UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

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FORM 10-K

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[X]   ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
     SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2006 or

[    ]   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
     SECURITIES EXCHANGE ACT OF 1934

Commission file number    000-49804

Kyphon Inc.



|Delaware                 | 77-0366069                             
|------------------------ | ---------------------------------------
|(State of incorporation) | (I.R.S. Employer Identification Number)

1221 Crossman Avenue
Sunnyvale, California      94089

(408) 548-6500

Securities registered pursuant to Section 12(b) of the Act:



|Title of each class: Common Stock, $0.001 par value | Name of each exchange on which registered: The NASDAQ Stock Market LLC
|--------------------------------------------------- | ----------------------------------------------------------------------

Securities registered pursuant to Section 12(g) of the Act:
                  Not applicable

Indicate by check mark if the
registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
    Yes  
x    No

Indicate by check mark if the
registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.
    Yes  
 ̈    No

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

Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K, or any amendment to
this Form 10-K.

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer.
See definistion of "accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange Act).
    Large accelerated filer  
x

Indicate by check mark whether the registrant is a shell company (as
defined in Rule 12b-2 of the Exchange Act).
    Yes  
 ̈    No

The aggregate market value of the voting stock held by non-affiliates of the
registrant, based upon the closing sale price of the common stock on June 30,
2006 (which is the last business day of registrant's most recently completed
second fiscal quarter), as reported on the NASDAQ Stock Market was
approximately $983.3 million.  Shares of common stock held by each executive
officer and director and by each person who owns 5% or more of the outstanding
common stock have been excluded in that such persons may be deemed affiliates.
This determination of affiliate status is not necessarily a conclusive
determination for other purposes.

At February 15, 2007, the registrant had 45,362,409 shares of common stock outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Items 10, 11, 12, 13 and 14 of Part III of this Form 10-K incorporate
information by reference from the registrant's definitive proxy statement to be
filed with the Securities and Exchange Commission within 120 days after the
close of the fiscal year covered by this annual report.




KYPHON INC.

                        FISCAL YEAR 2006 ANNUAL REPORT ON FORM 10-K
                               TABLE OF CONTENTS



|Part I.    |                                                                                                              | Page
|---------- | ------------------------------------------------------------------------------------------------------------ | ----
|Item 1.    | Business                                                                                                     | 4   
|Item 1A.   | Risk Factors                                                                                                 | 37  
|Item 1B.   | Unresolved Staff Comments                                                                                    | 52  
|Item 2.    | Properties                                                                                                   | 52  
|Item 3.    | Legal Proceedings                                                                                            | 52  
|Item 4.    | Submission of Matters to a Vote of Security Holders                                                          | 54  
|Part II.   |                                                                                                              |     
|Item 5.    | Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities | 55  
|Item 6.    | Selected Financial Data                                                                                      | 56  
|Item 7.    | Management's Discussion and Analysis of Financial Condition and Results of Operations                        | 57  
|Item 7A.   | Quantitative and Qualitative Disclosures about Market Risk                                                   | 74  
|Item 8.    | Financial Statements and Supplementary Data                                                                  | 75  
|Item 9.    | Changes in and Disagreements with Accountants on Accounting and Financial Disclosure                         | 106 
|Item 9A.   | Controls and Procedures                                                                                      | 106 
|Item 9B.   | Other Information                                                                                            | 106 
|Part III.  |                                                                                                              |     
|Item 10.   | Directors; Executive Officers and Corporate Governance                                                       | 106 
|Item 11.   | Executive Compensation                                                                                       | 106 
|Item 12.   | Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters               | 106 
|Item 13.   | Certain Relationships and Related Transactions and Director Independence                                     | 106 
|Item 14.   | Principal Accountant Fees and Services                                                                       | 107 
|Part IV.   |                                                                                                              |     
|Item 15.   | Exhibits and Financial Statement Schedules                                                                   | 108 
|Signatures |                                                                                                              | 111 

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PART 1

This Annual Report on Form 10-K contains forward-looking statements within
the meaning of the federal securities laws.  These statements include, but are
not limited to, those concerning our intentions, beliefs and expectations
regarding our future growth, levels of expenses and operating results;
developments in Medicare and third-party payor coverage and reimbursement of our
products; the timing and success of our clinical trials and regulatory
submissions; our belief that our cash and cash equivalents will be sufficient to
satisfy our anticipated cash requirements; our expectations regarding our
revenues and customers; our distributors and territorial expansion efforts; our
planned or proposed acquisitions of technologies or businesses; and our plans to
pursue research, development and commercialization of additional spine products
developed internally or arising from acquisitions.  These statements are subject
to risks and uncertainties that could cause actual results and events to differ
materially from those expressed or implied by such forward-looking statements.
For a detailed discussion of these risks and uncertainties, see the "Risk
Factors" section in Item 1A of this Form 10-K.  We caution the reader not
to place undue reliance on these forward-looking statements, which reflect
management's analysis only as of the date of this Form 10-K.  We undertake no
obligation to update forward-looking statements to reflect events or
circumstances occurring after the date of this Form 10-K.

ITEM 1.	  BUSINESS

Overview

Kyphon Inc., a Delaware corporation founded in 1994 and
headquartered in Sunnyvale, California, is a global medical device company
specializing in the design, manufacture and marketing of medical devices to
treat and restore spinal anatomy and diagnose the source of low back pain using
minimally invasive technology.

With the acquisition of InnoSpine, Inc. in early 2006, and St. Francis
Medical Technologies, Inc. in early 2007, and the proposed acquisitions of
certain assets of Disc-O-Tech Medical Technologies, Ltd. and its U.S. subsidiary
(which we refer to as Disc-O-Tech) (assuming we obtain regulatory approval and
we complete the acquisitions), we will have three product platforms:  Spinal
Fracture Management and Repair, Disc Disease Diagnosis and Therapies and Spinal
Motion Preservation.  All three product families will be sold and supported
through our existing sales organizations in North America and Europe, in
addition to distributors in selected areas outside the U.S.

We define these three product platforms as follows:

- Spinal Fracture Management and Repair

- Disc Disease Diagnosis and Therapies

- Spinal Motion Preservation

As of December 31, 2006, we believe we have trained approximately 10,400
physicians in North America, Europe and Asia-Pacific on the balloon kyphoplasty
technique, and these physicians had used our instruments to treat approximately
285,000 patients and 335,000 spinal fractures.  To support these physicians, we
have built a large and growing worldwide direct sales organization that numbered
approximately 480 field-based sales professionals as of December 31, 2006.
Balloon kyphoplasty treatment of spinal compression fractures has been shown to
result in significant patient benefits, including reduction of spinal deformity,
increased mobility and improved quality of life.  The risks of procedures using
our instruments include the same risks common to performing surgery using
anaesthesia and to performing surgery on older patients.  In addition, like
other spine surgeries, procedures using our instruments may result in serious
complications, including embolization, cardiac arrest, cerebrovascular accident,
myocardial infraction, nerve injury, paralysis and death.  However, balloon
kyphoplasty has been demonstrated to have a low complication rate.

In February 2003, we acquired Sanatis GmbH, a privately held developer and
manufacturer of orthopaedic biomaterials based in Rosbach, Germany.  This
acquisition provided us with a core competency in biomaterials and represented a
strategic response to surgeons' expressed desire to use materials that resorb or
remodel into bone in traumatic fracture patients rather than using more
traditional bone filler materials.  We obtained a CE Mark (a mark that allows us
to market a product throughout the European Union) for our first product from
the acquisition of Sanatis, our KyphOsTM calcium phosphate cement,
in December 2003, and we are now authorized to sell this material in Europe.

In January 2006, we acquired InnoSpine, Inc., or InnoSpine, a company focused
on developing and marketing its proprietary technology platform for the
diagnosis and potential treatment of axial low back pain due to disc
degeneration.  InnoSpine's initial technology, which was cleared for marketing
by the Food and Drug Administration (FDA) in April 2005, was developed with the
aim of improving the results available from existing discography techniques
through a novel diagnostic method known as the Functional Anaesthetic
DiscographyTM (F.A.D.) procedure, which involves a single-use
disposable device with no capital equipment requirements.  In contrast to
traditional provocative discography which relies on delivery of fluid under
pressure to provoke pain in a disc while the patient is prone, the F.A.D.
procedure is a unique, minimally invasive procedure that utilizes a
catheter-based system anchored in the disc space to deliver mild anaesthetic to a
candidate disc while the patient loads his or her spine in positions that cause
pain.  If the pain sensations from normal loading are relieved by anaesthetic
delivery to the degenerated disc, then the disc can be identified for further
treatment.  We began a limited commercial launch in the U.S. of our
DiscyphorTM system for practicing the F.A.D. procedure in the third
quarter of 2006.

In January 2007, we acquired St. Francis Medical Technologies, Inc., or St.
Francis, a company that manufactures the X-STOP Interspinous Process
Decompression (IPD®) System, the first FDA-approved interspinous
process device for treating lumbar spinal stenosis (LSS), for $525.0 million in
cash, plus additional revenue-based contingent payments of up to $200.0 million
payable in either cash or a combination of cash and stock, at our election in
2008.  The X-STOP IPD System received a CE mark in Europe in 2001 and has
been commercially available since December 2002.  We closed our acquisition of
St. Francis in January 2007.  The X-STOP technology is complementary to
our own extension limiting technology for the treatment of LSS, our
next-generation, percutaneous Aperius PercLID device, which we commercially launched
in a very limited manner in late 2006 in Europe, for the purpose of conducting
physician preference testing.

In December 2006, we agreed to acquire the non-vertebroplasty, spine-related
product assets and associated intellectual property rights of Disc-O-Tech
Medical Technologies, Ltd., a privately held Israeli company, and its U.S.
subsidiary (which we refer to together as Disc-O-Tech), and made cash payments
of $100.0 million as purchase consideration.  We also agreed to acquire all of
Disc-O-Tech's vertebroplasty assets and related intellectual property rights for
a total of another $120.0 million, payable in three equal annual installments
beginning January 2008.  An additional $20.0 million in
contingent payments, plus royalties, may also be paid based on the development
of further technologies following closing of the second agreement.  Completion
of the transactions is subject to various conditions, including the expiration
or termination of the waiting period under the Hart-Scott-Rodino Antitrust
Improvements Act of 1976, or HSR Act.  The Federal Trade Commission has
issued second requests for information with respect to its review of our
acquisition of the non-vertebroplasty assets and our acquisition of the
vertebroplasty assets.  The purchase price under both agreements is payable even
if regulatory approvals are delayed or not obtained.  There can be no assurance
that the Federal Trade Commission will not block our purchase of all or any of
the assets under either purchase agreement, or that we will otherwise complete
all or part of the acquisitions.  We may have to divest or license to
third parties some or all of the assets proposed to be acquired, which may be detrimental
to our business and our ability to recoup our material investment in the assets
subject to this agreement.

Completion of the non-vertebroplasty transaction, if and when that occurs,
will enable us to further broaden our focus in minimally invasive spine by
adding the B-TwinTM Expandable Spinal System technology for minimally
invasive fusion in patients with degenerative disc disease in the lumbar and
cervical spine.  This technology is CE marked and available in Europe, but not
presently available in the United States.  Back pain affects four out of five
persons in the United States at some point in their lives, with more than
150,000 lumbar and nearly 200,000 cervical spinal fusions performed each year to
treat common spinal conditions such as degenerative disc disease and

We intend to pursue the research, development and commercialization of spine
products arising from these acquisitions, and we may also choose to do so based
on our licenses to various portfolios of patents we have acquired, including
from Bonutti Research in August 2002, Dr. J. Lee Berger in April 2005, and Dr.
Harvinder Sandhu in November 2005, as well as other product initiatives, to
complement our existing KyphX and Discyphor instruments and to
leverage our experienced sales force and expertise in spinal fracture
treatments.  The full commercialization of products from these acquisitions will
require additional research, development, and regulatory approvals and/or
clearances, and may require clinical studies prior to market launch in the U.S.
and/or abroad.  In addition, we may pursue additional acquisitions, including
acquisitions of non-spinal fracture treatment technologies or biologics as well
as technologies having application elsewhere in the spine, as appropriate and
consistent with our long-term vision for Kyphon.

Spinal Fracture Management and Repair

Anatomy and Prevalence of Vertebral Compression Fractures

The spinal column contains 24 bones called vertebrae.  Each vertebra
consists of a large block of bone, called the vertebral body, which helps
maintain upright posture.  The vertebral body consists of soft inner, or
cancellous, bone surrounded by a thin outer shell of hard, or cortical, bone.
The soft tissue between each vertebral body is generally referred to as the
intervertebral (spinal) disc.  Each vertebra also has bone segments that extend
out from the vertebral body, called the posterior elements, which surround and
protect the spinal cord.  Balloon kyphoplasty and vertebroplasty treat
compression fractures of the vertebral body, known as vertebral compression
fractures.

We believe there are approximately 700,000 clinically-diagnosed vertebral
compression fractures in approximately 550,000 patients each year due to
osteoporosis in North America, Europe and Japan.  Osteoporosis is a disease that
primarily affects women and men over the age of 50, and is characterized by bone
deterioration that leads to an increased susceptibility to such fractures.
These fractures can result in significant pain, reduced physical function and
diminished quality of life.  They can also result in a forward curvature of the
spine, kyphosis, which can decrease lung function and is associated with an
increased risk of death.  We also estimate that each year in North America,
Europe and Japan, 150,000 fractures occur in 50,000 cancer patients due to the
cancer or its treatments, also with debilitating consequences.  Multiple
myeloma, a cancer of blood cells that affects bone, and the spread of various
cancers into bone, are the most common causes of spinal fracture due to cancer.
Additionally, we estimate that there are 100,000 patients per year in North
America, Europe and Japan that suffer traumatic vertebral compression fractures
which may be treatable with minimally invasive techniques similar to the
treatments for fractures caused by osteoporosis and cancer.

Consequences of Vertebral Compression Fractures

When the spine is structurally weakened, routine downward pressure can cause
a vertebral body to collapse and fracture.  These fractures are referred to as
vertebral compression fractures.  Fractures of the vertebral body, located at
the front of the spinal column, can cause the spine to tilt forward.  Over time,
these fractures can result in a curved deformity of the spine and a
forward-stooped posture called kyphosis. Vertebral compression fractures are caused
primarily by deterioration of the inner cancellous bone due to osteoporosis.
Other causes of spinal fractures include trauma, cancerous and benign tumors and
infection.

Unrepaired spinal fractures can result in serious physical and emotional
consequences, including:

- Increased Risk of Mortality

- Acute and Chronic Pain

- Health Effects Resulting from Organ Compression

- Functional Limitation

- Increased Risk of Additional Fractures

- Emotional Effects.  Studies have demonstrated that the physical
deformity caused by spinal fractures, and the resulting fear of falling, can
create patient anxiety and clinical depression, leading to a reduction in normal
daily and social activities.

Alternative Treatments of Spinal Fractures

When treating a patient with a spinal fracture, an orthopaedic surgeon's
primary objective, as with any fracture, is to reduce the fracture, that is, to
return the bone toward its pre-fracture position.  While surgeons can use
conventional orthopaedic surgical techniques to reduce and otherwise repair
spinal fractures, such as traumatic fractures in younger patients, these
procedures are highly invasive and especially risky for elderly patients.  As a
result, before the development of less invasive alternatives, physicians rarely
referred their patients with osteoporosis and cancer for surgical procedures to
repair spinal fractures, but instead prescribed therapies and treatments
designed to simply manage the pain.

Patients suffering from spinal fractures caused by osteoporosis are subject
to heightened risks during the performance of traditional spine surgery due to
their advanced age and poor bone quality.  Similar to patients with fractures
due to osteoporosis, patients with fractures due to cancer are often poor
surgical candidates and have been typically treated with pain management
regimens only.  Of the patients in our addressable traumatic fracture market, we
believe that some are treated surgically today using more invasive open fracture
reduction techniques and others are treated conservatively with non-surgical
interventions.

The primary alternative treatment methods for vertebral compression fractures
are as follows:

Non-Surgical Management.  Due to the limitations of conventional
surgery for patients with spinal fractures, the majority of these patients are
treated with conservative physical rehabilitation and pain management therapies.
These methods do not involve surgical intervention and do not repair the
fractured spine.  These conservative therapies can comprise many techniques,
alone or in combination, including:

- bed rest, in the hospital or at home;
- prescription and over-the-counter pain medication;
- back braces;
- home healthcare;
- physical therapy;
- exercise;
- chiropractic care; and
- radiation in cancer patients.

Pain Management Therapies.  These therapies are designed to provide
pain relief while the fractured vertebra slowly sets in its collapsed position.
Treatment periods can be lengthy, resulting in expensive hospital stays and
follow-up care.  These therapies can also worsen the underlying problem.  For
example, bed rest is known to cause bone and muscle loss, making recovery more
difficult in elderly patients, and potentially leading to additional fractures.
In addition, doctors report that patient compliance with these therapies is low
because of the:

- prolonged nature of treatment;
- patients' reluctance to wear back braces;
- difficulty and pain associated with exercise and physical therapy; and
- inadequate pain reduction.

Vertebroplasty.  Alternatively, physicians may opt to stabilize the
fractured area with a treatment that has become known as vertebroplasty.
Vertebroplasty does not restore the spinal anatomy, but is aimed simply at
reducing the pain associated with the fracture.  Because vertebroplasty freezes
the vertebral body in its collapsed position, patients may continue to suffer
the physical, emotional and quality of life problems associated with the
unrepaired spinal fractures.

Conventional Spine Surgery.  Spine surgery is complex and risky given
the proximity of the surgical site to the spinal cord and major organs.
Conventional spine surgery can repair fractured vertebrae and restore height,
but is highly invasive and involves significant risks.  These surgeries involve
making long incisions in the patient's chest or back so that stainless steel
instruments can move the fractured bones back into their normal position.
However, the instruments used in these surgeries are not optimally designed to
manipulate deteriorated osteoporotic bone.  The fractured bones are then held in
place by metal implants, which, in the case of elderly patients with
osteoporosis, can fail to hold due to the softness of the inner cancellous bone
to which they are attached.  As a result, this surgery is performed in very
limited circumstances to treat osteoporosis-related vertebral compression
fractures.  The invasiveness of conventional spine surgery may lead to death,
additional spinal cord injury, extensive post-operative hospital stays and
prolonged bed rest for recovery.  Additional complications may include bowel,
lung and nerve damage, pain, embolization, infection and blood clots.  Due to
these risks, among others, conventional spine surgery is rarely performed to
treat osteoporosis and cancer-related fractures, and is used to treat only a
portion of the trauma-related fractures.

The Kyphon Solution for Treatment of Vertebral Compression Fractures

Kyphon provides surgeons with procedural solutions for repairing fractures
during minimally invasive spine surgery known as balloon kyphoplasty.  Our
instruments have also been used in open surgical procedures.  We generally refer
to our instruments as the KyphX instruments.

Minimally invasive spinal fracture surgeries using our KyphX
instruments typically involve the insertion of two of our disposable proprietary
balloon devices into the fractured bone.  The spine specialist inflates our
balloons to compact and move the deteriorated bone.  As a result of the
inflation of the balloons, some or all of the collapse caused by the fracture
may be reversed.  This reversal can be more difficult if the bone has already
begun healing in its fractured position.  However, we have also developed
products that facilitate treatment of chronic fractures that may have partially
healed.  After the bone has been moved, the balloons are removed, and the
newly-created cavities are stabilized by filling them with the spine specialist's
choice of bone filler material, typically a relatively viscous, plastic polymer
bone cement that is introduced under low pressure and then hardens in place.  We
sell a proprietary bone cement known as KyphX® HV-RTM
bone cement for this purpose, which is both CE-Marked in Europe and cleared by
the FDA in the U.S. for balloon kyphoplasty.

We have trained approximately 10,400 physicians, including 4,400 overseas in
the use of our KyphX instruments.  We believe these physicians have used
our instruments to treat approximately 285,000 patients and 335,000 spinal
fractures worldwide.

Balloon kyphoplasty has been reported to result in significant improved
patient outcomes, including:

- vertebral body height restoration;
- angular deformity correction;
- vertebral body volume increase;
- significant reduction in back pain;
- significant reduction in the number of days per month that the patient
remains in bed;
- significant improvement in the patient's quality of life;
- significant improvement in the patient's ability to perform the activities
of daily living;
- high rates of patient satisfaction with the procedure;
- significant improvement in pain and mobility; and
- a low complication rate.

Currently, our FDA clearance permits us to promote in the United States our
line of KyphX® Inflatable Bone Tamps, devices used to move and
compact bone, for use as conventional bone tamps for the reduction of fractures
and/or the creation of a void in cancellous bone in the spine (including use
during balloon kyphoplasty with KyphX HV-R bone cement), hand,
tibia (a leg bone), radius (an arm bone) and calcaneus (the heel bone).

KyphX HV-Rbone cement is indicated for the treatment of
pathological fractures of the vertebral body due to osteoporosis, cancer, or
benign lesions using a balloon kyphoplasty procedure.  Cancer includes multiple
myeloma and metastatic lesions, including those arising from breast or lung
cancer, or lymphoma.  Benign lesions include hemangioma and giant cell
tumor.

Recently, we concluded an extensive review of the published clinical
literature describing the results for 1,947 patients treated with balloon
kyphoplasty and 6,808 patients treated with vertebroplasty.  The data in the
published literature demonstrate that balloon kyphoplasty is associated with a
statistically significantly lower procedure-related complication rate and a
statistically significantly lower procedure-related bone cement complication
rate, as compared to vertebroplasty, although bone cement leakage may still
occur with balloon kyphoplasty.  As a result, we have now introduced the
corresponding comparative claims into our educational and marketing
materials.

Our Products and Their Use During Minimally Invasive Balloon
Kyphoplasty Spine Fracture Procedures

Spinal fracture procedures using our KyphX instruments are minimally
invasive and are generally performed by spine-focused orthopaedic surgeons and
neurosurgeons, as well as interventional radiologists and interventional
neuroradiologists.  A spine specialist first creates a working channel through
the patient's back into the fractured vertebral body using one of our
KyphX Bone Access Systems.

The physician then inserts one of our proprietary disposable KyphX
Inflatable Bone Tamps into the fractured bone and carefully inflates it with
fluid using X-ray images to monitor the procedure.  The surgeon most often
chooses to create a second access channel into the same vertebra being treated
and inserts a second balloon into the other side of the vertebra.  Surgeons can
control inflation volume and pressure using our KyphX Inflation Syringe.
Inflation of the balloons compacts the soft inner bone creating a cavity inside.
When possible, this inflation also pushes the hard outer bone up toward its
natural position, reducing the fracture.

The KyphX Inflatable Bone Tamps are then removed, and the surgeon
chooses a bone filler material to insert into the void, typically our
proprietary KyphX HV-R Bone Cement.  Using the KyphX Bone Filler
Device, the surgeon delivers the chosen bone filler material into the void under
manual control and low pressure in an attempt to minimize the risk of leakage of
the bone filler material into the spinal canal or the surrounding tissue.

Once the procedure is complete, the incisions are closed, typically with a
small number of stitches.  These procedures are usually performed in the
operating room, but may also be performed in radiology suites or in ambulatory
surgical centers.  Surgeons choose local or general anesthesia based on the
patient's health and preference and the number of fractures to be treated.  The
entire surgical procedure is usually performed in about one hour per fracture
treated.  Because the patients are often older, they are usually admitted for
observation in an overnight hospital stay although the procedure may also be
performed on an out-patient basis.

In December 2006, we signed two definitive agreements to acquire certain
product assets and associated intellectual property rights of Disc-O-Tech.  One
of the transactions relates to, among other technologies and rights, the SKy
Bone Expander System, which is available only outside the U.S. for use in the
treatment of vertebral compression fractures.

Under the other agreement, we have agreed to acquire Disc-O-Tech's Confidence
System and all related assets.  We have not completed either of these
acquisitions, and both are still subject to regulatory approval.

Our Spinal Fracture Management and Repair Products

We currently sell the following instruments, as well as our proprietary
brands of bone filler materials which are used in spinal fracture procedures:

|Product Category                                                          | Description                                                         | Function                                                    
|------------------------------------------------------------------------- | ------------------------------------------------------------------- | ------------------------------------------------------------
|KyphX Bone Access Systems (several varieties)                             | Set of small disposable tools                                       | Create a working channel into fractured bone                
|KyphX Inflatable Bone Tamps (several
varieties)                           | Disposable balloon catheter                                         | Compact soft inner bone and move hard outer bone            
|KyphX Xpander Inflation Syringe                                           | Disposable syringe with rotating  handle and pressure gauge         | Inflate the KyphX Inflatable Bone Tamps                     
|KyphX Bone Filler Device                                                  | Disposable stainless steel nozzle with inner rod and plastic
handle | Deliver bone filler materials into bone cavity              
|KyphX Bone Biopsy Device                                                  | Disposable stainless steel tube and rod                             | Take a sample of bone for evaluation purposes               
|KyphX Curettes (several varieties)                                        | Disposable stainless steel device with articulating
tip             | Scrape or score bone in the spine                           
|KyphX HV-Rpolymethylmethacrylate bone cement and
KyphOs calcium phosphate | Bone filler materials                                               | Bone filler materials used in balloon kyphoplasty
procedures

If and when we are able to complete our acquisition of certain assets of
Disc-O-Tech (which is still subject to regulatory approval), we will add the
following instruments to our product line:

|Product Category         | Description                                                               | Function                                                                                                                                            
|------------------------ | ------------------------------------------------------------------------- | ----------------------------------------------------------------------------------------------------------------------------------------------------
|SKy Bone Expander System | Disposable, expandable polymer device                                     | Deploy within the soft inner bone of a vertebra                                                                                                     
|Confidence System        | Disposable cement injection system, including a PMMA bone
filler material | Inject thick cement into vertebral compression fractures where
height restoration may not be desired or viewed by the treating physician as
feasible

KyphX Bone Access Systems.  Our KyphX Bone Access
Systems are sterile sets of small disposable surgical tools used to access and
create a working channel into the fractured bone.  Our bone access systems are
available in several varieties, including our KyphX Introducer Tool Kit,
Osteo IntroducerSystem and Advanced Osteo Introducer System.  One
version contains a long guide pin, an instrument used to separate tissue, and a
small hand drill.  In addition, it contains two small tubes through which other
tools are passed and a proprietary handle that can be used with multiple
KyphX instruments.  A second version combines the instrument used to
separate tissue, the small tube through which other tools are passed and the
proprietary handle into one tool.  Alternative versions of this one tool can
either be pushed or twisted into and through bone.  All versions of the Bone
Access System contain a sterile needle used to penetrate hard bone.

KyphX Inflatable Bone Tamps.  Our proprietary KyphX
Xpander, Elevate, ExactandExpress Inflatable Bone Tamps are
disposable sterile devices that combine the functionality of a metal bone tamp
with the engineering principles of medical balloon technologies.  Unlike other
medical balloons, however, our balloons are specially designed to be used in
bone.  Other currently available medical balloons are not used in bone because
they are not appropriate in size, shape or durability, or are not designed to
provide lifting force.

Conventional bone tamps are rigid stainless steel instruments that move
fractured hard bone and compact soft bone using indirect mechanical force.
While it is the goal of orthopaedic surgeons to move a fractured area all at
once, conventional bone tamps are not used to do this without a large incision
and without significant tissue and bone disruption.  Unlike other bone tamps,
the KyphX Inflatable Bone Tamps contain a balloon that can be placed
inside a fractured bone through a narrow working channel and expanded to move
fractured bone all at once.  Once inside, the balloon portion of the
KyphX Inflatable Bone Tamp is carefully inflated under X-ray monitoring.
This inflation applies direct lifting force to compact the soft inner bone and
move the broken hard outer bone back towards its prefracture position.

KyphX Xpander Inflation Syringe.  Our KyphX XpanderInflation Syringe is a disposable sterile device with a rotating handle and
a built-in pressure gauge that precisely controls the inflation of our
KyphX Inflatable Bone Tamps.  The rotating handle allows the surgeon to
deliver a measured volume of the fluid that inflates the balloon.

KyphX Bone Filler Device.  The KyphX Bone Filler Device
is a disposable stainless steel nozzle with an inner rod and a plastic handle.
KyphX HV-R bone cement can be loaded into the nozzle and pushed into the
void with the inner rod under low pressure and fine manual control.

KyphX Bone Biopsy Device.  Our KyphX Bone Biopsy Device
is a disposable, stainless steel tube and rod that can be used to take biopsy
samples of bone for further evaluation.

KyphX Curettes.  Our KyphXCurettes are disposable,
stainless steel devices with articulating tips that are used to scrape or score
bone in the spine.  Our KyphX Curettes are sold in various tip
configurations and lengths.

KyphX Bone Filler Materials.  We have developed our own
KyphX HV-R polymethylmethacrylate (PMMA) bone cement with the
appropriate handling characteristics for minimally invasive use in balloon
kyphoplasty procedures in the spine.  We obtained a CE Mark for our KyphX
HV-R bone cement in October 2002 and began selling it in Europe to spine
surgeons who use our KyphX instruments.  We obtained FDA clearance for
use of our KyphX HV-Rbone cement as a bone filler material for balloon
kyphoplasty in April 2004 and began immediate commercialization in the U.S.

We obtained a CE Mark for our first product from our acquisition of Sanatis
GmbH, our KyphOs calcium phosphate cement, in December 2003, and started
selling this bone filler material in Europe during 2004.  In 2006, we obtained a
CE Mark on KyphOs-FS, a new calcium phosphate cement, with shorter
setting times and KyphOs-FSR, also a calcium phosphate cement, with a
barium sulfate additive for increased radiopacity.

SKy Bone Expander System.  The SKy Bone Expander is an
expandable polymer device, intended for use in the treatment of thoracic and
lumbar spine vertebral body compression fractures.  The SKy Bone Expander is
inserted into the collapsed vertebra in a reduced device configuration of 4 mm
in diameter, and is then expanded to up to 14 mm or 16 mm in height.  The SKy
Bone Expander is removed and bone void filler is injected into the vertebral
body.  The SKy Bone Expander is currently available outside of the United
States, primarily through distributor sales organizations.  Kyphon is evaluating
plans to bring the product into current distribution channels, as well as to
bring the core technology in the SKy Bone Expander System to the U.S.  There are
no defined plans to incorporate the product into Kyphon's current business in
the U.S. and our proposed acquisition of Disc-O-Tech's SKy Bone Expander remains
subject to regulatory clearance.

Confidence System.  The Confidence System allows for the
injection of highly viscous cement into a vertebral compression fracture.  The
Confidence System is placed into the fracture, and then highly viscous cement is
injected into the vertebral compression fracture.  Similar to balloon
kyphoplasty procedures, the procedure is minimally invasive and can typically be
performed in less than an hour.  Because a balloon is not used in the typical
Confidence System procedure, height restoration is not typically attained.  The
ability to inject high viscosity cement, and to do so while the surgeons hands
are outside of the fluoroscopic field, are unique advantages of this product.
We intend to incorporate these features into other products, in addition to
marketing the Confidence System.  Our proposed acquisition of Disc-O-Tech's
Confidence System remains subject to regulatory clearance.

Our Strategy in Spinal Fracture Management Repair

Our mission is to become the recognized global leader in restoring spinal
function through minimally invasive therapies.  In particular, the key elements
of our strategy in spinal fracture repair are to:

- Establish Minimally Invasive Balloon Kyphoplasty Surgery Using Our KyphX
Instruments as the Standard of Care for Spinal Fracture Repair

- Continue to Penetrate the Market for the Treatment of Spinal Fractures
with Our Experienced Direct Sales Force

- Educate Primary Care Physicians

- Expand Marketing Claims

- Develop and Introduce New Products to Address Different Indications.

- Support Appropriate Levels of Facility and Physician Coverage and
Reimbursement in the United States

- Expand our Global Commercial Reach

Disc Disease Diagnosis and Therapies

Anatomy and Presence of Degenerative Disc Disease

We estimate that between 70% and 80% of the U.S. population
experiences debilitating low back pain due to degenerative disc disease at least
once in their lifetime.  Discogenic pain, or pain originating in the
intervertebral disc, in the lumbar spine is one of major contributors to low
back pain.  There are several reasons for this pain, including compression of
the disc due to age or obesity, or herniation of the disc, where a small portion
of the nucleus pulposus (biological material inside the disc) leaks out of the
disc and irritates the spinal cord.  Spine surgery, including spinal fusion and
total disc arthroplasty, and other intradiscal interventions are increasingly
being used to treat degenerative disc disease.  We believe that, in the U.S.
alone, over 200,000 lumbar spine interventions are performed annually to treat
discogenic pain of the lumbar spine.  However, outcomes from surgical
interventions for this disease are unpredictable, with clinical success rates
averaging between 50% and 70% in the published literature.  We believe that
incomplete diagnosis is one contributor to the poor success rates of lumbar
spine interventions for degenerative disc disease.

Consequences of Degenerative Disc Disease

Degenerative disc disease is a term used to describe changes in

- Loss of Fluid in the Affected Disc.

- Discogenic Pain.

- Reduction in Activity.

Initial treatment regimens for discogenic low back pain typically involve
non-operative therapies, including bed rest, pain medication, exercise, and
physical therapy for a period of three to six months.  If conservative care
is not effective in addressing the symptoms, many patients receive injections of
anesthetics and/or steroids to manage the pain non-operatively.

If these methods fail, many patients are offered spinal surgery.  For
patients suffering from chronic back pain caused by degenerative disc disease,
spine fusion is the most common surgical treatment option recommended. 
Spine fusion involves the fusing of adjoining vertebrae in cases where the
patient has advanced disc degeneration.  The procedure involves a surgical
incision in the patient's back or abdomen, removal of the affected disc and the
insertion of bone graft, metal implants and/or a spine fusion cage to join the
two adjacent vertebrae.  This procedure is designed to stabilize the spinal
segment, thereby relieving the pain associated with the affected disc.  The
risks of spinal fusion surgery include blood loss and infection, as well as an
extended recovery time for most patients.

Alternative Means of Diagnosing Discogenic Pain

Typical means of diagnosis of discogenic back pain include imaging studies
and/or provocative discography:

Imaging Studies.  The vast majority of physicians who diagnose
patients suspected of suffering from discogenic low back pain utilize Magnetic
Resonance Imaging (MRI) as the initial diagnostic study.  Use of MRI in these
patients indicates which intervertebral discs are degenerated, resulting in a
condition known as degenerative disc disease.  However, the clinical literature
indicates that many patients with degenerative disc disease do not suffer from
low back pain, and conversely, intervertebral discs that are painful do not
always appear to be degenerated in MRI.

Provocative Discography.  Many patients also undergo an interventional
diagnostic procedure known as provocative discography (or discogram) to
determine which, if any, discs are causing the patient's low back pain.
Provocative discography involves the injection of a radiopaque contrast agent,
under pressure, into the suspected discs with the aid of fluoroscopic imaging.
The primary goal of provocative discography is to reproduce the patient's usual
pain by pressurizing the suspected discs individually. This pressurization is
thought to mimic the pressure created on the disc when the patient performs the
activities that cause pain for the patient.  The pain caused during the
discography is described as similar (concordant) or dissimilar (discordant) to
the pain the patient typically experiences.  If the pain is similar, the disc at
that level is often determined to be positive for discogenic pain, and if the
pain is dissimilar, the test is often determined to be negative.  If no pain is
generated during the injection, the test is determined to be negative.
Additionally, the radiopaque contrast agent allows the clinician to image the
anatomy of the disc by observing the flow and distribution of contrast as it is
injected into the disc space.

Recent publications suggest that provocative discography can be positive in
patients without low back pain and also in patients who have back pain that is
known to be non-discogenic.  As a result, we believe that an additional
diagnostic procedure may be useful in diagnosing discogenic low back pain.

The Kyphon Solution for Diagnosis of Discogenic Back Pain:
DiscyphorTM Catheter for Functional Anaesthetic DiscographyTM

Kyphon acquired the Discyphor product line from InnoSpine in January
2006.  These products are used in a procedure known as Functional Anaesthetic
DiscographyTM (F.A.D.), which is a diagnostic procedure designed to
determine if an intervertebral disc is a source of low back pain in adults.  The
core balloon catheter technology was cleared by the FDA in April 2005 pursuant
to a 510(k) submission for delivery of local anaesthetic, radiopaque contrast or
saline solution to the intradiscal space.

The F.A.D. Procedure involves the placement of Discyphor Catheter(s)
into one or more intervertebral discs suspected to be potential pain generators.
Provocative discography may be performed at each suspected level prior to the
F.A.D. procedure at these levels.

Our Products and Their Use for the Diagnosis of Discogenic Back
Pain

To begin a functional anaesthetic discogram, the patient is first asked
to perform activities that exacerbate his/her typical low back pain.
Anaesthetic is then injected into one suspected intervertebral disc at a time.
If the patient experiences pain relief following anaesthetic injection while
performing the activities that are typically painful, the injected disc(s) are
concluded to be pain generators.  If a patient does not experience pain relief
following anaesthetic injection while performing the pain-eliciting activities,
the injected disc(s) are not considered to be pain generators.  To date, over
650 F.A.D. procedures have been performed by over 100 clinicians, including pain
management physicians, interventional radiologists, and spine surgeons.

We currently sell the following instruments used in disc disease
diagnosis:

|Product Category           | Description                                                           | Function                                                                      
|-------------------------- | --------------------------------------------------------------------- | ------------------------------------------------------------------------------
|DiscyphorCatheter System   | Disposable balloon catheter and related access and inflation
products | Create access to an intervertebral disc for injection of
anaesthetic/saline   
|DiscyphorIntroducer Needle | Custom disposable spinal access needle                                | Create access to an intervertebral disc                                       
|DiscyphorSpinal Needle     | Disposable spinal needle                                              | Perform provocative discography and facilitate placement of
Discyphor Catheter

Our Strategy for Building our Discogenic Back Pain Diagnosis Business

Our goal is to make the DiscyphorTM Functional Anaesthetic
DiscographyTM (F.A.D.) procedurethe standard interventional diagnostic
procedure for diagnosing the source of low back pain.  The specific elements of
our strategy for F.A.D. include the following:

- Grow our base of users of the Discyphor Catheter System

- Initiate Clinical Trials to Support Expanded Indications for Discyphor
Products
- comparative diagnostic claims with provocative discography, and
- claims surrounding predictive value of F.A.D. on surgical interventional
outcomes for discogenic pain.

- Establish Specific Reimbursement Guidelines for F.A.D

- Develop Next Generation Discyphor Product Lines

Market Opportunity for Minimally Invasive Lumbar Spinal Fusion

Spinal fusion is the most common surgical procedure for the treatment of
painful degenerative disc disease (DDD) resulting in chronic low back pain.
Kyphon estimates that the U.S. spinal fusion market included over 300,000
procedures in 2006, comprised of 200,000 lumbar procedures and 100,000 cervical
procedures.  Current spinal fusion products require implantation through open
back and abdomen surgery, which results in high levels of blood loss and
infection risk, as well as extended patient recovery time.  We believe that a
percutaneous solution can provide potential advantages such as less blood loss,
reduced tissue and muscle trauma, lowered risk of neurological damage and
infection, and shorter procedure and recovery time. In addition, a percutaneous
fusion procedure may enable spine specialists to treat those patients who
ordinarily may not be good candidates for a traditional open and invasive fusion
procedure.

