the Emerging Issues Task Force (EITF) reached a consensus on EITF No. 03-06, Participating Securities and Two-Class Method under FASB Statement No. 128, Earnings per Share. EITF No. 03-06 addresses a number of questions regarding the computation of earnings per share (EPS) by companies that have issued securities other than common stock that contractually entitle the holder to participate in dividends and earnings of the company when, and if, it declares dividends on its common stock. EITF No. 03-06 also provides further guidance in applying the two-class method of calculating EPS. EITF No. 03-06 clarifies what constitutes a participating security and how to apply the two-class method of computing EPS once it is determined that a security is participating, including how to allocate undistributed earnings to such a security. The consensus reached on EITF No. 03-06 is effective for fiscal periods beginning after March 31, 2004 and requires restatement of prior period earnings per share amounts to ensure comparability year over year. The adoption of EITF No. 03-06 did not have any impact on our results of operations or financial condition.

Factors Affecting Future Operating Results

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

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