The Kyphon Solution for Minimally Invasive Lumbar Spinal Fusion

Our proposed acquisition of Disc-O-Tech's percutaneous B-Twin Expandable
Spinal fusion technology (which has not yet been completed and remains subject
to regulatory approval) will provide us with a minimally invasive product line
for lumbar spinal fusion, a procedure undertaken for patients with severe
degenerative disc disease and spondylolisthesis.  Although a CE mark for the
B-Twin Expandable Spinal fusion technology was obtained in August 2001, this
technology is not currently available in the United States.  The minimally
invasive fusion procedure is intended to result in less trauma to the patient
than alternative surgical procedures.  In addition, the B-Twin procedure is
believed to be simpler and more straightforward for the spine surgeon to perform
than other surgical alternatives.  The B-Twin System is a minimally invasive
titanium device for use in percutaneous spinal fusion procedures for treatment
of painful degenerative disc disease in the lumbar spine (lower back) and
cervical spine (neck).  The system is the only percutaneous interbody cage on
the market, and has been used in percutaneous spinal fusion procedures, as well
as mini open posterior, lumbar interbody fusion (PLIF) procedures.

The Use of the B-Twin Expandable Spinal System During Minimally
Invasive Spinal Fusion

The B-Twin Expandable Spinal System is used in conjunction with bone graft or
other suitable materials as a stand-alone implant for spinal stabilization
during lumbar spinal fusion surgery, as well as in conjunction with additional
traditional or minimally invasive spinal implants.  The non-expanded B-Twin
implant is preloaded on a single use Delivery System.  Following discectomy
(disc removal), endplate preparation (scratching) and bone graft insertion, the
B-Twin implant is introduced into the intervertebral space using the Delivery
System.  Once in position, it is expanded and then released from the Delivery
System.  Using the same procedure, a second equal-size B-Twin implant is
introduced into the contralateral side of the same intervertebral space.  The
B-Twin Expandable Spinal System is implanted using an open posterior, open
anterior or posterior-lateral percutaneous surgical approach. The B-Twin Expandable Spinal System
is introduced into the intervertebral space, following discectomy, in a narrow
configuration of 5 mm in diameter.  It can then be expanded to a size range of
7.5 to 15 mm in diameter, depending upon the size chosen by the physician.

The Cervical B-Twin Expandable Spinal System utilizes similar technology to
the lumbar product, and is intended for use in cervical interbody fusion
procedures, with bone graft, in skeletally mature patients with degenerative
disc disease of the cervical spine, at one or two levels.  The implantation
procedure is performed via a percutaneous approach through a 4.3 mm cannula
(working sleeve).  Following placement of bone graft, the Cervical B-Twin
Expandable Spinal System is introduced into the intervertebral space in its
reduced diameter of 3.3 mm, and is then gradually expanded in a controlled
manner to 8 mm.  Following its expansion, theCervical B-Twin is released from its Delivery
System.  Using the same procedure, a second device may be
introduced.

The B-Twin technology offers certain potential advantages
over existing spinal fusion products.

- Percutaneous Procedure.

- Minimizes Bone Dissection.

- Ease of Use.

- Most Procedures Can Now be Performed Posteriorly.

Our Strategy for Entering the Fusion Market

The following describes our strategy for entering the fusion market when and
if we complete the acquisition of these assets from Disc-o-Tech:

- Continue Penetration of International Markets.

- Introduce the B-Twin Technology to U.S. Markets

- Develop a Minimally Invasive Fusion Product Line.

Spinal Motion Preservation

Our recent acquisition of St. Francis provides us with the
X-STOP Interspinous Process Decompression (IPD) System, the first
FDA-approved product in the U.S. for the treatment of mild to moderate lumbar spinal
stenosis, a narrowing of the space surrounding the spinal cord.  This procedure
is intended to provide the patient with less trauma and greater relief than
alternative surgical procedures or conservative therapies can provide.  In
addition, the X-STOP procedure is believed to be simpler and more
straightforward for the spine surgeon to perform than other surgical
alternatives.

Anatomy and Prevalence of Lumbar Spinal Stenosis

With the acquisition of St. Francis we have entered the market for the
treatment of lumbar spinal stenosis (LSS).  LSS is a narrowing or constriction
of the spinal canal, which causes impingement on the spinal cord and nerve roots
that extend from the spine to the legs.  LSS is most often caused by
degenerative or arthritic conditions that lead to changes in the intervertebral
discs, ligaments and facet joints surrounding the spinal canal.  LSS most
commonly occurs in the lower three levels of the lumbar spine.  The impinged
nerves commonly cause pain, weakness and numbness in the lower back or buttocks
that further radiates to the thighs and lower legs.  Patients suffering from LSS
typically live with significant lifestyle constraints that limit daily
activities and quality of life.

According to Verispan, there are currently approximately 1.4 million
individuals in the United States with a primary or secondary diagnosis of LSS.
Approximately 500,000 of these patients are treated with conservative,
non-operative therapies.  Approximately 140,000 additional patients in the United
States undergo spinal surgery for LSS annually.  In addition, many LSS sufferers
do not seek treatment.  Our initial target market for theX-STOP
procedure consists of LSS sufferers with moderate symptoms whose condition is
not responding to conservative, non-operative therapies or who would otherwise
receive a laminectomy.  We estimate this initial target market consists of over
200,000 procedures annually in the United States.  The aging of the United
States population as well as increases in the prevalence of obesity are expected
to contribute to growth in the incidence of LSS.

Consequences of Lumbar Spinal Stenosis

Consequences of LSS are typical of a slowly progressing,
chronic, painful disease state.   Individuals suffering from this progressive
disease typically enter into a cascade of decline in their quality of life.
This cascade often progresses as follows:

- Pain During Activity

- Reduction in Activity Due to Pain and Discomfort

- Restriction of Day to Day Activity

Alternative Treatments for Lumbar Spinal Stenosis

Treatment for patients diagnosed with LSS depends on the severity of the
disease.  Physicians typically treat patients with milder forms of LSS through
conservative, non-operative therapies.  If symptoms do not improve, physicians
may recommend surgical procedures.

- Conservative, Non-Operative Therapies.

- Surgical Procedures.

We believe that the traditional treatment paradigm for LSS leaves the patient
population faced with a choice of therapeutic alternatives, each of which has
significant drawbacks. Conservative, non-operative therapies generally provide
only temporary symptom relief, have diminishing efficacy, may result in side
effects, and typically are viewed as only a short-term solution.  On the other
end of the continuum of care, laminectomy is an invasive, open surgical
procedure performed under general anesthesia with inherent safety risks.  The
surgery involves prolonged hospital stays, extended recovery periods and,
occasionally, long-term physical therapy and is not advisable for seriously ill
patients or patients who have co-morbidities.  Accordingly, we believe that a
significant market opportunity exists for a less invasive procedure that is
designed to address the underlying causes of LSS rather than merely manage or
temporarily alleviate the symptoms.  We also believe that the availability of
such a procedure could cause many LSS sufferers to seek treatment or reconsider
their therapeutic options.

The Kyphon Solution for Treatment of Lumbar Spinal Stenosis

Kyphon provides surgeons with a procedural solution to moderate LSS.  The
X-STOP Interspinous Process Decompression (IPD) System, represents a new
motion-preserving approach to the treatment of LSS that provides physicians and
patients with a safe and effective treatment alternative that fills the current
gap in the continuum of care between conservative, non-operative therapies and
laminectomy. Unlike conservative, non-operative therapies, the X-STOP
device addresses the underlying cause of LSS by reducing the narrowing or
constriction of the neural pathways and the neural foramina, the tunnels through
which the nerves traverse.  TheX-STOP device is implanted in a less
invasive procedure that may be performed under local anesthesia and does not
require the permanent removal of bone and connective tissue.  The procedure,
therefore, does not compromise any potential future therapeutic options.

The current Indication for Use of the X-STOP IPD System is as follows:

The X-STOP Interspinous Process Decompression (IPD) System
("X-STOP") is indicated for treatment of patients aged 50 or older
suffering from neurogenic intermittent claudication secondary to a confirmed
diagnosis of lumbar spinal stenosis (with X-ray, MRI, and/or CT evidence of
thickened ligamentum flavum, narrowed lateral recess and/or central canal
narrowing).  The X-STOP is indicated for those patients with moderately impaired
physical function who experience relief in flexion from their symptoms of
leg/buttock/ groin pain, with or without back pain, and have undergone a regimen
of at least 6 months of non-operative treatment.  The X-STOP may be implanted at
one or two lumbar levels in patients in whom operative treatment is indicated at
no more than two levels.

We believe that the principal benefits of ourX-STOP System are:

- Efficacious, Motion-Preserving Therapy

- Less Invasive, Cost-Effective Procedure.

- Rapid Symptom Relief.

- Preserves Treatment Options.

- May Enable Patients to Resume More Active Lifestyle

- Ease of Use.

- Favorable Safety Profile.

- Available to Broad Patient Population

The Use of the X-STOP System During Minimally Invasive Spine Surgery

Spinal surgery using our X-STOP IPD instruments is minimally invasive
and generally performed by spine-focused orthopaedic surgeons and neurosurgeons.
The procedure may be performed under local or general anesthesia as chosen by
the surgeon based on the patient's health and preference.  The procedure is
usually performed  in a hospital operating room.  The procedure involves the
following steps:

- Position Patient and Administer Anesthesia

- Gain Access to Spinous Space through Small Incision.

- Determine Appropriate X-STOP Implant Size.

- Position X-STOP Spacer Assembly and Secure Adjustable Wing.

- Confirm Final Position and Close Incision.

Approximately one-half of X-STOP patients receive a single implant and
approximately one-half of patients receive X-STOP implants at two levels
in their spinal column.  The surgical procedure typically is performed in less
than 90 minutes.

Our Products for Spinal Motion Preservation

X-STOP System: This system is the first less invasive, non-fusion
motion-preserving device to receive FDA premarket approval for the treatment of
lumbar spinal stenosis (LSS).  We believe the X-STOP Interspinous Process
Device represents a significant advancement in LSS treatment.  The X-STOPIPD is a spinal implant designed to fit within the interspinous space.  The
X-STOPIPD mechanically limits extension and is able to:



- Reduce biomechanical loads on facet joints; and

- Decrease pressure on intervertebral discs.

The design of the X-STOP device enables it to be inserted without
removing bone or ligaments, resulting in a procedure that can be performed under
local anesthesia.  The X-STOP device is not physically attached to bone
or other structures in the spinal area.  This makes the procedure reversible,
which preserves future treatment options for the patient should they be
necessary.

The X-STOP device is currently offered in five sizes in the United
States, ranging from 6 to 14 mm and six sizes in Europe, ranging from 6 to 16
mm.  The X-STOP device is currently made either entirely from titanium or
with titanium wings and a PEEK spacer.  Our initial FDA premarket approval for
the X-STOP IPD received in November 2005 was for a titanium device.  We
received FDA approval for the PEEK device in August 2006.  Both versions of the
X-STOP IPD are commercially available in Europe.

In addition to the X-STOP implant, there are a range of surgical
instruments for use by the surgeon in implanting the X-STOP device.
These surgical instruments include tissue dilators, a sizing distractor for
determining the appropriate size of the X-STOP device and tools for
insertion of the spacer and attachment of the wing.  These surgical instruments
are sterilizable and reusable.  The surgical instruments are available through
our sales channels on a loaner basis or may be purchased directly by the
hospital.  The principal X-STOP surgical instruments include, small
dilator, large dilator, sizing distractor, spacer insertion tool, wing insertion
tool and hex driver for adjustable wing attachment.

Aperius PercLID  System: The Aperius product represents the next
generation in the treatment of Lumbar Spinal Stenosis.  Developed internally by
a team of Kyphon engineers, our Aperius technology is intended to further
simplify the treatment of LSS, while providing the same benefits and mechanism
of action as the X-STOP device.  An expandable device, the Aperius
implant is percutaneously placed between the spinous processes, and then
expanded in place, to end in a position similar to the X-STOP device.  In
its expanded state, the Aperius implant is designed to stay in place, and not to
migrate.

Similar to theX-STOP device, our Aperius product requires a
specifically designed set of instrumentation for its placement.  However, unlike
the X-STOP device, the instrumentation to deliver the Aperius implant is
not re-usable, and is discarded after each placement of the device.  This
single-use design enables the hospital to avoid the management and continuous
processing and sterilization of a set of instruments, and simplifies the case
preparation for the operating room staff and physicians.

Limited physician testing of our Aperius technology began in Europe in November 2006.
We are carefully monitoring the initial clinical experience, and have had
satisfactory  results to date.  We intend to continue to gather this clinical
information, and to begin to aggressively market the Aperius technology in
Europe in the first half of 2007.  We have not yet formulated a regulatory
strategy for our Aperius technology in the United States.  While the final
position in the body and likely indication of our Aperius and theX-STOP
technologies are similar, we believe that a separate regulatory approval will be
necessary for the Aperius product, which will require additional clinical
studies.

Our Strategy for our Spinal Motion Preservation Business

The X-STOP IPD System allows us to be a leading provider of
motion-preserving medical devices for the treatment of LSS and other spinal
degenerative diseases.  The key elements of our strategy in this area are as
follows:



- Establish Kyphon products as the Standard of Care for the Treatment of
Moderate LSS in the U.S.

- Increase Awareness of LSS Among Physicians and Patients.

- Expand Indications for the X-STOP IPD System into New
Markets.

- Continue to Penetrate the Market for the Treatment of LSS with Our
Experienced Direct Sales Force.

- Establish a Motion-Preserving Franchise.

- Establish our Aperius Technology as the Next-Generation Product for the Treatment of
Lumbar Spinal Stenosis.

- Support Appropriate Levels of Facility and Physician Coverage and
Reimbursement in the United States.

- Expand our Global Commercial Reach.

Sales and Marketing of All of Our Products

We market and sell our Spinal Fracture Management and Repair, Disc Disease
Diagnosis and Therapies, and Spinal Motion Preservation products through our
direct sales force in the United States and Europe, which numbers approximately
480 field-based sales professionals as of December 31, 2006.  In addition, for
certain markets outside the United States, we market some or all of our products
through sales agents or distributors who are not employees of the company.  Our
target customer base includes the approximately 21,000 physicians who perform
spine surgery, including orthopaedic spine surgeons, neurosurgeons,
interventional radiologists and interventional neuroradiologists in the U.S.,
Europe and other selected countries.  No customer accounted for more than 10% of
total net sales in 2006, 2005 or 2004.

Our U.S. sales organization is comprised of spine consultants who act as
the primary customer contact.  These spine consultants have extensive experience
selling medical devices, generally focusing on emerging technologies.  We expect
we will need to continue to increase the size of our sales organization in order
to increase sales and market penetration and to provide the significant, ongoing
level of customer support required by our sales strategy.  We have trained
approximately 10,400 physicians in the U.S., Europe and Asia-Pacific to perform
the balloon kyphoplasty procedure with our KyphX instruments.
Approximately 1,400 physicians in the U.S. have been trained to perform the
X-STOP procedure.  We anticipate that physician training on the X-STOP
IPD System will be a significant part of our strategy in 2007.  Finally,
approximately 100 physicians in the U.S. have been trained on the use of our
Discyphor Catheter System for Functional Anaesthetic Discography.

We have operated mainly in the United States, and 79%, 84% and 88% of our
sales were to customers located within the United States in 2006, 2005 and 2004,
respectively.  The majority of our international sales are derived from European
Union countries.  Our European operations are presently headquartered in Belgium
with direct sales organizations in the major European countries.  We anticipate
continuing to build direct sales organizations in the major European countries
while establishing distributor or agency arrangements in the smaller ones.  We
intend to follow a similar model in Europe to the one established in the United
States, working with internationally recognized physicians initially as we
expand our training, reimbursement and selling activities.  We are also
establishing an operational presence in Switzerland including manufacturing,
distribution and certain research and development activities, to support the
growth of our international business.  In 2006, we initiated the construction of
new office and warehouse space in Neuchâtel, Switzerland to replace the
adjacent temporary facilities currently in use.  We expect this to serve as the
operational center of our international business, and expect it to be completed
in the first half of 2008.

We are still in the early stages of initiating the sales process in selected
Asia-Pacific markets.  We have initially trained surgeons and sold products in
South Korea and China.  In 2004, we formed our Japanese subsidiary, Kyphon
Nippon KK, and have formulated and begun to execute on our clinical and
regulatory plans for Japan.  In addition, we have sold our products in Canada
through a direct sales force, and in Brazil, Puerto Rico, Argentina, Chile and
Mexico through distributors, and we have established a presence in certain
additional Asian countries, South Africa and Australia.  Overall, we now sell
our products in over 40 countries around the world.

Other Business Initiatives

With our acquisitions of InnoSpine and St. Francis and our proposed
acquisitions of certain spine-related assets of Disc-O-Tech (which have not yet
been completed and remain subject to regulatory approval), we have moved beyond
our original sole focus of Spinal Fracture Management and Repair, to also now
include Disc Disease Diagnosis and Therapies and Spinal Motion Preservation.  We
have a variety of internal resources dedicated to supporting research and
development in each of these areas, as well as potential business development
opportunities.  We also continue to examine additional areas in the minimally
invasive treatment of spine diseases, such as cancer therapy aimed at addressing
the actual cancerous conditions that affect the spine rather than merely the
effects of those cancerous conditions.  We believe all of these business
initiatives provide further opportunity to grow our company in the area of
minimally invasive spine.

We are committed to becoming the recognized global leader in restoring spinal
function through minimally invasive therapies.  With three leading product
franchises in diagnosing and treating diseases of the spine, all of which are
based upon minimally invasive approaches, we believe we are positioned as the
leader in the minimally invasive spine field.  To continue this leadership, we
expect further organic development and business development opportunities will
be required, and we are prepared to execute upon these opportunities as
appropriate.

Reimbursement Overview



In the United States, healthcare providers generally rely on third-party
payors, principally private insurers and governmental payors such as Medicare
and Medicaid, to cover and reimburse all or part of the cost of a medical device
and of the procedure in which the medical device is used.  Our ability to
commercialize our products successfully depends in significant part on the
extent to which appropriate coverage and reimbursement for our technology and
related procedures are obtained from third-party payors.  These third-party
payors, and in particular managed care organizations, are increasingly
challenging the prices charged for medical products and services and instituting
cost containment measures to control or significantly influence the purchase of
medical products and services.  These cost containment measures, if instituted
in a manner affecting the coverage or payment for our technology, could
adversely affect our business and our financial condition.

Establishing adequate coverage and reimbursement for any new medical
technology is a challenge given the current emphasis on cost-containment.  To
successfully establish coverage and reimbursement for our technology, generally
we must prove that our technology improves health outcomes, such as functional
ability, and does so in a cost-effective manner.

Reimbursement for the Balloon Kyphoplasty Procedure

Approximately 90% of patients in the U.S. with spinal fractures caused by
osteoporosis are insured under Medicare, while the rest are insured primarily by
private payors.  Most patients with spinal fractures caused by cancer and trauma
are insured by private payors.  Medicare and private payors have provided
coverage and reimbursement for procedures in which our technology is used.
Private payors often follow the coverage and payment policies of Medicare.  We
cannot assure you that government or private third-party payors will cover and
reimburse the procedures using our technology in whole or in part in the future
or that payment rates will be adequate.

Medicare coverage for procedures using our technology currently exists in the
hospital setting (inpatient and outpatient).  For both inpatient and outpatient
spinal fracture reduction procedures, Medicare reimburses the facilities in
which the procedures are performed based upon prospectively determined amounts.
As to hospital inpatient stays, a prospective payment is determined by the
patient's condition and other patient data and procedures performed during the
inpatient stay, using a classification system known as Diagnosis-Related Groups
(DRG).

For procedures using our technology performed in hospital outpatient
departments, payment is based on the Ambulatory Payment Classification (APC)
under which the procedure is categorized.  The Centers for Medicare &
Medicaid Services (CMS), the Federal agency responsible for administering the
Medicare program, assigns procedures that are comparable, both clinically and in
terms of the resources required, to the same APCs.  Hospitals performing
outpatient procedures for Medicare patients using our products are paid the
applicable APC payment rate for the outpatient procedure, regardless of the
actual cost for such treatment.

In addition to payments to hospitals for procedures using our technology,
Medicare makes separate payments to physicians for their professional services
under the national Medicare Physician Fee Schedule.  In all 50 states and in the
District of Columbia, Medicare reimburses physicians for their professional
services when they perform procedures using our KyphX instruments, and
reimburses them the same amount regardless of whether the procedure is inpatient
or outpatient.  As of January 1, 2006, there were three Category I CPT codes, or
reimbursement codes, established describing procedures in which our products are
used: CPT codes 22523, 22524 and 22525.

In Europe, kyphoplasty has been assigned a code in the recently implemented
German OPS system.  In other European countries, we continue to focus efforts on
obtaining reimbursement coverage for the procedure, although no assurances can
be provided that such efforts will result in favorable outcomes for us.  We are
aware that in the past, one or more competitors have attempted to adversely
affect our ability to acquire timely and appropriate levels of reimbursement in
several foreign countries by seeking much lower levels of reimbursement for
their own competitive products that may not support the pricing or anticipated
pricing of our products in those markets.

Reimbursement for the X-STOP Procedure

We believe the majority of the patients suffering from lumbar
stenosis that may be appropriate candidates for the X-STOP procedure are
insured in the U.S. under Medicare, while the rest are insured primarily by
private payors.  We cannot assure you that government or private third-party
payors will cover and reimburse the procedures using our technology in whole or
in part in the future or that payment rates will be adequate.

Medicare coverage for procedures using our technology currently exists in the
hospital setting (inpatient and outpatient) for
interspinous decompression procedures.  Medicare reimburses the facilities in
which the procedures are performed based upon prospectively determined amounts.
As to hospital inpatient stays, a prospective payment is determined by the
patient's condition and other patient data and procedures performed during the
inpatient stay, using the DRG classification system.  Hospitals performing
inpatient procedures using our products are paid the applicable DRG payment rate
for the inpatient stay, regardless of the actual cost for such treatment.  In
addition to the DRG payment hospitals may receive a new technology payment from
CMS.

As to procedures using our technology performed in hospital outpatient
departments, payment is based on the APC under which the procedure is
categorized.  CMS, the Federal agency responsible for administering the Medicare
program, assigns procedures that are comparable, both clinically and in terms of
the resources required, to the same APCs.  Both the new technology add-on
payment and the pass through payment are in effect for no less than two years
and no more than three years.

In addition to payments to hospitals for procedures using our technology,
Medicare makes separate payments to physicians for their professional services
under the national Medicare Physician Fee Schedule.    Effective January 1,
2007, there are two Category III CPT codes, or reimbursement codes, describing
procedures in which our products are used: CPT "T" codes 0171T and
0172T.  These codes are considered "tracking codes" and do not have a
preset level of reimbursement so reimbursement decisions are made in the local
CMS offices.  As the codes became effective January 1, 2007, it is too early to
know the impact the codes will have on our business.

Manufacturing

We believe our manufacturing operations are in compliance with regulations
mandated by the FDA and the European Union.  We have been a FDA-registered
and California-licensed medical device manufacturer since 1998 and have had our
EC Certificate since February 2000.  We are subject to unannounced
inspections by the FDA, TÜV, our notified body, and the Food and Drug
Branch of the California Department of Health Services, or CDHS, and these
inspections may include the manufacturing facilities of our
subcontractors.  The FDA inspected our Sunnyvale, California manufacturing
facility during 2006 and all observations raised have been adequately addressed.
We have also been inspected by the CDHS and European auditors and there have
been no material audit findings as a result of these inspections.



We inspect, assemble, test, package and sterilize components that we
manufacture, as well as components manufactured to our specifications by outside
contractors.  We inspect each lot of components and finished instruments to
determine compliance with our specifications.

The purchased components for our instruments are generally available from
more than one supplier.  There are no contractual obligations by suppliers
to continue to supply to us, nor are we contractually obligated to purchase from
a particular supplier.  We have identified and qualified alternate
suppliers for materials in our KyphX Inflatable Bone Tamps and most of
our other KyphX instruments.  Although additional suppliers
have been identified for certain, presently sole-sourced items, including our
inflation syringe and our proprietary bone cement, none has been qualified at
this time.

We are currently increasing our manufacturing capabilities as we increase
commercialization efforts.  We may experience difficulties in scaling-up
production, including problems with production yields and quality control and
assurance, which may adversely affect our business and growth.

Research and Development

Our research and development group focuses on developing new products to
address unmet patient and market needs, and product line expansion with respect
to our existing products with the concomitant goal of enhancing revenue.  A
major focus of the group is to explore new technologies primarily for use in
minimally invasive spinal procedures in the following product platforms,
including but not necessarily limited to:

- Spinal Fracture Management and Repair

- Disc Disease Diagnosis and Therapies

- Spinal Motion Preservation

In conjunction with these platforms, we intend to develop the following:

- additional instruments to facilitate the use of our products in fractures
that are particularly difficult to repair;
- Kyphon-branded biomaterials for use as bone void fillers;
- instruments and implants for the treatment of degenerative spinal disorders,
such as lumbar spinal stenosis;
- instruments and biomaterials for the diagnosis and treatment of spinal disc
disease; and
- minimally invasive instruments for spinal fusion.

Our expenditure for research and development totaled $40.0 million, $46.4
million and $22.2 million in 2006, 2005, and 2004, respectively.  Research and
development expense in 2005 included a $20.0 million one time expense associated
with the acquisition of an exclusive license to Dr. Harvinder Sandhu's early
invention rights concerning a directional bone tamp for treating vertebral
compression fractures and a $1.0 million one time expense associated with the
acquisition of an exclusive license to Dr. Lee Berger's patent portfolio
relating to expandable cavity-creation devices.

Unless an exemption is available, we will need approval or clearance from the
FDA to promote or market any of these products in the United States.  We cannot
be certain that we will be able to obtain approval or clearance for these
products.

Competition

In our Spinal Fracture Management and Repair product platform, we compete
with providers of non-surgical treatments, drugs to reduce pain, drugs to
prevent osteoporosis, open surgical procedures and instruments for
vertebroplasty.  Our products compete with conventional spine instrumentation in
the market for traumatic spinal fracture treatments.  We also are beginning to
see introductions into the marketplace of instruments designed to create voids
in vertebral bodies without any attempt at fracture reduction, which are
marketed as a safer alternative to vertebroplasty and a less expensive
alternative to balloon kyphoplasty.  Competition is likely to increase the
awareness and frequency of alternative procedures to balloon kyphoplasty.  We
are also beginning to see introduction by competitors of instruments designed to
achieve either or both void creation and fracture reduction, including copies of
our products in some Asia-Pacific countries.  These products are initially being
marketed in the U.S., Europe and Asia as equally effective and less expensive
than our KyphX products.  Numerous companies are developing and marketing
materials, including biomaterials, which may be used as bone filler materials.
Given the early stage of many of these competitive marketing efforts, it is
premature to determine what, if any, impact these products may have on our sales
growth.

Osteoporosis drugs marketed and in development today may, under some limited
circumstances, reduce the risk of fracture by up to 70%.  These drugs are made
by large pharmaceutical companies such as Merck, Eli Lilly, Wyeth, Procter &
Gamble, Novartis AG and Aventis Pharmaceuticals.  These drugs and future drugs
may further reduce the incidence of spinal fractures over time.

Our products for the diagnosis of low back pain compete against other methods
for the diagnosis of degenerative disc disease, such as imaging studies and
provocative discography.  We believe that products specifically designed and
used in the diagnosis of degenerative disc disease are not a meaningful
percentage of any company's revenue.

Our products for lumbar spinal stenosis compete primarily with conservative,
non-surgical therapies in the United States, including pain killers and other
pain medications.  No other spinal device implants are approved for lumbar
spinal stenosis in the United States.  In the United States, we know of at least
four clinical trials that have been initiated by competitors seeking to gain
approval to market and sell their products in the Untied Sates with an
indication that includes the treatment of lumbar spinal stenosis.  These trials
are long and complex, and we do not know if, or when, they may result in
competitive entry into the United States market.

Outside of the United States, and in Europe in particular, several
competitors are marketing products that compete directly with our X-STOP
IPD System and Aperius products.  These competitors include both large and
small spine companies.  We believe our products to be superior in performance,
but do not have extensive clinical data to definitely prove this point of view.
As a result, physicians in these non-U.S. markets utilize several different
factors in their usage decisions, including price and relationships with the
vendor or the vendor's representative.  While we believe we have a leading share
position in several countries, there are several other markets we do not have a
leading share position, due either to the success of another competitor in that
market, or our lack of presence in that market.

Our products for the performance of cervical and spinal fusion compete
against a wide variety of products marketed by several competitors around the
world.  The largest companies in the spine medical device industry all have
significant revenues derived from products designed for use in spinal fusion,
including Medtronic, Johnson and Johnson and Synthes.  However, as these
products have matured and less differentiation is seen by customers, several new
companies have been formed to produce, market and sell products similar to the
products marketed by the large spine companies.  Several of these companies are
relatively small, and rely upon their distributors and customers as investors.
As a result, traditional pedicle screw and rod products used in these procedures
are rapidly commoditizing.  Our strategy in this market is not to market similar
devices to these various companies, but rather, to bring to market innovative
devices that enable the physician to perform spinal fusion procedures in a much
less invasive fashion.  Such innovative products may require changes in
physician technique, and may only be applicable to a proportion of the spinal
fusion procedures currently done in the market today.  However, less invasive
products that are as effective as the traditional fusion products, less
traumatic for the patient, simpler to use for the physician and lower cost for
both the hospital and the overall healthcare system are widely desired in the
marketplace.  It is these types of products that we intend to develop.

Any products that we commercialize will be subject to intense competition.
Overall, we believe the primary competitive factors that affect our instruments
are the cost of our products and the cost of procedures performed with our
products, third-party payor coverage and reimbursement status, effectiveness and
safety.  Many of our competitors and potential competitors in these markets have
substantially greater financial, technical and marketing resources than we do,
and they may succeed in developing products that may be more effective than ours
or that would render our instruments obsolete or noncompetitive.  In addition,
these competitors often have significantly greater experience and brand
recognition than we do in their respective fields.  These competitors may also
be willing to conduct their business in ways that are not beneficial to our
ability to continue to provide our products as we now do, such as by
substantially undercutting our prices or by seeking very low levels of
third-party payor reimbursement in various geographic markets in order to penetrate
those markets quickly.  Our ability to compete successfully will depend on our
ability to develop innovative products that reach the market in a timely manner
through our direct sales channel, receive adequate third-party payor coverage
and reimbursement and are safer, less invasive and less expensive than
alternatives available for the same condition.  Because of the size of the
potential market, we anticipate that companies will dedicate significant
resources to developing competing products and procedures.  Our technologies and
instruments may be rendered obsolete or uneconomical by technological advances
or entirely different approaches developed by one or more of our competitors.
We may also be forced to protect our market space through enforcement of our
intellectual property rights, which would be expensive to do and likely would
constitute a significant distraction to our executive team and which efforts
ultimately may not succeed.

Patents and Proprietary Technology

We believe that in order to have a competitive advantage, we must develop,
maintain and protect the proprietary aspects of our technologies.  We rely on a
combination of patents, trademarks, trade secrets, non-disclosure and other
contractual agreements and technical measures to protect our intellectual
property rights.  Kyphon®, KyphX®, KyphX HV-RTM and
KyphOsTM are some of our trademarks.  We have trademark rights in
these and others of our marks in the United States and have registrations issued
and pending in the United States and other countries for these and others of our
trademarks.  As of December 31, 2006, we had over 50 issued U.S.
patents, 60 issued foreign patents, 130 pending U.S. patent
applications, and 160 pending foreign applications.  Our patent portfolio also
includes 26 U.S. patents that we exclusively licensed from Bonutti Research in
August 2002, and 5 U.S. patents that we licensed from Dr. J. Lee Berger in April
2005.

Under the terms of our agreement with Bonutti Research, we acquired the
exclusive right to develop minimally invasive balloons and related products for
use within joints, ligaments, tendons, or cartilage in the spine and the
co-exclusive right to develop minimally invasive balloons and related products for
use in orthopaedic applications in joints, ligaments, cartilage, nerves or
tendons outside of the spine.

Under the terms of our agreement with Dr. Berger, we acquired exclusive
rights to certain technology including, among other things, technology relating
to expandable cavity-creation devices.

In February 2003, we acquired Sanatis GmbH, a privately-held developer
and manufacturer of orthopaedic biomaterials based in Rosbach, Germany.  Sanatis
has filed four patent applications covering inventions relating to calcium
cement formulations and a cement delivery technology.

In November 2005, Kyphon and Dr. Harvinder Sandhu, a well-respected
orthopaedic surgeon, entered into an agreement for Kyphon to acquire an
exclusive license to Dr. Sandhu's early invention rights concerning a
directional bone tamp for treating vertebral compression fractures.  As a result
of our exclusive license agreement with Dr. Sandhu, we recorded a one-time
charge of $20.0 million in our financial statements for the period ending
December 31, 2005.  This charge consisted of a cash payment of $5.0 million made
to Dr. Sandhu in November 2005 and a contractual obligation to make a series of
milestone payments totaling up to an additional $15.0 million beginning in 2006,
a second payment of $5.0 million of which was made in November 2006, according to the terms of the agreement.
The license agreement also includes a capped royalty stream on any future
developed product that practices Dr. Sandhu's technology.

Later in November 2005, Dr. Sandhu and Kyphon filed suit in federal district
court in Memphis, Tennessee against Medtronic Sofamor Danek (MSD) and several
other related corporate entities seeking compensatory and punitive damages and
injunctive relief for breach of contract and related covenants, trade secret
theft, fraud, and correction of inventorship of several patents and patent
applications presently owned by MSD, including U.S. Patent No. 6,676,665.  The
suit also requests, among other relief, that MSD transfer to Dr. Sandhu
ownership of the disputed patents and patent applications.  The dispute concerns
inventions related to an expandable, mechanical bone tamp for use in treating
vertebral compression fractures that Dr. Sandhu invented in the late 1990's and
which he confidentially disclosed and discussed with MSD.  The complaint alleges
that MSD later filed for several patents encompassing and claiming Dr. Sandhu's
inventions without naming him as inventor of that technology, and that it also
incorporated Dr. Sandhu's inventions into its internal Equestra/Arcuate
project without his permission.  In May 2006, the Company also sued MSD in the
same Tennessee court for willfully infringing five of the Company's U.S. patents
(numbers 4,969,888, 5,108,404, 6,235,043, 6,440,138, and 6,863,672) with its
Equestra/Arcuateproduct.  Discovery is underway, and various motions are
pending that seek to address the merits of Dr. Sandhu's and Kyphon's claims.
Trial was initially set for April 2007, but may be delayed so that all of Dr.
Sandhu's and Kyphon's claims may be heard in a single trial.  We intend to
vigorously prosecute our and Dr. Sandhu's cases against MSD.

In January 2006, we closed our acquisition of InnoSpine, a developer of a
proprietary technology platform for the diagnosis and potential treatment of
axial low back pain due to disc degeneration.  InnoSpine has filed for patent
protection on various aspects of the technology.

In connection with our acquisition of St. Francis, we acquired intellectual
property rights associated with the X-STOP Interspinous Process
Decompression System and other technologies related to the treatment of lumbar
spinal stenosis.  As of December 31, 2006, these assets included over 40 issued
U.S. patents, 10 issued foreign patents, 80 pending U.S. patent applications,
and 20 pending foreign patent applications.

In connection with our definitive agreement to acquire the
non-vertebroplasty, spine-related assets of Disc-O-Tech (for which regulatory
approval to close has not yet been received), we will acquire intellectual
property rights associated with the B-Twin product line, the SKy product line,
and associated tools and instruments.  In connection with our second definitive
agreement to acquire the vertebroplasty assets of Disc-O-Tech (for which
regulatory approval to close has not yet been received), we will acquire all of
the intellectual property rights of Disc-O-Tech related to its vertebroplasty
technology.

We require our employees, consultants and advisors to execute confidentiality
agreements in connection with their employment, consulting or advisory
relationships with us.  We also require our employees, consultants and advisors
who we expect to work on our products to agree to disclose and assign to us all
inventions conceived during the work day, using our property or which relate to
our business.  Despite any measures taken to protect our intellectual property,
unauthorized parties may attempt to copy aspects of our products or to obtain
and use information that we regard as proprietary.  Finally, our competitors may
independently develop similar technologies and file for patent rights that we
ultimately may infringe or which may undermine our own patent rights.  Because
of the importance of our patent portfolio to our business, we may lose market
share to our competitors if we fail to protect our intellectual property rights
or are unable to adequately enforce those rights.

The medical device industry is characterized by the existence of a large
number of patents and frequent litigation based on allegations of patent
infringement.  As the number of entrants into our market increases, the
possibility of a patent infringement claim against us increases.  While we make
an effort to ensure that our products do not infringe other parties' patents and
proprietary rights, our products and methods may be covered by U.S. patents held
by our competitors or others.  In addition, our competitors may assert that
future products we may market may infringe their patents.  From time to time, we
may approach, or may be approached by, others about licensing their patent
rights, or about their infringement of our patent rights.  The outcome of any of
these contacts is never certain, and may lead to costly disputes, which may not
be resolved in our favor.  Any claims, with or without merit, and regardless of
whether we are successful on the merits, would be time consuming, result in
costly litigation and diversion of technical and management personnel, cause
shipment delays, require us to develop non-infringing technology or require us
to enter into royalty or licensing agreements, which may not be available to us
on commercially reasonable terms, if at all.  An adverse determination in a
judicial or administrative proceeding regarding an infringement claim and
failure to obtain necessary licenses or develop alternative non-infringing
technologies could prevent us from manufacturing and selling our products, which
could have a material adverse effect on our business and financial condition and
cause our stock price to decline.

Government Regulation

Our products are medical devices subject to extensive regulation by the FDA
under the Federal Food, Drug and Cosmetic Act and by states under various state
regulations.  FDA regulations govern, among other things, the following
activities that we perform:

- product design and development;
- product testing;
- product manufacturing;
- product labeling;
- product storage;
- product advertising and promotion; and
- product sales and distribution.

Unless an exemption applies, each medical device that we wish to commercially
distribute in the United States requires either 510(k) clearance or premarket
approval from the FDA prior to marketing.  The FDA classifies medical devices
into one of three categories.  Devices deemed to pose relatively less risk are
placed in either class I or II, which requires the manufacturer to submit, and
FDA to clear, a premarket notification known as a 510(k) submission,
demonstrating the device's substantial equivalence to a legally marketed
predicate.  Some low-risk devices are exempted from this requirement.  Devices
deemed by the FDA to pose the greatest risk, such as life-sustaining,
life-supporting or implantable devices, or devices deemed not substantially
equivalent to a previously 510(k)-cleared device, are placed in class III
requiring premarket approval.

510(k) Clearance Pathway. To obtain 510(k) clearance, we must
submit a premarket notification demonstrating that the proposed device is
substantially equivalent in intended use and technological characteristics (or
if different in technological characteristics, a demonstration that the proposed
device is at least as safe and effective as the predicate device) to a
previously 510(k)-cleared device or a device that was in commercial distribution
before May 28, 1976 for which the FDA has not yet called for submission of
premarket applications, or is a device that has been reclassified from class III
to class II or I.  The FDA's 510(k) clearance pathway usually takes from three
to 12 months, but it can last significantly longer.  During this period, the FDA
may request additional information.

After a device receives 510(k) clearance, any modification 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 could
require premarket approval.  The FDA requires each manufacturer to make this
determination in the first instance, but the FDA can review any manufacturer's
decision.  If the FDA disagrees with a manufacturer's decision not to seek a new
510(k) clearance, the agency may retroactively require the manufacturer to seek
510(k) clearance or premarket approval.  The FDA can also require the
manufacturer to cease marketing and/or recall the modified device until 510(k)
clearance or premarket approval is obtained.

Our KyphX Inflatable Bone Tamps currently have 510(k) clearance for
use as conventional bone tamps for the reduction of fractures and/or the
creation of a void in cancellous bone in the spine (including use during balloon
kyphoplasty with KyphX HV-RBone Cement), hand, tibia, radius and
calcaneus.  The KyphX Inflation Syringe is a 510(k)-cleared product that
we currently obtain from contract suppliers.  We believe our KyphX
Introducer Tool Kit, Osteo Introducer System, Advanced Osteo
Introducer System, Bone Biopsy Device, Bone Access needles, Latitude
Curette, and KyphX Bone Filler Device, when sold as manual orthopaedic
surgical instruments, are Class I devices and are therefore exempt from 510(k)
clearance or premarket approval requirements.  Our 510(k) clearances permit us
to promote particular short and/or long-term benefits of balloon kyphoplasty,
including, for example:

- vertebral body height restoration;
- angular deformity correction;
- vertebral body volume increase;
- significant reduction in back pain;
- significant reduction in the number of days per month that the patient
remains in bed;
- significant improvement in the patient's quality of life;
- significant improvement in the patient's ability to perform the activities
of daily living;
- high rates of patient satisfaction with the procedure;
- significant improvement in pain and mobility; and a
- low complication rate.

Premarket Approval. A premarket approval application, or PMA,
must be submitted if a device cannot be cleared through the 510(k) process.  A
PMA must normally be supported by extensive data including, but not limited to,
technical, preclinical and clinical studies, manufacturing information and
labeling to demonstrate to the FDA's satisfaction the safety and effectiveness
of the device.

After a PMA is filed, the FDA begins an in-depth review of the submitted
information, which generally takes between one to three years, but may take
longer.  During this review period, the FDA may request additional information
or clarification of the information already provided.  Also, in many cases, an
advisory panel of experts from outside the FDA will be convened to review and
evaluate the application and provide recommendations to the FDA as to the
approvability of the device.  In addition, the FDA will conduct a preapproval
inspection of the manufacturing facility to ensure compliance with the quality
system regulations and may also conduct inspections of the clinical
investigators' and study sponsors' sites involved in the clinical studies
supporting the PMA.  New PMAs or PMA supplements are required for significant
modifications to the manufacturing process, labeling and design of a device that
is approved through the premarket approval process.  PMA supplements in certain
circumstances require submission of the same type of information as that
contained in an original PMA, but limited in scope to the changes from the
device covered by the original premarket approval.  PMA supplements may not
require extensive clinical data or review of the application by an advisory
panel, but both are possible.

Clinical Studies. Clinical studies are almost always required
to support a premarket approval application and are sometimes required for a
510(k) premarket notification.  These studies may require submission of an
application for an investigational device exemption (IDE).  The IDE application
must be supported by appropriate data, such as animal and laboratory testing
results, showing that it is safe to test the device in humans and that the
testing protocol is scientifically sound.  The IDE must be approved in advance
by the FDA unless the product is deemed to be a non-significant risk device
eligible for more abbreviated IDE requirements.  Clinical studies for
significant risk devices may begin once the IDE application is approved by the
FDA and the appropriate institutional review boards at the clinical trial
sites.

Any clinical studies we sponsor in the United States must be conducted in
accordance with FDA regulations.  These clinical studies will require that we
submit, and obtain FDA approval of, an IDE prior to commencing clinical studies,
unless they are conducted after marketing approval or clearance has been
obtained and the products are used within their cleared/approved Indications for
Use.  The results of any clinical studies that we conduct or sponsor may not be
sufficient for us to obtain any additional clearances or approvals or to support
additional marketing claims for our devices over what we already have.

Postmarket. After a device is placed on the market, numerous
regulatory requirements apply.  These include:

- the Quality System regulations, which require manufacturers to follow
extensive testing, control, documentation and other quality assurance procedures
during the design and production processes;
- the Medical Device Reporting (MDR) regulation, which requires that
manufacturers report to the FDA instances where their device may have caused or
contributed to a death or serious injury or may have malfunctioned in a way that
would likely cause or contribute to a death or serious injury if the malfunction
were to recur; and
- FDA regulations that prohibit the promotion of medical devices for
unapproved or "off-label" uses.

We have had to file what we believe is a low number of MDRs for our products,
although more may be required as the number of procedures performed with our
products increases.  Through 2006, we have not faced any product liability
litigation although such litigation is common in the medical device industry and
we may have to defend such litigation at some point in the future.

We are subject to inspection by the FDA to determine our compliance with
regulatory requirements.  If the FDA finds that we have failed to comply, it can
institute a wide variety of enforcement actions, ranging from a public warning
letter to more severe sanctions including:

- fines, injunctions, and civil penalties;
- recall or seizure of our products;
- operating restrictions, partial suspension or total shutdown of production;
- refusing our requests for 510(k) clearance or premarket approval of new
products;
- withdrawing 510(k) clearance or premarket approvals already granted; and
- criminal prosecution.

The FDA also has the authority to require us to repair, replace or refund the
cost of any medical device that we have manufactured or distributed in certain
circumstances.

Other Federal and State Healthcare Laws. Our operations are
subject to various federal and state healthcare laws commonly referred to as
"fraud and abuse" laws, including anti-kickback laws, false claims
laws and other laws prohibiting health care fraud and false statements. 
The federal Anti-Kickback Statute prohibits persons from knowingly and willfully
soliciting, receiving, offering or providing remuneration directly or indirectly
to induce either the referral of an individual, or the furnishing, recommending,
or arranging of a good or service, for which payment may be made under a federal
healthcare program such as Medicare and Medicaid.  The Department of Health
and Human Services (HHS) has issued regulations, commonly known as safe harbors,
that deem certain arrangements meeting specified requirements to comply with the
federal Anti-Kickback Statute.  We seek to have our business conduct and
arrangements with health care professionals comply with such safe harbors and
have adopted codes of conduct to guide our activities in that regard.  Business
conduct and arrangements that do not fully satisfy each applicable safe harbor
may result in increased scrutiny by government enforcement authorities such as
the HHS Office of Inspector General.  Scrutiny of our industry under these laws
appears to be increasing and several orthopaedic companies were recently
subpoenaed by the federal government regarding their relationships with, and
payments to, health care professionals.  Many states have adopted prohibitions
similar to the federal Anti-Kickback Statute.  Some of these state laws apply to
health care services reimbursed by any source, not only by the Medicare and
Medicaid programs, and do not have exceptions identical to those under the
federal law.



The federal False Claims Act prohibits any person from knowingly presenting,
or causing to be presented for payment, a false or fraudulent claim for payment
to the federal government.  Suits filed under the False Claims Act, known
as "qui tam" actions, can be brought by any individual (known
as a "relator" or, more commonly, "whistleblower") on behalf
of the government.  In addition, certain states have enacted laws modeled
after the federal False Claims Act.  The frequency of filing of qui
tam actions has increased significantly in recent years, causing greater
numbers of health care companies to have to defend a False Claim action.
Although we believe we are in substantial compliance with the health care laws
relevant to our Company, we are aware that a complaint against us, which we
believe is a qui tam complaint is presently being investigated by a U.S.
Attorney's Office (Please see the related discussion in Item
1A, Risk Factors).

The Health Insurance Portability and Accountability Act of 1996 (HIPAA),
includes at least two related federal statutes:  health care fraud and false
statements relating to health care matters.  The healthcare fraud statute
prohibits knowingly and willfully executing a scheme to defraud any health care
benefit program, including private payors.  The false statements statute
prohibits knowingly and willfully falsifying, concealing or covering up a
material fact or making any materially false, fictitious or fraudulent statement
in connection with the delivery of or payment for health care benefits, items or
services.

We have adopted corporate policies, compliance programs and codes of conduct
to assist our employees in complying with these laws and we train our employees
on how to engage appropriately with health care providers under these laws.  We
believe we are in substantial compliance with these laws.  Nevertheless, given
the nature of our business and our industry, our activities relating to the sale
and marketing of our products may be subject to scrutiny under any or all of
these health care laws.  We may also face increased risk of investigation and
enforcement based on the actions of our customers.  For example, the amount of
facility reimbursement available for balloon kyphoplasty performed on an
out-patient basis, while recently increased, has been and remains lower than
reimbursement available for balloon kyphoplasty performed on an in-patient basis
with an overnight stay.  While a treating physician typically decides to perform
kyphoplasty on a particular patient in either an in-patient or an out-patient
basis based on the standard of medical necessity, we believe the difference in
reimbursement available may sometimes influence the treatment decisions of
certain hospitals and physicians.  Violations of these laws may be punishable by
criminal and/or civil sanctions, including significant fines and civil monetary
penalties, as well as possible exclusion from federal health care programs
(including Medicare and Medicaid).  Our activities could be challenged due to
the broad scope of these laws and increased attention being given to them by law
enforcement authorities.  An accusation that we have violated these laws, and
any resulting enforcement or other regulatory or legal activity against us,
or against the physicians who perform procedures with our products or our customers
who purchase our products could adversely affect our
business and our financial condition, which could cause our stock price to
decline.

International. International sales of medical devices are
subject to foreign government regulations, which vary substantially from country
to country.  The time required to obtain approval by a foreign country may be
longer or shorter than that required for FDA approval, and the requirements may
differ.  The primary regulatory authority in Europe is that of the European
Union, or EU, which consists of 25 countries encompassing most of the major
countries in Europe.  Other countries, such as Switzerland, have voluntarily
adopted laws and regulations that mirror those of the EU with respect to medical
devices.  The EU has transposed into law numerous directives and adopted many
harmonizing standards pertaining to the design, manufacture, clinical study,
labeling and adverse event reporting of medical devices.  Devices that comply
with the requirements of relevant EU medical device directives will be entitled
to bear the CE marking of conformity, indicating that the device conforms to the
requirements of the applicable directives and, accordingly, can be commercially
distributed throughout Europe.  The method of assessing conformity varies
depending on the class of the product, but normally involves a combination of
self-assessment by the manufacturer and a third-party assessment by a
"Notified Body."  This third-party assessment includes an audit of the
manufacturer's quality system and possibly specific testing of the
manufacturer's product.  An assessment by a Notified Body residing in one
country within the EU is required in order for a manufacturer to commercially
distribute the product throughout the EU.  During this process, we must
demonstrate compliance with recognized harmonized standards pertaining to our
quality systems for the design and manufacture of products.

We have obtained CE Marking permitting us to commercialize certain of our
products in Europe, including a calcium phosphate biomaterial that we acquired
with the acquisition of Sanatis GmbH.  While no additional premarket
approvals in individual EU countries are required prior to the marketing of a
device bearing the CE Mark, practical complications with respect to market
introduction may occur.  For example, differences among countries have
arisen with regard to labeling requirements.

Seasonality



Our business is seasonal in nature.  Historically, demand
for our products has been the highest in the first and second quarters in the
U.S. and in the second and fourth quarters in Europe.  In the U.S., during the
fourth quarter, our net sales generally reflect the reduced number of selling
days due to the holiday season.  In Europe, we traditionally experience somewhat
lower sales volumes in the third quarter months than throughout the rest of the
year as a result of the European summer holiday schedule.  In addition, the
fourth quarter in Europe is typically favorably impacted by our customers'
budget utilization and our distributors' fulfillment of their annual purchase
commitments.

Operating Segment and Geographic Information

We operate in one segment, using one measurement of profitability to manage
our business.  Sales and other financial information by geographic area is
provided in Note 11 to our consolidated financial statements that are included
in this Annual Report.

Employees

As of December 31, 2006, we had a total of 1,090 employees, with 127 people
in operations, 113 people in research and development, 674 people in sales,
marketing and professional education and 176 people in general and
administrative.  None of our employees are represented by a labor union, and we
believe our employee relations are good.

Available Information

We are subject to the reporting requirements under the Securities Exchange
Act of 1934.  Consequently, we are required to file reports and information with
the Securities and Exchange Commission (SEC), including reports on the following
forms:  annual report on Form 10-K, quarterly reports on Form 10-Q, current
reports on Form 8-K, and amendments to those reports filed or furnished pursuant
to Section 13(a) or 15(d) of the Securities Exchange Act of 1934.  These reports
and other information concerning the Company may be accessed through the SEC's
website at http://www.sec.gov.

You may also find free electronic copies of our annual report on Form 10-K,
quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to
those reports filed or furnished pursuant to Section 13(a) or 15(d) of the
Securities Exchange Act of 1934 on our website at http://www.kyphon.com.  Such
filings are placed on our website as soon as reasonably practicable after they
are filed with the SEC.

ITEM 1A.	  RISK FACTORS

Factors Affecting Future Operating Results

Our future success depends on our ability to develop and successfully
introduce new products, product extensions and improvements to existing products
to address unmet patient and market needs.

Our current products offer orthopaedic surgeons and neurosurgeons,
interventional radiologists and interventional neuroradiologists minimally
invasive treatments for the spine in three areas: Spinal Fracture Management,
Disc Disease Diagnosis and Therapies and Spinal Motion Preservation with the
majority of our revenues derived from balloon kyphoplasty for the treatment of
vertebral compression fractures using our KyphX instruments. We cannot
assure you that the market for the treatment of spinal fractures will continue
to generate significant or consistent demand for our KyphX instruments.

Also, the X-STOPdevice, our product for treating lumbar
spinal stenosis, or LSS, was approved for sale in the United States only in late
2005. It is difficult to predict the market acceptance and future growth rate or
size of the market for the X-STOPdevice. The expansion of the
X-STOPdevice market depends on a number of factors, such as:

- physician and patient preference for the X-STOPdevice
over current therapies or procedures;
- physician and patient experience with the X-STOPdevice
including ease of implantation, safety profile, degree of symptom relief and
procedure recovery time;
- short and long-term safety and efficacy outcomes of the X-STOPdevice;
- effectiveness of sales and marketing efforts to increase physician and
patient awareness of the X-STOPdevice; and
- availability of adequate coverage and reimbursement for hospitals and
surgeons.

If the X-STOPdevice fails to achieve market acceptance,
our business and results of operations would be harmed, and our stock price
would likely decline.

Demand for our products could be significantly diminished by alternative
treatment methods, and by new technologies or products that replace and render
our products obsolete or too expensive. Our future success is dependent upon,
among other factors, our ability to develop, obtain regulatory clearance or
approval for, manufacture, sell and achieve market acceptance of new products,
product extensions and improvements to our existing products. The extent of, and
rate at which, market acceptance and penetration are achieved by future products
is a function of many variables. These variables include price, safety,
efficacy, reliability, marketing and sales efforts, the availability of adequate
third-party coverage and reimbursement for procedures using our new products and
the existence of competing products and general economic conditions affecting
purchasing patterns. Our ability to market and sell new products, product
extensions and improvements to our existing products may also be subject to
government regulation, including clearance and approval by the FDA and foreign
government agencies. Any failure in our ability to successfully develop, obtain
regulatory approval for, manufacture, sell and achieve market acceptance of our
new products, product extensions or improvements to our existing products could
adversely affect our business and our financial condition, which could cause our
stock price to decline.

Our success is dependent upon the availability of adequate physician and
hospital reimbursement by third-party payors for our products.

Our ability to commercialize our products
successfully depends in significant part on the extent to which appropriate
coverage and reimbursement for our products and related procedures are obtained
from third-party payors, including governmental payors such as Medicare.
Uncertainty exists as to the coverage and reimbursement status of new medical
technologies.  Procedures using our X-STOPtechnology and our
KyphX instruments are currently covered and reimbursed by the Medicare
program and other governmental and private third-party payors.  As a result of
developments in both physician and hospital reimbursement, including the
establishment of new reimbursement codes describing kyphoplasty or the lack of
specific reimbursement codes in the case of the X-STOPtechnology, some physicians and hospitals in some states may believe that
the level of reimbursement they receive is too low to support performing these
procedures. Continued use of our X-STOPand KyphX
technologies by the medical community may be adversely impacted if physicians
perceive that they do not receive sufficient reimbursement from third-party
payors for their services in performing the procedures using our instruments. As
of now, it is not possible to assess with any degree of certainty whether the
implementation of reimbursement code changes has had or will have any material
impact on the behavior of clinicians with respect to their interest in
performing our procedures.

Specifically, with regards to the X-STOPdevice, physician
reimbursement is governed by two new Category III CPT codes, effective January
1, 2007.  Category III codes are temporary codes for emerging technology and
services.  In the future, new, Category I CPT codes, for which national payment
levels are established, could be implemented with respect to the X-STOPdevice or may not be available at all.  In the event such
new codes are implemented, it is possible that reimbursement under such codes
could be at lower levels than what physicians and hospitals are currently
receiving under general, unspecified codes or will receive under Category III
CPT codes.  As of now, it is not possible to assess the full impact of
procedure-specific X-STOPdevice CPT codes on our business or
results of operations.

In addition, reimbursement for competing procedures, such as laminectomies or
vertebroplasty, may also continue to be perceived in some cases as more
favorable for the physician or hospital than that available for using our
products and thus may reduce the frequency with which procedures using our
products are performed, which could harm our revenues.



If domestic or international third-party payors adversely change coverage
or reimbursement policies for certain procedures, our ability to market and sell
our products would be adversely impacted, which would harm our business,
revenues and operating results.

Third-party payors, including Medicare and private health
maintenance organizations and insurance plans, are increasingly challenging the
prices charged for medical products and services and may institute adverse
changes in their coverage or reimbursement policies for procedures using our
products.  Governmental and private third-party payors are developing
increasingly sophisticated methods of controlling healthcare costs and are
exploring more cost-effective methods of delivering healthcare, including the
placement of limitations on the circumstances under which a procedure is covered
and other restrictions.  While many governmental and private third-party payors
currently provide coverage and reimbursement for the procedures in which our
instruments are used, we cannot assure you that procedures in which our
technology is used will continue to be reimbursed at current rates or that
third-party payors will continue to consider our technology cost-effective and
provide coverage and reimbursement for our technology, in whole or in part.  If
third-party payors adopt new limits or restrictions on coverage and
reimbursement of procedures using our products, such a development could
significantly impact the willingness of hospitals, clinics and doctors to
purchase and use our instruments, which in turn could adversely affect our
business and our financial condition, which could cause our stock price to
decline.

In the United States, there have been, and we expect there will continue to
be, a number of legislative and regulatory proposals to change the healthcare
system, including the Medicare program.  Some of these proposals have involved
changes that could significantly affect our business.  Future legislative or
policy initiatives directed at increasing the accessibility of healthcare and
reducing costs could be introduced on either the federal or state level.  We
cannot predict the impact on our business of any legislation or regulations
related to the healthcare system that may be enacted or adopted in the future.
In addition, healthcare 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, or already do, sell our instruments, and these efforts are expected to
continue in both the United States and abroad.  Reimbursement and healthcare
payment systems in international markets vary significantly by country and
include both government-sponsored healthcare and private insurance.  Given that
the vast majority of our revenues indirectly rely on government-funded
healthcare systems that reimburse our customers for their use of our products to
treat patients, any adverse change in governmental payors' coverage and/or
reimbursement policies, including as a result of reaction to rapidly escalating
budget pressures, would adversely impact our ability to market and sell our
products, harm our business and reduce our revenues.

If we are unable to successfully integrate our recent acquisitions into
our business, we could encounter difficulties that harm our business.

We have not previously attempted to integrate businesses or assets of the
size or complexity presented by both the acquisition of St. Francis and the
proposed acquisition of certain spine-related assets of Disc-O-Tech.  St.
Francis' implantable technology is technology with which we have little
experience.  Disc-O-Tech's spine-related assets include other technologies to
treat disease states with which we are unfamiliar.  We are faced with many
challenges in integrating what we have acquired, including becoming an effective
competitor in markets where we have not previously participated and adequately
protecting our investments in those acquisitions.  We must quickly learn and
incorporate into our business the acquired clinical, regulatory, reimbursement,
intellectual property, legal, operational, distribution and financial control
environment for Sarbanes-Oxley Act compliance, which will require a large amount
of financial and personnel resources.  If we are unable to effectively and
efficiently integrate these acquisitions while remaining sufficiently focused on
our existing balloon kyphoplasty business, our present business and financial
condition may be harmed.  Even if we successfully integrate these acquisitions,
we may still fail to achieve the revenues, cost savings, growth prospects and
any or other synergies expected from the transactions, which may prevent us from
realizing the full potential related to these significant financial investments.
These acquisitions and their resulting integrations may dilute our earnings per
share, harm our liquidity, disrupt our ongoing business, distract our management
and employees, increase our expenses, create an unfavorable impression of our
company in the public markets for our equity, and expose us to new risks and
liabilities, any or all of which could harm our business and cause our stock
price to decline.  We may also be subject to similar risks if we acquire other
companies in the future.

We have taken on a significant amount of debt in order to
finance our acquisition of St. Francis Medical Technologies, Inc. and our
proposed acquisitions of certain assets of Disc-O-Tech Medical Technologies,
Ltd. and its U. S. subsidiary.  Our substantial indebtedness could restrict our
operations and make us more vulnerable to adverse business or economic
conditions.

On January 18, 2007, we borrowed
$425.0 million pursuant to a senior secured credit agreement in order to finance
our acquisition of St. Francis, and on January 31, 2007, we effected a private
placement of $400.0 million principal amount of convertible senior notes under
Rule 144A.  Approximately $355.0 million of the net proceeds of the convertible
note offering, together with borrowings of approximately $70.0 million under our
revolving credit facility, were used to pay down the term loan in its entirety.
Our substantial indebtedness could have important consequences for our
stockholders.  For example, it could:

- make it difficult for us to satisfy our financial obligations, including
making scheduled principal and interest payments;
- limit our ability to borrow additional funds for working
capital, capital expenditures, acquisitions and general corporate and other
purposes;
- require us to dedicate a substantial portion of our cash
flow from operations to payments on our indebtedness, thereby reducing the
availability of our cash flow to fund working capital, capital expenditures and
acquisitions and for other general corporate purposes;
- increase our vulnerability to economic downturns and
competitive pressures in our industry;
- place us at a competitive disadvantage compared to our
competitors that have less debt in relation to cash flow; and
- limit our flexibility in planning for, or reacting to,
changes in our business and our industry.



The absence of prospective, randomized, controlled clinical trial data
supporting surgical treatment of vertebral compression fractures over
conservative care and the treatment of such fractures with balloon kyphoplasty
has caused some influential physicians to speak out against adoption of balloon
kyphoplasty, which may adversely affect our business and our financial
condition.

A handful of vocal physicians continue to publicly criticize the cost and
merits of balloon kyphoplasty as a procedure for treating vertebral compression
fractures.  We believe this is due, in part, to the absence to-date of
prospective, randomized, controlled clinical trial data on the effectiveness of
balloon kyphoplasty and the perceived economic cost difference between balloon
kyphoplasty and vertebroplasty.  Certain influential physicians and others in
professional societies, have publicly stated their opposition to both balloon
kyphoplasty and Kyphon based on this lack of perceived justification for the
cost or economics of the procedure.  We have recently completed enrollment in a
randomized, controlled trial comparing balloon kyphoplasty versus non-surgical
management.  While one month data is available, one year follow-up data will not
be available until late 2007 or early 2008. In addition, while we have commenced
enrollment in a randomized, controlled trial comparing balloon kyphoplasty to
vertebroplasty, we believe it will be several years before enrollment is
completed and any data is available.  We cannot predict whether the trials'
results or the response to such results will demonstrate the benefits of
treatment of vertebral compression fractures with balloon kyphoplasty.  We also
cannot predict how the presence of negative public criticism to adoption of our
products for treating patients ultimately may affect our business or our
revenues.

If primary care physicians are unwilling or unable to
refer patients to trained clinicians that use our X-STOP and KyphX
products to treat LSS or vertebral compression fractures, respectively, our
revenues will suffer and our business may not expand or may decline.

A key element of our business strategy is to educate
primary care physicians and spine specialists on the use of our X-STOP
and KyphX technologies as an alternative to conservative pain management
therapies and more invasive surgical procedures.  We believe primary care
physicians are an important source of patient referral, and, therefore, it is
important to educate them about our products and the clinical outcomes of these
procedures.  We believe that primary care physicians and spine specialists may
not widely adopt our products unless they determine, based on experience,
clinical data, published, peer-reviewed journal articles and recommendations and
support of our products by influential practitioners, that our products provide
benefits or an attractive alternative to conventional treatments of lumbar
spinal stenosis and spinal fractures.  In the case of balloon kyphoplasty, such
clinical data is not currently available and we cannot predict when such data
will be available or the response to such data.  If primary care physicians do
not recommend and support our products, then our future growth will be harmed
and our business may decline.

We may experience delays
in obtaining, or may be unable to obtain, the regulatory approvals necessary to
close either or both of the transactions with Disc-O-Tech.

The Federal Trade Commission (FTC) has issued second requests
for information in connection with our agreements to acquire the vertebroplasty
and non-vertebroplasty spinal assets of Disc-O-Tech.  The FTC's review process
may delay for many months our ability to close either transaction and
incorporate those assets into our business, and may result in material
conditions being placed on our ability to obtain the necessary regulatory
approvals or in our inability to close one or both of the transactions.  We may have to divest
or license to third parties some or all of the assets proposed to be acquired,
which may be detrimental to our business and our ability to recoup our material
investment in the assets subject to this agreement.  Regardless of the outcome
with the FTC, we are required to pay Disc-O-Tech the full amount due in
connection with the transaction.  In the event that we are forced to dispose of
some or all of the assets that we propose to acquire, the price we receive may
be significantly less than the price we are obligated to pay Disc-O-Tech.  In
addition, pursuant to a development agreement to be entered into in connection
with our proposed acquisition of Disc-O-Tech's vertebroplasty assets, we will be
obligated to pay two of the Disc-O-Tech founders up to an aggregate of $20
million if they develop, at their own cost and expense, a vertebral compression
fracture repair system.  In addition, they will be entitled to receive
contingent service payments equal to 5% of the worldwide consolidated gross
sales for this product, less standard returns and allowances.  In order to
dispose of the vertebroplasty assets, we will either have to ensure that the
acquirer assumes our obligations under the development agreement or that the
founders are otherwise compensated.

Because we may face significant competition from other companies with
greater resources or superior technology than we have, we may be unable to
maintain our competitive position and sales of our products may decline, and our
revenues may decline as a result.

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, some with more
resources than ours, are developing and have already introduced products to
directly compete with ours in similar procedures, both in the United States and
abroad, including, in some instances, copies of our technology for distribution
in one or more foreign markets.  For example, in September 2006, Medtronic
Sofamor Danek, or MSD, also known as Medtronic Spine, a company with
significantly more resources than Kyphon, introduced its Equestra/Arcuateproduct to compete with our technology for treating vertebral compression
fractures.  Additionally, Medtronic Spine, Abbott Labs, and Paradigm Spine have opened
IDEs in the U.S. to seek regulatory approval for their respective interspinous
process spacer products to treat lumbar stenosis and are already selling their products
in Europe to compete with our X-STOP technology.  Some of these competitors'
products may be successful as a result of being less expensive alternatives to
our products, or other advantages that make 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 KyphX
instruments, in particular.  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, are subject to sufficient levels of government and third party
reimbursement, and address patient and surgeon requirements.  We compete with
many larger companies that enjoy competitive advantages, including:

- longer-standing distribution networks and relationships with healthcare
providers and payors;
- additional lines of products and the ability to bundle products to offer
higher discounts or other incentives to gain a competitive advantage;
- greater experience completing preclinical testing and clinical trials and
obtaining FDA and other regulatory approvals; and
- greater resources for product development, manufacturing, sales and
marketing and patent litigation.

If we are unable to compete effectively against existing or future
competitors, sales of our instruments will decline.

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

We believe that the proprietary technology embodied in our instruments and
methods gives us a competitive advantage.  Maintaining this competitive
advantage is important to our future success.  We rely on patent protection in
the U.S. and abroad, as well as on a combination of copyright, trade secret and
trademark laws, to protect our proprietary technology.  However, these legal
means afford only limited protection and may not adequately protect our rights
or permit us to gain or keep any competitive advantage.  For example, our
patents may be challenged, invalidated or circumvented by third parties.  Our
two earliest patents, which we believe provide broad protection to our
technology, expire as early as February 2009.  Our patent applications may not
issue as patents at all or in a form that will be advantageous to us.  We may
not be able to prevent the unauthorized disclosure or use of our technical
knowledge or other trade secrets by consultants, vendors, former employees and
current employees, despite the existence of nondisclosure and confidentiality
agreements and other contractual restrictions.  Furthermore, the laws of foreign
countries may not protect our intellectual property rights to the same extent as
the laws of the United States and may permit others to copy our products abroad
without effective recourse.  We have recently detected what we believe are the
first attempts to copy some of our products for distribution in one or more
foreign countries.  In addition, in many foreign jurisdictions, we have either
acquired patent protection that is narrower in scope than our corresponding
protection in the U.S. or chosen, for various business reasons, not to pursue
any patent protection at all.  We also may not have the ability to prevent
infringing products from remaining on the market in at least some geographic
locations, and we may lose market share or have our growth impeded in those
geographic markets as a result.  To protect our rights, we may in the future
initiate other claims or litigation against third parties for infringement of
our proprietary rights.  We may also begin one or more patent proceedings in
various administrative agencies and patent offices to protect our patent rights
and prevent them from being undermined by our competitors' patent
filings.

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

The medical device industry has been characterized by extensive litigation
and administrative proceedings regarding patents and other intellectual property
rights.  Whether a medical device 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, especially
as we expand our business into other areas of technology, such as for diagnosis
and treatment of spinal conditions.  For example, Medtronic has brought suit against
us in the United States alleging that our KyphX technology for the treatment of
vertebral compression fracture, and which provides the majority our revenues,
infringes four of its patents.  Medtronic or others may choose to assert other patents
against us at any time.  From time to time, we receive correspondence from
various third parties accusing us of infringing their patents or inviting us to
license their patents.  In addition, they may claim that their patents have
priority over ours because they invented first or their patents were filed or
issued first.  Because patent applications can take many years to issue, there
may be applications now pending of which we may be aware or unaware, which may
later result in issued patents that our instruments or methods may infringe.
There could also be existing patents that one or more of our instruments or
methods may inadvertently be infringing.  As the number of competitors in the
market for minimally invasive spine disorder treatments grow, the possibility of
a patent infringement claim against us increases.

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

We expend considerable effort complying with federal and state healthcare
"fraud and abuse" laws, but, if we are found not to have fully
complied with such laws, our business and financial condition could be adversely
affected, which could cause our stock price to decline.



As part of the medical device industry, we are subject to various federal and
state healthcare laws generally collectively referred to as the healthcare
"fraud and abuse" laws.  Investigations and enforcement under these
laws within our industry is increasing, and at least five other medical device
manufacturers have recently been the subject of investigations and/or
enforcement activities by the United States government in connection with the
industry's interactions with, and payments to, healthcare professionals.  While
we educate and train our employees on how to interact appropriately with
healthcare providers under applicable laws, and while we believe we are in
substantial compliance with these laws, we cannot assure you that we will not be
subject to investigations or enforcement actions under any of these laws based
on the actions of our employees.  We
may also face increased risk of investigation and enforcement based on the
actions of our customers under these same laws. If our past or present
operations are judged to be in violation of any of the laws described above or
the other similar governmental regulations to which we are subject, we may
ultimately face associated adverse consequences, such as fines, penalties,
exclusion from healthcare programs and/or the curtailment and restructuring of
our operations, which could harm our business and our financial condition and
cause our stock price to decline.  Any action against us for violation of these
laws, even if we successfully defend against it, could cause us to incur
significant legal expenses, divert our management's attention from the operation
of our business and damage our reputation.  This, in turn, could adversely
affect our business and our financial condition, which could cause our stock
price to decline.

We are aware that a complaint, which we believe is a qui tam
complaint, is being evaluated by a U.S. Attorney's Office in connection with our
marketing and sales practices, including those relating to the Medicare
reimbursement available to our customer hospitals.  Our business and financial
condition could be adversely affected if a subpoena or an enforcement or other
action ultimately results from this investigation or through the process the
USAO will use with our customers to investigate the allegations even if no
enforcement or other action ultimately results.  This could cause our stock
price to decline.

In 2005, a U.S. Attorney's Office in New York, or USAO, received a complaint
that we believe is a qui tam complaint that alleges impropriety in our
business, including regarding our reimbursement practices.  Qui tam is a
provision under the False Claims Act (31 U.S.C.   3729 et seq.), which allows
for a private individual, or whistleblower with alleged knowledge of past or
present fraud on the U.S. federal government to bring suit on behalf of the
government.  Although no suit has been filed and no subpoena has been issued to
us in connection with this complaint, the USAO is investigating our sales and
marketing practices, including how we communicated with our customers in the
past regarding the Medicare reimbursement available to hospitals and the
appropriate site-of-service for using our products in surgery.  The USAO has
asked to review some of our documentation that may be relevant to the
investigation, which we have begun to produce, and has also interviewed some of
our ex-employees and some of our customers.  We continue to voluntarily
cooperate with the USAO and to permit the USAO to develop an informed opinion on
whether or not to pursue any action in connection with the complaint, although
timing on that decision is uncertain.  At the time, although we believe we are
in substantial compliance with the healthcare laws applicable to us, we do not
know whether the investigation itself, or the outcome of the investigation will
have a material adverse impact to our business, and cannot assure you regarding
any future path the USAO or any related lawsuit may take.  Our business and
financial condition could be adversely affected if a subpoena or an enforcement
or other action ultimately results from this investigation, either against us,
or against the physicians who perform procedures with our products or our
customers who purchase our products, and could also be harmed
through the process the USAO will use with our customers to investigate the
allegations, even if no enforcement or other action ultimately results.  This
could cause our stock price to decline.

We are involved in patent infringement litigation with Medtronic and related
entities that may harm our competitive position, may be costly to us and may
prevent us from selling our products.

Medtronic and several other related corporate entities (MSD) have filed suit against us
in federal district court in the Northern District of California, alleging that
our vertebral bone tamps infringe four balloon dilatation catheter patents
(numbers 4,820,349, 5,759,191, 5,759,173 and 6,179,856).  The suit seeks damages
based upon the making, using, selling and offering for sale of our products,
seeks enhanced damages for alleged willful infringement, and seeks to enjoin our
continued activities relating to these products.  While we intend to vigorously
defend this action, we cannot assure you that the outcome of this litigation
will be favorable to us.  If we lose the suit against us, it will hurt our
competitive position, it may be costly to us and it may prevent us from selling
our products.  In addition, if we lose, we may need to obtain a license to the
patented technology, which could be expensive, and which MSD may not grant us or
we could be required to license to MSD some of our own technology, which would
result in a partial loss of our competitive advantage in the marketplace, each
of which could seriously harm our business.  If MSD is successful in its patent
suit and is unwilling to grant us a license, we may be required to stop selling
our products that are found to infringe any of the asserted patents unless we
can redesign them so they do not infringe, which we may be unable to do.  In
addition, if we lose, we



MSD has also alleged that several of our patents relating to our vertebral
bone tamps are invalid.  We cannot assure you that we will be able to
successfully defend this action. If MSD is successful in invalidating these
patents, we will not be able to prevent our competitors, including MSD, from
using the technology claimed in these patents.  This will have a negative impact
on our competitive position and could seriously harm our business.

Defending this suit and prosecuting our related suit against MSD in federal
court in Memphis, Tennessee, will be expensive, the litigation may be protracted
and our confidential information may be compromised.  Whether or not we are
successful in these lawsuits, this litigation could consume substantial amounts
of our financial and managerial resources.  At any time, MSD may file additional
claims against us, or we may file further claims against MSD, which could
increase the risk, expense and duration of the litigations.  For more
information on our litigation with MSD, see "Part II-Item 1: Legal
Proceedings."

We are involved in a gender discrimination lawsuit that six of our current
and former female sales employees filed against us.  Failure to
successfully defend against this action could harm our business, financial
condition and operating results.

In June 2006, six of our current and former female U.S.-based sales
employees filed a gender discrimination lawsuit against Kyphon in federal
district court in the Northern District of California asking for injunctive
relief and damages in excess of $100 million.  The plaintiffs also seek to
convert their case against us into a class action.  Although we intend to
vigorously defend plaintiffs' lawsuit, this lawsuit threatens our reputation and
subjects us to potential liability for significant damages.  While we believe we
have multiple meritorious defenses to this action, we cannot assure you that we
ultimately will prevail on any issue in the litigation or that we will be able
to successfully defend plaintiffs' charges.  Failure to successfully defend
against this action could harm our business, financial condition and operating
results and cause our stock price to decline.

Our failure to maintain necessary regulatory clearances or approvals, or
to obtain additional regulatory clearances or approvals, in the United States
and abroad could hurt our ability to commercially distribute and market our
products.

Our products are considered medical devices and are subject to extensive
regulation in the United States and in foreign countries where we currently
conduct, or intend to conduct, our 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 take longer, require more
information, and be significantly more expensive than the 510(k) clearance
process.  So far, we have obtained 510(k) clearance for the KyphX
Inflatable Bone Tamps for fracture reduction or void creation in specific sites
including the spine (including for use during balloon kyphoplasty using our bone
cement), hand, tibia, radius and calcaneus, and clearance for our KyphX
HV-R Bone Cement for the treatment of pathological fractures of the
vertebral body due to osteoporosis, cancer, or benign lesions during balloon
kyphoplasty procedures.  These clearances allow us to promote
numerous

Our failure to comply with such regulations could lead to the imposition of
untitled letters, warning letters, injunctions, suspensions or loss of
regulatory clearances or approvals, product recalls, product seizures or civil
or criminal penalties.

We have begun to invest significant financial resources to conduct clinical
trials of our products, which will reduce our earnings during the foreseeable
future, and which may not ultimately provide data supportive of the use and
clinical efficacy of our products.

We anticipate conducting significant additional clinical trial activity both
in the United States and abroad to collect further data that may support the use
and clinical efficacy of our products.  The cost of these trials will be
significant, which may reduce our net income and earnings for the foreseeable
future.

In addition, the results of our clinical trials may not ultimately produce
data that are supportive of our products over other treatment alternatives, that
may support unfavorable conclusions regarding our technology, and that
ultimately may provide information that leads to a decreased rate of adoption of
our products for balloon kyphoplasty, which would harm our business and cause
our stock price to decline.

Finally, we may be unable to complete the clinical trials for a variety of
reasons, and therefore may not be able to provide additional clinical data on
our products.

As a condition of FDA premarket approval of the X-STOPdevice for
treatment of LSS, we are required to design and conduct additional clinical
study activity, and if the results of these additional study activities are not
satisfactory, the FDA could take action to limit our ability to market and sell
the X-STOP device.

As a condition of receipt of premarket approval from the FDA, for the
X-STOP technology, we are required by the FDA to conduct a single-arm
study involving 240 patients, all of whom will undergo an X-STOP
procedure.  This condition-of-approval study is being required by the FDA to,
among other things, determine whether patient selection criteria based on our
approved labeling are adequate, and to evaluate whether the results from our
pivotal study can be replicated with a larger number of patients.  In addition
to the condition of the approval study, we are required to continue to follow
patients in our pivotal study for five years.  In the event that the results of
this condition-of-approval study indicate that the X-STOP is less
efficacious in treating patients with moderate LSS symptoms than suggested by
the results of our pivotal study, or in the event unforeseen issues or safety
concerns arise, the FDA could require us to modify the labeling of the X-STOP device which could reduce the size of the indicated patient population
for the procedure.  In addition to reducing the portion of the LSS patient
population that would be candidates for the X-STOP device, any such
action would also likely adversely affect our plans for expanding the
indications for the X-STOP device.  Any FDA action to limit the indicated
patient population for the X-STOP device based on the results of our
condition-of-approval study would harm our business and results of operations,
and would likely cause our stock price to decline.

We are aware that third parties are conducting a variety of clinical studies
involving the X-STOP technology.  If those studies support conclusions
that reflect negatively on the safety or efficacy of the X-STOP
technology, our business and results of operations could be harmed, which
could cause our stock price to decline.

We are aware that third parties are in the process of conducting clinical
studies involving the X-STOP technology for the treatment of lumbar
spinal stenosis.  These studies were commenced before we purchased the technology
and may not have been designed or conducted in an optimal manner.   Additionally,
clinicians involved with the studies may not have had adequate training prior to
performing procedures involving the X-STOP IPD System.  We do not have and may not
obtain a full understanding of these studies or of all of the data that have been
generated.  Nevertheless, if one or more of those studies ultimately supports a
conclusion that reflects negatively on the safety or efficacy of the X-STOP
technology, our business and results of operations could be harmed, which could cause
our stock price to decline.

We have had no experience to date with the complex compliance and regulatory
requirements associated with developing, acquiring approval for and marketing
FDA class III devices, and if we are unable to successfully comply with these
more complex requirements, our business could be harmed.

To date, we have had no experience with developing, seeking regulatory
approval for or marketing in the U.S. class III medical devices, such as the
X-STOP IPD System for lumbar spinal stenosis that we recently acquired
from St. Francis.  Class III medical devices have more complex compliance
and regulatory requirements associated with them than class I or class II
devices, with which we are more familiar, and typically require more onerous
clinical trials in order to gain and maintain FDA approval for marketing and
promotion.  We can provide no assurance that we will be able to implement
the necessary systems, processes and procedures to ensure compliance with the
more complex regulations associated with class III devices.  If we unable
to successfully navigate all of the increased complexities associated with class
III devices, we will be unable to successfully integrate into our business, and
realize the full potential of our acquisition of, the X-STOP technology,
which could harm our business and cause our stock price to decline.

We may seek additional financing, which could result in
dilution to our stockholders or may not be available to us on acceptable terms,
if at all.

As of December 31, 2006, we had $81.9 million of cash and
cash equivalents and $120.2 million of short-term investments.  We believe our
cash generated from operations, together with our cash, cash equivalents,
investments, and borrowings available under our revolving credit facility will
be sufficient to meet our anticipated cash needs for working capital, capital
expenditures and any contingent payments that become due related to our recent
acquisitions for at least the next 12 months.  If existing cash, cash
equivalents, cash generated from operations and borrowings available to us under
our revolving credit facility are insufficient to satisfy our cash requirements,
whether as a result of expansion of product lines, increased capital
expenditures, additional clinical trials, or investment in new markets or
businesses, or for other reasons related to our business, we may seek to sell
additional equity or debt securities.  The sale of additional equity or the sale
of additional 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.  Additional financing may not be available to us when we need it or
it may not be available on favorable terms, if at all.  If we are unable to
obtain adequate financing when needed, we may have to delay, reduce the scope of
or eliminate our business development activities which could cause our stock
price to decline.

If we are unable to generate or borrow sufficient cash to make payments on
our indebtedness or to refinance our indebtedness on acceptable terms, our
financial condition would be materially harmed, our business may fail and you
may lose all of your investment.

Our ability to make payments on and to refinance our debt will depend on our
financial and operating performance, which may fluctuate significantly from
quarter to quarter, and is subject to prevailing economic conditions and
financial, business and other factors, many of which are beyond our control.  We
cannot assure you that we will continue to generate sufficient cash flow or that
we will be able to borrow funds in amounts sufficient to enable us to service
our debt or to meet our working capital and capital expenditure requirements.
If we are not able to generate sufficient cash flow from operations or to borrow
sufficient funds to service our debt, we may be required to sell assets or
equity, reduce capital expenditures, refinance all or a portion of our existing
debt or obtain additional financing.  If we are unable to meet our debt
obligations or fund our other liquidity needs, we may need to restructure or
refinance all or a portion of our debt on or before maturity or sell certain of
our assets.  We cannot assure you that we will be able to restructure or
refinance any of our debt on commercially reasonable terms, if at all, which
could cause us to default on our debt obligations and impair our liquidity.  Any
refinancing of our debt could be at higher interest rates and may require us to
comply with more onerous covenants, which could further restrict our business
operations.

We may not be able to finance future needs or adapt our business plan to
changes because of restrictions placed on us by our credit facility, the
indentures governing our notes and instruments governing our other
indebtedness.

The indentures for our notes and our credit facility contain affirmative and
negative covenants which restrict, among other things, our ability to:

- incur additional debt;
- sell assets;
- create liens or other encumbrances;
- make certain payments and dividends; or
- merge or consolidate.

All of these restrictions could affect our ability to operate our business
and may limit our ability to take advantage of potential business opportunities
as they arise.  A failure to comply with these covenants and restrictions would
permit the relevant creditors to declare all amounts borrowed under the relevant
facility, together with accrued interest and fees, to be immediately due and
payable.  If the indebtedness under the credit facility or our notes is
accelerated, we may not have sufficient assets to repay amounts due under the
credit facility, the notes or on other indebtedness then outstanding.  If we are
not able to refinance our debt, we could become subject to bankruptcy
proceedings, and you may lose all or a portion of your investment because the
claims of our creditors on our assets are prior to the claims of our
stockholders.

If we are unable to expand our in-house manufacturing capacity in a timely
manner, or if we do not accurately project demand, we could have excess capacity
or insufficient capacity, either of which could adversely affect our operating
results.

We currently manufacture substantially all of our KyphX instruments in
our facilities located in Sunnyvale, California.  We plan to expand our
manufacturing capacity at this facility.  In addition, we will be devoting
significant resources during 2007 towards establishing our new facilities in
Neuchâtel, Switzerland that will include manufacturing capacity.  We plan
to manufacture a secondary supply of our KyphX instruments in this
facility, in addition to manufacturing our proprietary KyphOs calcium
phosphate bone cement.  We could experience difficulties and disruptions in the
manufacture of our KyphX instruments during capacity expansion in our
Sunnyvale facility, prior to bringing up our Neuchâtel facility.  In both
our Sunnyvale and Neuchâtel facilities, we could also face the inability
to procure and install the necessary manufacturing equipment, a shortage of
components used in our products, a lack of availability of qualified
manufacturing personnel, difficulties in achieving consistent quality control
from new manufacturing lines, difficulties in obtaining or maintaining
compliance with regulatory requirements mandated by the FDA and the European
Union and an inability to maintain sufficient manufacturing capacity.  We may
experience delays, disruptions, capacity constraints and other problems in our
manufacturing operations, and, as a result, product shipments to our customers
could be delayed, which would negatively impact our revenues, competitive
position and reputation.  If we are unable to expand our manufacturing capacity
in a timely manner, or if we do not accurately project demand, we will have
excess capacity or insufficient capacity, either of which could seriously harm
our profitability and cause our stock price to decline.

We are dependent on single source suppliers and manufacturers for the
X-STOP device, and the loss of any of these suppliers or manufacturers,
or their inability to supply us with an adequate supply of materials could harm
our business.

We rely exclusively on contract manufacturers to produce our X-STOP device and the surgical instruments we market for use with the X-STOP procedure.  In order for us to be successful, our contract
manufacturers must be able to provide us with products and components in
substantial quantities, in compliance with strictly enforced regulatory
requirements, in accordance with agreed upon specifications, at acceptable costs
and on a timely basis.  The failure of our contract manufacturers to comply with
strictly enforced regulatory requirements could expose us to regulatory
enforcement.  Our anticipated growth could strain the ability of our contract
manufacturers to deliver an increasingly larger supply of products, materials
and components.  Manufacturers often experience difficulties in scaling up
production, including problems with production yields and quality control and
assurance.  If we are unable to obtain sufficient quantities of our products and
surgical instruments to meet customer demand on a timely basis, we could lose
customers, our reputation may be harmed and our business could suffer.

Any significant delay or interruption in the supply of the X-STOP
device or the materials it is made of, or our inability to obtain alternate
sources at acceptable prices and in a timely manner could impair our ability to
meet the demand of our customers and harm our business.  Identifying and
obtaining regulatory approval for additional or replacement manufacturers or
suppliers may not be accomplished quickly or at all and could involve
significant additional costs.  Any supply interruption or failure to obtain
additional suppliers would limit our ability to sell our products and could
therefore harm our business and results of operations and cause our stock price
to decline.

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

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

- a significant increase in manufacturing costs associated with the need to
obtain replacement components;
- our inability to meet demand for our instruments, which could lead to
customer dissatisfaction and damage our reputation; and
- delays associated with regulatory qualifications required for use of
replacement suppliers.

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

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

We manufacture medical devices that are used on patients in spine surgery
procedures.  Spine surgery, including implantation of the X-STOPdevice or balloon kyphoplasty, involves risk of serious complications,
including cardiac arrest, cerebrovascular accident, myocardial infarction,
pulmonary embolism, and death.  The use of bone filler material by surgeons to
fill the void created using our KyphX Inflatable Bone Tamp may also lead
to these complications, as a result of leakage of the bone filler material into
the spinal canal or surrounding tissue or for other reasons.  We are aware that
some of these complications have occurred during procedures performed with our
products, including our KyphX HV-R bone cement and KyphOs
calcium phosphate, and we have had to publicly report that information through
filing a Medical Device Report to the FDA or Vigilance Reports in the EU.
Increased reporting of adverse events in connection with the use of our or other
bone void filler materials during balloon kyphoplasty could expose us to
increased risk of product liability litigation, and our current insurance
coverage limits may not be adequate and we may not be able to obtain continued
product liability coverage on commercially reasonable terms, if at all.
Companies, including ours, which produce devices for use in the spine, are
subject to a significant risk of product liability litigation.  If any of our
devices 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
devices increase.  Product liability insurance is expensive and may not be
available to us in the future on acceptable terms, if at all.  In addition,
increased reporting of adverse events may lead to regulatory action by the FDA
which could adversely affect our ability to market products and/or result in
other adverse consequences to our Company, our employees and our business,
including but not limited to civil and criminal penalties, recall, seizure, and
product withdrawal, which in turn could adversely affect our business and our
financial condition and cause our stock price to decline.

We derive a significant portion of our operating results from sales outside
the United States, which are subject to additional risks arising from
international operations and sales.

Sales outside of the United States account for a significant percentage of
our revenues and we intend to continue to expand our presence in international
markets.  International net sales accounted for $83.7 million or approximately
21% of total net sales in 2006.  Our international operations and sales are
subject to a number of further risks in addition to those faced for our
business, generally including:

- our products may sell at lower prices outside the United States;
- agreements may be difficult to enforce;
- receivables may be difficult to collect through a foreign country's legal
system;
- foreign customers may have longer payment cycles;
- foreign countries may impose additional withholding taxes or otherwise tax
our foreign income, impose tariffs or adopt other restrictions on foreign
trade;
- U.S. export licenses may be difficult to obtain;
- intellectual property may be more difficult to acquire and enforce in
foreign countries, and copying of our products in certain jurisdictions may
become widespread;
- terrorist activity may interrupt distribution channels or impact our
customers or employees; and
- fluctuations in exchange rates may affect product demand and adversely
affect the profitability, in U.S. dollars, of products sold in foreign markets
where payments are made in local currencies.

Any one or more of these factors stated above could have an adverse effect on
our non-U.S. financial condition, results of operations and business and cause
our stock price to decline.

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

With the present exception of Canada, South Africa and some of the larger
countries in Europe, we sell our KyphX instruments in foreign markets
through distributors and sales agents.  To the extent we rely on distributors,
our success will depend upon the efforts of others, over which we may have
little control.  We are in the process of terminating X-STOP IPD
distributors in the U.S. and in certain countries in Europe.  We may not be able
to effect a successful transition to either our own sales force or to new
distributors.  We both establish and terminate relationships with distributors
in foreign jurisdictions in the ordinary course of business.  We may also
terminate or modify other distribution relationships in further geographic
locations in the future.  If we lose a distributor or a distributor fails to
perform, our revenues will be harmed in those geographies, and the market for
our products may also be harmed in those geographies as a result of the
distributor's or agent's actions.  Alternative sales channels are available in
these geographic markets; however, their establishment could consume substantial
time and resources.

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

Our world-wide direct sales organization has increased from approximately 31
employees in October 2000 to over 480 field-based employees in December 2006,
which we believe represents significant growth over a relatively short period of
time.  Our world-wide organization as a whole has increased from approximately
131 employees in October 2000 to over 1,090 employees in December 2006.  We
intend to continue growing rapidly.  The growth that we have experienced, and in
the future likely will experience, provides challenges to our organization,
requiring us to rapidly expand our personnel and manufacturing operations.  We
may not be able to hire sufficient personnel to meet our growth goals or may
have difficulty managing such rapid growth.  As a result, our failure to recruit
additional sales and other 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.

We are dependent on our senior management team and key personnel, and the
loss of any of them could harm our business.

Our continued success depends in part upon the continued availability and
contributions of our senior management team and key personnel.  We have entered
into an employment agreement with Richard W. Mott, but this agreement does not
guarantee his service for any specified period of time.  We have not entered
into employment agreements with any of our other senior management or key
personnel.  The loss of members of our senior management or key personnel, or
our inability to attract and retain other qualified personnel or advisors could
adversely affect our business and financial condition, which could cause our
stock price to decline.

We may be adversely affected by the impact of environmental and safety
regulations.

We are subject to federal, state, local and foreign laws and regulations
governing the protection of the environment and occupational health and safety,
including laws regulating the disposal of hazardous wastes and the health and
safety of our employees.  We may be required to obtain permits for governmental
authorities for certain operations.  If we violate or fail to comply with these
laws and regulations, we could incur fines, penalties or other sanctions, which
could adversely affect our business and our financial condition and cause our
stock price to decline.  We could incur material expenses in the future relating
to compliance with future environmental laws.  In addition, we could be held
responsible for costs and damages arising from any contamination at our present
facilities or third-party waste disposal sites.  Such costs could be material.
We cannot completely eliminate the risk of contamination or injury resulting
from hazardous materials, and we may incur material liability as a result of any
contamination or injury.



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

Our basic corporate documents and Delaware law contain provisions that enable
our management to attempt to resist a takeover unless it is deemed by management
and our Board of Directors to be in the best interests of our stockholders.
Those provisions might discourage, delay or prevent a change in the control of
our company or a change in our management.  Our Board of Directors may also
choose to adopt further anti-takeover measures without stockholder approval.
The existence and adoption 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.

We have experienced and may continue to experience increases in our general
and administrative costs as a result of additional securities and corporate
governance laws and regulations.

The Sarbanes-Oxley Act of 2002 that became law in July 2002, as well as the
rules and regulations subsequently implemented by the SEC and the NASDAQ
exchange on which we are listed, required significant changes to our corporate
governance practices.  These new rules and regulations have resulted in
increased legal and financial compliance costs, make some activities more
difficult, time consuming and/or costly, and make it more difficult and more
expensive for us to obtain directors and officers liability insurance, all of
which may affect our financial performance.  These new rules and regulations may
also make it more difficult for us to attract or retain qualified executive
officers and members of our Board of Directors, particularly to serve on our
Audit Committee.  We may experience additional increases in our general and
administrative costs as a result of additional securities and corporate
governance laws and regulations that may be enacted in the future.

We can provide no assurance regarding our, or our independent registered
public accountants', conclusions after December 31, 2006 with respect to the
effectiveness of our internal control over financial reporting.

Section 404 of the Sarbanes-Oxley Act of 2002 requires us to include an
internal control report from management in our Annual Report on Form 10-K.  The
internal control report must include a statement:



- about management's responsibility for establishing and maintaining adequate
internal control over financial reporting;
- identifying the framework used by management to conduct the required
evaluation of the effectiveness of our internal control over financial
reporting;
- concerning management's assessment of the effectiveness of our internal
control over financial reporting as of the period covered by the Annual Report,
including a statement as to whether or not internal control over financial
reporting is effective; and
- that our independent auditors have issued an attestation report on
management's assessment of internal control over financial reporting.

While we expended significant resources in developing the necessary
documentation and testing procedures required by Section 404, given the risks
inherent in the operation of internal controls over financial reporting, we can
provide no assurance as to our, or our independent auditor's, conclusions after
December 31, 2006 with respect to the effectiveness of our internal control over
financial reporting.  Although we received unqualified opinions as of December
31, 2006, if we are unable to maintain compliance with all of the requirements
imposed by Section 404, or if we are unable to complete any assessment of our
internal controls, or if our internal controls are not designed or operating
effectively, we may conclude that our internal control over financial reporting
is not effective and our external auditors may either disclaim an opinion as it
relates to management's assessment of the effectiveness of our internal control
or may issue a qualified opinion on the effectiveness of our internal controls.
Investors may lose confidence in the reliability of our financial statements,
which could cause the market price of our common stock to decline and which
could affect our business and financial condition.

Our facilities are located near known earthquake fault zones, and the
occurrence of an earthquake or other natural disaster or catastrophic event
could cause damage to our facilities and equipment, which could require us to
cease or curtail operations and could hurt our revenues.

Our facilities are located near known earthquake fault zones and
are vulnerable to significant damage from earthquakes.  We are also vulnerable
to damage from other types of disasters, including fires, floods, power loss,
communications failures and similar events including the effects of war or acts
of terrorism.  If any disaster of this sort were to occur, our ability to
operate our business at our facilities could be seriously or completely impaired
or destroyed and our revenues could be significantly impacted as a result of our
inability to continue to supply products to our customers.  The insurance we
maintain may also not be adequate to cover our own losses resulting from
disasters or other business interruptions.

ITEM 1B.	  UNRESOLVED STAFF
COMMENTS

None

ITEM 2.	  PROPERTIES

Our United States operations and our corporate headquarters are located
in an approximately 151,000 square foot facility in Sunnyvale, California, where
we conduct our manufacturing, warehousing, research, regulatory and
administrative activities.  This includes an additional 43,434 square
feet which we leased pursuant to an amendment to our existing lease
agreement on September 28, 2005.  The combined facilities are leased
through August 2014.  Under the terms of the lease agreement, we have the option
to have additional square footage built and leased to us in the same surrounding
campus.

Our European operations are located in an approximately 28,000
square foot facility in Brussels, Belgium, where we conduct sales,
clinical, regulatory and administrative activities.  The facility is leased
through December 2011 and includes offices, storage and warehouse
facilities.  We also have a leased research facility located in Rosbach, Germany
through January 2008.  In addition, we have leased individual sales offices in
many of the major countries in Europe and offices in Japan and Canada, expiring
at various dates through 2013.  In
November 2005, we entered into a two year lease for an approximately 16,000
square foot facility in Neuchâtel, Switzerland.  This lease will serve as
a temporary facility for us to conduct administrative and distribution
activities for our international business while we build a larger facility in
Neuchâtel.  In May 2006, we entered into a Real Estate Leasing Contract
with Credit Suisse for the financing of the new facility.  The construction of
the building began in July 2006, and we anticipate the completion of the new
building in late 2007.  We plan to conduct manufacturing, distribution,
administrative and certain research and development activities in this facility
to support the growth of our international business.

We believe that our facilities are suitable and have adequate capacity to
meet our current needs and that additional or substitute space will be available
to accommodate our future needs.

ITEM 3.	  LEGAL PROCEEDINGS

In November 2005, Dr. Harvinder Sandhu, a well-respected orthopaedic surgeon,
and Kyphon filed suit in federal district court in Memphis, Tennessee against
Medtronic Sofamor Danek (MSD) and several other related corporate
entities seeking compensatory and punitive damages and injunctive relief for
breach of contract and related covenants, trade secret theft, fraud, and
correction of inventorship of several patents and patent applications presently
owned by MSD, including U.S. Patent No. 6,676,665.  The suit also requests,
among other relief, that MSD transfer to Dr. Sandhu ownership of the disputed
patents and patent applications.  The dispute concerns inventions related to an
expandable, mechanical bone tamp for use in treating vertebral compression
fractures that Dr. Sandhu invented in the late 1990's and which he
confidentially disclosed and discussed with MSD.  The complaint alleges that MSD
later filed for several patents encompassing and claiming Dr. Sandhu's
inventions without naming him as inventor of that technology, and that it also
incorporated Dr. Sandhu's inventions into its internal Equestra/Arcuate
project without his permission.  In May 2006, the Company also sued MSD in the
same Tennessee court for willfully infringing five of the Company's U.S. patents
(numbers 4,969,888, 5,108,404, 6,235,043, 6,440,138, and 6,863,672) with its
Equestra/Arcuateproduct.  Discovery is underway, and various motions are
pending that seek to address the merits of Dr. Sandhu's and Kyphon's claims.
Trial was initially set for April 2007, but may be delayed.  We intend to
vigorously prosecute our and Dr. Sandhu's case against MSD.

In April 2006, MSD and several related entities filed suit against us in
federal district court in the Northern District of California, alleging that our
vertebral bone tamps and/or related products infringe three angioplasty balloon
dilatation catheter patents (numbers 4,820,349, 5,759,191 and 6,179,856) and a
single claim of patent number 6,096,038, which generally concerns treatment of
the disc space.  MSD has since dropped the `038 patent from the suit and
asserted another dilatation catheter patent, number 5,759,173.  The suit seeks
damages based upon the making, using, selling and offering for sale of our
products, seeks enhanced damages for alleged willful infringement, and seeks to
enjoin our continued activities relating to these products.  In October 2006, we
were denied permission to seek a declaratory judgment that another MSD patent
generally concerned with treatment of the disc space and related to the `038
patent, number 7,115,128 also has no application to our kyphoplasty technology.
Although we intend to vigorously defend MSD's California lawsuit, MSD's action
against us subjects us to potential liability for damages, including treble
damages, and could require us to cease making, using or selling the affected
products, or to obtain a license in order to continue to manufacture, use or
sell the affected products.  While we believe we have multiple meritorious
defenses to this action, we cannot assure you that we ultimately will prevail on
any issue in the litigation or that we will be able to successfully defend MSD's
charges, nor can we provide assurance that any license required would be made
available on commercially acceptable terms, if at all. Failure to successfully
defend against MSD's action could harm our business, financial condition and
operating results.  Due to the inherent uncertainties of litigation, we cannot
accurately predict the ultimate outcome of this matter at this time and,
therefore, cannot estimate the range of possible loss.

In 2005, a U.S. Attorney's Office (USAO) received a complaint
that we believe is a qui tamcomplaint that alleges impropriety in our
business, including regarding our reimbursement practices. Although no subpoena
has been issued to us in connection with this complaint, the USAO is
investigating our sales and marketing practices, including how we communicated
with our customers in the past regarding the Medicare reimbursement available to
hospitals and the appropriate site-of-service for using our products in surgery.
The USAO has asked to review some of our documentation that may be relevant to
the investigation, much of which we have already produced.  We believe we are in
substantial compliance with the healthcare laws applicable to us.  Even though
we have not received a subpoena regarding the complaint or its allegations, we
continue to voluntarily cooperate with the USAO, to permit the USAO to develop
an informed opinion on whether or not to pursue any action in connection with
the complaint based in part on the information we provide, although timing on
that decision is uncertain.  At this time, we do not know whether the
investigation or its outcome will have a material adverse impact to our
business, and cannot assure you regarding any future path the USAO or any
related lawsuit may take.  Due to the uncertainties inherent in this process, we
cannot accurately predict the ultimate outcome of this matter at this time and,
therefore, cannot estimate the range of possible loss.

In June 2006, six of our current and former female U.S.-based sales
employees filed a lawsuit against Kyphon in federal district court in the
Northern District of California.  They allege, among other things, that
Kyphon has engaged in gender and pregnancy discrimination
against them, and also contend that they and their lawyers should be
permitted to represent an alleged class of all of our present and many former
female Spine Education Specialists, Spine Associates and Spine Consultants
because all of those women were also allegedly discriminated against on account
of their gender and pregnancy status.  The plaintiffs claim that they
are due assorted damages of at least $100 million.  The case is
in its early stages; no trial date has been set.
Although we intend to vigorously defend plaintiffs' lawsuit, this lawsuit
threatens our reputation and subjects us to potential liability for significant
damages.  While we believe we have multiple meritorious defenses to this action,
we cannot assure you that we ultimately will prevail on any issue in the
litigation or that we will be able to successfully defend plaintiffs' charges.
Failure to successfully defend against this action could harm our business,
financial condition and operating results.  Due to the inherent uncertainties of
litigation, we cannot accurately predict the ultimate outcome of this matter at
this time and, therefore, cannot estimate the range of possible loss.

In addition, we are subject to legal proceedings, claims, and litigation
arising in the ordinary course of business, including employment-based claims
and intellectual property litigation.  While the outcome of these matters is
currently not determinable, we do not expect that the ultimate costs to resolve
these matters will have a material adverse effect on our consolidated financial
position, results of operations, or cash flows.

ITEM 4.	  SUBMISSION OF MATTERS TO A VOTE OF SECURITY
HOLDERS

No matters were submitted to a vote of security holders during the fourth
quarter of the fiscal year covered by this Annual Report on Form 10-K.

---



PART II

ITEM 5.	  MARKET FOR THE REGISTRANT'S COMMON EQUITY, RELATED
STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

Our common stock is quoted on the NASDAQ Stock Market under the symbol
"KYPH".  The following table shows the high and low closing sale
prices of our common stock for each quarterly period for the past two years as
reported on the NASDAQ Stock Market:

`Common Stock
                                         --------------------
                                            High        Low
Fiscal Year 2005                         ---------  ---------
     First quarter                      $   28.47  $   23.86
     Second quarter                     $   34.79  $   24.28
     Third quarter                      $   44.93  $   34.06
     Fourth quarter                     $   46.40  $   37.76

Fiscal Year 2006                                                           
     First quarter                      $   42.95  $   33.74
     Second quarter                     $   43.50  $   33.11
     Third quarter                      $   39.58  $   31.16
     Fourth quarter                     $   44.98  $   33.10`

We had 96 stockholders of record as of February 15, 2007.

Since our incorporation, we have never declared or paid any dividends on our
capital stock.  We currently expect to retain future earnings, if any, for use
in the operation and expansion of our business, repayment of debt and do not
anticipate paying any cash dividends in the foreseeable future.  In addition,
our current credit facility places certain restrictions on paying cash
dividends.

We did not sell any unregistered securities during the period covered by this
Annual Report on Form 10-K, other than our convertible senior notes as described
in our Current Report on Form 8-K filed with the SEC on February 12, 2007.

Our Board of Directors approved a stock repurchase program on November 7,
2002, pursuant to which we may purchase up to 2,000,000 shares of our
outstanding common stock.  The duration of the repurchase program is open-ended.
Under the program, we may purchase shares of common stock through open market
transactions at prices deemed appropriate by management and the Board of
Directors.  The purchases will be funded from available working capital.  In
2002, we repurchased 30,000 shares pursuant to this repurchase program.  We have
not repurchased any of our common stock since 2002.



ITEM 6.	  SELECTED FINANCIAL DATA

The following tables contain selected consolidated financial data derived
from our consolidated financial statements for each of the last five years.  The
consolidated statement of operations data for the years ended December 31, 2006,
2005 and 2004, and the consolidated balance sheet data as of December 31, 2006
and 2005 are derived from our audited consolidated financial statements included
in this Annual Report on Form 10-K.  The consolidated statement of operations
data for the years ended December 31, 2003 and 2002, and the consolidated
balance sheet data as of December 31, 2004, 2003 and 2002 are derived from our
audited consolidated financial statements not included in this Annual Report on
Form 10-K.  Historical results are not necessarily indicative of future results.
The selected consolidated financial data set forth below should be read in
conjunction with our consolidated financial statements, the related notes and
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" included elsewhere in this Annual Report on Form 10-K.  In
2007, we completed our acquisition of St. Francis and expect to complete
our proposed acquisitions of certain spine-related assets of Disc-O-Tech,
and its U.S. subsidiary if we are able to obtain the necessary regulatory
approvals to close those acquisitions.  The selected consolidated financial
data set forth below excludes the results of these transactions.

`Year Ended December 31,
                                                      ----------------------------------------------------------
                                                         2006        2005        2004        2003        2002
                                                      ----------  ----------  ----------  ----------  ----------
                                                                   (in thousands, except per share amounts)
Consolidated Statement of Operations Data:                                                                      
Net sales                                            $   407,790 $   306,082 $   213,414 $   131,028 $    76,316
Cost of goods sold                                        52,176      35,843      24,734      16,794      10,416
                                                      ----------  ----------  ----------  ----------  ----------
Gross profit                                             355,614     270,239     188,680     114,234      65,900
                                                      ----------  ----------  ----------  ----------  ----------
Operating expenses:
  Research and development                                39,971      46,383      22,238      16,031      22,512
  Sales and marketing                                    194,057     144,768     106,103      69,538      44,083
  General and administrative                              60,351      34,951      25,972      16,328      11,849
                                                      ----------  ----------  ----------  ----------  ----------
      Total operating expenses                           294,379     226,102     154,313     101,897      78,444
                                                      ----------  ----------  ----------  ----------  ----------
Income (loss) from operations                             61,235      44,137      34,367      12,337     (12,544)
Interest income (expense) and other, net                   9,487       3,979       1,250         986      (2,794)
                                                      ----------  ----------  ----------  ----------  ----------
Income (loss) before income taxes                         70,722      48,116      35,617      13,323     (15,338)
Provision (benefit) for income taxes                      30,990      18,280      13,900     (14,000)         --
                                                      ----------  ----------  ----------  ----------  ----------
Net income (loss)                                    $    39,732 $    29,836 $    21,717 $    27,323 $   (15,338)
                                                      ==========  ==========  ==========  ==========  ==========

Net income (loss) per share:
  Basic                                              $     0.89  $     0.70  $     0.54  $     0.71  $    (0.63)
                                                      ==========  ==========  ==========  ==========  ==========
  Diluted                                            $     0.86  $     0.66  $     0.50  $     0.65  $    (0.63)
                                                      ==========  ==========  ==========  ==========  ==========
Weighted-average shares outstanding:
  Basic                                                   44,436      42,803      40,449      38,433      24,405
                                                      ==========  ==========  ==========  ==========  ==========
  Diluted                                                 46,313      45,336      43,670      42,090      24,405
                                                      ==========  ==========  ==========  ==========  ==========

                                                                              As of December 31,
                                                      ----------------------------------------------------------
                                                         2006        2005        2004        2003        2002
                                                      ----------  ----------  ----------  ----------  ----------
                                                                              (in thousands)
Consolidated Balance Sheet Data:                                                                                
Cash, cash equivalents and investments               $   202,153 $   194,473 $   115,799  $    85,479 $   74,303
Working capital                                          228,046     216,504     153,926       86,564     83,504
Total assets                                             428,606     316,632     213,389      154,480    101,524
Deferred stock-based compensation                             --         116       2,113        6,435     11,947
Total stockholders' equity                            $  344,700  $  250,056  $  179,635  $   134,250 $   91,514`

ITEM 7.	  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 is organized as follows:

- Executive summary.
- Critical accounting policies and estimates.  This section discusses
those accounting policies that both are considered important to our financial
condition and results of operations, and require us to exercise subjective or
complex judgments in their application.  In addition, all of our significant
accounting policies, including our critical accounting policies, are summarized
in Note 2 to our consolidated financial statements.
- Results of operations.  This section provides our analysis and outlook
for the significant line items on our condensed consolidated income
statements.
- Stock-based compensation.
- Seasonality.
- Liquidity and capital resources.
- Recent accounting pronouncements.
- Factors affecting future operating results.

Executive Summary

Company Description.  We are a global medical device company
specializing in the design, manufacture and marketing of medical devices used to
treat and restore spinal anatomy and diagnose low back pain using minimally
invasive technology.  Our original technology for performing balloon kyphoplasty
is presently used primarily by spine specialists, including orthopaedic surgeons
and neurosurgeons, interventional radiologists and interventional
neuroradiologists, who repair compression fractures of the spine caused by
osteoporosis, trauma, cancer or benign lesions through minimally invasive spine
surgeries.  Most alternative treatments for these types of spinal fractures are
either highly invasive or are only pain management therapies.  In 2006, we
acquired rights to Functional Anaesthetic Discography (F.A.D.)
technology which is used to diagnose the source of low back pain and is useful
to provide additional information to physicians in determining how to
appropriately treat their patients.  We commenced a limited initial launch of
our F.A.D. technology in the third quarter 2006 and we expect to pursue a
measured, deliberate market roll-out throughout 2007.  In January 2007, we also
acquired rights to the X-STOP Interspinous Process Decompression
(IPD) technology for treating lumbar spinal stenosis (LSS), which is
complimentary to some of our own internally developed technology for treating
LSS.  Our commercial products presently consist of our KyphX instruments,
which are used to treat spinal fractures during balloon kyphoplasty, including
our proprietary KyphX balloon technology and our proprietary brands of
bone filler materials;  our Discyphor F.A.D. technology for diagnosing
low back pain; our X-STOP IPD technology for treating lumbar spinal
stenosis; and our internally developed Aperius PercLID technology for
treating lumbar spinal stenosis which we are presently trialing on a very
limited basis in several European locations.

In January 2007, we acquired rights to the X-STOP Interspinous Process
Decompression (IPD) technology, a proprietary technology platform for the
treatment of lumbar spinal stenosis, through our acquisition of St. Francis
Medical Technologies, Inc. (St. Francis), a privately held company in Alameda,
California.  The X-STOP technology is complementary to our existing
extension limiting technology for the treatment of LSS.  The total estimated
purchase price, excluding transaction costs, of approximately
$725.0 million comprised $525.0 million in cash upon closing, plus
additional revenue-based contingent payments of up to $200.0 million payable in
either cash or a combination of cash and stock, at Kyphon's election.  The
payments are contingent upon the attainment of certain revenue thresholds during
specified periods through June 2008.  We expect to record $204.9 million of
identifiable intangible assests as a result of this acquistion, which we expect
to amortize on a straight line basis over the next 10 years.  We also expect to
expense in-process research and development costs of $21.3 million in the first
quarter of 2007.  We financed the transaction through a combination of cash on
hand and bank financing.

We also executed two definitive agreements in December 2006 with Disc-O-Tech
Medical Technologies, Ltd. and its U.S. subsidiary (Disc-O-Tech) to acquire,
respectively, all of its non-vertebroplasty spine-related assets, including
minimally invasive technologies for performing fusion and vertebral body
augmentation, for $100.0 million in cash ($60.0 million paid up-front in
December 2006 and another $40.0 million paid February 1, 2007), and all of its
vertebroplasty assets for a total of an additional $120.0 million payable in
three equal annual installments beginning in January 2008.  We also agreed to
pay up to an additional $20.0 million for the development of future technologies
upon closing of the vertebroplasty asset purchase agreement.  The closing of the
non-vertebroplasty transaction, if and when that occurs, will enable us to
further broaden our focus in minimally invasive spine by adding the
B-TwinTM Expandable Spinal System technology for minimally invasive fusion in
patients with degenerative disc disease in the lumbar and cervical spine, which
is CE marked but not presently available in the U.S.  The non-vertebroplasty
assets also include Disc-O-Tech's SKyTM Bone Expander System, which is
available only outside the U.S. for use in the treatment of vertebral
compression fractures.  The assets to be acquired under the vertebroplasty
agreement include Disc-O-Tech's ConfidenceTM Cement System, which would be
another treatment option complementary to our existing KyphX technology
for vertebral compression fractures, depending on a patient's individual needs
and a clinician's goals for his or her patients.  The Confidence System
incorporates a delivery mechanism that is designed to provide controlled
injection of putty-like cement, reduce clinician radiation exposure and
streamline cement preparation.  Kyphon's ability to offer such additional
minimally invasive diagnostic and therapeutic tools to our customers is a
natural next step in broadening our product offerings. We have not yet received
clearance from the Federal Trade Commission to close either of these
transactions and may not be able to do so for some time, if at all.  We will
still be obligated to pay the purchase price even if the closings do not occur.

Our corporate headquarters and United States operations are located in
Sunnyvale, California, where we conduct our manufacturing, warehousing, research
and development, regulatory and administrative activities.  Outside the United
States, we operate a sales, clinical, regulatory and administrative facility in
Brussels, Belgium, a research and biomaterials manufacturing facility in
Rosbach, Germany, a clinical, regulatory and administrative facility in Japan,
and we have direct selling operations in many of the major countries in Europe,
South Africa, Australia and in Canada.  In November 2005, we leased a temporary
facility in Neuchâtel, Switzerland in which to conduct our administrative
and distribution activities for our international business while we build a
larger facility in that same location.  In May 2006, we entered into a real
estate leasing contract with Credit Suisse for the financing of the new
facility.  The construction of the building began in July 2006, and we
anticipate the completion of the new building in late 2007.  We plan to conduct
manufacturing, distribution, administrative and certain research and development
activities in the Switzerland facility to support the growth of our
international business.  In August 2006, we commenced distribution activities to
our European customers and established a shared financial services center in
Neuchâtel.  Our global distribution network consists of a direct sales
organization of almost 480 individuals who market our products in the U.S.,
Europe and Canada.  We also have distributors and sales agents in other
countries in which we do not have a direct sales force.  In Japan, we are
presently focused primarily on procuring the appropriate governmental regulatory
clearances and approvals necessary to market and sell our KyphXproducts,
and as of December 31, 2006, we have enrolled 57 of the 81 patients required in
our Japanese clinical trial.

Products and Significant Business Trends.  Our net sales in
2006 consisted almost entirely of the sales of our KyphX instruments,
including our KyphX Inflatable Bone Tamps, KyphX Inflation
Syringe, KyphX Bone Access Systems, KyphX Bone Filler Device,
KyphX Curettes, KyphX Bone Biopsy Device, KyphX HV-R Bone
Cement, KyphXMixer and our CE-Marked KyphOs calcium phosphate
from our acquisition of Sanatis GmbH (Sanatis).  Our Discyphor F.A.D.
technology contributed an immaterial amount to our revenues in 2006.

During 2006, our business experienced significant growth.  Net sales in 2006
increased to $407.8 million, compared to $306.1 million in 2005,
representing growth of 33%.  We trained over 2,400 physicians during 2006 to
perform balloon kyphoplasty with our technology, primarily in the United States
and in Europe.  In the U.S., we added 267 new hospitals to our balloon
kyphoplasty customer base during 2006.

We have now moved beyond our original sole focus of Spinal Fracture
Management and Repair, through treatment of vertebral compression fractures, to
our second and third business platforms, disc disease diagnosis and therapies
and spinal motion preservation.  We have a variety of internal resources
dedicated to supporting research and development in this area as well as
potential business development opportunities.  Another business focus, cancer
therapy aimed at addressing the actual cancerous conditions that affect the
spine rather than merely the effects of those cancerous conditions, such as
vertebral compression fractures, remains an area of interest for us, and we
continue to investigate how we can best serve this market.  We also will
continue to evaluate other additional potential opportunities for growth in our
business by evaluating external products and technologies.  Some of the
opportunities we are presently investigating include technologies and products
that address degenerative disc disease.  These efforts may require us to seek
additional funding and may be dilutive to our earnings.  Although we have
succeeded in diversifying our business through our recent external business
development activities, we will remain largely dependent on our balloon
kyphoplasty technologies for treating vertebral compression fractures for the
foreseeable future.  We thus will continue, at least for the foreseeable future,
to bear the traditional risks associated with being a company whose revenues are
principally derived from one procedure.  In addition, in connection with our
recent acquisitions, we now are engaged in trying to efficiently and
successfully integrate St. Francis' business into our ongoing balloon
kyphoplasty business, which will take substantial resources and may result in
significant distraction of our management team.  If we are successful in gaining
clearance from the FTC to close our transactions with Disc-O-Tech, we may also
have to integrate those assets into our business at the same time we are
integrating St. Francis' business, which will require further resources.

We are beginning to experience increasing competition in our business for
treating vertebral compression fractures, including from companies introducing
products that are significantly less expensive than our own technologies and
apparently are intended to compete with our products on price.  We believe trial
of such products by our customers will continue for the foreseeable future,
which is beginning to cause us to lose revenues, undermine some of our existing customer
relationships, bring pricing pressures to bear on our existing business and
product lines, cause at least some slow-down in adoption of our technologies,
and potentially harm our reputation.  We are also on the verge of entering
markets for our products, such as for the treatment of lumbar spinal stenosis
and spinal fusion, in which significant competition already exists, the type of
which we have not faced before in our business.  We believe that if we are
unable to compete aggressively and effectively against the other companies who
are either entering our markets or are already serving the markets we are
entering, including through effective enforcement of our intellectual property
rights, we may not be able to realize the type of growth in our business that we
have experienced in the past or that we otherwise might be able to experience in
the absence of such competition.

As our company grows and we achieve more success in the markets we serve, we
face increasing scrutiny from various regulatory authorities.  Although we
believe we are in substantial compliance with the healthcare and other laws that
are applicable to us, we may have to defend our company against various charges
that we have violated laws, rules or regulations applicable to us.  As discussed
in detail in Item 3 - Legal Proceedings, we are presently involved in
discussions with a U.S. Attorney's office relating to various aspects of our
past conduct.  If we are unable to successfully navigate such issues, our
business could be at risk, especially due to the restrictions to which we are
subject as a result of the significant debt we have undertaken in connection
with our recent acquisitions.

During 2006, several developments in reimbursement for our core kyphoplasty
business occurred.  In August 2006, for example, the Centers for Medicare &
Medicaid Services (CMS) published the 2007 Final Rule with tentative payment
rates regarding the Hospital Inpatient Prospective Payment System (HIPPS)
proposing that the tentative reimbursement rates available to hospitals in 2007
would reflect a slight increase in rates over 2006 levels.  In October 2006, the
final payment rates were published in the Federal Register and the two primary
DRG payment rates related to kyphoplasty increased by 2.1% and 5.8%,
respectively, over 2006 levels.  The payment rates were effective October 2006
for fiscal year 2007.  On November 1, 2006, CMS posted the Final Rule on the
Hospital Outpatient Prospective Payment System (HOPPS), stating that the
reimbursement available to a facility for performing balloon kyphoplasty in an
outpatient setting in 2007 would be increased by approximately 54% for one-level
and 53% for two-level procedures, respectively, over 2006 levels.  Both of
these rules are effective for procedures performed on or after January 1, 2007.

The status of our significant current clinical trials follows:



- We secured approval from the Japanese Ministry of Health to begin our
clinical trial in the third quarter of 2005.  Our Japanese trial is a single arm
study that will enroll a total of 81 patients with spinal fractures and follow
them for 2 years.  Patient enrollment is presently expected to conclude in the
first half of 2007.  Data from this trial, in addition to clinical data obtained
from studies previously completed in the U.S. and Europe, will be used to
support regulatory approval in Japan for balloon kyphoplasty.  If approved, we
could begin commercialization in Japan in approximately 2009.



- We initiated a randomized controlled trial comparing balloon kyphoplasty and
vertebroplasty in October 2006.  This trial will consider several important
study endpoints including perioperative safety, function, quality of life,
vertebral body height restoration, rate of subsequent fractures and angular
deformity correction.  It will also include an economic and healthcare
utilization analysis.  This trial is designed to enroll approximately 1,200
patients at up to 75 sites with two-year follow-up.

Substantial portions of our pre-clinical studies and all
of our clinical trials are performed by third-party contract research
organizations and other vendors.  We accrue costs for clinical trial activities
performed by contract research organizations based upon the level of patient
enrollment and amount of work completed on each study.  The difficulty in
predicting the timing of patient enrollment can create volatility in our
expenses.  All such costs are charged to research and development expenses as
incurred.

During 2006, we continued to strengthen our board of directors and management
team.  In July 2006, Frank M. Phillips, M.D. joined our board of directors.  Dr.
Phillips is currently Professor of Orthopaedic Surgery and Director of the
Section of Minimally Invasive Spine Surgery at Rush University Medical Center in
Chicago.  Prior to this position, Dr. Phillips served as the Director of The
University of Chicago Spine Center, in addition to being an Associate Professor
of Surgery at The University of Chicago.  Dr. Phillips is certified by the
American Board of Orthopaedic Surgery and has authored over 50 clinical and
basic science publications and presentations dealing with spinal procedures.

In September 2006, Maureen L. Lamb joined Kyphon as our Vice President, Chief
Financial Officer and Treasurer.  Ms. Lamb has over 20 years of financial
management experience and comes to Kyphon from Photon Dynamics, Inc., where she
served as Chief Financial Officer.  Before that, she held several senior
financial management positions for eleven years at KLA-Tencor, including serving
as its Vice President of Finance for five years.  Ms. Lamb received her
Bachelor's degree in Government from Harvard College and her Masters in Business
Administration from the Wharton School of the University of Pennsylvania.  She
succeeds Arthur T. Taylor as our Chief Financial Officer, who had served as both
Chief Operating Officer and Chief Financial Officer since his promotion in
February 2006.  Mr. Taylor continues as our Chief Operating Officer.

Also in September 2006, Alexandre M. DiNello joined Kyphon as our Vice
President, Research and Development.  Mr. DiNello has over 17 years of medical
device industry experience, including senior research and development and/or
strategic development roles at Abbott Spine, OmniSonics Medical Technologies,
DePuy Spine, a division of Johnson & Johnson and AcroMed Corporation, which
was purchased by DePuy Spine.  He received his Bachelor of Science degree in
Mechanical Engineering from the University of California, Santa Barbara, a
Masters degree in Biomedical Engineering from the University of Virginia, and a
Masters in Business Administration from the Weatherhead School of Management at
Case Western Reserve University in Ohio.

In May 2006, Dr. Clemens Troche joined Kyphon as our Vice
President, Marketing and Business Development, International.
Prior to joining Kyphon, Dr. Troche worked in various pharmaceutical companies
(PharmaVentures, Bayer Inc., Boehringer Ingelheim and Schwarz Pharma) in various
marketing, pricing, health economics and business development functions.  He has also
worked as a consultant for various life sciences and health care companies to address
projects in the areas of business development, organizational management,
strategic marketing and research and development.   Dr. Troche studied human
medicine in Germany (Universities of Muenster and Heidelberg) and the U.S.
(Tulane University, New Orleans, LA). After also completing a doctorate focusing on
epidemiological psychiatry at the University of Heidelberg, Dr. Troche worked as a
fully licensed physician and a researcher in neurosciences.  He then obtained a
Master of Public Health from Yale University and a Masters in Business Administration
in a joint program from the University of Bradfod (UK) and NIMBAS in Utrecht
(The Netherlands).

In June 2006, Robert E. Johnson, joined Kyphon as our Vice President, Chief
Compliance Officer.  Prior to joining Kyphon, Mr. Johnson served as the Chief
Compliance Officer for Chiron Corporation (now Novartis Vaccines &
Diagnostics, Inc.).  Mr. Johnson also worked for eight years for Sabre Holdings
Corporation, where he created its first corporate compliance program, led its
London legal department and served as General Counsel and Senior Vice President
for its GetThere LP subsidiary in Menlo Park, California.  He began his career
as a commercial litigator with the Houston law firm of Baker Botts LLP.  Mr.
Johnson earned his Bachelor of Arts degree summa cum laude in American Studies
and English from The University of North Carolina at Chapel Hill and his J.D.
from The University of Virginia School of Law.

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 clearances and compliance for our
products, obtain adequate public and private payor reimbursements 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, including
but not limited to the United States Food and Drug Administration (FDA).
Failure to comply with regulatory requirements could adversely affect our
business and our financial condition, which could cause our stock price to
decline.  Additionally, our industry is highly competitive and our success
depends on our ability to compete successfully.  A detailed discussion of these
and other factors is provided in the "Factors Affecting Future Operating
Results" section below.

Critical Accounting Policies and Estimates

All of our significant accounting policies are described in Note 2 to our
consolidated financial statements.  However, certain of our more critical
accounting policies require the application of significant judgment by
management in selecting the appropriate assumptions for calculating financial
estimates.  By their nature, these judgments are subject to an inherent degree
of uncertainty.  These judgments are based on our historical experience, terms
of existing contracts, our observance of trends in the industry, information
provided by our customers, and information available from other outside sources,
as appropriate.  Different, reasonable estimates could have been used in the
current period.  Additionally, changes in accounting estimates are reasonably
likely to occur from period to period.  Both of these factors could have a
material impact on the presentation of our financial condition, changes in
financial condition, or results of operations.  We believe that the following
financial policies and estimates are both important to the portrayal of our
financial condition and results of operations and require subjective or complex
judgments.  Further, we believe that the items discussed below are properly
recorded in the consolidated financial statements for all periods presented.
Management has discussed the development, selection, and disclosure of our most
critical financial estimates with the Audit Committee of our Board of Directors
and our independent registered public accounting firm.  The judgments about
those financial estimates are based on information available as of the date of
the consolidated financial statements.  Those financial policies and estimates
include:

Revenue recognition.

Accounts receivable allowances.  We make estimates on the
collectibility of customer accounts based primarily on analysis of historical
trends and experience and changes in customers' financial condition.  Management
uses its best judgment, based on the best available facts and circumstances, and
records a reserve against the amounts due to reduce the receivable to the amount
that is expected to be collected.  These reserves are reevaluated and adjusted
as additional information is received that impacts the amount reserved.  Our
accounts receivable allowances have been less than 1% of net sales for each of
the years ended December 31, 2006, 2005 and 2004.

Our accounts receivable balance was $73.9 million and
$55.5 million, net of allowances for doubtful accounts and for product
returns of $1.9 million and $1.6 million at December 31, 2006 and 2005,
respectively.

Excess and obsolete inventories.  We value our inventory at the
lower of cost or market.  Cost is computed on a first-in, first-out basis.  We
regularly review inventory quantities on hand and record a provision for excess
and obsolete inventory based primarily on our estimated forecast of product
demand and production requirements for the next twelve months.  A significant
decrease in demand could result in an increase in the amount of excess inventory
quantities on hand.  Additionally, our industry is characterized by regular new
product development that could result in an increase in the amount of obsolete
inventory quantities on hand due to cannibalization of existing products.  Also,
our estimates of future product demand may prove to be inaccurate, in which case
we may be required to increase the provision needed for excess and obsolete
inventory.  In the future, if additional inventory write-downs are required, we
would recognize additional cost of goods sold at the time of such determination.
Regardless of changes in our estimates of future product demand, we do not
increase the value of our inventory above its adjusted cost basis.  Therefore,
although we make every effort to ensure the accuracy of our forecasts of future
product demand, significant unanticipated decreases in demand or technological
developments could have a significant impact on the value of our inventory and
our reported operating results.

Our reserve for excess and obsolete inventories was $861,000 and $991,000 at
December 31, 2006 and 2005, respectively.

Accounting for income taxes.  We determine deferred tax assets and
liabilities based upon the difference between the financial statement and tax
bases of assets and liabilities using the enacted tax rates in effect for the
year in which the differences are expected to affect taxable income.  The tax
consequences of most events recognized in the current year's financial
statements are included in determining income taxes currently payable.  However,
because tax laws and financial accounting standards differ in their recognition
and measurement of assets, liabilities, equity, revenue, expenses, gains and
losses, differences arise between the amount of taxable income and pretax
financial income for a year and between the tax bases of assets or liabilities
and their reported amounts in the financial statements.  Because it is assumed
that the reported amounts of assets and liabilities will be recovered and
settled at their carrying value, respectively, a difference between the tax
basis of an asset or a liability and its reported amount in the balance sheet
will result in a taxable or a deductible amount in some future years when the
related liabilities are settled or the reported amounts of the assets are
recovered, hence giving rise to a deferred tax asset or liability.  We must then
assess the likelihood that our deferred tax assets will be recovered from future
taxable income and to the extent we believe that recovery is not likely, we must
establish a valuation allowance.

As part of the process of preparing our consolidated financial statements, we
are required to determine our income taxes.  This process involves determining
our actual current tax exposure together with assessing temporary differences
that may result in deferred tax assets.  Management judgment is required in
determining any valuation allowance recorded against our deferred tax assets.
Any such valuation allowance would be based on objective positive evidences and
the period over which our deferred tax assets would be recoverable.  As of
December 31, 2006 and 2005, we have recorded no valuation allowance, based on
our belief that it is more likely than not that we will be able to utilize our
deferred tax assets before they expire.

Purchase accounting.  Purchase accounting requires extensive
accounting estimates and judgments to allocate the purchase price between
in-process research and development, other identifiable intangible assets, tangible
assets, and goodwill as required by generally accepted accounting principles in
the United States.  To assist in determining the value of any in-process
research and development and certain other intangibles, a third party valuation
is typically obtained as of the acquisition date.  Purchased in-process research
and development is defined as the value assigned to those projects for which the
related products have not received regulatory approval when acquired.  At the
time of the purchase, the research and development projects were not considered
to have reached technological feasibility and they had no alternative future
use.  Determining the portion of the purchase price allocated to in-process
research and development and other intangible assets requires us to make
significant estimates.  The amount of the purchase price allocated to purchased
in-process research and development and other intangible assets is determined by
estimating the future cash flows of each project or technology and discounting
the net cash flows back to their present values.  The discount rate used is
determined at the time of the acquisition in accordance with standard valuation
methods.  For purchased in-process research and development, these methodologies
include consideration of the risk of the project not achieving commercial
feasibility.

Goodwill and Impairment of Long Lived Assets, Including
Acquisition-Related Intangibles.

Significant judgments and assumptions are required in the forecast of future
operating results used in the preparation of the estimated future cash flows,
including profit margins, long-term forecasts of the amounts and timing of
overall market growth and our percentage of that market, groupings of assets,
discount rates and terminal growth rates.  In addition, significant estimates
and assumptions are required in the determination of the fair value of our
tangible long-lived assets, including replacement cost, economic obsolescence,
and the value that could be realized in orderly liquidation.  Changes in these
estimates could have a material adverse effect on the assessment of our
long-lived assets, thereby requiring us to write down the assets.

Stock Option Valuation.

Prior to January 1, 2006, we accounted for our stock-based
employee compensation arrangements under the intrinsic value method prescribed
by Accounting Principles Board Opinion No. 25, Accounting for Stock Issued
to Employees ("APB No. 25"), as allowed by SFAS No. 123,
Accounting for Stock-based Compensation ("SFAS No. 123"), as
amended by SFAS No. 148, Accounting for Stock-Based
Compensation - Transition and Disclosure ("SFAS No. 148"). As a result, no
expense was recognized for options to purchase our common stock that were
granted with an exercise price equal to fair market value at the date of grant
and no expense was recognized in connection with purchases under our employee
stock purchase plan for the years ended December 31, 2005 and 2004.  During the
years ended December 31, 2005 and 2004, we recognized employee stock-based
compensation expense of $1.8 million and $2.9 million, respectively, under APB
No. 25 related to stock options previously issued with exercise prices below the
deemed fair market value of our common stock at the date of grant.

Effective January 1, 2006, we adopted the provisions of SFAS No. 123(R),
"Share-Based Payment", which requires the measurement and recognition
of compensation expense in the financial statements for all share-based payment
awards made to employees and directors, including employee stock options and
employee stock purchases based on estimated fair values.  Accordingly,
stock-based compensation cost is measured at grant date, based on the fair value of
the award, and is recognized as expense over the employee requisite service
period for each separately vesting tranche of the award.  To estimate the
fair value of an award, we use the binomial-lattice option pricing model.  This
model considers a range of assumptions related to volatility, risk-free interest
rate and employee exercise behavior.  Expected volatilities are based on a blend
of implied market volatilities, historical and peer group volatilities.  The
risk-free rate is derived from the U.S. Treasury zero-coupon yield curve in
effect at the time of grant over the contractual term of the option.  The
binomial-lattice model also incorporates exercise and forfeiture assumptions
based on an analysis of historical data.  The expected life of the stock option
grants is derived from the output of the binomial-lattice model and represents
the period of time that options granted are expected to be outstanding.
Further, the forfeiture rate also impacts the amount of aggregate compensation.
Under SFAS No. 123 forfeitures are recognized only as they actually occur
whereas under SFAS No. 123(R) forfeiture rates are included in
the initial accrual of compensation cost and revised as actual experience
differs from initial estimates.

We have adopted SFAS No. 123(R) using the modified prospective
method.  Accordingly, previously reported amounts have not been restated.  Under
this method, compensation cost recognized during the year ended December 31,
2006, includes: (a) compensation cost for all share-based payments granted
prior to, but not yet vested as of January 1, 2006, based on the grant date
fair value estimated in accordance with the original provisions of SFAS
No. 123 amortized on a straight-line basis over the options' vesting
period, and (b) compensation cost for all share-based payments granted
subsequent to January 1, 2006, based on the grant-date fair value estimated
in accordance with the provisions of SFAS No. 123(R) amortized on a
graded vesting basis over the options' vesting period.  Kyphon has elected to
use the method described in paragraph 81 of SFAS No. 123(R) (the "long
form" method) for the calculation of its pool of excess tax benefits
available to absorb tax deficiencies recognized subsequent to the adoption of
SFAS No. 123(R).  Employee stock-based compensation expense recognized under
SFAS No. 123(R) for the year ended December 31, 2006 was $27.6 million.



Prior to the adoption of SFAS No. 123(R), we used the intrinsic value method
in accounting for our employee stock options, and presented disclosure of pro
forma information as if we had accounted for stock-based compensation using the
fair value method.

Results of Operations

Comparison of years ended December 31, 2006, 2005 and 2004

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:

`Year Ended December 31,
                                                    ------------------------------------------------------------------
                                                             2006                   2005                   2004
                                                    --------------------   --------------------   --------------------
                                                                 % of                   % of                   % of
                                                     Amount    Net sales    Amount    Net sales    Amount    Net sales
                                                    ---------  ---------   ---------  ---------   ---------  --------- 
U.S. net sales                                     $ 324,108         79 % $ 257,558         84 % $ 187,526         88 %
International net sales                               83,682         21 %    48,524         16 %    25,888         12 %
                                                    ---------  ---------   ---------  ---------   ---------  ---------
Net sales                                            407,790        100 %   306,082        100 %   213,414        100 %
Cost of goods sold                                    52,176         13 %    35,843         12 %    24,734         12 %
                                                    ---------  ---------   ---------  ---------   ---------  ---------

Gross profit                                         355,614         87 %   270,239         88 %   188,680         88 %
                                                    ---------  ---------   ---------  ---------   ---------  ---------

Operating expenses:
  Research and development                            39,971         10 %    46,383         15 %    22,238         10 %
  Sales and marketing                                194,057         47 %   144,768         47 %   106,103         50 %
  General and administrative                          60,351         15 %    34,951         12 %    25,972         12 %
                                                    ---------  ---------   ---------  ---------   ---------  ---------
      Total operating expenses                       294,379         72 %   226,102         74 %   154,313         72 %
                                                    ---------  ---------   ---------  ---------   ---------  ---------

Income from operations                                61,235         15 %    44,137         14 %    34,367         16 %
Interest income and other, net                         9,487          2 %     3,979          2 %     1,250          1 %
                                                    ---------  ---------   ---------  ---------   ---------  ---------

Income before income taxes                            70,722         17 %    48,116         16 %    35,617         17 %
Provision for income taxes                            30,990          7 %    18,280          6 %    13,900          7 %
                                                    ---------  ---------   ---------  ---------   ---------  ---------
Net income                                         $  39,732         10 % $  29,836         10 % $  21,717         10 %
                                                    =========  =========   =========  =========   =========  =========`

Net Sales.  Net sales increased $101.7 million, or 33%, in 2006
compared to 2005, and increased $92.7 million, or 43%, in 2005 compared to 2004.
The increases in net sales in 2006 primarily resulted from an increase in the
number of physicians trained in the use of our KyphX instruments as well
as a 27% increase in the number of procedures performed by trained physicians
per month compared to 2005.  During 2006 approximately 2,400 physicians were
trained in the use of our KyphX instruments.  The increases in net sales
in 2005 primarily resulted from the 2,200 more physicians trained in the use of
our KyphX instruments during 2005 as well as a 18% increase in the number
of procedures performed by trained physicians per month compared to 2004.
Domestic sales increased $66.6 million, or 26% in 2006 compared to 2005 and
$70.0 million, or 37% in 2005 compared to 2004.  International sales increased
$35.2 million, or 72% in 2006 compared to 2005, and $22.6 million, or 87% in
2005 compared to 2004.  International sales also reflected the favorable
currency impact of $2.1 million in 2006 and an unfavorable currency impact of
$0.5 million in 2005 based on prior year's average Euro exchange rates.  No
customer accounted for more than 10% of total net sales in 2006, 2005 or 2004.
As of December 31, 2006, we believe we have trained approximately 6,000 spine
specialists in the U.S. and approximately 4,400 clinicians in other parts of the
world, primarily Europe.  These physicians have used our KyphX
instruments in approximately 285,000 patients and 335,000 spinal fractures
worldwide.  We believe the total number of potential physicians who may perform
balloon kyphoplasty procedures using our products is approximately 11,000 in the
U.S.  Internationally, the number of physicians who may perform balloon
kyphoplasty is not as well-defined, but we believe it to be more than 10,000.
Including sales of the X-STOP products and the products from our
proposed acquisitions of the spine-related assets of Disc-O-Tech,
we have targeted a range of $565 million to $585 million in net sales for 2007,
with international net sales comprising 21% to 24% of total net sales.  We expect 80%
to 85% of our net sales for 2007 will be derived from balloon kyphoplasty
procedures.

Cost of Goods Sold.  Cost of goods sold consists of material,
labor, subcontract, and overhead costs.  Cost of goods sold increased $16.3
million, or 46%, in 2006 compared to 2005, and increased $11.1 million, or 45%,
in 2005 compared to 2004.  The absolute increase in cost of goods sold over the
years from 2004 to 2006 resulted primarily from increased material, labor,
subcontract and overhead costs in relation to the increased sales volume of our
products.  The cost of goods sold as a percentage of net sales increased from
2005 to 2006 primarily as a result of employee stock-based compensation expense
recognized under SFAS No. 123(R), increased inventory reserves taken during
2006, increased distribution costs associated with shipping product throughout
the European Union and developed technology amortization of InnoSpine.  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.  Cost of goods sold for 2007 will
include additional costs of approximately $8.0 million due to the sale of
inventory acquired from St. Francis which was written-up to reflect the fair
value at the date of acquisition.

Research and Development.  Research and development expenses
consist of costs for product research, product development, clinical functions
and outside costs related to clinical trials and personnel.  Research and
development expenses decreased $6.4 million, or 14%, in 2006 compared to 2005.
Research and development expenses increased $24.1 million, or 109%, in 2005
compared to 2004.  Expenses for 2005 included license acquisition charges of
$20.0 million to Dr. Harvinder Sandhu and $1.0 million to Dr. Lee Berger.
Excluding these charges research and development expenses increased $14.6
million, or 57%, in 2006 as compared to 2005.  Excluding the license charges the
increase in 2006 from 2005 was primarily attributable to a $4.0 million increase
in stock-based compensation expense due to the adoption of FAS 123(R), increased
personnel costs of $3.6 million, increased clinical studies expense of $2.8
million, increased consulting expenses of $1.6 million, increased engineering
and lab expenses of $894,000, increased facilities costs of $787,000, and
increased travel expenses of $497,000.  The increase in 2005 from 2004 was
primarily attributable to the license acquisition charges of $21.0 million.  The
remaining increase of $3.1 million was attributable to increased personnel costs
of $2.3 million, increased clinical studies expense of $1.3 million, increased
engineering and lab expenses of $611,000, increased travel expenses of $604,000,
and increased facilities costs of $576,000, offset by a decreased research and
development consulting fees of $1.4 million and decreased educational grants of
$990,000.  We expect to continue to make substantial investments in research and
development and anticipate that research and development expenses in 2007 will
increase in absolute dollars due largely to new product development in our three
product platforms and due to the continuation of and commencement of clinical
studies.  We anticipate conducting significant additional clinical trial
activity both in the United States and abroad to collect further data that may
support the use and clinical efficacy of our products.  As a result of our
acquisition of St. Francis and the closing of our proposed acquisitions of the spine-related
assets of Disc-O-Tech, we expect to expense in-process research and development
costs of approximately $55.8 million in 2007.

Sales and Marketing.  Sales and marketing expenses consist of
costs for personnel, physician training programs and marketing activities.
Sales and marketing expenses increased $49.3 million, or 34%, in 2006 compared
to 2005.  Sales and marketing expenses increased $38.7 million, or 36%, in 2005
compared to 2004.  The increase in 2006 from 2005 was primarily attributable to
a $27.7 million increase in the costs of hiring, training and compensating
additional direct selling representatives, a $10.5 million increase in
stock-based compensation expense due to the adoption of SFAS No. 123(R), increased
sales and marketing travel expenses of $6.7 million, and increased facility
expenses of $4.0 million.  The increase in 2005 from 2004 related primarily to a
$28.3 million increase in the costs of hiring, training and compensating
additional direct selling representatives, increased advertising, trade shows,
educational and promotional activity expenses of $3.5 million, increased sales
and marketing travel expenses of $3.1 million, increased facilities expenses of
$1.6 million and increased educational grants of $1.1 million.  As we continue
to commercialize our KyphX instruments on a global basis and integrate
the X-STOP products and the products from our proposed acquisitions of
the spine-related assets of Disc-O-Tech into our sales channel, we expect to
significantly increase our sales and marketing efforts and expenditures in
absolute dollars.

General and Administrative.  General and administrative
expenses consist of costs for personnel, professional service fees, expenses
related to intellectual property rights, Sarbanes-Oxley compliance and general
corporate expenses.  General and administrative expenses increased $25.4
million, or 73%, in 2006 compared to 2005.  General and administrative expenses
increased $9.0 million, or 35%, in 2005 compared to 2004.  The increase in 2006
from 2005 was primarily attributable to a $10.2 million increase in stock-based
compensation expense due to the adoption of SFAS No. 123(R), increased personnel
costs of $8.0 million, increased consulting fees of $2.5 million, increased
litigation expenses of $1.6 million, and increased travel expense of $1.4
million.  The increase in 2005 from 2004 was primarily attributable to increased
consulting and outside professional service fees of $3.7 million, increased
personnel costs of $3.0 million, and increased litigation costs of $1.3 million.
We expect general and administrative expenses to increase in the future as we
add personnel, incur litigation expenses and integration costs related to our
acquisitions, continue to expand our patent portfolio and incur additional
public reporting, governmental compliance and investor-related expenses as a
public company, and incur start-up costs for our new facility in Switzerland.
Therefore, we anticipate that our general and administrative expenses will
increase in absolute dollars as we expand our infrastructure.

Amortization of Acquired Identifiable Intangible Assets.  As a
result of the acquisition of St. Francis and the proposed acquisitions of
certain spine-related assets of Disc-O-Tech, we expect to incur significant
amortization expense related to these acquired identifiable intangible assets in
2007.  We have not yet determined the appropriate income statement
classification of the amortization expense of the acquired identifiable
intangible assets.

Interest Income and Other, Net.  Interest income and other,
net, increased $5.5 million in 2006 compared to 2005.  Interest income and
other, net, increased $2.7 million in 2005 compared to 2004.  The increase in
2006 compared to 2005, and the increase in 2005 compared to 2004 resulted
primarily from an increase in interest income due to higher cash, cash
equivalents and investment balances, as well as higher interest rates.  Our
cash, cash equivalents and investments balances were $202.2 million, $194.5
million, and $115.8 million as of December 31, 2006, 2005, and 2004,
respectively.  We expect interest expense for 2007 to increase as a result of
our borrowings under the credit facility and the convertible notes issuances,
and the amortization of the related debt issuance costs.  In addition, due to
the retirement of the Term Loan Facility, we expect to write-off debt issuance
costs of approximately $8.4 million in 2007.

Provision for Income Taxes.

At December 31, 2006, we had utilized all federal and state net operating
loss carryforwards and federal research and development tax credit
carryforwards.

At December 31, 2006, we had research and development tax credit
carryforwards of approximately $2.8 million for state income tax purposes.  The
state research and development tax credit can be carried forward indefinitely.

Changes to Previously Announced 2006 Fourth Quarter and Annual Results.
On January 30, 2007, we announced our 2006 results.  In connection with preparing
our Form 10-K we identified two balance sheet adjustments.  The first adjustment
in the amount of approximately $149.3 million eliminates deferred payments previously
recorded at December 31, 2006 in connection with our proposed acquisition agreements
with Disc-O-Tech.  We concluded the deferred payments should be recorded when due.
The second adjustment, of approximately $4.0 million, reflects the netting of our  deferred tax assets
and deferred tax liabilities, where right of offset exists.

There was no change to our fiscal 2006 annual or fourth quarter net income as
previously announced.

Stock-Based Compensation

Effective January 1, 2006, we adopted the provisions of SFAS No. 123(R),
which requires the measurement and recognition of compensation expense for all
share-based payment awards made to employees and directors, including employee
stock options and employee stock purchases based on estimated fair values.
Accordingly, stock-based compensation cost is measured at grant date, based on
the fair value of the award, and is recognized as expense over the employee
requisite service period for each separately vesting tranche of the award. 
Employee stock-based compensation expense recognized under SFAS No. 123(R) for
the year ended December 31, 2006 was $27.6 million.  Prior to the adoption
of SFAS 123(R), Kyphon used the intrinsic value method in accounting for our
employee stock options, and presented disclosure of pro forma information as if
we had accounted for stock-based compensation using the fair value method.
Kyphon elected to adopt the modified prospective application method as provided
by SFAS No. 123(R).  Accordingly, previously reported amounts have not been
restated.  During the years ended December 31, 2005 and 2004, we recognized
employee stock-based compensation expense of $1.8 million and $2.9 million,
respectively, under APB No. 25 related to stock options previously issued with
exercise prices below the deemed fair market value of our common stock at the
date of grant.

We estimate the value of employee stock options on the date of grant using a
binomial-lattice model.  The determination of fair value of share-based payment
awards on the date of grant using an option-pricing model is affected by our
stock price as well as assumptions regarding a number of highly complex and
subjective variables.  These variables include, but are not limited to our
expected stock price volatility over the term of the awards, and actual and
projected employee stock option exercise behaviors.

During the year ended December 31, 2006, we recognized stock-based
compensation charges related to our employee stock options and employee stock
purchase plan of $24.5 million, and $3.1 million, respectively.  As of December
31, 2006, stock-based compensation expense of $150,000 was capitalized as
inventory.  As of December 31, 2006, the unrecorded stock-based compensation
balance related to employee stock options was $25.3 million after estimated
forfeitures and will be recognized over an estimated weighted-average remaining
requisite service period of 2.6 years.  As of December 31, 2006, the unrecorded
stock-based compensation balance related to employee stock purchase rights under
the 2002 ESPP was $119,000 which will be recognized in January 2007.

Stock-based compensation expense for 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
stock-based compensation expense of approximately $1.4 million, $1.3 million and
$929,000 in 2006, 2005 and 2004, respectively.

In June 2006, our stockholders approved the termination of our 2002 Employee
Stock Purchase Plan, or 2002 ESPP, effective after the February 1, 2007
purchase, and the adoption of our 2007 Employee Stock Purchase Plan, or 2007
ESPP.  The 2007 ESPP took effect after the final purchase date under the 2002
ESPP of February 1, 2007, at which time the 2002 ESPP automatically
terminated.  The 2007 ESPP reduces the "look-back" period
available under any offering, by eliminating the 24-month "look-back"
period presently available under the 2002 ESPP and replacing it with a six-month
"look-back" period.  The price of the common stock purchased
shall be the lower of 85% of the fair market value of the common stock at the
beginning of an offering period or at the end of a purchase period.  The maximum
number of shares authorized for sale under the 2007 ESPP is 1,000,000.  The
Board of Directors may amend, suspend or terminate the 2007 ESPP at any time.
Kyphon has determined that the cancellation of the 2002 ESPP effectively
occurred in June 2006 at the time of stockholder approval.  As the
cancellation of purchase periods subsequent to February 1, 2007 were not
accompanied by a concurrent replacement grant, in accordance with the provisions
of SFAS No. 123(R), unrecognized compensation cost of $562,000 was recognized
immediately in June 2006 for the awards cancelled.

Seasonality

Our business is seasonal in nature.  Historically, demand for our
products has been the highest in the first and second quarters in the U.S. and
in the second and fourth quarters in Europe.  In the U.S., during the fourth
quarter, our net sales generally reflect the reduced number of selling days due
to the holiday season.  In Europe, we traditionally experience somewhat lower
sales volumes in the third quarter months than throughout the rest of the year
as a result of the European summer holiday schedule.  In addition, the fourth
quarter in Europe is typically favorably impacted by our customers' budget
utilization and our distributors' fulfillment of their annual purchase
commitments.

Liquidity and Capital Resources

Credit Facility. As of December 31, 2006, we had $81.9 million
of cash and cash equivalents, $120.2 million of short-term investments, and
working capital of $228.0 million.  Our cash and cash equivalents and
investments increased by $7.7 million during 2006. As of December 31,
2006, unrealized losses related to available-for-sale-investments are considered
to be temporary.

In October 2006, we entered into a syndicated credit facility which provided
us with a five-year $300.0 million revolving line of credit, including a $50.0
million sublimit for the issuance of standby letters of credit, a $25.0 million
sublimit for swing line loans and a $100.0 million sublimit for multicurrency
borrowings.  On January 18, 2007, we amended the October 2006 credit
facility, and in conjunction with the acquisition of St. Francis, Kyphon,
together with certain of its subsidiaries, entered into a credit agreement (the
Credit Agreement) to replace and refinance the above-described credit facility
with Bank of America, N.A., as administrative agent, swing line lender and
letter of credit issuer, and Banc of America Securities LLC as sole lead
arranger and sole book manager.  The credit facilities thereunder were
syndicated to a group of lenders (the Lenders).

The Credit Agreement provides for a $250.0 million senior secured revolving
credit facility, maturing October 20, 2011, which can be expanded to $300.0
million under certain circumstances.  The revolving credit facility includes a
$50.0 million sublimit for the issuance of standby U.S. dollar letters of
credit, a $25.0 million sublimit for U.S. dollar swingline loans and a $100.0
million sublimit for multicurrency borrowings.  The Credit Agreement also
provided for a $425.0 million term loan facility maturing seven years from
the closing date which, together with the revolving credit facility, we refer to
as the Facility.  Kyphon may terminate or permanently reduce the commitments
available under the revolving credit facility and prepay the Term Loan Facility
without premium or penalty at any time.

The Facility was used by Kyphon to finance the acquisition of St. Francis,
and may be used for general corporate purposes including acquisitions, capital
expenditures, working capital and other purposes.  In addition to certain
initial fees, Kyphon is obligated to pay a commitment fee based on the total
revolving commitment.  In January 2007, in connection with the acquisition of
St. Francis, we borrowed $425.0 million under the Facility.

The revolving credit facility will bear interest at Base Rate plus 0.25-1.25
or LIBOR plus 1.25-2.25% (such range of margins being related to the
consolidated leverage ratio of Kyphon).  Letter of credit fees are based on the
LIBOR loan margins.

Kyphon's obligations under the Facility are secured by substantially all of
its assets.

The Credit Agreement contains customary affirmative covenants regarding
Kyphon and its subsidiaries. Upon the occurrence of an event of default under
the Credit Agreement, the Lenders could elect to declare all amounts outstanding
under the Facility to be immediately due and payable.  Events of default under
the Credit Agreement include payment defaults, breaches of covenants and
bankruptcy events.

The Credit Agreement contains negative covenants which restrict Kyphon from:
(i) incurring liens other than liens incurred pursuant to the Facility and other
customary permitted liens; (ii) making investments, other than customary
permitted investments and investments subject to certain baskets; (iii)
incurring debt other than indebtedness pursuant to the Credit Agreement,
subordinated indebtedness, an unsecured convertible note offering, customary
permitted indebtedness and indebtedness subject to certain baskets; (iv)
entering into mergers and consolidations other than the Acquisition,
acquisitions paid 100% with equity of Kyphon or acquisitions not exceeding a
certain purchase price, where such limitation on price is based on the
consolidated senior secured leverage ratio and other limitations; (v) selling
assets, subject to certain customary exceptions; (vi) issuing dividends, stock
redemptions and other restricted payments; (vii) incurring capital expenditures
exceeding a certain threshold; (viii) transactions with affiliates; (ix) the
cash payment of the cash/stock earnout obligations of Kyphon incurred in
connection with the Acquisition, where such payments are subject to certain
limitations; (x) permitting the consolidated interest coverage ratio to fall
below a certain threshold and the consolidated leverage ratio and the
consolidated senior secured leverage ratio to be greater than a certain
threshold; (xi) prepaying subordinated indebtedness, other than prepayments
pursuant to a refinancing permitted thereunder or if certain requirements are
satisfied and (xi) other customary negative covenants for a facility of this
nature.

Convertible Notes. In February 2007, we issued $200.0 million
aggregate principal amount of Convertible Senior Notes due 2012 and $200.0
million aggregate principal amount of Convertible Senior Notes due 2014.
Interest on the notes due 2012 will be paid semiannually at a rate of 1.00% per
year and interest on the notes due 2014 will be paid semiannually at a rate of
1.25% per year.  Upon the occurrence of certain defined events, the Convertible
Senior Notes will be convertible into cash up to the principal amount, and if
applicable, shares of common stock in respect of any conversion value above the
principal amount, based on an initial conversion rate of 17.1951 shares of
common stock per $1,000 principal amount of notes, which is equivalent to an
initial conversion price of approximately $58.16 per share.

The Senior Convertible Notes rank equal in right of payment to all of our
other existing and future senior unsecured indebtedness.  The Senior Convertible
Notes will rank senior in right of payment to all of Kyphon's existing and
future subordinated indebtedness and effectively subordinated in right of
payment to all of its subsidiaries' obligations (including secured and unsecured
obligations) and subordinated in right of payment to its secured obligations to
the extent of the assets securing such obligation.

In connection with the offering, we entered into convertible note hedge
transactions with affiliates of the initial purchasers.  These transactions are
intended to reduce the potential dilution to our stockholders upon any future
conversion of the notes.  The call options, which cost an aggregate $112.0
million, were recorded as a reduction of additional paid-in capital, net of tax
benefit.  We also entered into warrant transactions concurrently with the
offering, pursuant to which we sold warrants to purchase our own common stock to
the same counterparties that entered into the convertible note hedge
transactions.  The convertible note hedge and warrant transactions effectively
will increase the conversion price of the convertible notes to approximately
$75.04 per share of our common stock.  Proceeds received from the issuance of
the warrants totaled approximately $77.0 million and were recorded as an
addition to additional paid-in capital.

On February 6, 2007, we used net proceeds of approximately $355.0 million
from the issuance of the Convertible Senior Notes, described below, together
with borrowings under the Revolving Credit Facility, to prepay the Term Loan
Facility in its entirety.

Cash Provided by Operating Activities.  Our operating cash flow
in 2006 was primarily the result of our operational profitability.  Net cash
provided by operations was $54.9 million attributable primarily to net income of
$39.7 million and adjustments for non-cash charges related to stock-based
compensation of $29.1 million and depreciation and amortization of $6.7 million.
Net cash provided by operations in 2005 was $67.9 million attributable primarily
to net income of $29.8 million and adjustments for non-cash charges related to
tax benefits from stock options of
$18.5 million.  Net cash provided by operations in 2004 was $31.0 million in
2004 attributable primarily to net income of $21.7 million and adjustments for
non-cash charges related to tax
benefits from stock options of $8.7 million.  In January 2006, we adopted SFAS
No. 123(R), which requires that the excess benefit of tax deductions over the
recognized compensation cost for employee stock options be reported as cash flow
from financing activities rather than as cash flow from operations.

The increases in cash provided by operating activities for all periods was
adjusted by changes in our working capital, primarily in accounts receivable,
inventories and accrued liabilities.  Accounts receivable increased by $16.9
million, $16.4 million and $17.6 million during 2006, 2005, and 2004,
respectively, due to increases in our net sales.  Inventories increased by $7.3
million in 2006 to meet the increased demand for our products and full launch of
our FAD product in 2007.  Inventories decreased by $552,000 in 2005 due to
improved inventory management.  Inventories increased by $5.1 million during
2004 to meet the increased demand for our products.  Accrued liabilities
increased by $6.8 million, $26.3 million and $9.0 million during 2006, 2005, and
2004, respectively, due to our increased operating expenses and income taxes.
As of
December 31, 2005, accrued liabilities included $15.0 million relating to the
license acquisition charge from our agreement with Dr. Sandhu.

Cash Used in Investing Activities.  Net cash used in investing
activities was $75.7 million, $100.9 million, and $11.2 million in 2006, 2005,
and 2004, respectively.  Cash used in investing activities reflected purchases
of property and equipment for all periods.  During 2006, cash used for investing
activities reflected the net purchases of investments of $1.5 million, payment
of $2.2 million in connection with an  equity investment in a private company,
and payment of $60.0 million in connection with our definitive agreements to
acquire Disc-O-Tech.  During 2005, cash used for investing activities reflected
the net purchases of investments of $90.4 million, and payment of $2.4 million
in connection with the acquisition of InnoSpine.  During 2004, cash used in
investing activities reflected the net purchases of investments of $1.6 million.
We expect our purchases of property and equipment in 2007 to increase due to the
expansion of our Sunnyvale facility and the establishment of our new
manufacturing, distribution and research and development facilities in
Switzerland.

Cash Provided by Financing Activities.  Net cash provided by
financing activities was $24.5 million, $22.3 million, and $9.8 million in 2006,
2005, and 2004, respectively.  Cash provided during 2006 was attributable to
proceeds from the issuance of common stock under the employee stock plan of $6.3
million, the exercise of stock options of $13.9 million, and excess tax benefit
related to stock-based compensation plans of $4.4 million.  Cash provided by
financing activities during 2005 was attributable to proceeds from the issuance
of common stock under the employee stock purchase plan of $4.7 million and the
exercise of stock options of $17.6 million.  Cash provided during 2004 was
attributable to proceeds from the issuance of common stock under the employee
stock purchase plan of $3.4 million and the exercise of stock options of $6.4
million.

Contractual Cash Obligations.  At December 31, 2006 we had
contractual cash obligations as follows (in thousands):

`Payment Due by Periods
                                                   ------------------------------------------------------
                                                     Total      2007     2008-2009   2010-2011  After 2011
                                                   ---------  ---------  ----------  ---------  ---------
Operating leases                                  $  22,347  $   3,567  $    6,115  $   6,038  $   6,627
Consulting agreement                                  1,656        944         712         --         --
License agreement                                    10,000     10,000          --         --         --
Disc-O-Tech payment obligations                     160,000     40,000      80,000     40,000         --
Purchase commitments with contract
   manufacturers and suppliers                        8,779      8,779          --         --         --
Purchase obligations                                  7,169      7,169          --         --         --
Asset retirement obligation                             669         --          --        373        296
                                                   ---------  ---------  ----------  ---------  ---------
Total commitments                                 $ 210,620  $  70,459  $   86,827  $  46,411  $   6,923
                                                   =========  =========  ==========  =========  =========`

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 and a portion of the asset retirement obligations are
denominated in foreign currencies and were translated in the tables above based
on their respective U.S. dollar exchange rates at December 31, 2006.  These
future payments are subject to foreign currency exchange rate risk.

We remain obligated to make a series of annual payments totaling up to $15.0
million related to the license acquisition agreement with Dr. Sandhu of which
$5.0 million was paid in the fourth quarter of 2006.  The payments of these
additional obligations may be accelerated upon defined events and circumstances
or may be forgiven upon the occurrence of a third party event, outside the
control of the Company.  Based on management judgment, ability and intent, this
remaining obligation in the amount of $10.0 million has been classified as
current liability as of December 31, 2006.

In January 2006, we completed our acquisition of InnoSpine, Inc. (InnoSpine),
a privately held company focused on developing and marketing its proprietary
technology platform for the diagnosis and potential treatment of axial low back
pain due to disc degeneration.  The terms of the acquisition called for an
initial purchase price of $2.5 million in cash to the shareholders of InnoSpine,
plus the possibility of up to an additional $27.5 million in cash or stock,
based on achievement of clinical and other milestones as well as royalties on
future net sales.  This contingent purchase price liability is not included in
the table above.

In December 2006, we executed two definitive agreements with Disc-O-Tech
Medical Technologies, Ltd. and its U.S. subsidiary (Disc-O-Tech) to acquire,
respectively, all of its non-vertebroplasty spine-related assets, including
minimally invasive technologies for performing fusion and vertebral body
augmentation, for $100.0 million in cash ($60.0 million paid up-front in
December 2006 and another $40.0 million paid February 1, 2007), and all of its
vertebroplasty assets for a total of an additional $120.0 million payable in
three equal annual installments beginning in January 2008.  We will still be
obligated to pay the purchase price even if the closings do not occur.
We also agreed to pay up to an additional $20.0
million for the development of future technologies upon closing of the
vertebroplasty asset purchase agreement.  This contingent purchase price
liability is not included in the table above.  We have not yet received
clearance from the Federal Trade Commission to close either of these
transactions and may not be able to do so for some time, if at all.

In January 2007, we completed our acquisition of St. Francis Medical
Technologies, Inc. (St. Francis).  The total estimated purchase price, excluding
transaction costs, of approximately $725.0 million was comprised $525.0
million in cash upon closing, plus additional revenue-based contingent payments
of up to $200.0 million payable in either cash or a combination of cash and
stock, at Kyphon's election.  The payments are contingent upon the attainment of
certain revenue thresholds during specified periods through June 2008.  Neither
the initial purchase price or the contingent purchase price liability are
included in the table above.  We financed the transaction through a combination
of cash on hand and bank financing.

Purchase Commitments with Contract Manufacturers and
Suppliers.  We purchase components from a variety of suppliers
and use contract manufacturers to provide manufacturing services for our
products. During the normal course of business, in order to manage manufacturing
lead times and to help assure adequate component supply, we enter into
agreements with contract manufacturers and suppliers that either allow them to
procure inventory based upon criteria as defined by us or that establish the
parameters defining our requirements.  In certain instances, these agreements
allow us the option to cancel, reschedule, and adjust our requirements based on
our business needs prior to firm orders being placed.  Consequently, only a
portion of our reported purchase commitments arising from these agreements are
firm, noncancelable, and unconditional commitments.  The purchase commitments
for inventory are expected to be fulfilled within one year.

Purchase Obligations

Off-Balance Sheet Arrangements.  We do not have any off-balance
sheet financing as of December 31, 2006.  All of our subsidiaries are included
in the financial statements, and we do not have relationships with any special
purpose entities.

Stock Repurchase.  Our Board of Directors approved a stock
repurchase program on November 7, 2002, pursuant to which we may purchase up to
2,000,000 shares of our outstanding common stock.  The duration of the
repurchase program is open-ended.  Under the program, we may purchase shares of
common stock through open market transactions at prices deemed appropriate by
management and the Board of Directors.  The purchases will be funded from
available working capital.  In 2002, we repurchased 30,000 shares pursuant to
this repurchase program.  We have not repurchased any of our common stock since
2002.

Summary.  We believe our cash generated from operations,
together with our cash, cash equivalents, investments, and borrowings available
under our revolving credit facility will be sufficient to meet our anticipated
cash needs for working capital, capital expenditures and our contractual
payments and any contingent payments that become due related to the acquisitions
described for at least the next 12 months.

Recent Accounting Pronouncements

In June 2006, the FASB issued Interpretation
No. 48, "Accounting for Uncertainty in Income Taxes-an Interpretation
of FASB Statement No. 109" (FIN 48).  FIN 48 clarifies the
accounting for uncertainty in income taxes recognized in a company's financial
statements in accordance with SFAS No. 109, "Accounting for Income
Taxes." FIN 48 prescribes a recognition threshold and measurement attribute
for the financial statement recognition and measurement of a tax position taken
or expected to be taken in a tax return.  FIN 48 is effective for fiscal
years beginning after December 15, 2006.  We are currently evaluating the
impact, of the adoption of FIN 48 will
have on our financial statements or related disclsoures.

In September 2006, the FASB issued SFAS No. 157, "Fair Value
Measurements" (SFAS 157).  SFAS 157 defines fair value, establishes a
framework for measuring fair value in accordance with generally accepted
accounting principles and expands disclosures about fair value measurements.
The provisions of SFAS 157 are effective for fiscal years beginning after
November 15, 2007 and is to be applied prospectively.  We are currently
evaluating the impact, of the adoption of SFAS 157 will have on our
financial reporting.

In September 2006, the SEC issued Staff Accounting Bulletin No. 108 (SAB 108)
in order to eliminate the diversity of practice surrounding how public companies
quantify financial statement misstatements.  Traditionally, there have been
two widely-recognized methods for quantifying the effects of financial statement
misstatements:  the "roll-over" method and the "iron
curtain" method.  The "roll-over" method focuses primarily
on the impact of a misstatement on the income statement, including the reversing
effect of prior period misstatements; but its use can lead to the accumulation
of misstatements in the balance sheet.  The "iron-curtain"
method, on the other hand, focuses primarily on the effect of correcting the
period-end balance sheet with less emphasis on the reversing effects of prior
period errors on the income statement.  We currently use the "iron-curtain"
 method for quantifying identified financial statement
misstatements.  In SAB 108, the SEC staff
established an approach that requires quantification of financial statement
misstatements based on the effects of the misstatements on each of our financial
statements and the related financial statement disclosures.  This model is
commonly referred to as a "dual approach" because it requires
quantification of errors under both the "iron curtain" and the
"roll-over" methods.  SAB 108
permits existing public companies to initially apply its provisions either by
(i) restating prior financial statements as if the "dual approach" had
always been used or (ii) recording the cumulative effect of initially applying
the "dual approach" as adjustments to the carrying values of assets
and liabilities as of the beginning of the current fiscal year with an
offsetting adjustment to the opening balance of retained earnings in the year of
adoption.  Use of the "cumulative effect" transition method
requires detailed disclosure of the nature and amount of each individual error
being corrected through the cumulative adjustment and how and when it
arose.  The provisions of SAB 108 must be applied to annual financial
statements no later than the first fiscal year ending after November 15, 2006.
  Upon adoption, there was no impact on our financial statements or related
disclosures.

ITEM 7A.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Our exposure to interest rate risk at December 31, 2006 is related
primarily to our investment portfolio.  Our investment portfolio includes fixed
rate debt instruments of the U.S. government and its agencies and high quality
corporate issuers.  A change in prevailing interest rates may cause the fair
value of our investments to fluctuate.  For example, if we hold a security that
was issued with a fixed interest rate at the then-prevailing rate and the
                                                                                prevailing rate rises, the fair value of the principal amount of our investment
will probably decline.  To minimize this risk, investments are generally held to
maturity and the weighted average duration of our investments is 12 months or
less.  Due to the short-term nature of these investments, we believe we have no
material exposure to interest rate risk arising from our investments.

We have operated mainly in the United States, and 79%, 84%, and 88% of our
sales were made in U.S. dollars in 2006, 2005, and 2004, respectively.  The
majority of our non-U.S. sales are derived from European Union countries and
denominated in the Euro.  Monthly income and expense from our European
operations are translated using average rates and balance sheets are translated
using month end rates.  Differences are recorded within stockholders' equity as
a component of accumulated other comprehensive income or to the income
statement, as applicable.  As our revenues denominated in currencies other than
the dollar increase, we have an increased exposure to foreign currency rate
risk.  Based on our overall exposure for foreign currency at December 31, 2006,
a hypothetical 10% change in foreign currency rates would not have a material
impact on our net sales and operating expenses.  We may elect to mitigate this
rate risk, in part or in whole, through the purchase of forward currency
contracts.

---

ITEM 8.	  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA



REPORTS OF MANAGEMENT

Statement of Management's Responsibility

Kyphon's management has always assumed full accountability for maintaining
compliance with our established financial accounting policies and for reporting
our results with objectivity and the highest degree of integrity.  It is
critical for investors and other users of the Consolidated Financial Statements
to have confidence that the financial information that we provide is timely,
complete, relevant, and accurate. Management is responsible for the fair
presentation of Kyphon's Consolidated Financial Statements, prepared in
accordance with generally accepted accounting principles (GAAP), and has full
responsibility for their integrity and accuracy.

Management, with oversight by Kyphon's Board of Directors, is working to
continually strengthen an ethical climate so that our affairs are conducted to
the highest standards of personal and corporate conduct. Management also has
established an effective system of internal control over financial reporting.
Kyphon's policies and practices reflect corporate governance initiatives that
are compliant with the listing requirements of NASDAQ and the corporate
governance requirements of the Sarbanes-Oxley Act of 2002.  We are committed to
enhancing shareholder value and fully understand and embrace our fiduciary
oversight responsibilities.  We are dedicated to ensuring that our high
standards of financial accounting and reporting as well as our underlying system
of internal controls are maintained.  Our culture demands integrity and we have
the highest confidence in our processes, our internal controls, and our people,
who are objective in their responsibilities and who operate under the highest
level of ethical standards.

Management's Report on Internal Control Over Financial
Reporting

Management is responsible for establishing and maintaining
adequate internal control over financial reporting for Kyphon.  Internal control
over financial reporting is a process designed to provide reasonable assurance
regarding the reliability of financial reporting and the preparation of
financial statements for external purposes in accordance with generally accepted
accounting principles.  Internal control over financial reporting includes those
policies and procedures that: (i) pertain to the maintenance of records
that in reasonable detail accurately and fairly reflect the transactions and
dispositions of the assets of the company; (ii) provide reasonable
assurance that transactions are recorded as necessary to permit preparation of
financial statements in accordance with generally accepted accounting
principles, and that receipts and expenditures of the company are being made
only in accordance with authorizations of management and directors of the
company; and (iii) provide reasonable assurance regarding prevention or
timely detection of unauthorized acquisition, use, or disposition of the
company's assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial
reporting may not prevent or detect misstatements.  Also, projections of any
evaluation of effectiveness to future periods are subject to the risk that
controls may become inadequate because of changes in conditions, or that the
degree of compliance with the policies or procedures may deteriorate.

Management (with the participation of the principal executive officer and
principal financial officer) conducted an evaluation of the effectiveness of
Kyphon's internal control over financial reporting based on the framework in
Internal Control-Integrated Framework issued by the Committee of
Sponsoring Organizations of the Treadway Commission.  Based on this evaluation,
management concluded that Kyphon's internal control over financial reporting was
effective as of December 31, 2006.  Management's assessment of the
effectiveness of Kyphon's internal control over financial reporting as of
December 31, 2006 has been audited by PricewaterhouseCoopers LLP, an independent
registered public accounting firm, as stated in their report which is included
herein.

---







|KYPHON INC.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS                                              
|----------------------------------------------------------------------------------------------------
|                                                                                                    
|Consolidated Financial Statements:                                                                  
|Report of Independent Registered Public Accounting Firm                                             
|Consolidated
Income Statements for the years ended December 31, 2006, 2005 and
2004                 
|Consolidated Balance
Sheets at December 31, 2006 and 2005                                           
|Consolidated
Statements of Cash Flows for the years ended December 31, 2006, 2005 and
2004          
|Consolidated
Statements of Stockholder's Equity for the years ended December
31, 2006, 2005 and 2004
|Notes to
Consolidated Financial Statements                                                          
|                                                                                                    
|Financial Statement Schedule:                                                                       
|Schedule II
Valuation and Qualifying Accounts                                                       

---

Report of Independent Registered Public Accounting
Firm

To the Board of Directors and 
Stockholders of Kyphon Inc.: 
We have completed integrated audits of Kyphon Inc.'s consolidated financial
statements and of its internal control over financial reporting as of December
31, 2006, in accordance with the standards of the Public Company Accounting
Oversight Board (United States).  Our opinions, based on our audits, are
presented below.
Consolidated financial statements and financial statement schedule 
In our opinion, the consolidated financial statements listed in the accompanying
index, present fairly, in all material respects, the financial position of
Kyphon Inc. and its subsidiaries at December 31, 2006 and 2005, and the results
of their operations and their cash flows for each of the three years in the
period ended December 31, 2006 in conformity with accounting principles
generally accepted in the United States of America.  In addition, in our
opinion, the financial statement schedule listed in the accompanying index
presents fairly, in all material respects, the information set forth therein
when read in conjunction with the related consolidated financial statements.
 These financial statements and financial statement schedule are the
responsibility of the Company's management.  Our responsibility is to express an
opinion on these financial statements and financial statement schedule based on
our audits.  We conducted our audits of these statements in accordance with
the standards of the Public Company Accounting Oversight Board (United States).
Those standards require that we plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free of material
misstatement.  An audit of financial statements includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements, assessing the accounting principles used and significant estimates
made by management, and evaluating the overall financial statement presentation.
 We believe that our audits provide a reasonable basis for our opinion.

As discussed in Note 2 to the Notes to Consolidated Financial Statements, the
Company changed the manner in which it accounts for stock-based compensation in
2006.
Internal control over financial reporting 
Also, in our opinion, management's assessment, included in Management's Report
on Internal Control Over Financial Reporting appearing under Item 8, that the
Company maintained effective internal control over financial reporting as of
December 31, 2006 based on criteria established in Internal Control -
Integrated Framework issued by the Committee of Sponsoring Organizations of
the Treadway Commission (COSO), is fairly stated, in all material respects,
based on those criteria.  Furthermore, in our opinion, the Company maintained,
in all material respects, effective internal control over financial reporting as
of December 31, 2006, based on criteria established in Internal Control -
Integrated Framework issued by the COSO.  The Company's management is
responsible for maintaining effective internal control over financial reporting
and for its assessment of the effectiveness of internal control over financial
reporting. Our responsibility is to express opinions on management's assessment
and on the effectiveness of the Company's internal control over financial
reporting based on our audit.  We conducted our audit of internal control over
financial reporting in accordance with the standards of the Public Company
Accounting Oversight Board (United States).  Those standards require that we
plan and perform the audit to obtain reasonable assurance about whether
effective internal control over financial reporting was maintained in all
material respects.  An audit of internal control over financial reporting
includes obtaining an understanding of internal control over financial
reporting, evaluating management's assessment, testing and evaluating the design
and operating effectiveness of internal control, and performing such other
procedures as we consider necessary in the circumstances.  We believe that our
audit provides a reasonable basis for our opinions. 
A company's internal control over financial reporting is a process designed to
provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in accordance
with generally accepted accounting principles.  A company's internal
control over financial reporting includes those policies and procedures that (i)
pertain to the maintenance of records that, in reasonable detail, accurately and
fairly reflect the transactions and dispositions of the assets of the company;
(ii) provide reasonable assurance that transactions are recorded as necessary to
permit preparation of financial statements in accordance with generally accepted
accounting principles, and that receipts and expenditures of the company are
being made only in accordance with authorizations of management and directors of
the company; and (iii) provide reasonable assurance regarding prevention or
timely detection of unauthorized acquisition, use, or disposition of the
company's assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting
may not prevent or detect misstatements.  Also, projections of any
evaluation of effectiveness to future periods are subject to the risk that
controls may become inadequate because of changes in conditions, or that the
degree of compliance with the policies or procedures may deteriorate. 
PricewaterhouseCoopers LLP 
San Jose, California 
February 28, 2007

---



Kyphon Inc.
                     Consolidated Income Statements
                    (in thousands, except per share amounts)

`Year Ended December 31,
                                                     ----------------------------------
                                                        2006        2005        2004
                                                     ----------  ----------  ----------
Net sales                                           $  407,790  $  306,082  $  213,414
Cost of goods sold                                      52,176      35,843      24,734
                                                     ----------  ----------  ----------

Gross profit                                           355,614     270,239     188,680
                                                     ----------  ----------  ----------

Operating expenses:
  Research and development                              39,971      46,383      22,238
  Sales and marketing                                  194,057     144,768     106,103
  General and administrative                            60,351      34,951      25,972
                                                     ----------  ----------  ----------
      Total operating expenses                         294,379     226,102     154,313
                                                     ----------  ----------  ----------

Income from operations                                  61,235      44,137      34,367
Interest income                                          8,960       3,998       1,314
Other income (expense), net                                527         (19)        (64)
                                                     ----------  ----------  ----------

Income before income taxes                              70,722      48,116      35,617
Provision for income taxes                              30,990      18,280      13,900
                                                     ----------  ----------  ----------
Net income                                          $   39,732  $   29,836  $   21,717
                                                     ==========  ==========  ==========

Net income per share:
  Basic                                             $     0.89  $     0.70  $     0.54
                                                     ==========  ==========  ==========
  Diluted                                           $     0.86  $     0.66  $     0.50
                                                     ==========  ==========  ==========

Weighted-average shares outstanding:
  Basic                                                44,436      42,803      40,449
                                                     ==========  ==========  ==========
  Diluted                                              46,313      45,336      43,670
                                                     ==========  ==========  ==========`

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

---



Kyphon Inc.
                           Consolidated Balance Sheets
                    (in thousands, except per share amounts)

`December 31,
                                                                      ----------------------
                                                                         2006        2005
                                                                      ----------  ----------
Assets                                                                                      
Current assets:
  Cash and cash equivalents                                          $   81,939  $   76,149
  Investments                                                           120,214     118,324
  Accounts receivable, net of allowances of $1,864 in 2006
    and $1,577 in 2005                                                   73,859      55,480
  Inventories                                                            11,869       9,265
  Prepaid expenses and other current assets                               7,520       5,899
  Deferred tax assets                                                     6,072      10,488
                                                                      ----------  ----------
      Total current assets                                              301,473     275,605

Property and equipment, net                                              27,590      15,977
Goodwill and other intangible assets, less accumulated
   amortization of $1,232 in 2006 and $88 in 2005                        14,742      15,377
Deferred tax assets                                                      14,955       6,749
Other assets                                                             69,846       2,924
                                                                      ----------  ----------
      Total assets                                                   $  428,606  $  316,632
                                                                      ==========  ==========

Liabilities and Stockholders' Equity                                                        
Current liabilities:
  Accounts payable                                                   $   10,447  $    9,308
  Accrued liabilities                                                    62,980      49,793
                                                                      ----------  ----------
      Total current liabilities                                          73,427      59,101

Other liabilities                                                        10,479       7,475
                                                                      ----------  ----------
      Total liabilities                                                  83,906      66,576
                                                                      ----------  ----------

Commitments and contingencies (Notes 4, 5 and 7)

Stockholders' equity:
  Preferred stock, par value: $0.001
    Authorized: 5,000 shares; none issued and outstanding                    --          --
  Common stock, par value:  $0.001
    Authorized: 120,000 shares
    Issued: 44,969 shares in 2006 and 43,843 shares in 2005
    Outstanding: 44,939 shares in 2006 and 43,813 shares in 2005             45          44
  Additional paid-in capital                                            284,672     231,312
  Treasury stock, at cost: 30 shares in 2006 and 2005                      (201)       (201)
  Deferred stock-based compensation                                          --        (116)
  Accumulated other comprehensive income                                  1,607         172
  Retained earnings                                                      58,577      18,845
                                                                      ----------  ----------
      Total stockholders' equity                                        344,700     250,056
                                                                      ----------  ----------

        Total liabilities and stockholders' equity                   $  428,606  $  316,632
                                                                      ==========  ==========`

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

---

Kyphon Inc.
                     Consolidated Statements of Cash Flows
                                 (in thousands)

`Year Ended December 31,
                                                                                  -------------------------------
                                                                                    2006       2005       2004
                                                                                  ---------  ---------  ---------
Cash flows from operating activities:                                                                            
  Net income                                                                     $  39,732  $  29,836  $  21,717
  Adjustments to reconcile net income to net cash provided by
    operating activities:
      Provision for accounts receivable allowances                                     714      1,366        737
      Provision for excess and obsolete inventories                                  2,136        757        158
      Depreciation and amortization                                                  6,674      4,274      2,817
      Deferred tax assets                                                           (2,957)    (3,764)     4,080
      Loss on disposal of property and equipment                                       220        182         93
      Tax benefit related to stock-based compensation plans                          4,198     18,517      8,741
      Excess tax benefit related to stock-based compensation plans                  (4,392)        --         --
      Stock-based compensation                                                      29,143      3,091      3,852
      Changes in operating assets and liabilities, net of effect of acquisition:
        Accounts receivable                                                        (16,865)   (16,408)   (17,581)
        Inventories                                                                 (7,333)       552     (5,127)
        Prepaid expenses and other current assets                                   (1,466)    (1,270)       343
        Other assets                                                                (4,647)       939     (1,975)
        Accounts payable                                                               944      3,898        (40)
        Accrued liabilities                                                          6,808     26,264      9,030
        Other liabilities                                                            1,945       (358)     4,156
                                                                                  ---------  ---------  ---------
            Net cash provided by operating activities                               54,854     67,876     31,001

Cash flows from investing activities:                                                                            
  Acquisition of property and equipment                                            (11,905)    (8,025)    (9,650)
  Maturities and sales of investments                                              202,843     38,600     19,945
  Purchases of investments                                                        (204,385)  (129,030)   (21,523)
  Disc-O-Tech acquisition deposits                                                 (60,000)        --         --
  Other investments and acquisitions, net of cash                                   (2,238)    (2,448)        --
                                                                                  ---------  ---------  ---------
            Net cash used in investing activities                                  (75,685)  (100,903)   (11,228)

Cash flows from financing activities:                                                                           
  Proceeds from issuance of common stock                                             6,286      4,697      3,421
  Proceeds from exercise of stock options                                           13,850     17,597      6,361
  Excess tax benefit related to stock-based compensation plans                       4,392         --         --
                                                                                  ---------  ---------  ---------
            Net cash provided by financing activities                               24,528     22,294      9,782
                                                                                  ---------  ---------  ---------
Effect of foreign exchange rate changes on cash                                      2,093       (354)       187
                                                                                  ---------  ---------  ---------
Net increase (decrease) in cash and cash equivalents                                 5,790    (11,087)    29,742

Cash and cash equivalents at beginning of year                                      76,149     87,236     57,494
                                                                                  ---------  ---------  ---------
Cash and cash equivalents at end of year                                         $  81,939  $  76,149  $  87,236
                                                                                  =========  =========  =========

Supplementary disclosure of non-cash investing and financing activities:                                         
  Capitalized building and related capitalized interest                          $   5,038  $      --  $      --
                                                                                  =========  =========  =========
  Lease financing liability                                                      $   4,992  $      --  $      --
                                                                                  =========  =========  =========
  Write-off of fully depreciated property and equipment                          $   2,442  $     847  $     187
                                                                                  =========  =========  =========

Supplemental disclosure of cash flow information:                                                                
  Cash paid during the year for interest                                         $     100  $      --  $      --
                                                                                  =========  =========  =========
  Cash paid during the year for income taxes                                     $  32,282  $   1,696  $     400
                                                                                  =========  =========  =========`

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

---



Kyphon Inc.
       Consolidated Statements of Stockholders' Equity
                      (in thousands)

`Accumulated     Retained
                                                                                            Common Stock    Additional                Deferred         Other        Earnings         Total
                                                                                        ------------------   Paid-In     Treasury   Stock-Based    Comprehensive   (Accumulated  Stockholders'
                                                                                         Shares    Amount    Capital      Stock     Compensation      Income        Deficit)        Equity
                                                                                        --------  --------  ----------  ----------  ------------  ---------------  -----------  ---------------
Balance at January 1, 2004                                                               39,440  $     39  $  171,359  $      (201)$     (6,435) $         2,196  $   (32,708) $       134,250
Exercise of stock options                                                                 1,542         2       6,359          --            --               --           --            6,361
Issuance of common stock under employee stock purchase plan                                 338        --       3,421          --            --               --           --            3,421
Issuance of common stock upon exercise of warrants                                            5        --          --          --            --               --           --               --
Tax benefits from exercise of common stock options                                           --        --       8,741          --            --               --           --            8,741
Deferred stock-based compensation, net of cancellations                                      --        --        (470)         --           470                            --               --
Amortization of deferred stock-based compensation                                            --        --          --          --         2,923               --           --            2,923
Non-employee stock-based compensation                                                        --        --          --          --           929               --           --              929
                                                                                                                                                                                ---------------
Components of other comprehensive income:
  Changes in unrealized gains (losses) on available-for sale investments, net of taxes       --        --          --          --            --              (73)          --              (73)
  Cumulative translation adjustments                                                         --        --          --          --            --            1,366           --            1,366
  Net income                                                                                 --        --          --          --            --               --       21,717           21,717
                                                                                                                                                                                ---------------
     Total comprehensive income                                                                                                                                                         23,010
                                                                                        --------  --------  ----------  ----------  ------------  ---------------  -----------  ---------------
Balance at December 31, 2004                                                             41,325  $     41  $  189,410  $     (201) $     (2,113) $         3,489  $   (10,991) $       179,635
Exercise of stock options                                                                 2,174         2      17,595          --            --               --           --           17,597
Issuance of common stock under employee stock purchase plan                                 314         1       4,696          --            --               --           --            4,697
Tax benefits from exercise of common stock options                                           --        --      18,517          --            --               --           --           18,517
Deferred stock-based compensation, net of cancellations                                      --        --        (165)         --           165                            --               --
Amortization of deferred stock-based compensation                                            --        --          --          --         1,832               --           --            1,832
Non-employee stock-based compensation                                                        --        --       1,259          --            --               --           --            1,259
                                                                                                                                                                                ---------------
Components of other comprehensive income:
  Changes in unrealized gains (losses) on available-for sale investments, net of taxes       --        --          --          --            --              (90)          --              (90)
  Cumulative translation adjustments                                                         --        --          --          --            --           (3,227)          --           (3,227)
  Net income                                                                                 --        --          --          --            --               --       29,836           29,836
                                                                                                                                                                                ---------------
     Total comprehensive income                                                                                                                                                         26,519
                                                                                        --------  --------  ----------  ----------  ------------  ---------------  -----------  ---------------
Balance at December 31, 2005                                                             43,813  $     44  $  231,312  $     (201) $       (116) $           172  $    18,845  $       250,056
Exercise of stock options                                                                   875         1      13,849          --            --               --           --           13,850
Issuance of common stock under employee stock purchase plan                                 251        --       6,286          --            --               --           --            6,286
Tax benefits from exercise of common stock options                                           --        --       4,198          --            --               --           --            4,198
Deferred stock-based compensation, net of cancellations                                      --        --        (116)         --           116               --           --               --
Stock-based compensation                                                                     --        --      29,143          --            --               --           --           29,143
                                                                                                                                                                                ---------------
Components of other comprehensive income:
  Changes in unrealized gains (losses) on available-for sale investments, net of taxes       --        --          --          --            --              140           --              140
  Cumulative translation adjustments                                                         --        --          --          --            --            1,295           --            1,295
  Net income                                                                                 --        --          --          --            --               --       39,732           39,732
                                                                                                                                                                                ---------------
     Total comprehensive income                                                                                                                                                         41,167
                                                                                        --------  --------  ----------  ----------  ------------  ---------------  -----------  ---------------
Balance at December 31, 2006                                                             44,939  $     45  $  284,672  $     (201) $         --  $         1,607  $    58,577  $       344,700
                                                                                        ========  ========  ==========  ==========  ============  ===============  ===========  ===============`

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

---

KYPHON INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. 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 by 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 spinal fractures.  The Company markets its products through sales
representatives in North America, and through a combination of sales
representatives, distributors and agents in its international markets.  The
Company is headquartered in Sunnyvale, California, has subsidiaries in many
countries in Europe, as well as in Canada, Japan, Australia and South
Africa.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Consolidation and Foreign Currency Translation

The consolidated financial statements include the accounts of the Company and
its wholly owned subsidiaries.  All material intercompany balances and
transactions have been eliminated.

The Company analyzes the functional currency determination for its
international subsidiaries on an annual basis, or more often as necessary.  For
the Company's international subsidiaries which use their local currency as their
functional currency, assets and liabilities are translated at exchange rates in
effect at the balance sheet date and revenue and expense accounts at average
exchange rates during the period.  Resulting translation adjustments are
recorded directly to cumulative comprehensive income.  Translation adjustments
resulting from the process of remeasuring into the United States dollar from the
foreign currency financial statements of the Company's wholly owned
subsidiaries, for which the United States dollar is the functional currency, are
included in other income (expense), net.

Use of Estimates

The preparation of financial statements in conformity with accounting
principles generally accepted in the United States of America requires
management to make estimates and assumptions that affect the reported amounts of
assets and liabilities and disclosure of contingent assets and liabilities at
the date of the financial statements and the reported amounts of revenues and
expenses during the reporting periods.  Actual results could differ from those
estimates.

Cash and Cash Equivalents

The Company considers all highly liquid investments purchased with original
maturities of three months or less to be cash equivalents.  Cash and cash
equivalents include money market funds, corporate notes and commercial
paper.  Cash equivalents comprised commercial paper and corporate notes in
the amounts of $25,906,000 and $7,251,000, as of December 31, 2006 and 2005,
respectively.  Cash equivalents are classified as available-for-sale and
therefore are carried at fair market value.  Related unrealized gains and losses
were insignificant as of December 31, 2006 and 2005.

Investments

Restricted Cash.  Under the terms of one of its facility leases,
the Company is required to issue an irrevocable standby letter of credit to the
lessor for the term of the facility lease.  The letter of credit is secured by a
certificate of deposit in the amount of $1,105,000 which was classified within
other assets as of December 31, 2006 and 2005.

Available-for-Sale.  All marketable investments are classified as
available-for-sale and therefore are carried at fair market value.  Unrealized
gains and losses, net of taxes, are reported as a separate component of
stockholders' equity.  Realized gains and losses on the sale of all such
investments are reported in earnings and computed using the specific
identification cost method and were insignificant for the years ended December
31, 2006, 2005 and 2004.  All of the Company's investments as of December 31,
2006 have maturities of one year or less.  The Company's available-for-sale
investments are summarized as follows (in thousands):

`December 31,
                                          ----------------------
                                             2006        2005
                                          ----------  ----------  
Asset-backed securities                  $   6,249    $  29,441
Variable-rate demand notes (1)             113,965          --
U.S. government and agency securities          --         6,506
Corporate debt secruities                      --        82,377
                                          ----------  ----------
    Total short-term investments         $ 120,214   $  118,324
                                          ==========  ==========


                                                        Gross        Gross     Estimated
                                           Adjusted   Unrealized  Unrealized     Fair
                                             Cost       Gains       Losses       Value
                                          ----------  ----------  -----------  ---------
December 31, 2006                                                                       
Asset-backed securities                  $   6,248   $        1  $        --  $   6,249
Variable-rate demand notes                 113,965           --           --    113,965
                                          ----------  ----------  -----------  ---------
    Total short-term investments         $ 120,213   $        1  $        --  $ 120,214
                                          ==========  ==========  ===========  =========

December 31, 2005                                                                       
Asset-backed securities                  $  29,474   $       --  $       (33) $  29,441
U.S. government and agency securities        6,509           --           (3)     6,506
Corporate debt securities                   82,575           --         (198)    82,377
                                          ----------  ----------  -----------  ---------
    Total short-term investments         $ 118,558   $       --  $      (234) $ 118,324
                                          ==========  ==========  ===========  =========`

(1) Variable-rate securities are securities with perpetual
maturities that are structured with short-term reset dates of generally 7 days.
At the end of the reset period, investors can sell or continue to hold the
securities at par.

The following table summarizes the estimated fair value of our securities held
in short-term investments classified by the stated maturity date of the security
(in thousands):

`As of
                                          December 31,
                                             2006
                                          ----------              
Due within 1 year                        $   6,249
Due from 1 year through 5 years                 --
Due from 5 years through 10 years               --
Due after 10 years                         113,965
                                          ----------
    Total short-term investments         $ 120,214
                                          ==========`

Investments in Other Entities.  In August 2006, the Company invested
$2,238,000 in a privately held company that designs and develops devices for
posterior fusion and dynamic stabilization of the lumbar spine.  The investment
is accounted for under the cost method of accounting and is included in other
assets in the Company's consolidated balance sheet as of December 31,
2006.

Accounts Receivable Allowances

The Company estimates allowances for doubtful accounts and for product
returns.  Specifically, the Company makes estimates on the collectibility of
customer accounts receivable and product returns based primarily on an analysis
of historical trends and experience and changes in customers' financial
condition.  The Company uses its judgment, based on the best available facts and
circumstances, and records an allowance against amounts due to reduce the
receivable to the amount that is expected to be collected.  These allowances are
reevaluated and adjusted as additional information is received that impacts the
amount reserved.

Inventories

Inventories are stated at the lower of cost or market.  Cost is computed on a
first-in, first-out basis.  The Company provides inventory allowances based on
excess and obsolete inventories determined primarily by future demand forecasts.
The allowance is measured as the difference between the cost of the inventory
and market based upon assumptions about future demand and charged to the
provision for inventory, which is a component of cost of goods sold.  At the
point of the loss recognition, a new, lower-cost basis for that inventory is
established, and subsequent changes in facts and circumstances do not result in
the restoration or increase in that newly established cost basis.

Depreciation and Amortization

Property and equipment are stated at cost less accumulated depreciation and
amortization.  Depreciation is provided using the straight-line method over the
estimated useful lives of the assets, generally two to five years.  Amortization
of leasehold improvements is provided on a straight-line basis over the life of
the related asset or the lease term, if shorter.  Upon the sale or retirement of
assets, the cost and related accumulated depreciation and amortization are
removed from the balance sheet and the resulting gain or loss is reflected in
other income (expense), net.  Repairs and maintenance expenses are expensed as
incurred.

Asset Retirement Obligations

The fair value of the asset retirement obligation is recognized in the
period in which it is incurred if a reasonable estimate of fair value can be
made.  In addition, the associated asset retirement cost is added to the
carrying amount of the associated asset and this additional carrying amount is
amortized over the life of the asset.  The Company's asset retirement
obligations are associated with its commitment to return property subject to
operating leases in London, UK, Brussels, Belgium, and Sunnyvale, California to
original condition upon lease termination.  The Company estimated that gross
expected future cash flows of approximately $894,000 would be required to
fulfill these obligations.

As of December 31, 2006, the Company has recorded asset retirement
obligations of approximately $669,000 and a corresponding increase in leasehold
improvements.  This amount represents the present value of expected future cash
flows associated with returning the leased properties to original condition.  A
portion of this amount is subject to foreign exchange rate fluctuations and has
been translated using the exchange rate at December 31, 2006.  The leasehold
improvements are being amortized to depreciation expense over the term of the
lease.  Related amortization expense was approximately $135,000, $61,000 and
$39,000 for the years ended December 31, 2006, 2005 and 2004, respectively.

Goodwill and Other Intangible Assets

The Company is amortizing its acquired intangible assets on a straight
line basis over a five to ten year period.  No amortization of goodwill has been
recorded.  Instead, the Company performs an impairment assessment by applying a
fair-value based test on an annual basis, or more frequently if changes in
circumstances or the occurrence of events suggest the remaining value is not
recoverable.  The annual goodwill impairment analysis is completed in the first
quarter of each year.  To date there has been no impairment of goodwill.
There have been no events or changes in circumstances subsequent
to the Company's annual tests which may indicate the asset is impaired.

Impairment of Long-Lived Assets

Long-lived assets are evaluated for impairment annually and whenever events
or changes in circumstances indicate that the carrying value of an asset may not
be recovered.  An impairment loss would be recognized when estimated
undiscounted future cash flows expected to result from the use of the asset and
its eventual disposition is less than its carrying amount.  Impairment, if any,
is measured as the amount by which the carrying amount of a long-lived asset
exceeds its fair value.  Through December 31, 2006, there have been no such
impairments.

Treasury Stock

In November 2002, the Board of Directors approved a stock repurchase program
pursuant to which up to 2,000,000 shares of the Company's outstanding common
stock may be repurchased from time to time.  The duration of the repurchase
program is open-ended.  Under the program, the Company may purchase shares of
common stock through open market transactions at prices deemed appropriate by
management and the Board of Directors.  As of December 31, 2006 and 2005, the
Company held 30,000 shares of treasury stock.  Treasury stock is accounted for
using the cost method.

Accounting for Stock-Based Compensation

Effective January 1, 2006, the Company adopted the provisions of Statement of
Financial Accounting Standards No. 123(R), "Share Based Payment"
("SFAS No. 123(R)"), which requires the measurement and recognition of
compensation expense for all share-based payment awards made to employees and
directors, including employee stock options and employee stock purchases based
on estimated fair values.  Accordingly, stock-based compensation cost is
measured at grant date, based on the fair value of the award, and is recognized
as expense over the employee requisite service period for each separately
vesting tranche of the award.  The Company elected to adopt the modified
prospective application method as provided by SFAS No. 123(R). 
Accordingly, previously reported amounts have not been restated.  The Company
also elected to use the method described in paragraph 81 of SFAS No. 123(R) (the
"long form" method) for the calculation of its pool of excess tax
benefits available to absorb tax deficiencies recognized subsequent to the
adoption of SFAS No. 123(R).  Employee stock-based compensation expense
recognized under SFAS No. 123(R) for the year ended December 31, 2006 was
$27,625,000.

The Company estimates the value of employee stock options on the date of
grant using a binomial-lattice model.  The binomial-lattice model used by the
Company to value employee stock options on the date of grant considers a range
of assumptions related to volatility, risk-free interest rate and employee
exercise behavior.  Expected volatilities are based on a blend of implied market
volatilities, historical and peer group volatilities.  The risk-free rate is
derived from the U.S. Treasury zero-coupon yield curve in effect at the time of
grant over the contractual term of the option.  The binomial-lattice model also
incorporates exercise and forfeiture assumptions based on an analysis of
historical data.  The expected life of the stock option grants is derived from
the output of the binomial-lattice model and represents the period of time that
options granted are expected to be outstanding.

The following table shows total
stock-based compensation expense for the year ended December 31, 2006, 2005 and
2004 (in thousands):

`Year Ended December 31,
                                                                        -------------------------------
                                                                          2006       2005       2004
                                                                        ---------  ---------  ---------

Cost of goods sold                                                     $   1,337  $    124   $     317
Research and development                                                   3,876       790         903
Sales and marketing                                                       11,596       797       1,324
General and administrative                                                10,816       121         380
                                                                        ---------  ---------  ---------
                                                                       $  27,625  $   1,832  $   2,924
                                                                        =========  =========  =========`



The effect of adopting SFAS No. 123(R) was as follows (in thousands, except
per share amounts):

`Year Ended
                                                                       December 31,
                                                                          2006
                                                                        ---------                      

Stock-based compensation by type of award:
  Employee stock options                                               $   24,473
  Employee stock purchase rights                                            3,152
                                                                        ---------
Total stock-based compensation expense                                     27,625
Tax effect on stock-based compensation                                     (8,478)
                                                                        ---------
Net effect on net income                                               $   19,147
                                                                        =========
Effect on net income per share:
  Basic                                                                $     0.43
  Diluted                                                              $     0.41`

As of December 31, 2006, stock-based compensation charges of approximately
$150,000 were capitalized as inventory.

During the year ended December 31, 2005 and 2004, the Company recognized
employee stock-based compensation expense of $1,832,000 and $2,924,000,
respectively, under APB No. 25 related to stock options previously issued with
exercise prices below the deemed fair market value of the Company's common stock
at the date of grant.  Upon the adoption of SFAS No. 123(R) on January 1, 2006,
the Company recorded a cumulative effect adjustment to eliminate the remaining
unrecognized deferred stock-based compensation of approximately $116,000 against
additional paid-in capital.  The Company did not record a cumulative effect
adjustment to record estimated forfeitures for these stock-based awards upon the
adoption of SFAS No. 123(R) as it was not significant.

Prior to the adoption of SFAS No. 123(R), the Company used the intrinsic
value method in accounting for its employee stock options, and presented
disclosure of pro forma information as if the Company had accounted for
stock-based compensation using the fair value method of each option on the date of
grant as follows (in thousands, except per share amounts):

`Year Ended December 31,
                                                                        --------------------
                                                                          2005       2004
                                                                        ---------  ---------           
Net income, as reported                                                $   29,836 $   21,717
Add:  Stock-based employee compensation expense included in
           reported net income, net of taxes                                1,136      1,784
Deduct:  Total stock-based employee compensation expense,
  determined under fair value based method for all awards, net of taxes   (15,698)    (9,897)
                                                                        ---------  ---------

Pro forma net income                                                   $   15,274 $   13,604
                                                                        =========  =========

Net income per share
Basic:
  As reported                                                          $     0.70 $     0.54
                                                                        =========  =========
  Pro forma                                                            $     0.36 $     0.34
                                                                        =========  =========
Diluted:
  As reported                                                          $     0.66 $     0.50
                                                                        =========  =========
  Pro forma                                                            $     0.34 $     0.31
                                                                        =========  =========`

Valuation Assumptions

The weighted-average assumptions used are as follows:

`Year Ended December 31,
                               -------------------------------

                                   Employee Stock Options
                               -------------------------------
                                 2006       2005       2004
                               ---------  ---------  ---------
Risk-free interest rate            4.82%      3.97%      3.04%
Expected volatility                  45%        51%        62%
Expected life (in years)            5.1        3.6        4.0
Dividend yield                       --         --         --
Fair value per option granted $   14.58  $   12.36  $   12.61
             
                                Employee Stock Purchase Plan
                               -------------------------------
                                 2006       2005       2004
                               ---------  ---------  ---------
Risk-free interest rate            4.75%      3.21%      1.22%
Expected volatility                  37%        58%        66%
Expected life (in years)            0.7        1.3        1.5
Dividend yield                       --         --         --
Fair value per share purchase $   10.98  $   11.96  $    6.80`

As of December 31, 2006, the Company had an unrecorded stock-based
compensation balance related to stock options of approximately $25,341,000 after
estimated forfeitures, which will be recognized over an estimated
weighted-average remaining requisite service period of 2.6 years.  As of December
31, 2006, the unrecorded stock-based compensation balance related to employee
stock purchase rights was $119,000, which will be recognized in January 2007.
During the year ended December 31, 2006, the Company granted approximately
1,883,000 stock options with an estimated total grant-date fair value of
approximately $27,451,000.

Non-Employee Stock-Based Compensation

The Company accounts for equity instruments issued to non-employees at their
fair value on the measurement date.  The Company uses the Black-Scholes option
pricing model to measure the value of the options granted to non-employees at
each vesting date to determine the appropriate charge to stock-based
compensation.  The options generally vest ratably over four years.  The values
attributable to these options have been amortized over the service period on a
graded vesting method.  The Company believes that the fair value of the stock
options is more reliably measurable than the fair value of the services
received.  The Company recognized stock-based compensation expense related to
non-employee options as follows (in thousands):



`Year Ended December 31,
                                   -------------------------------
                                     2006       2005       2004
                                   ---------  ---------  ---------
Research and development          $  1,045   $   159    $   231
Sales and marketing                    323       619         36
General and administrative              --       481        662
                                   ---------  ---------  ---------
                                  $  1,368   $ 1,259    $   929
                                   =========  =========  =========`

Concentrations of Credit Risk and Other Risks and Uncertainties

The Company's cash and cash equivalents are maintained with several financial
institutions.  Deposits in those institutions may exceed the amount of insurance
provided on such deposits.  Generally, these deposits may be redeemed upon
demand and are maintained with financial institutions of reputable credit and
therefore bear minimal credit risk.

For financial instruments consisting of cash and cash equivalents, accounts
receivable, accounts payable and accrued liabilities included in the Company's
financial statements, the carrying amounts approximate fair value due to their
short maturities.  Estimated fair values for marketable securities, which are
separately disclosed elsewhere, are based on quoted market prices for the same
or similar instruments.

The Company performs ongoing credit evaluations of its customers' financial
condition and, generally, requires no collateral from its customers.  No
customer accounted for more than 10% of total net sales for the years ended
December 31, 2006, 2005 and 2004.  No
customer accounted for more than 10% of total accounts receivable at
December 31, 2006 and 2005.

The Company receives certain of its components from sole suppliers.
Additionally, the Company relies on certain contract manufacturers and suppliers
to provide manufacturing services for its products.

The Company is subject to risks common to companies in the medical device
industry including, but not limited to, new technological innovations,
dependence on key personnel and suppliers, protection of proprietary technology,
compliance with government regulations, uncertainty of market acceptance and
reimbursement of products, product liability and the need to obtain additional
financing.

Revenue Recognition

The Company's revenue consists primarily of the sale of its products to
customers and distributors.  Revenue is considered to be realized or realizable
and earned when all of the following criteria are met: persuasive evidence of a
sales arrangement exists; delivery has occurred or services have been rendered;
the price is fixed or determinable; and collectibility is reasonably assured.
These criteria are generally met at the time of shipment when the risk of loss
and title passes to the customer or distributor.  Allowances are established for
product returns based upon historical trends and are recorded as a reduction to
revenue.

Shipping and Handling of Products

Amounts billed to customers for shipping and handling of products is
included in net sales and was approximately $1,463,000, $1,151,000 and $766,000
for the years ended December 31, 2006, 2005 and 2004, respectively.  Costs
incurred related to shipping and handling of products are included in cost of
goods sold.

Research and Development

Research and development costs, including new product development programs,
regulatory compliance, and clinical research are expensed as incurred.

Advertising Costs

Advertising costs, included in sales and marketing expenses, are expensed as
incurred.  Advertising costs were approximately $4,313,000, $4,934,000 and
$3,515,000 for the years ended December 31, 2006, 2005 and 2004, respectively.

Income Taxes

The Company accounts for income taxes under the asset and liability method
whereby deferred tax asset or liability account balances are calculated at the
balance sheet date using current tax laws and rates in effect for the year in
which the differences are expected to affect taxable income.  Valuation
allowances are established when necessary to reduce deferred tax assets to the
amounts more likely than not expected to be realized.

Comprehensive Income

The components of other comprehensive income are as follows (in
thousands):

`December 31,
                                                                    --------------------
                                                                      2006       2005
                                                                    ---------  ---------
Unrealized gain (losses) on available-for-sale investments,        $       1  $    (139)
   net of taxes
Translation adjustments                                                1,606        311
                                                                    ---------  ---------
                                                                   $   1,607  $     172
                                                                    =========  =========`

Net Income per Share

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

`Year Ended December 31,
                                                                        -------------------------------
                                                                          2006       2005       2004
                                                                        ---------  ---------  ---------
Net income                                                             $   39,732 $   29,836 $   21,717
                                                                        =========  =========  =========

Weighted-average shares outstanding                                        44,436     42,803     40,451
  Less: weighted-average shares subject to repurchase                          --         --         (2)
                                                                        ---------  ---------  ---------
Basic weighted-average shares outstanding                                  44,436     42,803     40,449
                                                                        ---------  ---------  ---------

Dilutive effect of:
  Employee stock options and purchase rights                                1,877      2,533      3,218
  Warrants                                                                     --         --          3
                                                                        ---------  ---------  ---------
Diluted weighted-average shares outstanding                                46,313     45,336     43,670
                                                                        =========  =========  =========

Net income per share:
  Basic                                                                $     0.89 $     0.70 $     0.54
                                                                        =========  =========  =========
  Diluted                                                              $     0.86 $     0.66 $     0.50
                                                                        =========  =========  =========`

The following potential dilutive securities were excluded from the
computation of diluted net income per share, as they had an antidilutive effect
(in thousands):

`December 31,
                                                     -------------------------------
                                                       2006       2005       2004
                                                     ---------  ---------  ---------

Options to purchase common stock                         2,049        575        509`

Recent Accounting Pronouncements

In June 2006, the FASB issued Interpretation No. 48,
"Accounting for Uncertainty in Income Taxes-an Interpretation of FASB
Statement No. 109" ("FIN No. 48").  FIN No. 48
clarifies the accounting for uncertainty in income taxes recognized in a
company's financial statements in accordance with SFAS No. 109,
"Accounting for Income Taxes." FIN 48 prescribes a recognition
threshold and measurement attribute for the financial statement recognition and
measurement of a tax position taken or expected to be taken in a tax
return.  FIN No. 48 is effective for fiscal years beginning after
December 15, 2006.  The Company is currently evaluating the impact, if any,
of the adoption of FIN No. 48 will have on its financial statements or related disclosures.

In September 2006, the FASB issued SFAS No. 157, "Fair Value
Measurements" ("SFAS No. 157").  SFAS No. 157 defines fair value,
establishes a framework for measuring fair value in accordance with generally
accepted accounting principles and expands disclosures about fair value
measurements.  The provisions of SFAS No. 157 are effective for fiscal years
beginning after November 15, 2007 and are to be applied prospectively.  The
Company is currently evaluating the impact, of the adoption of SFAS No.
157 will have on its financial reporting.

In September 2006, the SEC issued Staff Accounting Bulletin No. 108
("SAB 108") in order to eliminate the diversity of practice
surrounding how public companies quantify financial statement misstatements.
 Traditionally, there have been two widely-recognized methods for
quantifying the effects of financial statement misstatements:  the
"roll-over" method and the "iron curtain" method.  The
"roll-over" method focuses primarily on the impact of a misstatement
on the income statement, including the reversing effect of prior period
misstatements; but its use can lead to the accumulation of misstatements in the
balance sheet.  The "iron-curtain" method, on the other hand,
focuses primarily on the effect of correcting the period-end balance sheet with
less emphasis on the reversing effects of prior period errors on the income
statement.  The Company currently uses the "iron-curtain" method
for quantifying identified financial statement misstatements.  In SAB 108,
the SEC staff established an approach that requires quantification of financial
statement misstatements based on the effects of the misstatements on each of the
Company's financial statements and the related financial statement
disclosures.  This model is commonly referred to as a "dual
approach" because it requires quantification of errors under both the
"iron curtain" and the "roll-over" methods.  SAB 108
permits existing public companies to initially apply its provisions either by
(i) restating prior financial statements as if the "dual approach" had
always been used or (ii) recording the cumulative effect of initially applying
the "dual approach" as adjustments to the carrying values of assets
and liabilities as of the beginning of the current fiscal year with an
offsetting adjustment to the opening balance of retained earnings in the year of
adoption.  Use of the "cumulative effect" transition method
requires detailed disclosure of the nature and amount of each individual error
being corrected through the cumulative adjustment and how and when it
arose.  The provisions of SAB 108 must be applied to annual financial
statements no later than the first fiscal year ending after November 15, 2006.
 Upon adoption, there was no impact on the Company's financial statements
or related disclosures.

3. BALANCE SHEET COMPONENTS

Inventories (in thousands):

`December 31,
                                    --------------------
                                      2006       2005
                                    ---------  ---------           
Raw materials                     $    4,178  $   4,331
Work-in-process                        2,850      1,656
Finished goods                         4,841      3,278
                                    ---------  ---------
                                  $   11,869  $   9,265
                                    =========  =========`

Property and Equipment (in thousands):

`Depreciation
                                                       December 31,         and
                                                   -------------------- Amortization
                                                      2006       2005      Period
                                                   ---------  ---------  ---------
Furniture and fixtures                             $  3,734   $  2,405    2 - 5 years
Computer software and hardware                       10,843      8,194     3 years
Laboratory and manufacturing equipment                6,297      5,327     5 years
Leasehold improvements                               10,274      6,366    7 - 10 years
                                                   ---------  ---------
                                                     31,148     22,292
Less:  Accumulated depreciation and amortization    (12,168)    (8,871)
Plus:  Construction-in-progress                       8,610      2,556
                                                   ---------  ---------
                                                   $ 27,590   $ 15,977
                                                   =========  =========`

Depreciation and amortization expense relating to the Company's property and
equipment was approximately $5,824,000, $4,216,000 and $2,931,000 for the years
ended December 31, 2006, 2005 and 2004, respectively.

Goodwill and Intangible Assets:

Changes in the carrying amount of goodwill during the years ended
December 31, 2005 and 2006 are as follows (in thousands):

`Goodwill at January 1, 2005                $    4,927
Foreign currency translation                     (617)
                                            ----------
Goodwill at December 31, 2005                   4,310
Foreign currency translation                      492
                                            ----------
Goodwill at December 31, 2006              $    4,802
                                            ==========`

The components of the Company's intangible assets are as follows (in
thousands):

`December 31, 2006
                                            --------------------------------------------------
                                              Gross      Foreign
                                             Carrying    Currency   Accumulated                  Amortization
                                              Amount    Translation Amortization       Net          Period
                                            ----------  ----------  ------------   -----------   ------------
Developed technology                       $  11,000   $      --   $   (1,100)    $   9,900        10 years
Patent                                           142          30         (132)           40         5 years
                                            ----------  ----------  ------------   -----------
Total intangibles                          $  11,142   $      30   $   (1,232)    $   9,940
                                            ==========  ==========  ============   ===========

                                                           December 31, 2005
                                            --------------------------------------------------
                                              Gross      Foreign
                                             Carrying    Currency   Accumulated                  Amortization
                                              Amount    Translation Amortization       Net          Period
                                            ----------  ----------  ------------   -----------   ------------
Developed technology                       $  11,000   $      --   $       --     $  11,000        10 years
Patent                                           142          13          (88)           67         5 years
                                            ----------  ----------  ------------   -----------
Total intangibles                          $  11,142   $      13   $      (88)    $  11,067
                                            ==========  ==========  ============   ===========`

Amortization expense for the Company's intangible assets was approximately
$1,161,000, $35,000 and $39,000 for the years ended December 31, 2006, 2005 and
2004, respectively.  Based on the intangible assets held at December 31,
2006, and exchange rates in effect as of the balance sheet date, the Company
expects to recognize amortization expense of approximately $1,134,000 in years
2007, approximately $1,106,000 in 2008, and approximately $1,100,000 annually
from 2009 to 2015.

Other Assets (in thousands):

`December 31,
                                                    --------------------
                                                      2006       2005
                                                    ---------  ---------           
Disc-O-Tech nonrefundable deposit (Note 5)         $   60,000 $       --
Other                                                   9,846      2,924
                                                    ---------  ---------
                                                   $   69,846 $    2,924
                                                    =========  =========`

Accrued Liabilities (in thousands):

`December 31,
                                                    --------------------
                                                      2006       2005
                                                    ---------  ---------           
Payroll and related expenses                       $   27,576 $   19,665
License acquisition                                    10,000     15,000
Accrued income taxes                                    4,912      6,213
Legal, accounting and professional fees                 5,496      2,367
Clinical studies                                        1,608      1,165
Travel and entertainment                                1,743      1,184
Professional training courses                             299        206
Lease financing liability                               4,992         --
Other                                                   6,354      3,993
                                                    ---------  ---------
                                                   $   62,980 $   49,793
                                                    =========  =========`

Other Liabilities (in
thousands):

`December 31,
                                                    --------------------
                                                      2006       2005
                                                    ---------  ---------           
Deferred rent                                      $    5,149 $    3,610
Deferred tax liabilities                                  982         --
Contingent purchase price                               3,710      3,424
Other                                                     638        441
                                                    ---------  ---------
                                                   $   10,479 $    7,475
                                                    =========  =========`

4. LICENSE ACQUISITIONS

In April 2005, the Company entered into an agreement to exclusively
license, in the field of orthopaedics including all spinal applications, Dr. Lee
Berger's ("Dr. Berger") portfolio of patents concerning medical
devices and methods for creating voids in, or moving, tissue or bone, including
platform cannulae for expandable bodies.  The Company made an up-front payment
of $1,000,000 in April 2005 and has agreed to provide a
lifetime-capped royalty stream on any products that may be developed that
practice the licensed patent rights.  The $1,000,000 payment was immediately
expensed as research and development costs, as the technology acquired may be
used to develop products that have not been approved for sale by regulatory
authorities, have not yet reached technological feasibility, and was determined
to have no alternative future use.  In conjunction with the
license agreement, the Company entered into a consulting agreement with Dr.
Berger for services pertaining to research and development in the area of spinal
surgery.  Under the terms of the consulting agreement Dr. Berger is paid
$100,000 per year for a period of three years in exchange for these
services.  A small royalty is also now being paid to Dr. Berger on one
of the Company's KyphX products.

In November 2005, the Company entered into an agreement with Dr. Harvinder
Sandhu ("Dr. Sandhu"), an orthopaedic surgeon, to acquire an exclusive
license to Dr. Sandhu's early invention rights concerning a directional bone
tamp for treating vertebral compression fractures.  Under the terms of the
agreement, the Company made an up-front payment of $5,000,000 in November 2005,
an additional payment of $5,000,000 in November 2006 and is obligated to make a
series of payments totaling up to an additional $10,000,000.  Based on
management judgment, ability and intent, the remaining payment obligation of
$10,000,000 has been classified as a current liability as of December 31, 2006.
The $20,000,000 charge was immediately expensed to research and development as
the technology acquired may be used to develop products that have not been
approved for sale by regulatory authorities, have not yet reached technological
feasibility, and was determined to have no alternative future use.  The license
agreement also provides for a capped royalty stream on any future developed
product that practices Dr. Sandhu's technology.

5. ACQUISITIONS

InnoSpine, Inc.

On December 30, 2005, the Company acquired all of the outstanding stock
of InnoSpine, Inc. ("InnoSpine"), a privately held company focused on
developing and marketing its proprietary technology platform for the diagnosis
and potential treatment of axial low back pain due to disc degeneration.  The
transaction closed in January 2006, however, for accounting purposes the date of
acquisition was determined to be December 30, 2005.  The acquisition was made to
allow the Company to expand its focus on Spinal Fracture Management and Repair
to include disc repair and regeneration.  The purchase consideration consisted
of an initial purchase price of $2,500,000 in cash to the shareholders of
InnoSpine and other acquisition costs of $350,000.  In addition, the Company
agreed to pay up to an additional $27,500,000 in cash or stock, based on
achievement of clinical and other milestones as well as royalties on future net
sales.  These additional amount represents contingent consideration for
accounting purposes and have not been included in the purchase price equation
set out below.  This amount will be recognized as additional purchase price
consideration when such contingency has been resolved.  To date, no contingent
payments have been made.

The acquisition of InnoSpine was accounted for using the purchase method of
accounting.  The results of operations of InnoSpine have been included in the
Company's consolidated financial statements effective December 30, 2005.  The
purchase price was allocated to the net tangible and identifiable intangible
assets acquired and the liabilities assumed based on their estimated fair values
at the date of acquisition as determined by management.  Independent valuation
experts assisted the Company during the valuation of the intangible assets
acquired.

The fair value of the net assets acquired from InnoSpine exceeded the
consideration paid by the Company resulting in negative goodwill.  Because the
acquisition involves contingent consideration, the Company is required to
recognize additional purchase consideration equal to the lesser of the negative
goodwill or the maximum amount of contingent consideration of $27,500,000.
Accordingly, contingent consideration totaling $3,751,000 has been included in
the Company's determination of the total purchase price, of which $3,710,000 has
been classified as a non-current liability.  The remaining balance of
approximately $41,000 has been classified within accrued liabilities.  The total
purchase consideration was allocated as follows (in thousands):

`Developed technology            $     11,000
Deferred tax asset                       235
Assumed liabilities                     (267)
Contingent purchase price             (3,751)
Deferred tax liabilities              (4,367)
                                  ----------
                                $      2,850
                                  ==========`

The income approach was used to value InnoSpine's developed technology, which
included an analysis of the completion costs, cash flows, other required assets
and risk associated with achieving such cash flows.  The present value of these
cash flows was calculated with an effective tax rate of 40% and a discount rate
of 35% for the developed technology.  No amount of goodwill, if any, is expected
to be deductible for tax purposes.

Unaudited Pro Forma Financial Information

The following unaudited pro forma financial information is based on the
respective historical financial statements of the Company and InnoSpine.  The
unaudited pro forma financial information reflects the consolidated results of
operations as if the acquisition of InnoSpine had occurred at the beginning of
each period and includes the amortization of the resulting other intangible
assets.  The unaudited pro forma financial data presented are not necessarily
indicative of the Company's results of operations that might have occurred had
the transactions been completed at the beginning of each period, and do not
purport to represent what the Company's consolidated results of operations might
be for any future period (in thousands, except per share amounts).

`Year Ended December 31,
                                       ------------------------
                                          2005          2004
                                       ----------    ----------            
                                            (unaudited)

Pro forma net sales                   $   306,082  $    213,414
Pro forma net income                  $    29,653  $     21,552

Pro forma net income per share:

Basic                                 $      0.69  $       0.53
                                       ==========    ==========
Diluted                               $      0.65  $       0.49
                                       ==========    ==========

Weighted-average shares outstanding:

Basic                                      42,803        40,449
                                       ==========    ==========
Diluted                                    45,336        43,670
                                       ==========    ==========`

St. Francis Medical Technologies, Inc.

On January 18, 2007, the Company acquired all of the fully diluted equity of
St. Francis Medical Technologies, Inc. ("St. Francis"), a privately
held, California-based company that manufactures the X-STOP Interspinous
Process Decompression (IPD) System, a FDA-approved interspinous process
device for treating lumbar spinal stenosis (LSS).  The total estimated purchase
price, excluding transaction costs, of up to $725,000,000 was comprised of
$525,000,000 in cash upon closing, plus additional revenue-based contingent
payments of up to $200,000,000 payable in either cash or a combination of cash
and stock, at the Company's election.  The payments are contingent upon the attainment of certain
revenue thresholds during specified periods through June 2008.  This additional
amount represents contingent consideration for accounting purposes and has not
been included in the purchase price equation set out below.  This amount will be
recognized as additional purchase price consideration when such contingency has
been resolved.The Company financed the transaction through a
combination of cash on hand and bank financing (see Note 6).

The total estimated initial purchase price of St. Francis is as follows (in
thousands):

`Cash                                       $ 108,657
Debt issued (net of issuance costs)          416,343
Estimated direct transaction costs             6,000
                                           ----------
                                           $ 531,000
                                           ==========`

Disc-O-Tech Medical Technologies, Ltd.

On December 20, 2006, the Company entered into two definitive
agreements to acquire all of the spine-related product assets and associated
intellectual property rights of Disc-O-Tech Medical Technologies, Ltd. and its
U.S. subsidiary ("Disc-O-Tech") in a transaction to be accounted for
using the purchase method of accounting.  Completion of the first agreement, if
and when that occurs, will enable the Company to further broaden its focus in
minimally invasive spine by adding the B-TwinTM Expandable Spinal System
technology for minimally invasive fusion in patients with degenerative disc
disease in the lumbar and cervical spine, which is CE marked but not presently
available in the U.S.  The first agreement assets also include Disc-O-Tech's
SKyTM Bone Expander System, which is available only outside the U.S. for
use in the treatment of vertebral compression fractures.  The second agreement
assets include Disc-O-Tech's ConfidenceTM Cement System, which will be
another treatment option complementary to the Company's existing KyphX
technology for vertebral compression fractures depending on a patient's
individual needs and a clinician's goals for his or her patients.  The
Confidence System incorporates a delivery mechanism that is designed to provide
controlled injection of putty-like cement, reduce clinician radiation exposure
and streamline cement preparation.  The Company's ability to offer such
additional minimally invasive diagnostic and therapeutic tools to their
customers is a natural next-step in broadening our product offerings.

The aggregate estimated purchase price for both agreements, excluding
transaction costs, is approximately $220,000,000, plus a contingent payment
of up to $20,000,000 payable in cash.  Upon the signing of the first agreement
on December 20, 2006 the Company made a nonrefundable payment of $60,000,000
to Disc-O-Tech, comprised of $20,000,000 in cash and the release of $40,000,000
that was held in escrow.  As of December 31, 2006, pending closing of the acquisition
this payment of $60,000,000 is presented as a nonrefundable deposit on the
accompanying balance sheet.  On February 1, 2007, the Company made a nonrefundable
payment of an additional $40,000,000 to Disc-O-Tech.  Under the second of the
agreements, the Company will make nonrefundable payments to Disc-O-Tech for
aggregate amount of $120,000,000 in cash on a deferred basis, payable in three
equal annual installments beginning in January 2008.  An additional $20,000,000
in contingent payments, plus royalties, may also be paid based on the development
of further technologies following closing of the second agreement.  This additional
$20,000,000 represents contingent consideration for accounting purposes.  This
amount will be recognized as additional purchase price consideration when its
payment is finalized.  Closing of the acquisitions are subject to various
conditions, including the expiration or termination of the waiting period
under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, or HSR Act,
however, there can be no assurance that the Federal Trade Commission
will not block the Company's purchase of all or any of the assets under either
purchase agreement, or that they will otherwise complete all or part of the
acquisitions.  The Federal Trade Commission has issued second requests for
information with respect to its review of the Company's acquisition of the
non-vertebroplasty assets and the acquisition of the vertebroplasty assets.
The purchase price under both agreements is payable even if regulatory approvals
are delayed or not obtained.  The Company will complete the closing of the
acquisitions as soon as practicable after receipt of regulatory approvals.
If regulatory approvals are not obtained, the Company may divest or license to
third parties some or all of the assets proposed to be acquired.

6. BORROWINGS

Credit Facility

In October 2006, the Company entered into a syndicated credit facility which
provided the Company with a five-year $300,000,000 revolving line of credit,
including a $50,000,000 sublimit for the issuance of standby letters of credit,
a $25,000,000 sublimit for swing line loans and a $100,000,000 sublimit for
multicurrency borrowings.  On January 18, 2007, the Company amended the
credit facility and, in conjunction with the acquisition of St. Francis, the
Company, together with certain of its subsidiaries, entered into a Credit
Agreement to replace and refinance the above-described credit facility (the
"Credit Agreement") with Bank of America, N.A., as administrative
agent, swing line lender and letter of credit issuer, and Banc of America
Securities LLC as sole lead arranger and sole book manager.  The credit
facilities thereunder were syndicated to a group of lenders (collectively, the
"Lenders").

The Credit Agreement provides for a $250,000,000 senior secured revolving
credit facility (the "Revolving Credit Facility"), maturing
October 20, 2011, which can be expanded to $300,000,000 under certain
circumstances.  The Revolving Credit Facility includes a $50,000,000 sublimit
for the issuance of standby U.S. dollar letters of credit, a $25,000,000
sublimit for U.S. dollar swingline loans and a $100,000,000 sublimit for
multicurrency borrowings.  The Credit Agreement also provides for a
$425,000,000 term loan facility maturing seven years from the closing date (the
"Term Loan Facility" and together with the Revolving Credit Facility,
the "Facility").  The Company may terminate or permanently reduce the
commitments available under the Revolving Credit Facility and prepay the Term
Loan Facility without premium or penalty at any time.

The Facility was used by the Company to finance the acquisition of St.
Francis, (the "Acquisition") and may be used for general corporate
purposes including acquisitions, capital expenditures, working capital and other
purposes.  In addition to certain initial fees, the Company is obligated to pay
a commitment fee based on the total revolving commitment.  In January 2007, in
connection with the Acquisition, the Company borrowed $425,000,000 under this
Facility.

The Revolving Credit Facility will bear interest at Base Rate plus 0.25-1.25%
or LIBOR plus 1.25-2.25% (such range of margins being related to the
consolidated leverage ratio of the Company).  Letter of credit fees are based on
the LIBOR loan margins.

The Company's obligations under the Facility are secured by substantially all
of the assets of the Company.

The Credit Agreement contains customary affirmative covenants regarding the
Company and its subsidiaries.  Upon the occurrence of an event of default under
the Credit Agreement, the Lenders could elect to declare all amounts outstanding
under the Facility to be immediately due and payable.  Events of default under
the Credit Agreement include payment defaults, breaches of covenants and
bankruptcy events.

The Credit Agreement contains negative covenants which restrict the Company
from: (i) incurring liens other than liens incurred pursuant to the Facility and
other customary permitted liens; (ii) making investments, other than customary
permitted investments and investments subject to certain baskets; (iii)
incurring debt other than indebtedness pursuant to the Credit Agreement,
subordinated indebtedness, an unsecured convertible note offering, customary
permitted indebtedness and indebtedness subject to certain baskets; (iv)
entering into mergers and consolidations other than the Acquisition,
acquisitions paid 100% with equity of the Company or acquisitions not exceeding
a certain purchase price, where such limitation on price is based on the
consolidated senior secured leverage ratio and other limitations; (v) selling
assets, subject to certain customary exceptions; (vi) issuing dividends, stock
redemptions and other restricted payments; (vii) incurring capital expenditures
exceeding a certain threshold; (viii) transactions with affiliates; (ix) the
cash payment of the cash/stock earnout obligations of the Company incurred in
connection with the Acquisition, where such payments are subject to certain
limitations; (x) permitting the consolidated interest coverage ratio to fall
below a certain threshold and the consolidated leverage ratio and the
consolidated senior secured leverage ratio to be greater than a certain
threshold; (xi) prepaying subordinated indebtedness, other than prepayments
pursuant to a refinancing permitted thereunder or if certain requirements are
satisfied and (xi) other customary negative covenants for a facility of this
nature.

Convertible Notes

In February 2007, the Company issued $200,000,000 aggregate principal amount
of Convertible Senior Notes due 2012 and $200,000,000 aggregate principal amount
of Convertible Senior Notes due 2014.  Interest on the notes due 2012 will be
paid semiannually at a rate of 1.00% per year and interest on the notes due 2014
will be paid semiannually at a rate of 1.25% per year.  Both the 2012 Notes and
the 2014 Convertible Senior Notes will be convertible into cash up to the
principal amount, and if applicable, shares of common stock in respect of any
conversion value above the principal amount, based on an initial conversion rate
of 17.1951 shares of common stock per $1,000 principal amount of notes, which is
equivalent to an initial conversion price of approximately $58.16 per share.
The notes may be converted by the holders only under the following
circumstances: (1) during any fiscal quarter beginning after June 30, 2007
(and only during such fiscal quarter), if the last reported sale price of the
Company's common stock for at least 20 trading days in the 30 consecutive
trading days ending on the last trading day of the immediately preceding fiscal
quarter is greater than or equal to 130% of the applicable conversion price; (2)
during the five business-day period after any five consecutive trading-day
period (the "Measurement Period") in which the trading price per
$1,000 principal amount of note for each day of such Measurement Period was less
than 98% of the product of the last reported sale price of the Common Stock and
the conversion rate on each such day; (3) upon the occurrence of certain
specified corporate transactions; and (4) with respect to the 2012 Notes,
at any time on or after December 1, 2011, and with respect to the 2014 Notes, at
any time on or after December 1, 2013, in each case through the third business
day preceding the applicable maturity date.

The conversion rate will be subject to adjustment in some events but will not
be adjusted for accrued interest.  Upon conversion, the Company will pay cash
and shares of common stock, if any, based on a daily conversion value calculated
during a 30 trading-day observation period.



The Senior Convertible Notes rank equal in right of payment to all of the
Company's other existing and future senior unsecured indebtedness.  The Senior
Convertible Notes will rank senior in right of payment to all of the Company's
existing and future subordinated indebtedness and effectively subordinated in
right of payment to all of its subsidiaries' obligations (including secured and
unsecured obligations) and subordinated in right of payment to its secured
obligations to the extent of the assets securing such obligation.



In connection with the offering, the Company entered into convertible note
hedge transactions with affiliates of the initial purchasers.  These
transactions are intended to reduce the potential dilution to the Company's
stockholders upon any future conversion of the notes.  The call options, which
cost an aggregate $112,000,000 were recorded as a reduction of additional
paid-in capital, net of tax benefit.  The Company also entered into warrant
transactions concurrently with the offering, pursuant to which it sold warrants
to purchase its own common stock to the same counterparties that entered into
the convertible note hedge transactions.  The convertible note hedge and warrant
transactions effectively will increase the conversion price of the convertible
notes to approximately $75.04 per share of the Company's common stock.  Proceeds
received from the issuance of the warrants totaled approximately $77,000,000 and
were recorded as an addition to additional paid-in capital.

On February 6, 2007, the Company used the remaining proceeds, of
approximately $355,000,000, together with borrowings under the Revolving Credit
Facility, to retire the $425,000,000 senior secured term loan incurred to
complete the acquisition of St. Francis.

7. COMMITMENTS AND CONTINGENCIES

Operating leases

The Company has operations headquartered in Sunnyvale, California.  These
facilities are leased through August 2014.  Under the terms of the lease
agreement, the Company has the option to have additional square footage built in
the same surrounding campus.  Under the terms of the facility lease, the Company
is obliged to maintain an irrevocable standby letter of credit of $1,105,000.

The Company's European operations are headquartered in Brussels,
Belgium.  The facility is leased through December 2011 and includes
offices, storage and warehouse facilities.  An additional facility is
leased in Rosbach, Germany through January 2008 and the Company has leased sales
offices in many of the major countries in Europe as well as Japan, South Africa
and Canada, with expiration dates through 2013.  In November 2005, the Company
entered into a two year lease for a facility in Neuchâtel, Switzerland
that includes offices, storage and warehouse facilities and will serve as a
temporary facility for the Company while it builds a larger facility to support
manufacturing, distribution, administrative and certain research and development
activities.

The Company records rent expense on a straight-line basis.  As of December
31, 2006 and 2005, deferred rent of approximately $5,531,000 and $3,814,000,
respectively, had been recorded.  Through December 31, 2006, the Company has
received cash incentives of $1,194,000 from its landlord to be used for
leasehold improvements.  These amounts have been reflected as deferred rent and
property and equipment and are being amortized to rent expense and depreciation
expense, respectively, over the term of the Company's operating lease.  The
Company recognized rent expense of $3,355,000, $2,423,000 and $2,658,000 during
the years ended December 31, 2006, 2005 and 2004, respectively.

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

`Fiscal year ending December 31,

2007                                                        $  3,567
2008                                                           3,077
2009                                                           3,038
2010                                                           3,058
2011                                                           2,980
Thereafter through 2014                                        6,627
                                                            ---------
Total                                                       $ 22,347
                                                            =========`

Assets Under Construction

In May 2006, the Company entered into a real estate leasing contract
with Credit Suisse (the "lease agreement") for a facility in
Neuchâtel, Switzerland.  The lease agreement became effective in
July 2006 upon Credit Suisse's purchase of the land.  The lease agreement has a
term of 15 years with a fixed purchase option at expiration.  The total
commitment under the lease agreement is estimated at CHF 23,000,000
(approximately $18,857,000 in U.S. dollars per the exchange rate as of December
31, 2006), which includes the purchase of land and construction of the
facility.  In connection with the lease agreement, the Company entered into
a guaranty with Credit Suisse in the amount of CHF 11,000,000 (approximately
$9,019,000) with respect to its subsidiaries' obligations under the lease
agreement and has issued a CHF 4,500,000 (approximately $3,689,000) letter of
credit to Credit Suisse pursuant to the terms and conditions of the leasing
contract.

Since the Company has substantially all of the construction period risk,
the Company is accounting for the transaction as if it were the owner during the
construction period.  Accordingly, subsequent to commencement of the
construction, in July 2006, the Company has capitalized construction costs as
construction-in-progress.  As of December 31, 2006, the Company has recorded an
asset of approximately $5,038,000 for construction-in-process and a
corresponding liability of $4,992,000 for construction debt.

Royalty Agreements

The Company has license agreements with third parties.  The agreements
provide for payment of royalties based upon a specified percentage of future net
sales on any products that practice the licensed rights (see Notes 4 &
5).

Consulting Agreements

The Company has entered into various consulting agreements which expire
through 2008.  Under the terms of the consulting agreements, the Company will be
obligated to make payments of approximately $944,000 and $712,000 in the years
ending December 31, 2007 and 2008, respectively.

Indemnification Agreements

In the normal course of business, the Company may enter into contractual
arrangements under which the Company may agree to indemnify the third party to
such arrangement from any losses incurred relating to the services they perform
on behalf of the Company or for losses arising from certain events as defined
within the particular contract.  To date, the Company has not incurred any costs
as a result of such indemnifications and has not accrued any liabilities related
to such obligations in the accompanying consolidated financial statements.

The Company has entered into indemnification agreements
with its directors and officers that may require the Company to indemnify its
directors and officers against liabilities that may arise by reason of their
status or service as directors or officers, other than liabilities arising from
willful misconduct of a culpable nature; to advance their expenses incurred as a
result of any proceeding against them as to which they could be indemnified; and
to make good faith determinations as to whether or not it is practicable for the
Company to obtain directors' and officers' insurance.  The Company currently has
directors' and officers' insurance.

Litigation

In November 2005, Dr. Harvinder Sandhu, an orthopaedic
surgeon, and the Company filed suit in federal district court in Memphis,
Tennessee against Medtronic Sofamor Danek ("MSD") and several other
related corporate entities seeking compensatory and punitive damages and
injunctive relief for breach of contract and related covenants, trade secret
theft, fraud, and correction of inventorship of several patents and patent
applications presently owned by MSD, including U.S. Patent No. 6,676,665.  The
suit also requests, among other relief, that MSD transfer to Dr. Sandhu
ownership of the disputed patents and patent applications.  The dispute concerns
inventions related to an expandable, mechanical bone tamp for use in treating
vertebral compression fractures that Dr. Sandhu invented in the late 1990's and
which he confidentially disclosed and discussed with MSD.  The complaint alleges
that MSD later filed for several patents encompassing and claiming Dr. Sandhu's
inventions without naming him as inventor of that technology, and that it also
incorporated Dr. Sandhu's inventions into its internal Equestra/Arcuate
project without his permission.  In May 2006, the Company also sued MSD in the
same Tennessee court for willfully infringing five of the Company's U.S. patents
(numbers 4,969,888, 5,108,404, 6,235,043, 6,440,138, and 6,863,672) with its
Equestra/Arcuateproduct.  Discovery is underway, and various motions are
pending that seek to address the merits of Dr. Sandhu's and Kyphon's claims.
Trial was initially set for April 2007, but may be delayed.  No provision for
any liability that may result upon resolution of this matter has been made in
the accompanying financial statements.

During 2005, a U.S. Attorney's Office ("USAO") received a complaint
that the Company believes to be a qui tamcomplaint that alleges
impropriety in its business, including regarding its reimbursement practices.
Although no subpoena has been issued to the Company in connection with this
complaint, the USAO is investigating the Company's sales and marketing
practices, including how they communicated with their customers in the past
regarding the Medicare reimbursement available to hospitals and the appropriate
site-of-service for using their products in surgery.  The USAO has asked to
review some of the Company's documentation that may be relevant to the
investigation, much of which the Company has already produced.  The Company
believes it is in substantial compliance with the healthcare laws applicable to
them.  Even though the Company has not received a subpoena regarding the
complaint or its allegations, it continues to voluntarily cooperate with the
USAO, to permit the USAO to develop an informed opinion on whether or not to
pursue any action in connection with the complaint based in part on the
information provided, although timing on that decision is uncertain.  At
this time, the Company does not know whether the investigation or its outcome
will have a material adverse impact to its business, and cannot be assured
regarding any future path the USAO or any related lawsuit may take.  Due to the
uncertainties inherent in this process, the Company cannot accurately predict
the ultimate outcome of this matter at this time and, therefore, cannot estimate
the range of possible loss.  Accordingly, no provision for any liability that
may result upon resolution of this matter has been made in the accompanying
financial statements.

In April 2006, Medtronic and several related entities (MSD) filed suit against the
Company in federal district court in the Northern District of California,
alleging that the Company's KyphX vertebral bone tamps and/or related products
infringe three angioplasty balloon dilatation catheter patents (numbers
4,820,349, 5,759,191 and 6,179,856) and a single claim of patent number
6,096,038, which generally concerns treatment of the disc space.  MSD has since
dropped the `038 patent from the suit and asserted another dilatation catheter
patent, number 5,759,173.  The suit seeks damages based upon the making, using,
selling and offering for sale of the Company's products, seeks enhanced damages
for alleged willful infringement, and seeks to enjoin their continued activities
relating to these products.  In October 2006, the Company was denied permission
to seek a declaratory judgment that another MSD patent generally concerned with
treatment of the disc space and related to the `038 patent, number 7,115,128,
also has no application to the kyphoplasty technology.  Although the Company
intend to vigorously defend MSD's California lawsuit, MSD's action against it
subjects the Company to potential liability for damages, including treble
damages, and could require the Company to cease making, using or selling the
affected products, or to obtain a license in order to continue to manufacture,
use or sell the affected products.  While the Company believes it has multiple
meritorious defenses to this action, the Company cannot assure that it
ultimately will prevail on any issue in the litigation or that it will be able
to successfully defend MSD's charges, nor can the Company provide assurance that
any license required would be made available on commercially acceptable terms,
if at all.  Failure to successfully defend against MSD's action could harm the
Company's business, financial condition and operating results.  Due to the
inherent uncertainties of litigation, the Company cannot accurately predict the
ultimate outcome of this matter at this time and, therefore, cannot estimate the
range of possible loss.  No provision for any liability that may result upon
resolution of this matter has been made in the accompanying financial
statements.

In June 2006, six of the Company's current and former female U.S.-based sales
employees filed a lawsuit against the Company in federal district court in
the Northern District of California.  They allege, among other things, that
the Company has engaged in gender and pregnancy discrimination
against them, and also contend that they and their lawyers should be
permitted to represent an alleged class of all of our present and many former
female Spine Education Specialists, Spine Associates and Spine Consultants
because all of those women were also allegedly discriminated against on account
of their gender and pregnancy status.  The plaintiffs claim that they
are due assorted damages of at least $100,000,000.  The case is in its early
stages; no trial date has been set.
Although the
Company intends to vigorously defend plaintiffs' lawsuit, this lawsuit threatens
its reputation and subjects the Company to potential liability for significant
damages.  While the Company believes it has multiple meritorious defenses to
this action, it cannot assure you that it ultimately will prevail on any issue
in the litigation or that the Company will be able to successfully defend
plaintiffs' charges.  Failure to successfully defend against this action could
harm the Company's business, financial condition and operating results.  Due to
the inherent uncertainties of litigation, the Company cannot accurately predict
the ultimate outcome of this matter at this time and, therefore, cannot estimate
the range of possible loss.  No provision for any liability that may result upon
resolution of this matter has been made in the accompanying financial
statements.

From time to time, the Company may become involved in litigation relating
to additional claims arising from the ordinary course of business.  Management
of the Company does not believe the final disposition of these matters will have
a material adverse affect on the financial position, results of operations or
cash flows of the Company.

8. STOCKHOLDERS' EQUITY

Preferred Stock

In April 2002, the Board of Directors approved an amendment to the Company's
certificate of incorporation to authorize 5,000,000 shares of undesignated
preferred stock.  The Company's Board of Directors is authorized to determine
the designation, powers, preferences and rights of preferred stock.

Common Stock

Each share of common stock is entitled to one vote.  The holders of common
stock are also entitled to receive dividends whenever funds are legally
available and when declared by the Board of Directors, subject to the prior
rights of holders of all classes of stock outstanding.  No dividends have been
declared or paid as of December 31, 2006.

Employee Stock Purchase Plan

During 2006, the Company had an Employee Stock Purchase Plan (the "2002
ESPP"), under which eligible employees were permitted to purchase common
stock at a discount through payroll deductions.  The 2002 ESPP contained
consecutive, overlapping twenty-four month offering periods.  Each offering
period included four six-month purchase periods.  The price of the common stock
purchased was the lower of 85% of the fair market value of the common stock at
the beginning of an offering period or at the end of a purchase period.  The
Company issued approximately 251,000, 314,000 and 338,000 shares of common stock
in 2006, 2005, and 2004, respectively, under the 2002 ESPP.  As of December 31,
2006, approximately 718,000 shares of common stock remained reserved for future
issuance under the 2002 ESPP.

In June 2006, the Company's stockholders approved the termination of the 2002
ESPP, effective after the February 1, 2007 purchase, and the adoption of the
2007 Employee Stock Purchase Plan (the "2007 ESPP").  The 2007 ESPP
took effect after the final purchase date under the 2002 ESPP of February 1,
2007, at which time the 2002 ESPP automatically terminated.  The 2007 ESPP
reduces the "look-back" period available under any offering, by
eliminating the 24-month "look-back" period presently available under
the 2002 ESPP and replacing it with a six-month "look-back" period.
 The price of the common stock purchased shall be the lower of 85% of the
fair market value of the common stock at the beginning of an offering period or
at the end of a purchase period.  The maximum number of shares authorized for
sale under the 2007 ESPP is 1,000,000.  The Board of Directors may amend,
suspend or terminate the 2007 ESPP at any time.  The Company determined that the
cancellation of the 2002 ESPP effectively occurred in June 2006 at the time of
stockholder approval.  As the cancellation of purchase periods subsequent
to February 1, 2007 were not accompanied by a concurrent replacement grant,
unrecognized compensation cost of $562,000 was recognized immediately in June
2006 for the cancelled awards.

Stock Plans

The Company reserved shares of common stock for issuance under the 1996 Stock
Incentive Plan (the "1996 Plan").  Under the 1996 Plan, the Board of
Directors was authorized to issue incentive stock options to employees and
nonqualified stock options to consultants or employees of the Company.  The 1996
Plan is inactive, and no shares have been granted under the 1996 Plan since
2002.  Upon adoption of the 2002 Stock Plan, all shares previously available for
grant under the 1996 Plan were transferred to the 2002 Stock Plan.  Any
cancellations thereafter from the 1996 Plan are automatically added back to the
2002 Plan.

In April 2002, the Board of Directors adopted the 2002 Stock Plan.  The 2002
Stock Plan, which will terminate no later than 2012, provides for the granting
of incentive stock options to employees and nonqualified stock options and stock
purchase rights to employees, directors and consultants.

In April 2002, the Board of Directors adopted the 2002 Director Option Plan.
The 2002 Director Option Plan, which will terminate no later than 2012, provides
for the granting of nonqualified stock options to non-employee directors.  At
December 31, 2006, 90,000 shares of common stock remained reserved for future
issuance under the 2002 Director Option Plan.

For the 2002 Director Option Plan and the 2002 Stock Plan, the Board of
Directors has the authority to determine to whom options will be granted, the
number of shares, the term and exercise price (which cannot be less than the
estimated fair market value at date of grant for incentive stock options or 85%
of the estimated fair market value for nonqualified stock options).  If an
employee owns stock representing more than 10% of the outstanding shares, the
exercise price of any incentive stock option shall be at least 110% of estimated
fair market value, as determined by the Board of Directors.  The options are
exercisable at times and increments as specified by the Board of Directors, and
generally expire ten years from date of grant.

Activities under the 2002 Director Option Plan, the 2002
Stock Plan and the 1996 Plan, the ("Plans") are as follows:

`Options Outstanding
                                            ----------------------
                                                         Weighted
                                 Shares                   Average
                                Available    Number of   Exercise
                                for Grant     Shares       Price
                               -----------  -----------  ---------  
Balances, January 1, 2004       2,665,697    6,606,738  $   7.96

Additional shares reserved      1,971,987           --        --
Options granted                (3,044,300)   3,044,300     24.29
Options exercised                      --   (1,541,544)     4.13
Options cancelled                 475,897     (475,897)    18.43
                               -----------  -----------  ---------
Balances, December 31, 2004     2,069,281    7,633,597     14.59
Additional shares reserved      2,123,774           --        --
Options granted                (2,042,800)   2,042,800     34.03
Options exercised                      --   (2,173,882)     8.10
Options cancelled                 424,103     (424,103)    21.72
                               -----------  -----------  ---------
Balances, December 31, 2005     2,574,358    7,078,412     21.78
Options granted                (1,883,275)   1,883,275     38.26
Options exercised                      --    (875,248)     15.82
Options cancelled                 423,578    (423,578)     29.89
                               -----------  -----------  ---------
Balances, December 31, 2006     1,114,661    7,662,861  $  26.06
                               ===========  ===========  =========`

The options outstanding and exercisable at December 31, 2006 are as
follows:

`Options Outstanding                         Options Exercisable
                         -------------------------------------------------  -----------------------------------
                                         Weighted
                                          Average    Weighted   Aggregate                 Weighted   Aggregate
                                         Remaining    Average   Intrinsic                  Average   Intrinsic
        Range of            Number      Contractual  Exercise   Value (in     Options     Exercise   Value (in
    Exercise Prices      Outstanding   Life in Years   Price    thousands)  Exercisable     Price    thousands)
------------------------ ------------  ------------  ---------  ----------  ------------  ---------  ----------
     $0.05 - $3.00           566,852          3.86  $    1.07  $   22,292       566,852  $    1.07  $   22,292
     $6.95 - $10.43          270,180          6.09       8.52       8,613       210,885       8.42       6,745
    $10.50 - $15.40        1,024,214          5.95      13.45      27,601       968,762      13.34      26,215
    $19.40 - $27.66        2,737,552          7.51      24.02      44,838     1,496,103      23.79      24,857
    $27.90 - $40.39        2,560,563          9.16      37.57       7,234       427,836      36.84       1,524
    $40.50 - $45.34          503,500          8.85      41.74          --       114,630      41.50          --
                         ------------  ------------  ---------  ----------  ------------  ---------  ----------
                           7,662,861          7.62  $   26.06  $  110,578     3,785,068  $   18.87  $   81,633
                         ============  ============  =========  ==========  ============  =========  ==========`

The aggregate intrinsic value in the table above represents the total pretax
intrinsic value, based on options with an exercise price less than the Company's
closing stock price of $40.40 per share as of December 31, 2006, which would
have been received by the option holders had those option holders exercised
their options as of that date.  The total number of in-the-money options
exercisable as of December 31, 2006 was approximately 3,670,000.  As of December
31, 2005, there were approximately 2,739,000 outstanding options exercisable,
and the weighted-average exercise price was $14.40 per share.

The total intrinsic value of options exercised during the year ended December
31, 2006 was approximately $20,528,000.  The total cash received from employees
as a result of employee stock option exercises during the year ended December
31, 2006 was approximately $13,850,000.  In connection with these
exercises, the tax benefits realized by the Company for the year ended December
31, 2006 was approximately $6,798,000.  For the year ended December 31, 2006,
the Company recorded $7,557,000 of deferred tax assets associated with
nonqualified stock options as a result of the adoption of SFAS No. 123(R).

The Company settles employee stock option exercises with newly issued common
shares.

9. EMPLOYEE BENEFIT PLAN

The Company maintains a Section 401(k) Plan.  The 401(k) Plan provides
participating employees with an opportunity to accumulate funds for retirement
and hardship.  Eligible participants may contribute up to 100% of their eligible
earnings to the Plan Trust.  Beginning in December 2006, eligible participants
may contribute up to 50% of their eligible earnings to the Plan Trust.  The
Company started matching employees' contributions to the plan on March 15, 2003
at 25% of employee's individual 401(k) contributions up to a maximum matching
contribution of $2,000 per calendar year.  Beginning in January 2005, the
Company match was adjusted to 50% of an employee's individual 401(K)
contributions up to a maximum matching contribution of $2,000 per calendar year.
Beginning in January 2006, the Company match was changed to 50%
of the first 5% of compensation deferred to the 401(k) plan.  In
addition, if any employee receives less than a $2,000 match under
the new formula, the Company will true-up the 401(k) matching contribution at
year-end to 50% of an employee's 401(k) contributions up to a $2,000
matching contribution per calendar year.  The Company's matching contributions
totaled $1,858,000, $1,084,000 and $620,000 in 2006, 2005 and 2004,
respectively.

10. INCOME TAXES

U.S. and international components of income before the provision for
income taxes and the components of the provision for income taxes consisted of
the following (in thousands):

`Year Ended December 31,
                                                    -------------------------------
                                                      2006       2005       2004
                                                    ---------  ---------  ---------
U.S.                                               $  72,448  $  49,414  $  35,153
International                                         (1,726)    (1,298)       464
                                                    ---------  ---------  ---------
Total income before income taxes                   $  70,722  $  48,116  $  35,617
                                                    =========  =========  =========

Current
  Federal                                          $  30,405  $  15,576  $   7,892
  State                                                4,895      4,399      1,285
  Foreign                                              1,446        595        216
                                                    ---------  ---------  ---------
    Total current                                     36,746     20,570      9,393
                                                    ---------  ---------  ---------

Deferred
  Federal                                             (4,634)      (731)     4,286
  State                                                   45     (1,569)       433
  Foreign                                             (1,167)        10       (212)
                                                    ---------  ---------  ---------
    Total deferred                                    (5,756)    (2,290)     4,507
                                                    ---------  ---------  ---------
Total provision for income taxes                   $  30,990  $  18,280  $  13,900
                                                    =========  =========  =========`

At December 31, 2006, we had utilized all federal and state net operating
loss carryforwards and federal research and development tax credit
carryforwards.

At December 31, 2006, we had research and development tax credit
carryforwards of approximately $2,784,000 for state income tax purposes.  The
state research and development tax credit can be carried forward indefinitely.

Temporary differences and carryforwards that give rise to the Company's
deferred tax assets and liabilities are as follows (in thousands):

`December 31,
                                                         --------------------
                                                           2006       2005
                                                         ---------  ---------
Net operating loss carryforwards                        $      --  $     441
Research and development credit carryforwards               1,809      4,675
Capitalized research and development costs                    321        397
Purchased research and development                         11,007     11,122
Stock-based compensation                                    7,970         --
Intangibles                                                (3,910)    (4,367)
Foreign currency transaction gains                           (131)        --
Other, accruals and reserves                                3,961      4,969
                                                         ---------  ---------
Net deferred tax assets                                    21,027     17,237
                                                         ---------  ---------

Foreign currency transaction gains                           (982)        --
                                                         ---------  ---------

   Total                                                $  20,045  $  17,237
                                                         =========  =========`

Deferred tax assets relating to tax benefits of employee stock option grants
have been reduced to reflect the exercises in the year ended December 31, 2006.
Certain exercises resulted in tax deductions in excess of previously recorded
benefits based on the option value at the time of grant ("windfalls").
When the tax benefit reduces taxes payable, the Company will credit equity.  At
December 31, 2006, the Company recorded a credit to equity of $6,338,000.

Management periodically evaluates the recoverability of the deferred tax
assets and recognizes the tax benefit only as reassessment demonstrates that
they are more likely than not realizable.  At December 31, 2006, and 2005, the
Company did not provide a valuation allowance against its deferred tax assets
because it believes it is more likely than not that all deferred tax assets will
be realized in the foreseeable future.

The income tax provision differed from the
provision computed at the U.S. statutory tax rate as follows:

`Year Ended December 31,
                                                    -------------------------------
                                                      2006       2005       2004
                                                    ---------  ---------  ---------
Federal statutory rate                                  35.0 %     35.0 %     35.0 %
State, net of federal benefit                            4.5        4.7        4.7
Tax reserves                                             0.5        0.4       (0.2)
Stock-based compensation and other permanent differe     5.8        1.4        4.0
Research and development tax credits                    (2.0)      (3.5)      (4.5)
                                                    ---------  ---------  ---------
Total provision for income taxes                        43.8 %     38.0 %     39.0 %
                                                    =========  =========  =========`

11. OPERATING SEGMENT AND GEOGRAPHIC INFORMATION

The Company operates in one segment, using one measurement of profitability
to manage its business.  Geographic area net sales and long-lived assets are
summarized as follows:

`Net Sales                 Long-Lived Assets
                    ----------------------------    -------------------------
                       Year Ended December 31,             December 31,
                    ----------------------------    -------------------------
                      2006      2005      2004       2006     2005     2004
                    --------  --------  --------    -------  -------  -------
United States            79 %      84 %      88 %       69 %     78 %     83 %
Germany                  12         9         6          1        1        1
Switzerland              --        --        --         20       --       --
Other                     9         7         6         10       21       16
                    --------  --------  --------    -------  -------  -------
                        100 %     100 %     100 %      100 %    100 %    100 %
                    ========  ========  ========    =======  =======  =======`

Net sales are attributed to countries based on the shipping location of the
external customers.  Long-lived assets are comprised of property and equipment,
net.

12. QUARTERLY FINANCIAL DATA (UNAUDITED)

The following tables contain selected unaudited Consolidated Income Statement
data for each quarter of 2006 and 2005 (in thousands, except per share
amounts):

`Year 2006 Quarter Ended
                                                ----------------------------------------------
                                                Mar. 31,     Jun. 30,     Sep. 30,   Dec. 31,
                                                ---------    ---------    ---------  ---------  
Net sales                                      $  91,428    $ 101,062    $ 102,678  $ 112,622
Gross profit                                      80,463       87,874       89,357     97,920
Net income                                     $   8,493    $   9,480    $   9,531  $  12,228
Net income per share:
   Basic                                       $    0.19    $    0.21    $    0.21  $    0.27
   Diluted                                     $    0.19    $    0.21    $    0.21  $    0.26
Weighted-average shares outstanding:
   Basic                                          44,032       44,327       44,572     44,806
   Diluted                                        45,882       46,221       46,305     46,680




                                                             Year 2005 Quarter Ended
                                                ----------------------------------------------
                                                Mar. 31,     Jun. 30,     Sep. 30,   Dec. 31,
                                                ---------    ---------    ---------  ---------  
Net sales                                      $  66,234    $  75,026    $  79,014  $  85,808
Gross profit                                      58,309       66,532       69,558     75,840
Net income                                     $   6,421    $   7,936 (1)$  11,754  $   3,725 (2)
Net income per share:
   Basic                                       $    0.15    $    0.19    $    0.27  $    0.09
   Diluted                                     $    0.15    $    0.18    $    0.26  $    0.08
Weighted-average shares outstanding:
   Basic                                          41,843       42,512       43,195     43,637
   Diluted                                        44,231       44,660       45,898     46,130


Note 1: Net income includes license agreement fees of $1,000,000.
Note 2: Net income includes license acquisition charges of $20,000,000.`

---





KYPHON INC.
SCHEDULE II 
VALUATION AND QUALIFYING ACCOUNTS 
FOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006(in thousands)

`Balance at   Charged to                   Balance
                                                  Beginning     Costs and                  at End of
Description                                        of Year      Expenses     Deductions      Year
-----------------------------------------------  ------------  -----------  ------------  -----------
Allowances for accounts receivable
  Fiscal year ended 2004                        $        500          737           183  $     1,054
  Fiscal year ended 2005                               1,054        1,366           843        1,577
  Fiscal year ended 2006                        $      1,577          714           427  $     1,864

Allowance for inventories valuation:
  Fiscal year ended 2004                        $        625          158           254  $       529
  Fiscal year ended 2005                                 529          757           295          991
  Fiscal year ended 2006                        $        991        2,136         2,266  $       861`

ITEM 9.  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
ACCOUNTING AND FINANCIAL DISCLOSURE

None.

---

ITEM 9A.  CONTROLS AND PROCEDURES

Disclosure Controls and Procedures

Evaluation of disclosure controls and procedures.  Our Chief
Executive Officer, Richard W. Mott, and Chief Financial Officer, Maureen L.
Lamb, evaluated the effectiveness of Kyphon's disclosure controls and procedures
as of the end of the period covered by this report, and concluded that Kyphon's
disclosure controls and procedures were effective to ensure that information
Kyphon is required to disclose in the reports that we file or submit with the
Securities and Exchange Commission under the Securities Exchange Act of 1934, as
amended (or the Exchange Act) is recorded, processed, summarized and reported,
within the time periods specified in the Securities and Exchange Commission's
rules and forms, and to ensure that information required to be disclosed by
Kyphon in the reports that we file or submit under the Exchange Act is
accumulated and communicated to Kyphon's management, including our principal
executive officer and principal financial officer, as appropriate to allow
timely decisions regarding required disclosure.

Internal Control Over Financial Reporting

Management's annual report on internal control over financial
reporting.

Changes in internal control over financial reporting.  During
the quarter ended December 31, 2006, there were no changes in Kyphon's
internal control over financial reporting (as defined in Rule 13a-15(f)
under the Exchange Act) that have materially affected, or are reasonably likely
to materially affect, Kyphon's internal control over financial reporting.

ITEM 9B.  OTHER INFORMATION

None.



PART III

ITEM 10.  DIRECTORS; EXECUTIVE OFFICERS AND CORPORATE
GOVERNANCE

The information required by this Item is incorporated by reference to the
definitive proxy statement for our 2007 Annual Meeting of Stockholders to be
filed with the Securities and Exchange Commission within 120 days after the end
of our 2006 fiscal year (the "2007 Proxy Statement").

ITEM 11.  EXECUTIVE COMPENSATION



The information required by this Item is incorporated by reference to the
2007 Proxy Statement.

ITEM 12.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
MANAGEMENT AND RELATED STOCKHOLDER MATTERS

The information required by this Item is incorporated by reference to the
2007 Proxy Statement.

ITEM 13.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONSAND DIRECTOR INDEPENDENCE

The information required by this Item is incorporated by reference to the
2007 Proxy Statement.

ITEM 14.  PRINCIPAL ACCOUNTANT FEES AND SERVICES



The information required by this Item is incorporated by reference to the
2007 Proxy Statement.

---



PART IV

ITEM 15.  EXHIBITS AND FINANCIAL STATEMENT
SCHEDULES

(a)   (1) The financial statements required by Item 15(a) are filed
as Item 8 of this annual report.

(2)  The financial statement schedules required by Item 15(a) are filed as
Item 8 of this annual report.

(3)  Exhibits



|Number    |  | Description                                                                                                                                                                                                                               
|--------- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|          |  |                                                                                                                                                                                                                                           
|3.1(1)    |  | Amended and Restated Certificate of Incorporation of the
registrant.                                                                                                                                                                      
|          |  |                                                                                                                                                                                                                                           
|3.2(2)    |  | Amended and Restated Bylaws of the registrant.                                                                                                                                                                                            
|          |  |                                                                                                                                                                                                                                           
|4.1(3)    |  | Specimen common stock certificate of the registrant.                                                                                                                                                                                      
|          |  |                                                                                                                                                                                                                                           
|4.2(4)    |  | Indenture, dated as of February 6, 2007,
between Kyphon Inc. and U.S. Bank National Association as trustee (including
form of 1.00% Convertible Senior Note due 2012 and form of 1.25% Convertible
Senior Note due 2014).                 
|          |  |                                                                                                                                                                                                                                           
|4.3(4)    |  | Registration Rights Agreement, dated as of
February 6, 2007, among Kyphon Inc. and J.P. Morgan Securities Inc., Goldman,
Sachs & Co. and Banc of America Securities LLC, for themselves and the other
Initial Purchasers.                 
|10.1*(3)  |  | Form of Indemnification Agreement for directors and executive
officers.                                                                                                                                                                   
|          |  |                                                                                                                                                                                                                                           
|10.2*(3)  |  | 1996 Stock Option Plan, including form of option
agreement.                                                                                                                                                                               
|          |  |                                                                                                                                                                                                                                           
|10.3*(3)  |  | 2002 Stock Plan, including form of option agreement.                                                                                                                                                                                      
|          |  |                                                                                                                                                                                                                                           
|10.4*     |  | 2002 Stock Plan form of stock purchase right grant notice and restricted stock purchase agreement.                                                                                                                                        
|          |  |                                                                                                                                                                                                                                           
|10.5*(1)  |  | 2002 Director Option Plan, including form of option
agreement.                                                                                                                                                                            
|10.6*(13) |  | 2007 Employee Stock Purchase Plan, including form of employee
stock purchase plan subscription agreement.                                                                                                                                 
|          |  |                                                                                                                                                                                                                                           
|10.7(3)   |  | 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(3)   |  | Third Amendment to Lease dated March 29, 2002 for office space
located at 1350 Bordeaux Drive, Sunnyvale, CA 94089.                                                                                                                       
|          |  |                                                                                                                                                                                                                                           
|10.9*(3)  |  | Employment Agreement between the registrant and Gary L. Grenter
dated July 16, 2001.                                                                                                                                                      
|          |  |                                                                                                                                                                                                                                           
|10.10(3)  |  | Promissory Note Secured by Deed of Trust between the registrant
and Gary L. Grenter dated December 31, 2001.                                                                                                                              
|          |  |                                                                                                                                                                                                                                           
|10.11(3)  |  | Amended and Restated Stockholder Rights Agreement effective as
of December 14, 1999, among the registrant and certain stockholders of the
registrant.                                                                                     
|10.12*(5) |  | Employment Agreement between the registrant and Richard W. Mott
dated September 3, 2002.                                                                                                                                                  
|10.13+(5) |  | Sublicense Agreement effective as of August
19, 2002, between the registrant and Bonutti Research, Inc.                                                                                                                                   
|10.14(6)  |  | Stock Purchase Agreement by and between Kyphon and the
shareholders of Sanatis GmbH, dated February 15, 2003.                                                                                                                             
|10.15(7)  |  | Lease dated September 18, 2003 for office spaces located at
1221 Crossman Avenue and 480 Java Drive, Sunnyvale,
California.                                                                                                               
|10.16*(8) |  | Form of Severance Agreement entered into by and between Kyphon
Inc. and its executive officers.                                                                                                                                           
|10.17*(8) |  | Severance Agreement,
dated January 28, 2005, entered into by and between Kyphon Inc. and Richard W.
Mott.                                                                                                                                 
|10.18(9)  |  | First Amendment to Lease Agreement, made as of September 28,
2005, by and between Moffett Office Park Investors LLC, a Delaware limited
liability company, and Kyphon Inc.                                                                
|10.19(10) |  | Real Estate Leasing Contract (English translation) by and
between Kyphon Sarl and Credit Suisse, dated May 24, 2006.                                                                                                                      
|10.20(10) |  | Guaranty, by and between Kyphon Inc. and
Credit Suisse, dated May 26, 2006.                                                                                                                                                               
|10.21(11) |  | Employment Letter by and between Kyphon and
Maureen L. Lamb, Chief Financial Officer and Treasurer, dated September 1,
2006.                                                                                                              
|10.22(11) |  | Severance Agreement by and between Kyphon and
Maureen L. Lamb, Chief Financial Officer and Treasurer, dated September 20,
2006.                                                                                                           
|10.23(12) |  | Agreement and Plan of Merger, dated December
4, 2006, by and among Kyphon, Neptune Acquisition Sub, Inc., St. Francis Medical
Technologies, Inc., and Philip M. Young.                                                                    
|10.24(12) |  | Credit Agreement, dated January 18, 2007,
among Kyphon and certain subsidiaries as borrowers, Bank of America, N.A. as
administrative agent, swingline lender and letter of credit issuer, and the
other lenders and agents party thereto.
|10.25     |  | Form of Stockholder Support Agreement entered
into by and between Kyphon and the stockholders of St. Francis Medical
Technologies, Inc.                                                                                                   
|10.26+    |  | Asset Purchase Agreement (Non-Vertebroplasty Assets), dated December 20,
2006, by and among Kyphon, Disc-O-Tech Medical Technologies Ltd., and
Disc-O-Tech Orthopedic Technologies Inc.                                                   
|10.27+    |  | Asset Purchase Agreement (Vertebroplasty Assets), dated December 20,
2006, by and among Kyphon, Disc-O-Tech Medical Technologies Ltd., and
Disc-O-Tech Orthopedic Technologies Inc.                                                       
|21.1      |  | Subsidiaries of the registrant.                                                                                                                                                                                                           
|23.1      |  | Consent of PricewaterhouseCoopers LLP, Independent Registered
Public Accounting Firm                                                                                                                                                      
|31.1      |  | Certification of Chief Executive Officer pursuant to Section 302
of the Sarbanes-Oxley Act of 2002.                                                                                                                                       
|31.2      |  | Certification of Chief Financial Officer pursuant to Section 302
of the Sarbanes-Oxley Act of 2002.                                                                                                                                       
|32.1      |  | Certifications of Chief Executive Officer and Chief Financial
Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906
of the Sarbanes-Oxley Act of 2002.                                                           

(1)

(2)

(3)

(4) Incorporated
by reference from our Current Report on Form 8-K as filed with the Securities
and Exchange Commission on February 12, 2007.

(5) Incorporated by reference from
our Quarterly Report on Form 10-Q as filed with the Securities and Exchange
Commission on November 13, 2002.

(6)

(7)

(8)

(9)

(10)

(11)

(12)

(13)



* Management compensatory plan or arrangement required to be filed as an
exhibit pursuant to Item 15(c) of Form 10-K.

+

---





SIGNATURES



Pursuant to the requirements of Section 13 or 15(d) of the
Securities Exchange Act of 1934, the Registrant has duly caused this report to
be signed on our behalf by the undersigned, thereunto duly authorized, in the
City of Sunnyvale, State of California, on the 28th day of February, 2007.





Kyphon Inc.
    By:/s/ Richard W. Mott
   Richard W. Mott
                   President, Chief Executive Officer and Director
   (Principal Executive Officer)

KNOW ALL MEN AND WOMEN BY THESE PRESENTS, that each person whose signature
appears below constitutes and appoints Richard W. Mott and Maureen L. Lamb, his
attorneys-in-fact, each with the power of substitution, for him in any and all
capacities, to sign any amendments to this Report on Form 10-K, and to file the
same, with exhibits thereto and other documents in connection therewith, with
the U.S. Securities and Exchange Commission, hereby ratifying and confirming all
that said attorneys-in-fact, or his or their substitute or substitutes, may do
or cause to be done by virtue thereof.

Pursuant to the requirements of the Securities Exchange
Act of 1934, as amended, this report has been signed below by the following
persons on behalf of this registrant and in the capacities and on the dates
indicated:



|Signature                                             |  | Title                                                                                |  | Date             
|----------------------------------------------------- |  | ------------------------------------------------------------------------------------ |  | -----------------
|/s/ RICHARD W.
MOTT
Richard W. Mott                   |  | President, Chief Executive Officer and Director (Principal
Executive Officer)        |  | February 28, 2007
|                                                      |  |                                                                                      |  |                  
|/s/ MAUREEN L. LAMB
Maureen L. Lamb                   |  | Vice President, Chief Financial Officer (Principal Accounting and Financial Officer) |  | February 28, 2007
|                                                      |  |                                                                                      |  |                  
|/s/ JAMES T.
TREACE
James T. Treace                   |  | Chairman of the Board                                                                |  | February 28, 2007
|                                                      |  |                                                                                      |  |                  
|/s/ STEPHEN M. CAMPE                                  |  | Director                                                                             |  | February 28, 2007
|Stephen M. Campe                                      |  |                                                                                      |  |                  
|                                                      |  |                                                                                      |  |                  
|/s/ DOUGLAS W.
KOHRS
Douglas W. Kohrs                 |  | Director                                                                             |  | February 28, 2007
|                                                      |  |                                                                                      |  |                  
|/s/ JACK W. LASERSOHN
Jack W. Lasersohn               |  | Director                                                                             |  | February 28, 2007
|                                                      |  |                                                                                      |  |                  
|/s/ LOUIS J. LAVIGNE. JR.
Louis J. Lavigne, Jr.       |  | Director                                                                             |  | February 28, 2007
|                                                      |  |                                                                                      |  |                  
|/s/ FRANK M. PHILLIPS, M.D.
Frank M. Phillips, M.D.   |  | Director                                                                             |  | February 28, 2007
|                                                      |  |                                                                                      |  |                  
|/s/ KAREN D. TALMADGE,
PH.D.
Karen D. Talmadge, Ph.D. |  | Executive Vice President, Co-Founder, Chief Science Officer and Director             |  | February 28, 2007
|                                                      |  |                                                                                      |  |                  
|/s/ ELIZABETH H. WEATHERMAN
Elizabeth H. Weatherman   |  | Director                                                                             |  | February 28, 2007